Valuation of Bonds and Shares

Valuation of Bonds
Bond
A long-term debt instrument (a legal contract) in which a borrower
agrees to make payments of principal and interest, on specific dates,
to the holders of the bond.
Types of Bonds
Bonds with Maturity
Pure Discount Bonds
Perpetual Bonds
Bond Yields
Coupon rate
Current yield
Yield to maturity
Yield to call


Valuation of Bonds Contd

Bonds with Maturity:

Bond value = Present value of interest after n number of year +
Present value of maturity after n number of year.



Therefore,
Bond Value = I ( PVIAF
Kd, n
) + F ( PVIF
Kd, n
)

Valuation of Bonds Contd
Yield to Maturity:

The yield-to-maturity (YTM) is the measure of a
bonds rate of return that considers both the interest
income and any capital gain or loss. YTM is bonds
internal rate of return.

YTM = I + (m p) /n
0.4(m) + 0.6(p)
Where, I = Annual Interest
m = Maturity Value
p = Price of Bond
n = Number of years to maturity
Valuation of Bonds Contd
Current Yield

Current yield is the annual interest divided by the
bonds current value.

It is calculated as:




Value Current
Pmt Annual
CY
Value Current
Pmt Annual
CY
Valuation of Bonds Contd
Yield to Call:

The yield to call is the average annual rate of return that a bondholder will earn
under the following assumptions:
The bond is held to maturity
The interest payments are reinvested at the YTM

YTC = FV + m p
n n
1


0.4(m) + .0.6(p)

Where, FV = Face Value
m = Maturity Value
p = Price of Bond
n = Number of years to maturity
n
1
= Called Year


Valuation of Bonds Contd

Pure Discount Bonds:

A pure discount bond makes a single payment at the
maturity date of the bond.

Value of pure discount bond = PV of the amount on
maturity






Valuation of Bonds Contd

Perpetual Bonds:

A perpetual bond, is a bond with no maturity date.
Therefore, it may be treated as equity, not as debt.

PV = A
r

Where PV = Present Value of the Perpetuity, A = the
Amount of the periodic payment, and r = yield ,
discount rate or interest rate.

Valuation of Preference Share
Capital stock which provides a specific dividend that is paid before any
dividends are paid to common stock holders, and which takes
precedence over common stock in the event of a liquidation. Like
common stock, preference shares represent partial ownership in a
company, although preferred stock shareholders do not enjoy any of
the voting rights of common stockholders. Also unlike common stock,
preference shares pay a fixed dividend that does not fluctuate,
although the company does not have to pay this dividend if it lacks
the financial ability to do so. In general, there are four different types
of preferred stock: cumulative preferred, non-cumulative,
participating, and convertible. also called preferred stock.

P
o
= Preference
div
( PAVF
Kp, n
) + P
n
(PVF
Kp, n
)

Where, K
p
= Cost of Preference Share or expected rate of return.

P
n
= Maturity value of Preference shares at the end of n
number of year.


Valuation of Equity

The valuation of ordinary or equity shares is
relatively more difficult.
The rate of dividend on equity shares is not known;
also, the payment of equity dividend is
discretionary.
The earnings and dividends on equity shares are
generally expected to grow, unlike the interest on
bonds and preference dividend.

Dividend Discount Models

1
) 1 (
t
t
t
o
k
D
V
A procedure for valuing the price of a stock by using
predicted dividends and discounting them back to
present value. The idea is that if the value obtained from
the DDM is higher than what the shares are currently
trading at, then the stock is undervalued.




V
0
= Value of Stock
D
t
= Dividend
k = required return
No Growth Model
V
D
k
o

D is the constant dividend
k is the required rate of return
Stocks that have dividends that are expected to
remain constant

Constant Growth Model
Dividends are expected to grow at a constant
percent per period.
D
0
is most recent dividend, D
0
(1+g) is next
dividend
g = constant perpetual growth rate
k = required rate of return



g k
g D
V

) 1 (
0
0
Estimating Dividend Growth Rates
g ROE b

g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate. The
proportion of the firms earnings that is reinvested
in the business.
= (1- dividend payout rate)
Multi-Period Dividend-Discount Model

) 1 ( ) 1 ( ) 1 (
...
2
2
1
1
0
k
P D
k
D
k
D
V N
N N



P
N
= expected sales price of stock at time N
N = number of years the stock is to be held
Multi-Period Earnings-Discount
Model

) 1 (
) 1 (
...
) 1 (
2
) 1 (
2
) 1 (
1
) 1 (
1
0
k
N
P
N
E b
N
k
E b
k
E b
V

P
N
= expected sales price of stock at time N
N = number of years the stock is to be held
P/E Ratio and Growth
Opportunities
P
D
k g
E b
k b ROE
P
E
b
k b ROE
0
1 1
0
1
1
1








( )
( )
( )
b = retention ration
ROE = Return on Equity
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