Security Valuation

Basic Approach: PV (expected future cash flows)

Outline of Topics:
Valuing bonds
Valuing preferred stock
Valuing common stock
Discounted cash flow method
Dividend valuation method assuming:
Zero growth
Constant growth
Non-constant growth
Estimating g, the growth rate
Term structure of interest rates

Security Valuation
Determine the intrinsic value of:
(1) Bonds; (2) Preferred Stock; (3) Common Stock.
Bond Valuation
Assume a $1,000 par value bond, 10 years to maturity, with an 8%
coupon rate.
If the investor wants to earn a 10% return on the bond, how much
would he be willing to pay for it?
0
1
|
|
($877.11)
80
PV, @10%)

2
|
80

3
|
80

4
|
80

5
|
80

6
|
80

7
|
80

PMT = 80; FV = 1,000; N = 10; %r = 10; PV = ?

8
|
80

9
|
80

10
|
80
1,000

Bond Prices and Interest Rates

(1) Bond prices move inversely to interest rates (as do all security prices).
(2) All else held constant, the longer the maturity of the bond, the more sensitive is
its price to a change in interest rates.
Bond A: 20-year; 12% coupon; initial yield: 10%; Bonds value: $1,170.27
Bond B: 10-year; 12% coupon; initial yield: 10%; Bonds value: $1,122.89
Now assume that bond yields drop from 10% to 8%.
Bond A: New Value: $1,392.73;
% : +19%
Bond B: New Value: $1,268.40;
% : +13%
(3) All else held constant, the lower a bonds coupon rate, the more sensitive is
its price to changes in interest rates.
Bond A: same
Bond C: 20-year; 4% coupon; initial yield: 10%; Bonds value: $489.19
Again, assume r% drops to 8%:
Bond A: same
Bond C: New Value: $607.27;

% : +19%
% : +24%

Yield to Maturity
an estimate of the % yield earned on the bond
from the purchase date to the maturity date.
(1) If a bonds coupon rate = YTM; then its PV = Par value.

(2) If a bonds coupon rate > YTM; then its PV > Par value.
(3) If a bonds coupon rate < YTM; then its PV < Par value.

Valuing bonds with semi-annual interest payments:

Suppose Bond A has a maturity of $1,000 and a
10% coupon, with interest paid semi-annually.
(a) If there are 5 years to maturity, and the bond is priced to yield
8%, what is the bonds value today?
n = 10 r = 4 PMT = $50
FV = $1,000
(PV = $1,081.10) Selling at a premium

(b) Same bond, but now the yield is 10%. Price?

(r = 5) Selling at par
(c) Now the yield is 12%. Price?
(r = 6) Selling at a discount (PV = $926.40)

What is the effective yield in this case?

Eff. Yield = 12.36%

 Yield-to-Call (YTC):
Use the previous bond example (10 yr. bond, 8% coupon, YTM =10%; PV =
$877.11), except assume the bond will be called after 5 years with a call
premium of 10%:
0
1
2
3
4
5

($877.11)

80

80

80

80

80
1,100

If the bond pays the coupon semi-annually, what is the YTC?

PMT = 40; N = 10; FV = 1,100; PV = 877.11; %r = ?
[6.4482% x 2 = 12.896% compounded semi-annually].
Eff. Yield? = 13.31%.

Zero-Coupon Bonds
0
($10,000)

PV = -10,000; FV = 300,000
30

N = 30; %r = ?

$300,000 [12%]

Time Path of Bonds

How does the value of a bond change as it approaches its
maturity date?
Value
1250 _

1000 _
750 _
|
5

4 3 2 1
Years to maturity

Example: Bond A has a face value of $40,000 and matures in 20 years. It makes
no payments for the first 6 years, pays $2,000 semiannually for the next 8 years, and
$2,500 the last 6 years. Assume r = 12%, compounded semiannually. What is the
price?

12

13

28

2000 2000

29
2500

40
2500
40,000

PV of 2 annuities + principal:
PV of $2,000 annuity:
n=16, PMT=2000, r = 6%, PV = ? (20,211.79 as of t = 12)
20,211.79 / (1.06)12 10,044.64
PV of $2,500 annuity:
n=12, PMT=2500, r = 6%, PV = ? (20,959.61 as of t = 28)
20,959.61 / (1.06)28 4,100.33
PV (40,000 in pd. 40) = 3,888.89
10,044.64 + 4,100.33 + 3,888.89 = $18,033.86

Bond Valuation Example (continued)

Financial Calculator: Cash Flow Inputs
CF0 = 0
CF1 = 0
nj = 12
CF2 = 2,000
nj = 16
CF3 = 2,500
nj = 12
NPV =

PV(40,000) =

14,144.97
+
3,888.89
18,033.86

r = 6%

Preferred Stock Valuation

Dividend
Vps
Required rate of return

Ex. What is the value of preferred stock with a

$100 par value, paying a 6% dividend;
r = 12%:
PV = $6.00/.12 = $50

Preferred Stock Example

A share of PS pays a quarterly dividend of $2.50. If
the price is currently $50, what is the annual rate of
return?

Recall: V = Div/r
r = Div/V = $10/$50 = 20%
EAR=?
21.55%

Term Structure of Interest Rates

the relationship between bond yields and
maturities

Recently:
2-3 year: 4.85%
5 year:
4.80%
10 year: 4.87%
30 year: 5.02%

March 1980:
14%
13.5%
12.8%
12.5%

Yield Curve
www.bloomberg.com/markets

5%

1%
3Y

5Y

10Y

30Y

Yield Curve
www.bloomberg.com/markets

8%

6%

3Y

5Y

10Y

30Y

What determines the shape

of the yield curve?

(1) Expectations theory

the yield curve depends on expectations
about future inflation.
(2) Liquidity preference theory
there is a positive maturity risk premium.

Methods of Common Stock Valuation

(1) The Discounted Cash Flow Method (DCF)
0
|
($?)
($36.50)

1
|
$1.08

(r=8%)

2
|
$1.15
$40.25

(2) The Dividend Valuation Method Assuming Constant

Growth

D1
$1.20
$1.20
P0

$12
r - g .15 .05
.10
(3) The Dividend Valuation Method Assuming Zero Growth
(4) The Dividend Valuation Method Assuming Nonconstant
Growth
Po = PV(Phase #1) + PV(Phase #2) + + PV (Phase #n)

Nonconstant Growth Example

Bailey Inc. expects to pay a dividend of $1.25 next year and then have
it grow @ 9% for the next 3 years before growing @ 5% indefinitely
thereafter. (r = 10%)
What is the intrinsic value of the stock?
0

1.25

1.36

1.49

1.62

1.70

P4 = D5 / r-g
P4 = 1.70/(.10-.05) = $34.00
P0 = 1.25/1.10 + 1.36/(1.10)2 + 1.49/(1.10)3 + 1.62/(1.10)4 + 34/(1.10)4
= $27.71

Estimating the Capitalization Rate (r)

on a Stock
Recall: P0 = D1/(r-g)

r = D1/P0 + g or
r = DY + capital gains yield
How to calculate g?
g = Retention ratio x ROE

Example
The Taylor Co. had net income of $150,000 this past year.
It paid $45,000 in dividends on the companys equity of
$2,500,000.
There are 100,000 shares outstanding with a current
market value of 12 5/8 per share.
What is the required rate of return? (r = D1/P0 + g)
g = retention ratio x ROE = (1-Div. Payout) x NI/Equity
(1 - 45,000/150,000) x 150,000/2,500,000
= .7(.06) = 4.2%
r = D1/P0 + g = .45 (1.042) / 12.625 + .042 = 7.91%

Growth Opportunities
Growth opportunities refer to opportunities to
invest in positive NPV projects.
The value of a firm can be expressed as the sum of
the value of a firm that pays out 100% of its
earnings as dividends, plus the NPV of the growth
opportunities.

EPS
P
NPVGO
R

NPVGO Model
Example: Consider a firm that has forecasted EPS of
$5 and is currently priced at $75 per share; r = 16%.
Calculate the value of the firm as a cash cow.
EPS $5
P0

$31.25
R
.16

NPVGO must be:

$75 - $31.25 = $43.75

PROPERTIES
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