Topics Covered

Valuation of Bond & Stock - Concepts

Using PV Formulas to Value Bonds
How Common Stocks are Traded
How Common Stocks are Valued
Estimating the Cost of Equity Capital
Stock Prices and EPS

Valuation of Bonds and Stock

First Principles:
Value of financial securities = PV of expected
future cash flows

To value bonds and stocks we need to:

Estimate future cash flows:
Size (how much) and
Timing (when)

Discount future cash flows at an appropriate rate:

The rate should be appropriate to the risk presented by
the security.
5-2

Valuation Concepts
Valuation of a financial asset is based on
determining the present value of future cash
flows.
Required rate of return (the discount rate)
Depends on the markets perceived level of risk
associated with the individual security.
It is also competitively determined among companies
seeking financial capital.
Implying that investors are willing to accept low return
for low risk and vice versa.
Efficient use of capital in the past results in a lower
required rate of return for investors.
10-3

Concept of Yield to Maturity

The yield to maturity or the discount rate is
the required rate of return required by
bondholders.
Three factors influence the required rate of
return:
Required real rate of return.
Inflation premium.
Risk premium.
10-4

The Real Rate of Return

Demanded by the investor against current
use of the funds on a non-adjusted basis.
The financial rent the investors charges for the
usage of their funds for a given period.
Usually about 2 to 3%.

10-5

Inflation Premium
Compensation towards the negative effect of
inflation on the value of a dollar.
Premium added to the real rate of return:
Ensures that the investor will not pay the borrower to
use his or her funds.
The risk-free rate of return can be determined.

10-6

Risk Premium
Towards special risks of an investment.
Business risk: inability of the firm to retain its:
Competitive position.
Maintain stability and growth.

Financial risk: inability of the firm to meet its:

Debt obligations as and when due.

Is relative to the type of investments.

10-7

Risk Premium (contd)

Assuming the risk premium is 3%, an overall
required rate of return of 10% can be computed;

10-8

Increase in Inflation Premium

Assume this goes up from 4 to 6%, with everything else
being constant.

Present value of interest payments:

$100 annuity for 20 years at a discount rate of 12%;

10-9

Increase in Inflation Premium

(contd)
Present value of principal payment at maturity:
Present value of $1,000 after 20 years at a discount rate of 12%;

Total present value:

Assuming that increase inflation increases required rate of return
and decreases the bond price by $150 approximately.

10-10

Decrease in Inflation Premium

Assuming that the inflation premium declines:
The required rate of return (yield to maturity) decrease to
8%, where the 20 year bond with a 10% interest rate
would now sell for;
Present value of interest payments

10-11

5.1 Definition and Example

of a Bond
A bond is a legally binding agreement between a
borrower and a lender:
Specifies the principal amount of the loan.
Specifies the size and timing of the cash flows:
In dollar terms (fixed-rate borrowing)
As a formula (adjustable-rate borrowing)

5-12

5.1 Definition and Example

of a Bond
Consider a U.S. government bond listed as 6 3/8 of
December 2009.
The Par Value of the bond is $1,000.
Coupon payments are made semi-annually (June 30 and December
31 for this particular bond).
Since the coupon rate is 6 3/8 the payment is $31.875.
On January 1, 2005 the size and timing of cash flows are:

$31.875

$31.875

$31.875

$1,031.875

6 / 30 / 09

12 / 31 / 09

1 / 1 / 05

6 / 30 / 05

12 / 31 / 05

5-13

Valuation of Bonds
A bond provides an annuity stream of
interest payments and a principal payment
at maturity.
Cash flows are discounted at Y (yield to maturity).
Value of Y is determined in the bond market.
The price of the bond is:
Equal to the present value of regular interest
payments.
Discounted by the yield to maturity added to the
present value of the principal.
10-14

Valuing a Bond
Example
If today is January 2004, what is the value of the following
bond?
A German Government bond (Bund) pays a 5.375 percent
annual coupon, every year for 6 years. The par value of the
bond is 100 EURO.

Cash Flows
'05
'06
'07
'08
'09
'10
5.375 5.375 5.375 5.375 5.375 105.375

Valuing a Bond
Example continued
If today is January 2004, what is the value of the following bond?
A German Government bond (Bund) pays a 5.375 percent annual coupon, every
year for 6 years. The par value of the bond is 100 EURO.
The price at a 3.8% YTM is as follows

5.375
5.375
5.375
5.375 105.375
PV

2
3
4
5
1.038 1.038
1.038 1.038 1.038
$108.31

Valuing a Bond
Example continued
If today is January 2004, what is the value of the following bond?
A German Government bond (Bund) pays a 5.375 percent annual coupon, every
year for 6 years. The par value of the bond is 100 EURO.
The price at a 2.0% YTM is as follows

5.375 5.375
5.375
5.375 105.375
PV

2
3
4
5
1.02 1.02
1.02 1.02 1.02
$118 .90

Pure Discount Bonds

Information needed for valuing pure discount bonds:
Time to maturity (T) = Maturity date - todays date
Face value (F)
Discount rate (r)

$0

$0

$0

$F

T 1

Present value of a pure discount bond

at time 0:
F

PV

(1 r )

5-18

Pure Discount Bonds: Example

Find the value of a 30-year zero-coupon bond
with a $1,000 par value and a YTM of 6%.
$0

$0

$0

$1,000
0$ 0,1$

0 1229 30

29

30

F
$1,000
PV

$174.11
T
30
(1 r )
(1.06)
5-19

Level-Coupon Bonds
Information needed to value level-coupon bonds:
Coupon payment dates and time to maturity (T)
Coupon payment (C) per period and Face value (F)
Discount rate
$C
$C
$C
$C $ F

T 1

Value of a Level-coupon bond

= PV of coupon payment annuity + PV of
face value

C
1
F
PV 1

T
r
(1 r ) (1 r )T

5-20

Level-Coupon Bonds: Example

Find the present value (as of January 1, 2004), of a 6-3/8 coupon
T-bond with semi-annual payments, and a maturity date of
December 2009 if the YTM is 5-percent.
On January 1, 2004 the size and timing of cash flows are:

$31.875

$31.875

$31.875

$1,031.875

6 / 30 / 09

12 / 31 / 09

1 / 1 / 04

6 / 30 / 04

12 / 31 / 04

$31.875
1
$1,000
PV
1

$1,070.52

12
12
.05 2
(1.025) (1.025)
5-21

5.3 Bond Concepts

1.

Bond prices and market interest rates move in opposite

directions.

2.

When coupon rate = YTM, price = par value.

When coupon rate > YTM, price > par value (premium bond)
When coupon rate < YTM, price < par value (discount bond)

3.

A bond with longer maturity has higher relative (%) price

change than one with shorter maturity when interest rate
(YTM) changes. All other features are identical.

4.

A lower coupon bond has a higher relative price change than

a higher coupon bond when YTM changes. All other features
are identical.

5-22

5-23

Bond Value

YTM and Bond Value

$1400

When the YTM < coupon, the bond

trades at a premium.

1300
1200
1100

When the YTM = coupon, the bond

trades at par.

1000
800

0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8
Discount Ra

When the YTM > coupon, the bond trades at a discount.

5-24

Bond Value

Maturity and Bond Price Volatility

Consider two otherwise identical bonds.
The long-maturity bond will have much
more volatility with respect to changes
in the discount rate

Par

Short Maturity
Bond

Discount Ra

Long Maturity
Bond

5-25

Bond Value

Coupon Rate and Bond Price

Volatility
Consider two otherwise identical bonds.
The low-coupon bond will have much more
volatility with respect to changes in the discount
rate

High Coupon
Bond
Discount R
Low Coupon Bond

Price

Bond Prices and Yields

Yield

Determining Yield to Maturity from

the Bond Price
The yield to maturity (Y), that will equate the interest
payments ( ) and the principal payments ( ) to the price
of the bond ( ).
Assuming that a 15 year bond pays $110 per year (11%) in interest
and $1,000 after 15 years in principal repayment.
Choosing an initial percentage to try as a discount rate, we have:

10-27

Valuation and Preferred Stock

Preferred stock represents a perpetuity,
having no maturity date.
It has a fixed dividend payment.
It has no binding contractual obligation of
interest on debt.
Being a hybrid security, it does not have:
The ownership privilege of a common stock.
The legal provisions that could be enforced on debt.

10-28

Perpetuity of a Preferred Stock

Where,
= the price of the preferred stock;
= the annual dividend for the
preferred stock (constant);
= required rate of return (discount rate)
applied to preferred stock dividends.

A more usable formula is:

Assuming, the annual dividend is $10, and the stockholder requires a

10% rate of return, the price of the preferred stock would be:

10-29

Perpetuity of a Preferred Stock

(contd)

If the rate of return required by security holders change, the value of the
preferred stock also changes.
The longer the period of an investment, the greater the impact of a
change in the require rate of return.
With perpetual security, the impact is at a maximum.
Assuming that the required rate of return has increased to 12%. The
value of the preferred stock would be:

If it were reduced to 8%, the value of the preferred stock would be:

10-30

Stocks & Stock Market

Common Stock - Ownership shares in a
publicly held corporation.
Secondary Market - market in which already
issued securities are traded by investors.
Dividend - Periodic cash distribution from the
firm to the shareholders.
P/E Ratio - Price per share divided by
earnings per share.

Stocks & Stock Market

Book Value - Net worth of the firm according to
the balance sheet.
Liquidation Value - Net proceeds that would be
realized by selling the firms assets and
paying off its creditors.
Market Value Balance Sheet - Financial
statement that uses market value of assets
and liabilities.

Trading of Stocks
Primary Market
Secondary Market
52 weeks

High

Low

Stock (SYM)

Div
Yield

PE

Vol
(100s)

Close

Net
Change

3449

1876.4

Infosys
(INFOSYSTCH)

0.2%

39.52

1539

3177.9

1.4%

Quotations of Infosys in NSE as on 29 April, 2006

Valuing Common Stocks

If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock as a
PERPETUITY.

Div1
EPS1
Perpetuity P0
or
r
r
Assumes all earnings are
paid to shareholders.

Valuing Common Stocks

Constant Growth DDM - A version of the
dividend growth model in which dividends
grow at a constant rate (Gordon Growth
Model).

Valuing Common Stocks

Example- continued
If the same stock is selling for Rs.100 in the stock
market, what might the market be assuming about
the growth in dividends?

Rs.3.00
Rs.100
.12 g
g .09

Answer
The market is
assuming the dividend
will grow at 9% per
year, indefinitely.

Valuing Common Stocks

If a firm elects to pay a lower dividend, and
reinvest the funds, the stock price may increase
because future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as
dividends
Plowback Ratio - Fraction of earnings retained by the
firm.

Valuing Common Stocks

Growth can be derived from applying the
return on equity to the percentage of
earnings plowed back into operations.

g = return on equity X plowback ratio

Valuing Common Stocks

Example
Our company forecasts to pay a
Rs.8.33 dividend next year, which
represents 100% of its earnings.
This will provide investors with a
15% expected return. Instead, we
decide to plow back 40% of the
earnings at the firms current return
on equity of 25%. What is the
value of the stock before and after
the plowback decision?

Valuing Common Stocks

Expected Return - The percentage yield that an
investor forecasts from a specific investment over
a set period of time. Sometimes called the market
capitalization rate.

Div1 P1 P0
Expected Return r
P0

Valuing Common Stocks

Example: If Fledgling Electronics is selling for
Rs.100 per share today and is expected to sell for
Rs.110 one year from now, what is the expected
return if the dividend one year from now is
forecasted to be Rs.5.00?

5 110 100
Expected Return
.15
100

Valuing Common Stocks

The formula can be broken into two parts.
Dividend Yield + Capital Appreciation

Div1 P1 P0
Expected Return r

P0
P0

Valuing Common Stocks

Capitalization Rate can be estimated using the
perpetuity formula, given minor algebraic
manipulation.

Div1
Capitalization Rate P0
rg
Div1
r
g
P0

Valuing Common Stocks

Return Measurements

Div1
Dividend Yield
P0
Return on Equity ROE
EPS
ROE
Book Equity Per Share

Valuing Common Stocks

Dividend Discount Model - Computation of todays
stock price which states that share value equals
the present value of all expected future dividends.

Div1
Div2
Div H PH
P0

...
1
2
H
(1 r ) (1 r )
(1 r )
H - Time horizon for your investment.

Valuing Common Stocks

Example
Current forecasts are for XYZ Company to pay
dividends of Rs.3, Rs.3.24, and Rs.3.50 over the
next three years, respectively. At the end of three
years you anticipate selling your stock at a market
price of Rs.94.48. What is the price of the stock
given a 12% expected return?

Valuing Common Stocks

Example
Current forecasts are for XYZ Company to pay dividends of Rs.3,
Rs.3.24, and Rs.3.50 over the next three years, respectively. At the
end of three years you anticipate selling your stock at a market price of
Rs.94.48. What is the price of the stock given a 12% expected return?

3.00
3.24
3.50 94.48
PV

1
2
3
(1 .12) (1 .12)
(1 .12)
PV Rs.75.00

5.4 The Present Value

of Common Stocks
Dividends versus Capital Gains
Valuation of Different Types of Stocks
Zero Growth
Constant Growth
Differential Growth

5-48

Case 1: Zero Growth

Assume that dividends will remain at the same level
forever

Div1 Div2 Div3

Since future cash flows are constant, the
value of a zero growth stock is the
present value of a perpetuity:

Div1
Div2
Div3

P0
1
2
3
(1 r )
(1 r )
(1 r )
Div
P0
r
5-49

Case 2: Constant Growth

Assume that dividends will grow at a
constant rate, g, forever. i.e.
Div1 Div0 (1 g)
2

Div2 Div1 (1 g) Div0 (1 g)

3

Div3 Div
. 2 (1 g) Div0 (1 g)

.
.

Since future cash flows grow at a

constant rate forever, the value of a
constant growth stock is the
present value of a growing
perpetuity:
Div1

P0

r g

5-50

Case 3: Differential Growth

Assume that dividends will grow at different
rates in the foreseeable future and then will
grow at a constant rate thereafter.
To value a Differential Growth Stock, we need
to:
Estimate future dividends in the foreseeable
future.
Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.
5-51

Case 3: Differential Growth

Assume that dividends will grow at
rate g1 for N years and grow at
rate
g
thereafter
2

Div Div (1 g )
1

Div2 Div1 (1 .g1 ) Div0 (1 g1 )

.
.

DivN DivN 1 (1 g1 ) Div0 (1 g1 )

N
DivN 1 DivN (1 g2 ) Div0 (1 g1 ) (1 g2 )

.
.
.
5-52

Case 3: Differential Growth

Dividends will grow at rate g1 for N
years and grow at rate g2
2
thereafter

Div0 (1 g1 ) Div0 (1 g1 )

N
Div0 (1 g1 )

DivN (1 g2 )
Div0 (1 g1 )N (1 g2 )

N+1
5-53

Case 3: Differential Growth

We can value this as the sum of:
an N-year annuity growing at rate
T
g1

C
(1 g1 )

PA

r g1

(1 r )
T

plus the discounted value of a

perpetuity growing at rate g2 that
starts in year N+1
Div

N 1

r g2

PB
N

(1 r )
5-54

Case 3: Differential Growth

To value a Differential Growth Stock, we can

use

DivN 1

C
(1 g1 )T r g2

P
1
T
N

r g1
(1 r )
(1 r )

Or we can cash flow it out.

5-55

A Differential Growth Example

A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.

5-56

With the Formula

DivN 1

C
(1 g1 ) r g2

P
1

T
N

r g1
(1 r )
(1 r )
$2(1.08)3 (1.04)

(1.08)
.12 .04
$
2
(
1
.
08
)

1
P

3
3

.12 .08
(1.12)
(1.12)

$32.75

P $541 .8966
3
(1.12)
P $5.58 $23.31
P $28.89
5-57

A Differential Growth Example (continued)

3

$2(1.08) $2(1.08)
0

$2.16
0

$2.62
$2.52
.08

$2.33
2

$2(1.08) $2(1.08) (1.04)

P3

The constant
growth phase
beginning in
year 4 can be
valued as a
growing
at
$2perpetuity
.62
time
$32.75
3.

.08

$2.16 $2.33 $2.52 $32.75

$28.89
P0
2
3
1.12 (1.12)
(1.12)
5-58

5.5 Estimates of Parameters in the

Dividend-Discount Model
The value of a firm depends upon its growth
rate, g, and its discount rate, r.
Where does g come from?
Where does r come from?

5-59

Where does g come from?

g = Retention ratio Return on retained earnings

5-60

Where does r come from?

The discount rate can be broken into two
parts.
The dividend yield
The growth rate (in dividends)

In practice, there is a great deal of estimation

error involved in estimating r.

5-61

Valuing Common Stocks

Example
Our company forecasts to pay a Rs.8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with a 15%
expected return. Instead, we decide to plow back 40% of the earnings
at the firms current return on equity of 25%. What is the value of the
stock before and after the plowback decision?

No Growth

8.33
P0
Rs.55.56
.15

With Growth

g .25 .40 .10

5.00
P0
Rs.100.00
.15 .10

Valuing Common Stocks

Example - continued
If the company did not plowback some earnings, the stock
price would remain at Rs.55.56. With the plowback, the price
rose to Rs.100.00.
The difference between these two numbers) is called the
Present Value of Growth Opportunities (PVGO).

PVGO 100.00 55.56 Rs.44.44

Valuing Common Stocks

Present Value of Growth Opportunities
(PVGO) - Net present value of a firms future
investments.
Sustainable Growth Rate - Steady rate at
which a firm can grow: plowback ratio X
return on equity.

5.6 Growth Opportunities

Growth opportunities are opportunities to
invest in positive NPV projects.
The value of a firm can be conceptualized
as the sum of the value of a firm that pays
out 100-percent of its earnings as dividends
and the net present value of the growth
opportunities.
EPS
NPVGO
P
r
5-65

5.7 The Dividend Growth Model and

the NPVGO Model (Advanced)
We have two ways to value a stock:
The dividend discount model.
The price of a share of stock can be calculated
as the sum of its price as a cash cow plus the
per-share value of its growth opportunities.

5-66

The Dividend Growth Model and the

NPVGO Model
Consider a firm that has EPS of $5 at the end of
the first year, a dividend-payout ratio of 30%, a
discount rate of 16-percent, and a return on
retained earnings of 20-percent.
The dividend at year one will be $5 .30 = $1.50 per share.
The retention ratio is .70 ( = 1 -.30) implying a growth rate in
dividends of 14% = .70 20%
From the dividend growth model, the price of a share is:

Div1
$1.50

$75
P0
r g .16.14

5-67

The NPVGO Model

First, we must calculate the value of the firm
as a cash cow.

Div1 $5

$31.25
P0
r
.16

Second, we must calculate the

value of the growth opportunities.

.20
3
.
50
3.50 .16
$.
875

$43.75
P0
r g
.16.14

Finally, P0 31.25 43.75 $75

5-68

5.8 Price Earnings Ratio

Many analysts frequently relate earnings per share
to price.
The price earnings ratio is a.k.a. the multiple
Calculated as current stock price divided by annual EPS
The Wall Street Journal uses last 4 quarters earnings

Pricepershare
P/E ratio
EPS
Firms whose shares are in fashion sell at high multiples. Growth
stocks for example.
Firms whose shares are out of favor sell at low multiples. Value stocks
for example.

5-69

Other Price Ratio Analysis

Many analysts frequently relate earnings per
share to variables other than price, e.g.:
Price/Cash Flow Ratio
cash flow = net income + depreciation = cash flow
from operations or operating cash flow

Price/Sales
current stock price divided by annual sales per
share

Price/Book (a.k.a. Market to Book Ratio)

price divided by book value of equity, which is
measured as assets liabilities
5-70

5.9 Stock Market Reporting

52 WEEKS
YLD
VOL
NET
HI
LO STOCKSYM DIV % PE 100s HI LO CLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75
Gap has
been as
high as
$52.75 in
the last
year.

Gap pays a
dividend of 9
cents/share
Given the
current price,
the dividend
yield is %

Gap has
been as low
as $19.06 in
the last year.

Given the current

price, the PE ratio
is 15 times
earnings

Gap ended trading

at $19.25, down
$1.75 from
yesterdays close

6,517,200 shares
traded hands in the
last days trading

5-71

5.9 Stock Market Reporting

52 WEEKS
YLD
VOL
NET
HI
LO STOCKSYM DIV % PE 100s HI LO CLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75

Gap Incorporated is having a tough year, trading

near their 52-week low. Imagine how you
would feel if within the past year you had paid
$52.75 for a share of Gap and now had a
share worth $19.25! That 9-cent dividend
wouldnt go very far in making amends.
Yesterday, Gap had another rough day in a
rough year. Gap opened the day down
beginning trading at $20.50, which was down
from the previous close of $21.00 = $19.25 +
$1.75
Looks like cargo pants arent the only things on
5-72

5.10

Summary and Conclusions

In this chapter, we used the time value of

money formulae from previous chapters to
value bonds and stocks.
1. The value of a zero-coupon bond is
F
PV
T

(1 r )
C
2. The value of a perpetuity is
PV
r
5-73

5.10 Summary and Conclusions (continued)

3. The value of a coupon bond is the sum of
the PV of the annuity of coupon payments
plus the PV of the par value at maturity.
C
PV
r

1
1 T
(1 r )

F
T
(1 r )

The yield to maturity (YTM) of a bond is that single rate that discounts
the payments on the bond to the purchase price.

5-74

5.10 Summary and Conclusions (continued)

5. A stock can be valued by discounting its
dividends. There are three cases:
Div
Zero growth in dividendsP0
r
Div1
Constant growth in
P0
r g
dividends
DivN 1
Differential growth in dividends

g1 ) r g2
C
(
1

P
1

T
N

r g1
(1 r)
(1 r)

5-75

5.10 Summary and Conclusions (continued)

6. The growth rate can be estimated as:
g = Retention ratio Return on retained earnings

7. An alternative method of valuing a stock

was presented, the NPVGO values a stock
as the sum of its cash cow value plus the
present value of growth opportunities.
EPS
NPVGO
P
r
5-76

Valuation and Rates

of Return

EMBA 1, BUP

Maj Yeaseen

Example - 13% Discount Rate

Present value of interest payments:

Present value of principal payment at maturity

Total present value

10-78

Example 12% Discount Rate

Present value of interest payments

Present value of principal payment at maturity

Total present value

10-79

Semiannual Interest and Bond Prices

A 10% interest rate may be paid as $50 twice a year in the
case of semiannual payments.
To make the conversion:
Divide the annual interest rate by two.
Multiply the number of years by two.
Divide the annual yield to maturity by two.

Assuming a 10%, $1,000 par value bond has a maturity of

20 years, the annual yield at 12%:
10%/2 = 5% semiannual interest rate; hence 5% X $1,000 = %50
semiannual interest.
20 X 2 = 40 periods to maturity
12%/2 = 6% yield to maturity, expressed on a semiannual basis.
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Semiannual Interest and Bond Prices

(contd)
At a present value of a $50 annuity for the 40 periods, at discount
rate of 6%:
Present value of interest payments

Present value of principal payment at maturity

Total present value

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