Valuation Models

Bonds, Preferred Stock

and Common Stock

Copyright 2003 Stephen G. Buell

Market Value
Market value of any asset, whether it be a
bond, a share of preferred or common stock,
a rare painting or a classic car, is
theoretically the discounted value of the
expected cash flows

Copyright 2003 Stephen G. Buell

Valuation Models - Bonds

AT&T has a bond issue outstanding:
Coupon rate = 8%/yr comp semiannually
Matures in 20 years
Par value = face value = principal = 1,000

Calculate its market value

One additional piece of information is needed

Copyright 2003 Stephen G. Buell

Synonyms

interest rate
yield to maturity on comparable securities
market rate of return or market yield
going rate of return

Copyright 2003 Stephen G. Buell

Given i, find P 0
Lets assume that the yield to maturity or
interest rate on similar bonds is 10%/yr
compounded semiannually
P0 is the discounted value of the expected
cash flows
P0 is the discounted value of the annuity of
coupon payments and the return of principal
at maturity
Copyright 2003 Stephen G. Buell

Value of the AT&T bond

.08 1000
.10
C=
= 40/period, n = 20 2 = 40 periods and i =
= .05/period
2
2
C
C
C
1000
P0 =
+
+ L+
+
(1 + i)1 (1 + i )2
(1 + i)n (1 + i)n
40
40
40
1000
P0 =
+
+L +
+
(1.05 )1 (1. 05)2
(1.05 )4 0 (1.05) 4 0
1000
P0 = 40 (PVIFa 5% 40) +
(1.05 )4 0
40 PMT 5 I/yr 40 n 1000 FV
PV = 828.41 < 1000 Bond sells at a discount
Copyright 2003 Stephen G. Buell

Yield to Maturity on the AT&T bond

.08 1000
= 40/period, n = 20 2 = 40 periods and P = $828.41
2
C
C
C
1000
P0 =
+
+L +
+
(1 + i)1 (1 + i) 2
(1 + i )n (1 + i )n
40
40
40
1000
828 .41 =
+
+L +
+
(1 + i )1 (1 + i )2
(1 + i) 4 0 (1 + i )4 0
C=

1000
(1 + i)4 0
40 PMT -828.41 PV 40 n 1000 FV
828 .41 = 40( PVIFa i % 40 ) +

i = .05 /period or i = .10 /yr compounded semiannually

Copyright 2003 Stephen G. Buell

Internal Rate of Return (IRR)

n
CF1
CF2
CFn
CFt
+
+L+
=
1
2
n
t
(1+ r) (1+ r)
(1+ r)
t =1 (1 + r)
CFt = cash flow, end of period t

CF0 =

n = life of the project

r = IRR

Copyright 2003 Stephen G. Buell

Why the discount?

New 20 year securities being issued today
probably are paying a coupon of $100/yr
If it did sell for $1,000 it would yield only
8% which is less than other similar bonds
Price must adjust to bring the yield or
interest rate into line with similar bonds

Copyright 2003 Stephen G. Buell

Back in time
Its common for a new bond to be issued at
a price close to its par value of 1,000
5 years ago AT&T issued our bonds with a
maturity of 25 years and an annual coupon
of 8%. Lets assume that the interest rate at
that time was 8.2%/yr, compounded
semiannually. What was the issuing price?
Copyright 2003 Stephen G. Buell

Issuing price of AT&T bonds

.08 1000
.082
= 40/period, n = 25 2 = 50 periods and i =
= .041/period
2
2
C
C
C
1000
P0 =
+
+L +
+
(1 + i)1 (1 + i)2
(1 + i )n (1 + i )n

C=

40
40
40
1000
+
+L +
+
(1.041)1 (1.041)2
(1.041)5 0 (1.041)5 0
1000
P0 = 40 (PVIFa 4.1% 50) +
(1 + i) 5 0
P0 =

40 PMT 4.1 I/yr 50 n 1000 FV

PV = 978.88
Copyright 2003 Stephen G. Buell

Can you say capital loss?

What about the investor who bought these
very safe bonds 5 years ago and now wants
to sell?
Can she recover her $978.88?
No, only $828.41 because interest rates
have risen
Lets see an old slide again
Copyright 2003 Stephen G. Buell

Incredibly important relationships

i Pbonds
i Pbonds
Copyright 2003 Stephen G. Buell

Why the inverse relationship?

P0 =

C
C
C
1000
+
+ L+
+
(1 + i )1 (1 + i )2
(1 + i )n (1 + i )n

With thenumerators fixed (bondsare called"fixed income"

securities), if the denominator changes,the only thingthat can
give is that the left side of the equationhas to move in the
oppositedirection.

Copyright 2003 Stephen G. Buell

What if interest rate had fallen?

.08 1000
.05
C=
= 40/period, n = 20 2 = 40 periods and i =
= .025 /period
2
2
C
C
C
1000
P0 =
+
+ L+
+
(1 + i)1 (1 + i) 2
(1+ i )n (1 + i )n
40
40
40
1000
P0 =
+
+L +
+
(1.025 )1 (1 .025)2
(1 .025) 4 0 (1. 025)4 0
1000
(1.025) 4 0
40 PMT 2.5 I/yr 40 n 1000 FV
P0 = 40 (PVIFa 2.5 % 40 ) +

PV = 1376.54 > 1000 Bond sells at a premium

Copyright 2003 Stephen G. Buell

Why the premium?

New 20 year securities being issued today
probably are paying a coupon of $50/yr
If it did sell for $1,000 it would yield 8%
which is more than other similar bonds
Price must adjust to bring the yield or
interest rate into line with similar bonds

Copyright 2003 Stephen G. Buell

Rates of return over 5 year period

C
C
C
FV
+
+ L+
+
r = IRR
(1 + r)1 (1 + r ) 2
(1 + r )n (1 + r) n
40
40
40
828.41
978.88 =
1 +
2 + L+
10 +
10
(1 + r) (1 + r)
(1 + r)
(1 + r )
828.41
978.88 = 40( PVIFa r% 10 ) +
(1 + r )10
40 PMT 10 n 828.41 FV - 978.88 PV
P0 =

r = I/yr = 2.73%/period = 5.46%/yr comp semiannual ly

40
40
40
1376.54
978.88 =
1 +
2 + L+
10 +
10
(1 + r) (1 + r)
(1 + r)
(1 + r)
1376.54
978.88 = 40( PVIFa r% 10 ) +
(1 + r)10
40 PMT 10 n 1376.54 FV - 978.88 PV
r = I/yr = 7.02%/peri
Copyright
od =
2003
14.04%/yr
Stephen G.comp
Buell semiannual ly

Important observations
The longer the period to maturity, the more
sensitive is a bonds price to a given change in the
interest rate
Maturity is one factor affecting a bonds yield
Long-term bonds are inherently riskier than shortterm bonds and generally carry higher yields to
maturity
Especially true when rates are low and expected to
rise
Copyright 2003 Stephen G. Buell

Maturity vs. yield example

Bond A: iA=5%, CA=5%, n A=2, PA=1000

Bond B: iB=5%, C B=5%, n B=20, PB=1000
Instantaneously change iA= iB=8%
Verify that PA=945.55 and PB=703.11
3 percentage point rise in interest rate
produces a much bigger decrease in price of
long-term bond B than in short-term bond A
Copyright 2003 Stephen G. Buell

Interest rate risk

Interest rate risk is the possibility that the
interest rate will rise and the price of bonds
will fall.
The price of long-term bonds will fall more
than the price of short -term bonds for a
given change in the interest rate
Relationship between maturity and yield is
shown by the term structure of interest rates
Copyright 2003 Stephen G. Buell

Term Structure or Yield Curve

Yield to
Maturity

Years to Maturity

10

20

30

Copyright 2003 Stephen G. Buell

Preferred Stock

Perpetual infinite maturity

Constant fixed dividend never changes
Par value usually $50 or $100/share
If dividend rate=8% and par=$50,
D=.08x50 = $4.00/share
kp market capitalization or discount rate
for a share of preferred stock of the given
risk class
Copyright 2003 Stephen G. Buell

Preferred Stock Valuation

Ppfd =

D1
D2
D
Dt
+
+L+
=
1
2

(1 + k P ) (1 + k P )
(1 + kP )
(
1
+
kP ) t
t =1

For preferredstock, D1 = D2 = L = D
Ppfd =

D
kP
Copyright 2003 Stephen G. Buell

Common Stock
Why buy a share of common stock?
Capital gains
Dividend stream

Lets consider an arbitrary 10 year holding

period

Copyright 2003 Stephen G. Buell

Common Stock Valuation

D1
D2
D1 0
P1 0
+
+L +
+
(1 + ke )1 (1 + ke )2
(1 + ke )1 0 (1 + ke )1 0

P0 =

P1 0 = price per share paid by second investor at end of year 10

P1 0 =

D1 1
D1 2
Dn
Pn
+
+L +
+
(1 + ke )1 (1 + ke )2
(1 + ke )n 1 0 (1 + ke )n 1 0

could have a third investor, but assume n

P0 =

D1
D1 0
1
D1 1
D1 2
D
+L +
+
+
+L +
(1 + ke )1
(1+ ke )1 0 (1 + ke )1 0 (1 + ke )1 (1 + ke )2
(1 + ke )

P0 =

D1
D1 0
D1 1
D1 2
D
+L +
+
+
+ L+
(1 + ke )1
(1+ ke )1 0 (1 + ke )1 1 (1+ ke )1 2
(1 + ke )

P0 =
t =1

Dt
This equation is basis for all common stock valu ation
(1 + ke )t
Copyright 2003 Stephen G. Buell

Common Stock Growth Models

Need to make assumptions regarding the
behavior of the dividend stream
Normal growth model describing large
majority of firms
Supergrowth model describing the
exceptional firms

Copyright 2003 Stephen G. Buell

Normal Growth Model

Assumesdividendswill grow at an annualrate of g for an infinite duration
g is roughlyequalto the nominalgrowth of the economy 4 to 8%
D1 = D0 (1 + g )

D 2 = D1 (1 + g ) 1 = D0 (1 + g ) 2
M

D n = Dn1 (1 + g ) = D 0 (1 + g )
1

D1
D2
Dn
P0 = lim
+
2 + L+
n
n (1 + k ) 1
(1 + k e)
(1 + ke )

e
1
2
D (1 + g )
D (1 + g )
D (1 + g ) n
P0 = lim 0
+ 0
+ L+ 0

1
n
(1 + k e ) 2
(1 + k e )n
(1 + ke )
if n and ke > g
P0 =

D1
( ke g )

Copyright 2003 Stephen G. Buell

Normal Growth Model

if n and k e > g
D1
P0 =
(ke g )
Example : D1 = $2. 00, ke = 14%, g = 4%
2.00
Then P0 =
= $20. 00/share
(.14 . 04)
Copyright 2003 Stephen G. Buell

Super Growth graph (g>=ke)

gs

gn

time

N
Assumption: earningsand dividendsgrow at
super rate g s for N years before decliningto
a normal growthrate of g n for indefinitefuture
Analyzeas if stock is held for N years then soldfor PN
Copyright 2003 Stephen G. Buell

Super Growth Model

Dt
P0 =
t
t =1 (1 + k e )
N

P0 =
t =1
N

P0 =
t =1

Dt
PN
t +
N
(1 + k e) (1 + k e)
D0(1 + g s ) t
PN
+
(1 + ke )t
(1 + k e) N

PN = PV of dividendsN +1 to discountedto time N

N

P0 =
t =1
N

P0 =
t =1
N

P0 =
t =1
N

P0 =
t =1

D0(1 + g s ) t
1
DN +1
DN + 2
DN + 3

+
+
+
+ L+
(1 + ke )t
(1 + k e) N (1 + k e)1 (1 + k e) 2 (1 + k e) 3

D0(1 + g s ) t
1
DN (1 + g n )1 DN (1 + g n )2 DN (1 + g n ) 3

+
+
+
+ L+
(1 + ke )t
(1 + k e) N (1 + ke )1
(1 + k e) 2
(1 + ke )3

D0(1 + g s ) t
1
DN (1 + g n ) t
+

ke > g n and n
(1 + ke )t
(1 + k e) N t=1 (1 + ke ) t
D0(1 + g s ) t
1
D N +1
+

(1 + ke )t
(1 + k e) N k e g n
Copyright 2003 Stephen G. Buell

10

Super Growth example

g
gs =20%

gn=5%

time

N=3
N

P0 =

D 0(1 + g s )t

PN

D N +1

+
where PN =
(1+ ke )t
(1 + k e ) N
ke g n
t =1
Example: D0 = $ 1.0 0, gs = 2 0%, g n = 5%, ke = 1 5%, N = 3
P0 =

1 .0 0(1 .2 0)1 1. 0 0(1. 2 0) 2 1. 0 0(1. 2 0) 3

P3
+
+
+
(1. 1 5) 1
(1 .1 5)2
(1 .1 5)3
(1. 1 5)3

P3 =

D4
(1. 0 0)(1 .2 0)3 (1 .0 5)1
=
= 1 8. 1 4
ke g n
. 1 5 . 0 5

P0 = 3 .2 7 +

1 8. 1 4
= 1 5. 2 0
(1. 1 5) 3
Copyright 2003 Stephen G. Buell

Super Growth exam question

Find P1 and P30
P1 =

D2
D3
P3
+
+
(1 + k e )1 (1 + k e ) 2 (1 + k e ) 2

1. 44
1. 73
18 .14
+
+
(1 .15) 1 (1.15) 2 (1. 15) 2
P1 = $16. 28
P1 =

P30 =

D31
1. 00(1.20 ) 3(1. 05) 28
=
= $67. 74
ke g n
. 15 . 05
Copyright 2003 Stephen G. Buell

11