Pricing Bonds

price = PV(coupon payments) + PV(principal)

Where
r = Yield to Maturity
T = Time to Maturity
T t
r
ParValue
r
Coupon
) 1 ( ) 1 (
Price
T
1 t
+
+
+
=

=
Yield to maturity vs. Current Yield
YTM evolves from the bond price equation
Builds in the capital gain/loss from the difference
between market price and par value
Current Yield is just annual coupon payment divided by
bond price
Interest Rate Risk
Bond prices are sensitive to interest rate changes
How?
Sensitivity depends on:
1. Increase/decrease in YTM (increase less sensitive)
2. Term of bond (short-term less sensitive)
3. Coupon rate (higher coupons less sensitive)
4. YTM (higher YTM less sensitive)
Duration
Weight the cash flows of the bond by the time when
they are made
Quantifies the sensitivity of bond prices to interest rate
changes

=
+
=
T
t
t
t
ice
y
CF
t D
1
Pr
) 1 (
Duration
1. =T for zero-coupon bond
2. Duration is higher for:
Lower coupon bonds
Longer time to maturity (generally)
Lower YTM
3. =(1+y)/y for perpetuity
Passive Bond Management
Immunization
Matching durations of assets and liabilities such
that price risk and reinvestment risk exactly
cancel out
Passivewere not trying to identify
undervalued securities
Still have to monitor and actively update the
portfolio
Why?
Convexity
Duration only approximates the changes in
bond prices with changes in interest rates
Actual relation is not linear, but convex
Bonds generally gain more when rates fall
than they lose when rates rise
Good news for bondholders
Means that more convex bonds either
cost more and/or
have lower yields!
Active Bond Management
Usually takes the form of swaps
Substitution Swaps (based on mispricing)
Intermarket Spread Swaps (play on the yield spread)
Rate Anticipation Swaps (speculate on interest rates)
Pure Yield Pickup Swaps (move to longer duration
bonds that typically have higher rates)
More on swaps in FINC416 (Spring 07)
Chapters 11-12
Macroeconomic/Industry
Analysis
Equity Valuation
Outline
Macroeconomic/Industry Analysis (Chapter 11)
relies on relative valuation
Firm Specific AnalysisEquity Valuation
(Chapter 12)
Dividend Discount Model
DDM and Growth Opportunities
Multistage DDM
Sensitivity Analysis
Price/Earnings Analysis
Industry Analysis
The Business Cycle -
Trough: Economic recovery begins.
Cyclical industries that are sensitive to the economy should do well
(autos, washing machines, etc).
High beta stocks
Peak: Entering recession.
Defensive industries that are not sensitive to economic conditions
should do well (food producers, tobacco companies, public utilities,
pharmaceutical companies).
Lower beta stocks
Sensitivity to the Business cycle depends on:
(1) sales
(2) operating leverage
(3) financial leverage
Industry/Firm Life Cycle
Age
Sales
Start Up
Stable
Growth
Consoli
dation
Maturity Relative Decline
Rapid and
Increasing
Growth
Slowing
Growth
Minimal or
Negative
Growth
Industry/Firm Life Cycle
Start Up - New technology, high risk, high growth.
Consolidation - Survivors are more stable, market share
is more predictable, still grow faster than the overall
economy.
Maturity - Product reaches full potential, growth tracks
growth in economy, price competition.
Cash Cows - stable cash flows but little opportunity for
expansion.
Decline - Slow or no growth, competition or obsolete
product.
Firm-Specific analysis -
How do we choose stocks within an industry?
Equity Value Definitions:
Book Value - The net worth from the balance sheet
Liquidation Value - The value of the firm if broken
up and sold off (after paying off all obligations).
This may provide a floor for the stock price.
Replacement Cost - Cost to replace all assets less the
value of liabilities.
Tobins Q = Market Price / Replacement Cost
Firm Specific Analysis
In order to determine the value of a company, we must move
away from the balance sheet and actually forecast cash flows.
From forecasts, we can use models such as the Dividend Discount
Model or Price to Earnings multiples to estimate firm value.
Comparing our estimate of value to the current market price tells
us whether we should invest in the security.
Market Value - The price at which a security is currently trading.
Intrinsic Value - The present value of expected future cash flows.
This represents the value of the firm as an ongoing concern.
Intrinsic Value
We can calculate the intrinsic value of the stock as
the present value of all cash payments (including
dividends and end of period sales price)
For one period:
How can we determine k?
The markets consensus of k is the market
capitalization rate or required rate of return.
V
0
1 1
1
=
+
+
E D E P
k
( ) ( )
Example
Consider a security currently trading at $48. The
security is expected to pay dividends of $3 and is
expected to trade for $52 at the end of the year.
If the security has a beta of 1.2, R
f
=6% and the
market risk premium equals 5%, what is your
required rate of return for this security?
Use the CAPM!
E(R)= 6% + 1.2 ( 5%) = 12%
Example (cont.)
Calculate the intrinsic value of the stock.
Should you buy or sell this stock?
What is your expected HPR?
Is this consistent with your buy/sell decision above?
11 . 49 $
12 . 1
52 3
1
) ( ) (

1 1
0
=
+
=
+
+
=
k
P E D E
V
% 58 . 14
48
48 52 3 ] ) ( [ ) (
E(HPR)
0
0 1 1
=
+
=
+
=
P
P P E D E
ExampleDividend Discount Model
Consider a firm that has a beta of 1.2 and is expected to
pay dividends of $2 next year.
If the risk free rate is 4% and the market risk premium is
5%, what is the required rate of return of this stock?
Use the CAPM!
E(R)= 4% + 1.2 ( 5%) = 10%
If the firms dividends are expected to grow at a steady
rate of 6%, what is the intrinsic value of the firms
shares?
Use the Value of a growing perpetuity!
V
0
= D
1
/(r g) = $2/(.10 - .06) = $50 per share
Cash Flow ValuationsA Review
Value of a Perpetuity:

Value of a Constant Growth Perpetuity:

Alternatively,
Where g is the annual growth rate in the dividend stream
k is the market capitalization rate
g
P
D
k + =
0
1

k
D
V
1
0
=
g k
D
V

=
1
0

Valuation and Stock Pricing
Stocks represent claims on cash flows from the firm in
perpetuity.
Apply the perpetuity models for stock valuation.
Stock price (Value) is represented by constant growth
dividend discount model
More complicated analysis can incorporate the life cycle
of the firm and do multiple stages of growth in the
dividend discount model setting.
Used extensively by financial analysts
Aided by the use of spreadsheet modeling
Growth Opportunities (Estimating g)
Earnings retention ratio (b) is the proportion of
earnings not paid out in dividends but instead
reinvested in the firm.
A firm that has good investment (growth) opportunities should
reinvest earnings in the firm rather than paying out dividends.
If investors can reinvest the funds more profitably than the
firm, earnings should be paid out in the form of dividends.
In this case: g = ROE * b
Example
Consider three firms that have the same required rate of return
(k) of 10% and are all expected to have earnings of $5 next
year. ROE
1
= 10%, ROE
2
= 15%, ROE
3
= 7.5%.
Which firms should reinvest earnings?
Calculate the intrinsic value of each firm if
b=0, b=0.30, b=0.60, b=0.90
What is the present value of growth opportunities (PVGO) in
each case?
Note:
P
E
k
PVGO
0
1
= +
No growth value
Growth component
Extensions - Multistage DDM
Company ABC paid dividends this year of $4. The required
rate of return for the company is 14%. You forecast
dividend growth of 20% for the next four years after which
growth will drop to the steady rate of 10%.
What is the value per share of ABC stock?
2 stages of growth:
What should you do if the stock is currently trading at
$140?
4 4 3 3 2 2
14 . 1 / ) 2 . 1 ( 4 14 . 1 / ) 2 . 1 ( 4 14 . 1 / ) 2 . 1 ( 4 14 . 1 / ) 2 . 1 ( 4 + + +
27 . 153 $ ) 14 . 1 /( )] 10 . 14 /(. ) 1 . 1 ( ) 2 . 1 ( 4 [
4 4
=
Sensitivity Analysis
Estimates of value will be sensitive to your forecasts of the
input variables. Consider the previous example in which
the value of ABC stock was estimated to be $153.27
What happens to the calculated price estimate if you change your
estimate long-term growth from 10% to 9%?
Price
What happens to the calculated price if you change your estimate of k
from 14% to 13%?
Price
What happens to the calculated price if you change your estimate of
short-term growth from 20% to 18%?
Price
How do each of these changes affect your conclusions regarding the
buy/sell decision?
Price to Earnings (P/E) Analysis
We can also obtain a price estimate by multiplying projected
earnings by a forecast of the price/earnings multiple (P/E).
Consider two firms from the previous example where
earnings retention ratio differed:
The firm with good growth opportunities (and b=.6) was worth
P=$200, or P/E = 200/5= 40.
The firm with no growth opportunities was worth P=$50, or
P/E = 50/5 = 10.
The Result: P/E multiples can be good indicators of growth
opportunities.
Intuitively, prices reflect future expectations about cash flows.
Growth opportunities are valuable and reflected in prices (P).
P/E Analysis
The relation between P/E ratios and growth
opportunities can be expressed as follows:
or
We could also use P/E multiples to forecast the future price
in a multistage DDM model.
Problems with P/E:
Accounting Earnings
Related to the Business Cycle
Meaningless if E<0
P
0
1
= +
E
k
PVGO

P
E k
PVGO
E
k
0
1
1
1 = +

P/E Analysis
Analysis of some retailers (data as of 2/14/00 and 7/31/03)
Who is cheap, who is expensive?
2000 data 7/31/2003
symbol P/E P/E
GPS 42.6 25.59
IBI 21.21 --
LTD 19.83 16.27
TLB 19.13 17.06
ANF 18.44 15.9
AEOS 16.67 19.42
URBN 13.59 28.45
BEBE 11.88 29
ANN 9.39 17.64
DBRN 8.97 15.37
BKE 8.81 14.32
P/E Analysis - PEG ratio
A simple control is to divide P/E ratio by earnings
growth rate.
I took 1 year average forecast of earnings (is that good?)
2000 data 2000 data 2000 data 7/31/2003 7/31/2003 7/31/2003
symbol P/E g PEG P/E g PEG
GPS 42.6 0.22 1.93 25.59 0.17 1.52
IBI 21.21 0.15 1.37 -- -- --
LTD 19.83 0.15 1.36 16.27 0.15 1.11
TLB 19.13 0.16 1.18 17.06 0.15 1.17
ANF 18.44 0.29 0.63 15.90 0.12 1.29
AEOS 16.67 0.23 0.71 19.42 0.16 1.19
URBN 13.59 0.35 0.39 28.45 0.21 1.39
BEBE 11.88 0.20 0.60 29.00 0.21 1.37
ANN 9.39 0.21 0.44 17.64 0.14 1.23
DBRN 8.97 0.11 0.79 15.37 0.23 0.68
BKE 8.81 0.18 0.50 14.32 0.13 1.10
The Fools Rule
The Motley Fools say:
0 - 0.5 = BUY
0.5 - 0.65 = WEAK BUY
0.65 - 1.00 = HOLD
1.00 - 1.30 = LOOK TO SELL
1.30-1.70 CONSIDER SHORTING
>1.70 SHORT
Caveats
Mostly subjective cutoffs
Judgment is still required
P/E Analysis
More factors (k proxy is the dividend yield) are also likely to matter
We could run a regression of the form,
PE = +
1
(g) +
2
(k) +
3
(beta) +
If actual PE < expected PE then BUY
Compare the residual
2000 data 7/31/2003
symbol P/E g k P/E g k
GPS 42.6 0.22 0.0018 25.59 0.17 0.005
IBI 21.21 0.15 0.0165 -- -- --
LTD 19.83 0.15 0.018 16.27 0.15 0.024
TLB 19.13 0.16 0.0154 17.06 0.15 0.012
ANF 18.44 0.29 0 15.90 0.12 0
AEOS 16.67 0.23 0 19.42 0.16 0
URBN 13.59 0.35 0 28.45 0.21 0
BEBE 11.88 0.20 0 29.00 0.21 0
ANN 9.39 0.21 0 17.64 0.14 0
DBRN 8.97 0.11 0 15.37 0.23 0
BKE 8.81 0.18 0 14.32 0.13 0
P/E Analysis
Regression on g and k
2/14/2000 7/31/2003
symbol P/E Predicted Residual P/E Predicted Residual
GPS 42.60 17.21 25.39 25.59 15.74 9.85
IBI 21.21 15.37 5.84 -- -- --
LTD 19.83 15.12 4.71 16.27 15.16 1.11
TLB 19.13 15.58 3.55 17.06 15.13 1.93
ANF 18.44 19.18 -0.74 15.90 14.49 1.41
AEOS 16.67 17.57 -0.90 19.42 15.60 3.82
URBN 13.59 20.83 -7.24 28.45 16.77 11.68
BEBE 11.88 16.62 -4.74 29.00 16.94 12.06
ANN 9.39 17.00 -7.61 17.64 15.07 2.57
DBRN 8.97 14.21 -5.24 15.37 17.35 -1.98
BKE 8.81 16.00 -7.19 14.32 14.68 -0.36
P/E Regressions
Regression on g, k, and beta

2000 data 7/31/2003
symbol P/E Predicted Residual P/E Predicted Residual
GPS 42.60 17.21 25.39 25.59 18.01 7.58
IBI 21.21 15.37 5.84 -- -- --
LTD 19.83 15.12 4.71 16.27 18.77 -2.50
TLB 19.13 15.58 3.55 17.06 19.28 -2.22
ANF 18.44 19.18 -0.74 15.90 20.58 -4.68
AEOS 16.67 17.57 -0.90 19.42 21.97 -2.55
URBN 13.59 20.83 -7.24 28.45 20.54 7.91
BEBE 11.88 16.62 -4.74 29.00 22.41 6.59
ANN 9.39 17.00 -7.61 17.64 19.09 -1.45
DBRN 8.97 14.21 -5.24 15.37 -- --
BKE 8.81 16.00 -7.19 14.32 16.08 -1.76
P/E Analysis - Regression Screens
Basic Steps in Regression Screens
1. Use all firms in industry/sector/universe
2. Regress P/E on its underlying parameters
From Damodaran Table 8.2, using March 1997 data on 1,400 firms
P/E = 11.07 +27.8(g) + 0.73(k) + 2.94 (beta)
3. Examine errors
+ implies overvalued
- implies undervalued
Problems
Regressions only use those stocks with a P/E ratio
sample does not include negative earners
Persistence of errors...
Evidence from 2000 Analysis
GPS appeared to be overvalued
URBN, ANN, DBRN and BKE may be undervalued.
What actually happened?6 mos.18 mos. 30 mos. 48 mos. 68 mos.
Sell GPS -58% -72% -72% -62% -61%
Buy URBN -10% 61% 93% 244% 2059%
Buy ANN 102% 43% 80% 122% 240%
Buy BKE -20% 37% 28% 39% 160%
Buy DBRN 78% 58% 102% 80% 291%
Buy BEBE 49% 188% 28% 112% 364%
Others
LTD -7% -16% -13% 6% 51%
AEOS 37% 44% -4% 30% 190%
TLB 94% 118% 85% 91% 68%
ANF 59% 108% 57% 220% 318%
Evidence from 2003 Analysis
GPS, URBN and BEBE appeared to be overvalued
What actually happened? 6 mos. 12 mos. 18 mos. 27 mos.
Sell GPS 12% 28% 20% -22%
Sell URBN 114% 199% 337% 84%
Sell BEBE 27% 30% 190% 54%
ANF and maybe AEOS, DBRN and LTD were undervalued.
Buy ANF -12% 16% 73% 47%
Buy DBRN? 18% 28% 47% 54%
Buy AEOS? -5% 48% 132% 55%
Buy LTD? 15% 25% 58% 30%
Others
TLB 2% -6% -11% -13%
ANN 56% 43% 19% 35%
BKE 27% 37% 50% 47%