Chapter 4

Stock & Bond Valuation

Professor XXXXX
Course Name / Number

2007 Thomson South-Western

Valuation Fundamentals
The

greater the uncertainty about an

assets future benefits, the higher the
discount rate investors will apply
when discounting those benefits to
the present.
The valuation process links an assets
risk and return to determine its price.

22

Valuation Fundamentals

Future Cash Flows

33

Risk

Valuation

Bond Valuation
Fundamentals
Bonds are debt instruments used by business
and government to raise large sums of money
Most bonds share certain basic characteristics

First,

a bond promises to pay investors a fixed

amount of interest, called the bonds coupon.
Second, bonds typically have a limited life, or
maturity.
Third, a bonds coupon rate equals the bonds annual
coupon payment divided by its par value.
Fourth, a bonds coupon yield equals the coupon
payment divided by the bonds current market price

44

Valuation Fundamentals
Present Value of Future Cash Flows

Link Risk & Return

Expected
Return on Assets

Valuation

55

The Basic Valuation

Model

P0 = Price of asset at time 0 (today)

CFt = cash flow expected at time t

r = discount rate (reflecting assets risk)

n = number of discounting periods (usually years)

66

This model can express the price of any asset at t

= 0 mathematically.

Valuation Fundamentals
Bond Example
Company

issues a 5% coupon interest

rate, 10year bond with a $1,000 par
value on 01/30/04
Assume

annual interest payments

Investors

who buy company bonds

receive the contractual rights
$50

coupon interest paid at the end of

each year
$1,000 par value at the end of the 10th
year
77

Using the P0 equation, the bond would sell at a par value of $1,000.

Bonds: Premiums &

Discounts
What Happens to Bond Values if the Required
Return Is Not Equal to the Coupon Rate?
The bond's value will differ from its par value

88

R > Coupon Interest Rate

P0 < par value

= DISCOUNT

R < Coupon Interest Rate

P0 > par value

= PREMIUM

The Basic Equation (Assuming

Annual Interest)
Cash
(1)

flows include two components:

the annual coupon, C, which equals the stated

coupon rate, i, multiplied by M, the par value (that
is, C i M), received for each of the n years
(2) the par value, M, received at maturity in n
years

99

Time Line for Bond: Valuation 918%

Coupon,
$1,000 Par Bond, Maturing at End of 2017,
Required Return Assumed to be 8%

10
10

Bonds
Semi-Annual Interest Payments

An example....
Value a T-Bond
Par value =
$1,000
Maturity = 2
years
11
11

Coupon pay =

= $992.43

Yield to Maturity (YTM)

Rate of return investors earn if they buy
the bond at P0 and hold it until maturity.

The YTM on a bond selling at par will always equa

the coupon interest rate.
YTM is the discount rate that equates the
PV of a bonds cash flows with its price.
12
12

Risk-Free Bonds
A

risk-free bond is a bond that has

no chance of default by its issuer
Zero-coupon

treasuries
Coupon-paying treasuries

13
13

Risky Bonds

Treasury bonds provide a known contractual stream of cash

flows

Valuing an ordinary corporate bond involves the same steps:

the risk that the corporation may not make all scheduled
payments.

Yield spread between Treasury bonds and corporate bonds

14
14

write down the cash flows

determine an appropriate discount rate
calculate the present value.

Discount rate on corporate bond should be higher than on

Treasury bond with the same maturity because corporate
bonds carry default risk

if you can observe the market price of a bond, you can infer
what the markets required return must be.

The difference in yield to maturity between two bonds or two

classes of bonds with similar maturities

Bond Issuers
Bond

issuers

Corporate

bonds
Municipal bonds
Treasury bills
Treasury notes
Agency bonds

15
15

Bond Ratings
Bond

ratings

Moodys
Standard
Fitch

16
16

& Poors

Bond Ratings

17
17

Bond Ratings and Spreads at Different

Maturities at a Given Point in Time

18
18

Bond Price Behavior

Bond

price quotations

Bond

spreads reflect a direct

relationship with default risk

Bond

price behavior

Prices

change constantly

Passage

of time
Forces in the economy

19
19

Bond Prices and Yields for Bonds with

Differing Times to Maturity, Same 6%
Coupon Rate

20
20

Bonds: Time to Maturity

21
21

What does this tell you about the relationship

between bond prices & yields for bonds with the
equal coupon rates, but different maturities?

Bonds: Yield to Maturity

(YTM)

Rate of return investors earn if they buy

the bond at P0 and hold it until maturity.

The YTM on a bond selling at par will

always equal the coupon interest rate.

YTM is the discount rate that equates the

PV of a bonds cash flows with its price.
22
22

Evaluating the Yield Curve

Yields vary with maturity.
Yields offered by bonds must be sufficient to
offer investors a positive real return.
The real return on an investment approximately
equals the difference between its stated or
nominal return and the inflation rate.
The shape of the yield curve can change over
time.
Research shows the yield curve works well as a
predictor of economic activity, in the United
States and other large industrialized
economies.

23
23

Yield Curves for U.S.

Government Bonds

24
24

Term Structure Theories

Expectations

theory
Liquidity preference theory
Preferred habitat theory

25
25

Expectations Theory

26
26

Term Structure of Interest

Rates

Relationship between yield and maturity is

called the Term Structure of Interest Rates
Graphical

depiction is called a Yield Curve

Usually, yields on long-term securities are
higher than on short-term securities
Generally look at risk-free Treasury debt
securities

Yield curves normally upwards-sloping

Long

yields > short yields

Can be flat or even inverted during times of
financial stress

27
27

Stock Valuation: Preferred

Stock
Preferred stock is an equity security that is expected to pay
a fixed annual dividend for its life
PS0 = Preferred stocks value
DP = preferred dividend
rp = required rate of return
An example: A share of preferred stock pays $2.3 per share
annual dividend and with a required return of 11%
PS0
=
28
28

DP
rp

$2.3
0
= $20.90 /
=
share
0.11

Valuation Fundamentals
Common Stock
Value of a
Share of
Common Stock

P0=

P1 + D1
(1+r)

P0 = Present value of the expected stock price at the end of

period 1
D1 = Dividends received
r = discount rate
29
29

Valuation Fundamentals:
Common Stock

But how is P1 determined?

This

is the PV of expected stock price P 2,

plus dividend at time 2
P2 is the PV of P3 plus dividend at time 3,
etc...

30
30

Repeating this logic over and over, you

find that todays price equals PV of the
entire dividend stream the stock will
pay in the future

Zero Growth Model

To value common stock, you must make
assumptions about the growth of future
dividends
Zero growth model assumes a constant,
non-growing dividend stream:
D1 = D2 = ... = D

Plugging constant value D into the

common stock valuation formula reduces
to simple equation for a perpetuity:

P0 =
31
31

D
r

Constant Growth Model

Assumes dividends will grow at a constant

rate (g) that is less than the required return (r)
If dividends grow at a constant rate forever,
you can value stock as a growing perpetuity,
denoting next years dividend as D1:

P0=

D1
r-g

Commonly called the Gordon Growth Model.

32
32

Variable Growth

33
33

Variable Growth Model

Example

34
34

Estimate the current value of Morris Industries'

common stock, P0 = P2003

Assume

The most recent annual dividend payment of Morris

Industries was $4 per share

The firm's financial manager expects that these

dividends will increase at an 8% annual rate over the
next 3 years

At the end of the 3 years the firm's mature product

line is expected to result in a slowing of the dividend
growth rate to 5% per year forever

The firm's required return, r , is 12%

Variable Growth Model

Valuation Steps #1 & #2

Compute the value of dividends in 2004, 2005, and

2006 as (1+g1)=1.08 times the previous years
dividend
Div2004= Div2003 x (1+g1) = $4 x 1.08 = $4.32
Div2005= Div2004 x (1+g1) = $4.32 x 1.08 = $4.67
Div2006= Div2005 x (1+g1) = $4.67 x 1.08 = $5.04

Find the PV of these three dividend payments:

PV of Div2004= Div2004 (1+r) = $ 4.32 (1.12) = $3.86
PV of Div2005= Div2005 (1+r)2 = $ 4.67 (1.12)2 = $3.72
PV of Div2006= Div2006 (1+r)3 = $ 5.04 (1.12)3 = $3.59
Sum of discounted dividends = $3.86 + $3.72 + $3.59 = $11.17

35
35

Variable Growth Model

Valuation Step #3
Find the value of the stock at the end of the
initial growth period using the constant
growth model
Calculate next period dividend by
multiplying D2006 by 1+g2, the lower constant
growth rate:

D2007 = D2006 x (1+ g2) = $ 5.04 x (1.05) = $5.292

Then use D2007=$5.292, g =0.05, r =0.12 in

Gordon model:

36
36

$5.292
$5.292
D
2007
=
=
= $75.60
P2006 =
r - g 2 0.12 - 0.05
0.07

Variable Growth Model

Valuation Step #3

Find the present

value of this stock
price by
discounting
P(2006) by (1+r)3

$75.60 $75.60
P
2006
PV =
=
=
= $53.81
3
3
(1 r ) (1.12)
1.405
37
37

Variable Growth Model

Valuation Step #4
Add

the PV of the initial dividend

stream (Step #2) to the PV of stock
price at the end of the initial growth
period (P2006):
P2003 = $11.17 + $53.81 =
Current
(end of year 2003)
$64.98
stock price

Remember:
Because future growth rates might change, the variable growth mod
allows for a changes in the dividend growth rate.
38
38

Time Line for Variable Growth

Valuation

39
39

Free Cash Flow Approach

Begin by asking, what is the total operating
cash flow (OCF) generated by a firm?
Next subtract from the firms operating cash
flow the amount needed to fund new
investments in both fixed assets and current
assets.
The difference is total free cash flow (FCF).

Represents

the cash amount a firm could

distribute to investors after meeting all its other
obligations

40
40

Common Stock Valuation:

Other Options
Book

value

Net

assets per share available to

common stockholders after liabilities
are paid in full

Liquidation
Actual

41
41

value

net amount per share likely to

be realized upon liquidation &
payment of liabilities
More realistic than book value, but
doesnt consider firms value as a
going concern

Common Stock Valuation:

Other Options
Price

/ Earnings (P / E) multiples

Reflects

the amount investors will pay

for each dollar of earnings per share
P / E multiples differ between & within
industries
Especially helpful for privately-held
firms

42
42