FIN 5134:Financial Management and Practices

W4 : Bond and Stock Valuation

Dr. M. Anwar Ullah, FCMA

Southeast University Bangladesh
Faculty of Business
MBA Program: Summer 2016

anwarullah@hotmail.com Or anwar2023@yahoo.com.sg

September 15, 2020 6-1

 Valuation Fundamentals

Valuation is the process that establishes the link between the risk
and return to find the value or worth of an asset. The inputs required
for basic valuation are:
1.The expected returns in terms of cash flows
with their respective timings of occurrence.

2.Risk in terms of the required return

Basic Valuation Model
The basic value of an asset or a security is the sum of discounted value of
all the future expected cash flows.

The discount rate is the rate used as the required rate of return which is
dependent upon the level of risk.

If the investment in the asset is very risky, higher would be the discount rate.
If the investment in the asset is less risky, lower would be the discount rate.

September 15, 2020 6-2

 Valuation Fundamentals

• The (market) value of any investment asset is simply the present

value of expected cash flows.

• The interest rate that these cash flows are discounted at, is called
the asset’s required return.

• The required return is a function of the expected rate of inflation

and the perceived risk of the asset.

• Higher perceived risk results in a higher required return and lower

asset market values.

September 15, 2020 6-3

 Basic Valuation Model

PVIF, present value interest factor from Table A-3

PVIF, present value interest factor from Table A-2

September 15, 2020 6-4

 Interest Rates & Required Returns
• The interest rate or required return represents the price of
money.

• When funds are lent, the cost of borrowing is the interest

rate.

• Interest rates act as a regulating device that controls the flow

of money between supply and demand of Money.

• Bangladesh Bank regularly asses economic conditions and,

when necessary, initiate actions to change interest rates to
control inflation and economic growth.
• When funds are raised by issuing stocks or bonds, the cost
the company must pay is called the required return, which
reflects the suppliers expected level of return.

September 15, 2020 6-5

 Nominal and Real Interest Rate

• The real interest rate is the rate that creates an equilibrium

between the supply of savings and the demand for investment
funds in a perfect world.

• The nominal rate of interest is the actual rate of interest charged by the
supplier of funds and paid by the demander.

• The nominal rate differs from the real rate of interest, k* as a result of two
factors:
– inflation premium (IP), and
- risk premium (RP) are considered in real rate of interest.

Thus, Nominal rate of interest is, K = k* + IP + RP …....equation (1),

where, k* + IP = risk-free rate,
RP = risk premium

September 15, 2020 6-6

 Stock Valuation Models

Valuation of Ordinary Shares

Valuation of Ordinary Shares using
different Dividend Valuation Models

1. The Zero Growth Model

2. The Constant Growth Model
3. Variable Growth Model

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 Common Stock Return
Stock Returns are derived from both dividends and capital gains,
where the capital gain results from the appreciation of the stock’s
market price due to the growth in the firm’s earnings.
Mathematically, the expected return may be expressed as follows:
E(r) = D/P + g
k = D/P + g

For example, if the firm’s $1 dividend on a $25 stock is expected

to grow at 7%, the expected return is:

k = 1/25 + .07
= 11%
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 1. The Zero Growth Model
The zero dividend growth model assumes that the stock will pay the
same dividend each year.

Q. What would an investor be willing to pay for a stock if she expected to

receive a dividend of $2.50 each year indefinitely and her required return is
15%?
Solution. We know, k = D/P + g
Where,
k = required return
D = yearly dividend
P = Price of stock
g = dividend growth
Now using the given value we have -
0.15 = 2.5/P + 0
P = $16.67
So, the investor would willing to pay $16.67 for each stock.
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 1. The Zero Growth Model
Q. What rate of return would an investor expect if the current price of
a stock is $119 and she expected the firm to pay a constant dividend
of $4/year?

Solution.
k = D/P + g
k = 4/119 + 0
k = 3.4%
So, the rate of return that an investor might expect is 3.4%

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 2. The Constant Growth Model
The constant dividend growth model assumes that the stock will pay
dividends that grow at a constant rate each year.

Q. What would an investor be willing to pay for a stock if she just received a
dividend of $2.50, her required return is 15%, and she expected dividends to
grow at a rate of 5% per year.
Solution.
We know, k = D/P + g Where,
k = required return
D = yearly dividend
P = Price of stock
g = dividend growth
We have given that D = $2.50, k = 15.00%, and g = 5.00%,
now to calculate P = ?

Now using the given value we have -

0.15 = 2.5/P + 0.05
P = $26.25
So, the investor would willing to pay $26.25 for each stock.
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 2. The Constant Growth Model

Q. What is my expected return on a stock that costs

$26.50, just paid a dividend of $2.50, and has an
expected growth rate of 5%?

Solution.
k = D/P + g
k = 2.5/26.25 + 0.05
k = 14.5%

So, the rate of return that you can expect is 14.5%

09/15/20 12
 3. Variable Growth Model
The non-constant dividend growth model assumes that the stock will pay
dividends that grow at one rate during one period, and at another rate
in another year or thereafter.

The steps involved in valuing a share based on this approach are:

 
a. Computation of value of cash dividends at the end of each year during
the initial growth period.

b. Computation of present value of the dividends expected during the initial

growth period.

c. Finding the value of the share at the end of the initial growth year, which
would be the present value of all dividends expected from the end of
initial growth year till perpetuity assuming a constant growth rate.

d. Adding of the present value components found in (b) and (c) and this
would be the value of the share at the current date.

09/15/20 13
 Q. What would an investor be willing to pay for a stock if she just
received a dividend of $2.50, her required return is 15%, and she
expected dividends to grow at a rate of 10% per year for the first two
years, and then at a rate of 5% thereafter.
Solution.
Step 1: Compute the expected dividends during the first growth period.
g 10.0%
D0 $2.50
D1 $2.75
D2 $3.03
Step 2: Compute the Estimated Value of the stock at the end of year 2 using the
Constant Growth Model
D2 $3.03
k 15.00%
g 5.00%
P2? $30.3
Step 3: Compute the Present Value of all expected cash flows to find today's value
Cash PV at
Period Flow 15%
1 D1 $2.75 $2.39 Used Table A3
2 D2 $3.03 $2.29 Do
3 P2? $30.3 $20.00 Do
09/15/20 P0 ? $24.68 14
 Preferred Stock
• Preferred stock has stated annual dividend
– Constant dividend each period
– Dividend = dividend rate x par value

• Preferred stock has no maturity date

– Infinite horizon
– No payment of par value

• Fits constant dividend model with infinite

horizon

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 Valuation of Preferred Stock
1. Redeemable Preference share value
2. Irredeemable Preference share value

For Redeemable Preference share valuation

(formula is same used in Bond valuation )

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 Valuation of Preferred Stock

Irredeemable Preference share value

09/15/20 17
 Other Approaches to Stock Valuation

Book Value
• Value of a share = Net worth ÷ Number of outstanding equity shares.

•This method lacks sophistication and its reliance on historical balance

sheet data ignores the firm’s earnings potential and lacks any true
relationship to the firm’s value in the marketplace.

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 Other Approaches to Stock Valuation

Liquidation Value
Liquidation Value Per share = (Value realized from liquidating all assets –
Amount payable to creditors and preference holders) divided by number of
outstanding shares

•This measure is more realistic than book value because it is based on

current market values of the firm’s assets.

•However, it still fails to consider the earning power of those assets.

09/15/20 19
 Other Approaches to Stock Valuation

Valuation Using P/E Ratios

• Some stocks pay no dividends. Using P/E ratios are one
way to evaluate a stock under these circumstances.
• The model may be written as:
P = (m)(EPS)
where m = the estimated P/E multiple.

For example, if the estimated P/E is 15, and a stock’s earnings are
$5.00/share, the estimated value of the stock would be
P = 15*5 = $75/share.

09/15/20 20