C pter Chap

ValuationandRates ofReturn

Chapter10 Outline
y ValuationConcepts y Importanceof fValuation l y BasicValuationModel y 3FactorsthatInfluence theRequiredRateofReturn y ValuationofBonds y RelationshipBetweenBondPricesandYields y ValuationPreferredStock y ValuationofCommonStock y ValuationUsing gthePriceEarnings g Ratio y SummaryandConclusions

V l i C Valuation Concepts
y Thevalueorpriceofastockorbondisbasedupon

thepresentvalue offutureexpectedcashflows to the h i investor y Key inputstothevaluationprocessinclude: y CashFlows(returns), y Timing,and y RequiredReturn(risk).

ValuationConcepts
y Greater risk can be incorporated into an analysis

b using a higher required return or discount rate. by rate

y Discount rate used is investors required rate of

return, based on the markets estimates of risk, efficiency, ffi i and d expected d future f returns

ValuationConcepts Importanceof AssetValuation

y Valuation isimportant toanyfirm for 2 l f f atleast l

reasons:

1. Afirmmustcontinually yassessitsmarketvalue ifitsatisfiesitsgoalofshareprice maximization. 2. . Itmust us accu accurately a e y de determine e ethe eworth o o orvalue a ue ofitsbusinesswhensellingsecuritiestoraise longtermfunds.
y y

Firms( (Issuers) )willlosemoney y ifthey yundervalue theirbusinesses Wouldbeinvestorswould notwanttopaymore thanwhatthebusinessesareworth,sofirmsmust not tovervalue l their th i businesses. b i

ValuationConcepts BasicValuationModel
y TheVALUE ofanyasset isthePresentValue of

allfuturecashflows itisexpectedtoprovide overtherelevanttimeperiod.

CF CF CF n 1 2 V0 = + + + ... (1+ k)1 (1+ k)2 (1+ k)n

V0 =valueoftheassetattimezero CFt =cashflowexpectedattheendofyeart k=appropriaterequiredrateofreturn(discount rate) n=relevant l ttime ti period i d

ValuationofBonds BondCharacteristics
yDefinitions Bonds y Firms borrow money from lenders for the long term by issuing g securities which are called bonds:
y

y y

Firms collect the money when they issue the bond, or sell it to the public. Th money they The h collect ll i the is h amount of f the h loan. l The amount of the loan may be known as the par value, face value, maturity value, or the principal. The date on which the loan will be paid off is the maturity date. For many bonds, its life or maturity could b for be f a term of f 20 to 30 years.

ValuationofBonds Bond Characteristics

y Definitions CouponRate
y The issuer (firm) ( ) promises to make specified fixed income

payments (interest) each year(or semiannually) to the bondholders (lenders). ( )

y

These payments are known as the coupon (or interest) and are based on the coupon rate stated in the issued bonds. Interest payment is usually made semiannually. annually

y The coupon rate is the annual interest payment divided by

the face value of the bond. y This coupon rate on a bond is set at the time of issue and does not change for the life of the bond.

ValuationofBonds BondCharacteristics
yDefinitions Coupon Rate vs Yield to Maturity (YTM) y After a bond is issued, two major factors can occur: y Economic conditions can change y A firms risk can change y These changes will be reflected on the issued bond in its interest rate (also known discount rate, rate rate of return) and more specifically, Yield to Maturity (YTM). y While the interest and principal payment will remain unchanged if the bond is reissued, issued the price of the bond will change if the coupon rate deviates from the YTM. yYield to Maturity is the rate of return investors earn if they

buy the bond at the new price and hold it until maturity. maturity yThis is also the interest rate (or discount rate) at which the cash flows from the bond are discounted to determine its present value (New Price). Price)

PRICE&BONDVALUE
y Distinguishbetweenthevalueofabondandits

price.Underwhatconditionswouldvalueequal price?

3FactorsthatInfluencethe YTM(RequiredRateofReturn)
1.RealRateofReturn:
y representstheinterestcostoftheinvestment y intheearly1990 1990s s,57%, 7% butnowabout34%

2.InflationPremium:
y apremiumtocompensatefortheeffectsofinflation y lately, l l 2% %

3.RiskPremium:
y ap premiumassociatedwithbusinessandfinancialrisk y typically,26% So,theRequiredRateofReturnequals:

RealRateofReturn+InflationPremium+RiskPremium

RelationshipBetween B dP i and dYTM Bond Prices

RelationshipBetween BondPricesandYTM
y relatedtoYTM( ), Bondp pricesareinversely (BondYields), thatis,theymoveinopposite directions Asinterestratesintheeconomychange,thepriceor valueofabondchanges:
y iftherequiredrateofreturnincreases,thepriceofthe

bondwilldecrease y if fthe h required drateof freturndecreases, d the h priceof fthe h bondwillincrease

Table101

Bondpricetable
(10 Percent Interest Payment, 20 Years to Maturity) Yield to Maturity Bond Price 2 4 6 7 8 9 10 11 12 13 14 16 20 25 % . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,308.11 1 815 42 1,815.42 1,458.80 1,317.82 1,196.36 1,091.29 1,000.00 920.37 850.61 789.26 735.07 644 27 644.27 513.04 406.92

Table102

Impactoftimetomaturityonbond prices
TimePeriod inYears (of10percentbond) BondPricewith 8PercentYield toMaturity BondPricewith 12PercentYield toMaturity

0 . . . . . . . . 1 . . . . . . . . 5 . . . . . . . . 10 . . . . . . . . 15 . . . . . . . . 20 . . . . . . . . 25 . . . . . . . . 30 . . . . . . . .

$1,000.00 1,018.52 1,079.85 1,134.20 1,171.19 1,196.36 1,213.50 1,225.16

$1,000.00 982.14 927.90 887.00 863.78 850.61 843.14 838.90

Figure102

Relationshipbetweentimeto maturityandbondprice*
BondPrice($) 1,300 1,200 1,100 1,000 900 800 700 25 Assumes12%yieldtomaturity 10%bond,$1,000parvalue Assumes8%yieldtomaturity

30

15 Numberofyearsto maturity

*Therelationshipinthegraphisnotsymmetricalinnature.

R di Bond B dQ t ti Reading Quotations

Company Name C N
Issuer

Coupon
Coupon

(interest rate %)
Your Daily Paper
Maturity Price

(April 8, 2022 2022) )

Yield

y Date Maturity

Change

BC Tel

9.65

Apr p 8-22 138.5

6.488

+1.118

Price

(Last transaction price = $ $138 138..50/ 50/ $100 $100 of face value)

(Closing Yield price up $ $1 1.12/ 12/ (Annual interest $100 from Market price) previous day)

Change

ValuationofBonds BondExample
y parvalue =$1000 y coupon =6.5% 6 5%ofparvalueperyear, year paidsemiannually. annually y InterestPayment=$65peryear/2=$32.50every6

months. y maturity t it =24years(matures ( t in i 2029) )x2=48 8periods. i d y issuedbyAT&T.

$32.50$32.50$32.50$32.50$32.50$32.50+$1000

123 4

5..48

ValuationofBondFormula
It Pn + Pb = t (1 + Y ) n t =1 (1 + Y ) I1 I2 In Pn = + + .... + + (1 + Y )1 (1 + Y ) 2 (1 + Y ) n (1 + Y ) n 1 1 (1 + Y ) n Pn = I + n Y ( 1 + Y ) = I ( PVIFAY , n) + Pn( PVIFY , n )
Where: Pb =Priceofthebondn=totalnumberofperiods It=InterestPaymentsY=Yieldtomaturity(requiredrateofreturn) Pn =Principalpaymentatmaturity t =numbercorrespondingtoaperiod;runningfrom1ton
n

BondExampleProblem
y Supposeafirmdecidestoissue20yearbondswitha

parvalueof$1,000andannualcouponpayments. Thereturnonothercorporatebondsofsimilarriskis currently tl 12%, % sowed decide id t tooffer ff a12% %coupon interestrate. y Whatwouldbeafairpriceforthesebonds? 1000 120 20

Pb=? 0

120 1

120 2

120... 3 ...

BondExampleProblem
N=20 YTM=12 FV=1,000 ( )=120 PMT(A) SolvePV=$1,000
Note: Ifthecouponrate =YTM (rateof return,discountrate) )thebondwillsellat parvalue.

BondExampleProblem
y MathematicalSolution: y Pb =I(PVIFAY,n )+Pn (PVIFY,n )

=120(PVIFA.12,20 )+1000(PVIF.12,20 )
1 1 (1 + Y ) n = I Y Pn + n (1 + Y )

1 1 (1 + 0.12) 20 1000 = 120 + 20 0.12 (1 + 0.12)

=$1,000

Bond o dExample a p eProblem ob e

y Supposeinterestratesfall immediatelyafterwe

q )on issuethebonds.TheYTM( (required return) bondsofsimilarriskdropsto10%.Whatwould happentothebondsprice? N=20 YTM=10 FV=1,000 PMT(A)=120 SolvePV=$1,170.27 Note: Ifthecouponrate >YTM, thebondwillsellatapremium.

BondExampleProblem
y MathematicalSolution: y Pb =I(PVIFAY,n )+Pn (PVIFY,n )

=120(PVIFA.10,20 )+1000(PVIF.10,20 )
1 1 (1 + Y ) n = I Y Pn + n (1 + Y )

1 1 (1 + 0.10) 20 1000 = 120 + 20 0.10 (1 + 0.10)

=$1,170.27

BondExampleProblem
y Supposeinterestratesrise immediatelyafterwe

issue the i h bonds. b d The Th YTM(required ( i dreturn) )on bondsofsimilarriskrisesto14%.Whatwould happentothebond bonds sprice? N=20 YTM=14 FV=1,000 PMT(A) ( )=120 SolvePV=$867.54 Note: Ifthecouponrate <YTM, YTM thebondwillsellatadiscount.

BondExampleProblem
y MathematicalSolution: y Pb =I(PVIFAY,n )+Pn (PVIFY,n )

=120(PVIFA.14,20 )+1000(PVIF.14,20 )
1 1 (1 + Y ) n = I Y Pn + n (1 + Y )

1 1 (1 + 0.14) 20 1000 = 120 + 20 0.14 (1 + 0.14)

=$867.54

ValuationofBonds
Thevalueofabondismadeupof2parts:
y PVof payments (an fthe h interest i ( annuity) i ) y PVoftheprincipalpayment (alumpsum)

Theprincipalpaymentatmaturity:
y canalsobecalledthepar valueorfacevalue y isusually$1,000

Theinterestrateused:
y istheyieldtomaturity(discountrate) y alsocalledtherequiredrateofreturn

SemiannualCouponPayments andBondValues
y Theproceduretovaluebondspayingsemiannual

interest involvedcompoundinginterestmore frequentlythanannually: y Convertannual linterest( (coupon), ) I,to semiannual bydividingI by2. y Convert C number b of fyearstomaturity i tonumber b of6monthperiods tomaturitybymultiplyingn by2. 2 y ConvertYieldtoMaturity(requiredrateof return)fromannualtosemiannual bydividingY by2.

ValuationofPreferredStock Characteristics
y Firmscanalsoraiselongtermmoneybyissuingandselling

securitieswhich h harecalled ll dpreferred f dstocks k or shares. h y Investorswhopurchasethesesharesarecalled preferredshareholders y PreferredStockisahybridsecurity: y itslikecommonstock nofixedmaturity y(perpetuity). (p p y) y technically,itspartof equitycapital. y itslikedebt preferreddividendsarefixed. y Usuallysoldfor$25,$50,or$100pershare. y Dividendsarefixedeitherasadollaramountorasa percentage t of fparvalue. l

ValuationofPreferredStock Characteristics
y Example: In1988,Xeroxissued$75millionof8.25%preferred

stockat$50pershare.
y $4.125isthefixed,annualdividendpershare.

y Isvaluedwithoutanyprincipalpaymentsinceithasnoending

life. y Priceisbasedupon p PVoffuturedividends. y Creditors have prior claim on earnings; interest on debt must be paid before preferred stockholders can receive anything. y Once creditor d claims l h have b been met, preferred f d stock k has h priority over common stockholders in terms of claims on assets in q , that is dividends must be p paid before common liquidation, stockholders receive any payment.

ValuationofPreferredStock
yFailure to pay preferred dividend does not result in

bankruptcy. yTovalueaPreferredStock,weusethefollowingformula:

Dp Pp = kp
Where: Pp=PriceofPreferredStock Dp=AnnualDividendforPreferredStock Dp Kp=RequiredRateofReturnorDiscountRate

ValuationofPreferredStock Example
y an8.25% 5 dividendona$50 5 yXeroxp preferredp pays parvalue. ySupposeourrequiredrateofreturnonXerox preferredis9.5%.

Dp 4.125 Pp = = = $43.42 k p 0.095

ValuationofCommonStock Ch t i ti Characteristics

y Common stock represents equity or ownership;

includes voting rights. y Limitedliability:liabilityislimitedtotheamountof ownersinvestment owners investment. y ClaimsPriority:lowerthandebtandpreferred. y Unlike preferred stock, stock there is no preset dividend rate. Instead, dividends are paid at the discretion of the firms board of directors. y CommonStockisavariableincomesecurity. y dividendsmaybeincreasedordecreased, d depending d onearnings.

ValuationofCommonStock Characteristics

q tothep y Thevalueofcommonsharesisequal present valueofallfuturedividendsthecompanyisexpected topayoveraninfinitetimehorizon. y Thereare3possiblecases: y Nogrowth individends(valuedlikepreferred stock) y Constantgrowth individends y Variablegrowth individends y Requiredrateofreturnreflectsthedividendyieldon thestockandtheexpectedgrowthrateinthedividend

ValuationofCommonStock No GrowthModel
Underthenogrowth circumstance,theformula

issimilartopreferredstock:

D0 P0 = ke
Where: Po=PriceofCommonStocktoday D0=CurrentAnnualCommonDividend(constant Ke=RequiredRateofReturnonCommonStock

value) )

ValuationofCommonStock Constant GrowthModel

UndertheConstantGrowthModel,theformula

is:

D1 P0 = ke g
Where: Po=PriceofCommonStocktoday D1=Dividendattheendofthe1st year Ke=RequiredRateofReturnonCommonStock g=constantgrowthrateindividends

PriceEarningsRatio
y P/E=StockPrice/EPS y TheP/Egivesyouanideaofwhatthemarketiswilling

topayfor f the h companys earnings. i The Th higher hi h the h P/E themorethemarketiswillingtopayforthecompanys earnings earnings.

ValuationUsingthePriceEarnings Ratio
y ThePriceEarnings(P/E)ratiocanalsobeusedtovalue

commonstocks y TheP/Eratioisinfluencedbymanyfactors:
y the h earningsand dsales l growth hof fthe h firm f y therisk(orvolatilityinperformance) y thedebtequitystructure y thedividendpolicy y thequalityofmanagement y anumberofotherfactors
y TheaverageP/EratioforTSXComposite,excludingNortelandJDS

Uniphase,inearly2002was33to1

vs LowP/Es Highvs.
AstockwithahighP/Eratio:
y indicatespositiveexpectationsforthefutureofthe

company y meansthestockismoreexpensiverelativetoearnings y typicallyrepresentsasuccessfulandfastgrowingcompany y iscalledagrowth stock

AstockwithalowP/Eratio:
y indicatesnegativeexpectationsforthefutureofthe

company y iscalledavalue stock

Table104

Anexampleofstockquotations fromtheGlobeandMail

Source:ILXSystems,adivisionofThomsonInformationServicesInc.

R di Stock S kQuotations Q i Reading

Stock
(Total number of (Last price paid shares traded ( (100 100s) s) at close of trading)
Your Daily Paper
Company Volume High Low Close Change

Volume

Close

High

Inco

3760

29.150

28.500

28.600

-.400

(Highest price paid per share for the day was $29 $29..15) 15)

Low

Change

(Lowest price paid per share for the day was $28 $28..50) 50)

(Difference between todays price and previous days. day s. A .40 decrease)

SummaryandConclusions
yThevalueofsecuritiesisbased yThepriceofabond reflects

uponthepresentvalueof expectedfuturecashflows from theinvestment,discountedat therateofreturnrequired by investors yTherequiredrateofreturn includespremiumsforexpected inflation andtheperceivedrisk oftheinvestment

thepresentvalueoffuture paymentsofinterestand principal,discountedat currentmarket k bond b dyields i ld yThepriceofapreferredor commonstock reflectsthe presentvalueoffuture dividends,discountedat currentmarketdividend yields yAnalternativeforvaluing g commonstockistheprice earningsratio