Bond and Stock Valuation

VALUATION
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VALUATION
 Intrinsic value
 True value or fundamental value of an asset
which is may be different to the market value
 the worth of an asset is derived in-and-of-
itself, independent of other extraneous
factors.
 Market value
 It is determined by supply and demand on the
market
Valuation
 Market price > Intrinsic value ->
Overprice
 Market price < Intrinsic value ->
Underprice
 Market price = Intrinsic value ->
Equilibrium price or fair price
BOND VALUATION
 Bond is a debt that pay the par value at maturity date and
coupon payments over the lifetime of the bond.
Terminology/ debt securities
Terminology Description
Maturity date The time when the principal amount is repaid

Par/face value The principal amount of a bond which is repaid when the bond matures
/maturity value
Coupon The interest payment made to bond holders
Coupon rate The coupon rate is the interest rate that the issuer of the bond promises
to pay the bondholder
Yield to maturity Expected return is yielded to maturity, assuming that the bond will be
held until maturity, and that all coupon
BOND VALUATION
Basic Financial Principle
 The valuation of any financial
instrument equal the present value of
cash flows that investors expect the
instrument will pay out over time
Valuation of Bond
- What are the cash flows associated with a
Bond?
- What is the appropriate Yield to maturity to

value the Bond?
Valuation of Bond
 Value of a Bond is:
𝐶 𝐶 𝐶 𝑀
𝑃𝑑 = + 2
+ …..+ 𝑁
+ 𝑁
1 + 𝑟𝑑 1 + 𝑟𝑑 1 + 𝑟𝑑 1 + 𝑟𝑑
Where:
 M is the maturity value/ face value
 C is coupon payment
 N: number of period
 Rd : Yield to maturity/ required rate of return/ discount rate
 Pd : Bond price
Valuation of Debt Security
 Can we re-write this formula in a different way?
𝐶 𝐶 𝐶 𝑀
𝑃𝑑 = + 2
+ …..+ 𝑁
+ 𝑁
1 + 𝑟𝑑 1 + 𝑟𝑑 1 + 𝑟𝑑 1 + 𝑟𝑑
𝑀
𝑃𝑑 = 𝐶 × 𝐴𝐹(𝑛,𝑟𝑑) + 𝑁
1 + 𝑟𝑑
 Recall the present value annuity factor:

1 − 1 + 𝑟𝑑 −𝑁 𝑀
𝑃𝑑 = 𝐶( )+ 𝑁
𝑟𝑑 1 + 𝑟𝑑
 The relationship between the required rate
of return and coupon interest rates.
EXAMPLE
 SunCorp issues a 6.5% annual coupon bond with a $1.000 face value, which
mature in 3 years from now. Assume the yield to maturity of this bond is 3.9%
p.a.
(1) What is the par value, time to maturity, coupon payment, number of coupon
payment, and required rate of return of the bond?
(2) Calculate the price of SunCorp bond?
 Solution:
Par value or maturity value

Time to maturity
Coupon payment
Number of compounding periods
Required rate of return
Relationship between r and
the coupon interest
Question Required Coupon Par value The Price of
rate of rate number of bond
return period
1 3.9% 6.5% $1.000 3
2 6.5% 6.5% $1.000 3
3 15% 6.5% $1.000 3
Relationship between r and
the coupon interest
R< Coupon Rate P> Par value = PREMIUM
R =Coupon Rate P= Par value PAR

=
R> Coupon Rate P< Par value = DISCOUNT
Valuation of Debt Securities
 Semi- annual coupons versus annual
coupon payments
Question 4
 SunCorp issues a 6.5% p.a semi-annual coupon bond
with a $1.000 face value, which mature in 3 years
from now. Assume the yield to maturity of this bond
is 3.9% p.a.
Par value or maturity value 1000
Time to maturity 3 years
Coupon payment $65/2 = $32.5
Number of compounding periods 3x2 = 6
Required rate of return 3.9%/2 = 1.95%
Question Required Coupon Par value Number of Price of
rate of payment period to bond
return maturity
1 3.9% $65 $1.000 3
4 1.95% $32.6 $1.000 6
 The time path of a bond’s value
The time path of a bond’s value
Bond types Required Coupon Par value Number of Price of

rate of payment period to bond
return (6%) maturity
Premium 5.6% $60 $1.000 36
5.6% $60 $1.000 15
5.6% $60 $1.000 0
Par 6.0% $60 $1.000 36
6.0% $60 $1.000 15
6.0% $60 $1.000 0
Discount 6.4% $60 $1.000 36
6.4% $60 $1.000 15
6.4% $60 $1.000 0
The time path of a bond’s
value
Maturity date
The time path of a bond’s
value
 Interest Rate Risk
Interest Rate Risk
- How does the value of a bond change as interest rate
rise?
- Changes in bond values as interest rates change is
known as interest rate risk
- How much interest rate risk does a bond have?
Interest Rate Risk
Bond Yield
Current
Yield Coupon payment divided to bond price
Yield to Rate of return investor earned if they buy

Maturity the bond at P and hold the bond to maturity
Annual
YTM oncoupon payment
a bond selling divided
at par will alwaysto
equal thebond
couponprice
interest rate
YTM is the discount rate that acquire the PV

of a bond’s cash flow with its price
Bond Yield
 How do we calculate the Yield to maturity?
 We need……… Solve for……….
 Price of the bond (PV) - YTM = r
 Coupon rate
 Face value (M)
 Solve for rd
1 − 1 + 𝑟𝑑 −𝑁 𝑀
𝑃𝑑 = 𝐶( )+ 𝑁
𝑟𝑑 1 + 𝑟𝑑
Question 5
 What is the Yield to maturity of a 6.5% annual bond
with a $1.000 face value, which mature in 3 years.
The price of the bond is $1.072.29?
 Solution:
 P = 1.072.29
Terminology/ equity securities
Terminology Description
Common stock/ ordinary 1. Represent residual ownership of the firm (generally they have
stock limited liability)
2. Holders have important voting rights
3. No pre-set dividend rate
(i) Future dividend are uncertain
(ii) How do we forecast for future dividend?
Preferred stock 1. Claims of preferred stock holders are junior to claims of debt
holders BUT senior to those of common stock
2. Limited voting compared to common stock
3. Stock has a par value and a dividend rate
4. Failure to pay the dividend does not force issuing firm into
bankruptcy
Equity Valuation
 Three approaches
 Balance sheet model (Asset based
approach)
 Market based approach (Earning multiplier
approach)
 Discounting models
 Dividend discounting model
 Discounting Cash Flow (DCF)
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Dividend Discount Model
 The future cash flow for equity share
are dividends + expected price when it
will be sold in the future
 A Dividend Discount Model has been
developed based on the assumptions:
 Dividends are paid annually
 The first dividend is received one year after
the equity share is bought
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 If an investor intends to buy a share
now and keep it for 1 year after which
he will sell it
𝐷1 𝑃1
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 = 𝑉𝑜 = 𝑃𝑜 = +
(1 + 𝑟)1 (1 + 𝑟)1
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 The expected dividend per share is 3
and the share will fetch price of 18 a
year hence. What price would it sell for
now if investor’s required rate of return
is 12%? 𝐷1 𝑃1
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 = 𝑉𝑜 = 𝑃𝑜 = +
(1 + 𝑟)1 (1 + 𝑟)1
3 18
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 = 𝑉𝑜 = 𝑃𝑜 = + = 18.75
(1 + 0.12)1 (1 + 12)1
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Multi-period Dividend Discount
Model
 Like a bond, equity can be value as the present value
of a stream of cash flows, with dividends as our cash
flows
 The equation below that Vo can be calculated as a
series of cash flows in future period that are
discounted at r, where r is the required rate of return
for an equity investor
𝐷1 𝐷2 𝐷3 𝑉𝑛
𝑉𝑜 = 𝑃𝑜 = + + + … +
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑛
𝑛
𝐷𝑡 𝑉𝑛
𝑉𝑜 = 𝑃𝑜 = ෍ 𝑡
+
(1 + 𝑟) (1 + 𝑟)𝑛
𝑡=1
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NO/ZERO GROWTH MODEL
 If dividends were to remain constant
forever
𝐷1
𝑉𝑜 =
𝑟
 Use this model to value equity with
constant dividend like preferred stock
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 Constant dividend model
 If dividends are expected to remain constant, we can value
a share using the perpetuity approach
Where:
d1 = constant expected dividend payment
 Use this model to value equity with constant dividend like

preferred stock
NO/ZERO GROWTH MODEL
 Example
𝐷1
𝑉𝑜 =
𝑟
 E1 = D1 = 5.00
 r = 0.15
 Then Vo = 5.00/0.15 = 33.33
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 Constant growth valuation model
- Assume dividends will grow at a constant
rate (g) that is less than the required rate
of return (r)
Where:
D0 = the last dividend per share
G = constant compound expected growth rate in
dividend
WHAT DRIVE GROWTH IN
DIVIDEND
g = ROE x b
 Earning Retention Ratio (b)
 Return on Equity (ROE)
 Dividend payout ratio: Percentage of
earning paid out as dividend
 B is a fraction of earning retained and
reinvested in the firm
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CONSTANT GROWTH MODEL
(GORDON’s MODEL)
𝐷𝑜 (1 + 𝑔)
𝑉𝑜 =
𝑟−𝑔
 G = constant perpetual growth rate
 Note: r>g or we have a positive
denominator.
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DIVIDEND DISCOUNT MODEL
WITH CONSTANT GROWTH
 Do = 3.00, r = 12%, and g = 4%
𝐷𝑜 (1 + 𝑔)
𝑉𝑜 =
𝑟−𝑔
3(1 + 0.04) 3.12

𝑉𝑜 = = = 39
0.12 − 0.04 0.08
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DIVIDEND DISCOUNT MODEL
WITH CONSTANT GROWTH
 Do = 3.00, r = 12%,  Do = 3.00, r =  Do = 3.00, r = 12%,
and g = 4% 15%, and g = and g = 6%
4%
3(1 + 0.04) 3.12 3(1 + 0.04) 3.12 3(1 + 0.06) 3.18

𝑉𝑜 = = = 39 𝑉𝑜 = = = 28.36 𝑉𝑜 = = = 53
0.12 − 0.04 0.08 0.15 − 0.04 0.11 0.12 − 0.06 0.06
 Note that Vo is
sensitive to changes in
r and g. Thus, we must
take care when
estimating these value
for our analysis
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Two Stage Dividend Discount
Model
 Dividends like the economy and single stock do not
tend to grow at stable rates forever
 If one identifies a company with two defined stages of growth, use
the following two stage DDM
𝐷𝑜 (1+𝑔1 ) 𝐷𝑜 (1+𝑔1 )2 𝐷𝑜 (1+𝑔1 )3 𝑃𝑇

𝑉𝑜 = + + + …+
(1+𝑟) (1+𝑟)2 (1+𝑟)3 (1+𝑟)𝑇
𝐷𝑇 (1 + 𝑔2 )
𝑃𝑇 =
𝑟 − 𝑔2
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Model
 Example
 Let’s assume for a moment that our company
has just discovered the cure to insomnia and
has obtained a three year patent. That would
change our estimation of g for a period of 3
years. We will say that our company will now
grow at 10% for three years and then return
to our normalized 4% growth rate thereafter.
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Model
 First stage is 3 years with high growth
rate of 10% and long-term growth or
stable growth rate is 4% indefinitely
 Do = 3.00, g1 = 10%, t = 3
 After that g2 = 4%, r = 12%
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Model
𝑇
𝐷𝑜 (1 + 𝑔𝑡 )𝑡 𝑃𝑇
𝑉𝑜 = ෍ 𝑡
+
(1 + 𝑟) (1 + 𝑟)𝑇
𝑡=1
𝐷𝑇 (1 + 𝑔2 )
𝑃𝑇 =
𝑟 − 𝑔2
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Model
 Do = 3.00, g1 = 10%, t = 3; g2 = 4%,
r = 12%
𝐷𝑇 (1 + 𝑔2 )
𝑃𝑇 =
𝑟 − 𝑔2
DT=3 = 3(1+0.1)3 = 3.993
3.993(1+0.04)
𝑃𝑇 = = 51.909
0.12−0.04
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Model
 Do = 3.00, g1 = 10%, t = 3; g2 = 4%, r
= 12%
𝐷𝑜 (1+𝑔1 ) 𝐷𝑜 (1+𝑔1 )2 𝐷𝑜 (1+𝑔1 )3 𝑃𝑇
𝑉𝑜 = + + + …+
(1+𝑟) (1+𝑟)2 (1+𝑟)3 (1+𝑟)𝑇
3(1+0.1) 3(1+0.1)2 3(1+0.1)3 51.909

𝑉𝑜 = + + +
(1+0.12) (1+0.12)2 (1+0.12)3 (1+0.12)3
𝑉𝑜 = 45.74
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VALUATION

Maturity date The time when the principal amount is repaid

- What is the appropriate Yield to maturity to

 Recall the present value annuity factor:

Par value or maturity value

R< Coupon Rate P> Par value = PREMIUM

R =Coupon Rate P= Par value PAR

R> Coupon Rate P< Par value = DISCOUNT

 The time path of a bond’s value

Bond types Required Coupon Par value Number of Price of

 Interest Rate Risk

Yield to Rate of return investor earned if they buy

YTM is the discount rate that acquire the PV

 Use this model to value equity with constant dividend like

3(1 + 0.04) 3.12

3(1 + 0.04) 3.12 3(1 + 0.04) 3.12 3(1 + 0.06) 3.18

𝐷𝑜 (1+𝑔1 ) 𝐷𝑜 (1+𝑔1 )2 𝐷𝑜 (1+𝑔1 )3 𝑃𝑇

3(1+0.1) 3(1+0.1)2 3(1+0.1)3 51.909

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