CHAPTER 7

SECURITIES VALUATION
& INVESTMENT

114
CHAPTER OBJECTIVES

q Understand the basis of general asset

valuations

q Calculate the valuation of financial assets

including bonds and stocks

q Calculate the return on investment in bonds

and stocks.
2
CHAPTER OUTLINE
5.1. Basic valuation

5.2. Bond valuation and investment

+ Bond valuation
+ Yield to Maturity (YTM)

5.3. Stock valuation and investment

+ Types of stocks
+ Common stock valuation
+ Preferred stock valuation

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 5.1. Basic Valuation
• The value of any asset can be expressed in the general form as follows:

!"! !"" !"!"# !"#

q Asset value = ! + " + …+ !"# + #
#$% #$% (#$%) #$%

q CFt: cash flow expected to be generated by the asset in the period t

q r: the return that investors consider appropriate for holding such asset

• The asset value is affected by both CF and r. That is:

Ø The higher the CF, the higher the value of asset and vice versa

Ø The lower the r, the higher the asset value and vice versa

4
5.2. BOND VALUATION & INVESTMENT

5.2.1. Bond review

5.2.2. Bond valuation
+ Annual interest compounding bond ;
+ Semiannual interest compounding bond ;
+ Zero-coupon bond ;

5.2.3. Yield to Maturity (YTM)

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 5.2.1. Bond review

u A long term contract with an agreement that

the issuer’s obligation is to pay interest and
principal on a specific date
Ø Interest rate àcoupon rate. Interest can be
paid monthly, quarterly, semiannually,
annually
Ø The principal à face value of the bond
u Can be issued as bearer bonds or
registered bonds
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 5.2.1. Bond review

u Common bonds:
Ø Government bond: issued by the federal government, a
state or local government. Treasury notes (1 year to 10
years), treasury bond (exceeds 10 years)
Ø Municipal bond: issued by a state or local government
Ø Corporate bonds: issued by corporation. Unlike term
loan, corporate bond can be sold to different investors
Ø Mortgage bond: is secured by fixed assets.
Ø Debenture: unsecured bond, issued by strong
companies
Ø Zero coupon bond: pays no interest but sold at a
discount of par value
Ø Junk bond: corporate bond that have high risk

7
8
5.2.2. Bond valuation

q Annual interest compounding bond

q Semiannual interest compounding bond
q Zero-coupon bond

9
 5.2.2. Bond valuation
ANNUAL INTEREST COMPOUNDING
BOND VALUATION
Annual interest compounding bond:

Ø P: the intrinsic value of a bond (Bond value)

Ø F: face value of a bond
Ø r’: coupon rate
Ø r : discount rate
Ø C: coupon interest payment (= F * r’)
Ø n: number of years until maturity
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 5.2.2. Bond valuation
ANNUAL & SEMIANNUAL INTEREST
COMPOUNDING BOND VALUATION
Ø Annual interest compounding bond:

Ø Semiannual interest compounding bond

(coupon rate & discount rate unit: %/year; n:
number of years until maturity)

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 5.2.2. Bond valuation
EXAMPLE 1

The VIC company issues the 15-year-maturity bond,

with the face value of 1 million VND, and coupon rate of
15%/year. The discount rate is 10%/year. Please
calculate the intrinsic value of the bond in following
cases:
a) Annual interest compounding bond

b) Semiannual interest compounding bond

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 5.2.2. Bond valuation

ZERO-COUPON BOND
Ø Zero-coupon bond – a bond that pays no
interest but sells at a deep discount from its
face value.

Ø P: the intrinsic value of a bond

Ø F: face value of a bond
Ø r : discount rate
Ø n: number of years until maturity
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 5.2.2. Bond valuation
EXAMPLE 2

The ABC company issues the 20-year-maturity

zero-coupon bond, with the face value of 1
million VND. The market required rate of return
is 10%. What is the purchase price that
investors should pay for this bond ?

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 5.2.2. Bond valuation

EXAMPLE 3

In 1995, the SHN company issued the 25-year-maturity

bond, with the face value of 1 million VND, and coupon
rate of 10%/year. The coupon interest is paid annually.
1)Mr. Binh sold the bond in 2005. What was his selling
price in following cases:
a) The discount rate is 10%/ year.
b) The discount rate is 12%/ year.
c) The discount rate is 8%/ year.
2)Ms. Thuy sold the bond in 2019. The discount rate is
12% /year. What was her selling price ?
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 5.2.2. Bond valuation

BEHAVIOR OF BOND PRICES

q A higher bond price is associated with a lower
market required rate of return.
+ The market required rate of return = coupon rate
à intrinsic value of bond = face value (sell at par)

+ The market required rate of return < coupon rate

à intrinsic value of bond > face value (sell at a premium

+ The market required rate of return > coupon rate -

à intrinsic value of bond < face value (sell at discount)

q The price of a bond converges to face value as

time passes (pull to par effect – reduction of
 5.2.2. Bond valuation

INTEREST RATE RISK

q The risk that arises for bond owners from fluctuating interest
rates is called interest rate risk
q How much interest rate risk a bond has depends on how
sensitive its price is to inter-est rate changes
q This sensitivity directly depends on the time to maturity and
the coupon rate.
à All other things being equal, the longer the time to maturity,
the greater the interest rate risk
à All other things being equal, the lower the coupon rate, the
greater the interest rate risk.

17
 5.2.2. Bond valuation

INVESTMENT DECISIONS - BONDS

ØThe intrinsic value of a bond (P) > the

market value of a stock (MP) à should buy
this bond.

ØThe intrinsic value of a bond (P) < the

market value of a stock (MP) à should sell
this bond.

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 5.2.2. Bond valuation
EXAMPLE 10

The bond of REE company is traded in Hanoi

Securities Exchange. The face value of the bond is 1
million VND, and coupon rate is 15% /year. It remains
4.5 years to maturity. The coupon interest is paid
semiannually. The market required rate of return is
10% /year. The current market price of the bond is
1.15 million VND. Please calculate the intrinsic value
of the bond and recommend your investment decision:

147
 5.2.3. Yield to maturity
YIELD TO MATURITY – YTM
ØYTM is the internal rate of return of an investment in
a bond if the investor holds the bond until maturity, with
all payments made as scheduled and reinvested at the
same rate.

Annual interest compounding bond:

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 5.2.3. Yield to maturity

EXAMPLE 11
The annual interest compounding bond of AAA
company has the face value of 1,000,000 VND, coupon
rate of 10% /year. Ms. Hien buys the bond at the market
price of 980,000 VND. The bond remains 5 years to
maturity. Please compute the yield to maturity of Ms.
Hien:

149
 YIELD TO CALL– YTC
q Yield to call (YTC):

• The average rate of return earned on a bond if it is held until

the first call date

• Call price is the price that the issuer must pay to the
bondholder to recall the bond

v Ex: finding YTC of 05 years callable bond that pays 100,000

annually and investors pay 900,000 VND for the bond. Issuer
pays 1,050,000 VND to retire the bond at the end of year 2

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 5.3. Stock valuation and investment
5.3.1. Dividend Discounted Model
(DDM)
+ No growth stocks ;
+ Constant growth stocks ;
+ Growth phases stocks ;

5.3.2. Price-Earnings (P/E) method

5.3.3. Discounted Cash Flow model

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 5.3. Stock valuation & Investment
TYPES OF STOCKS
COMMON STOCK PREFERRED STOCK
1. Common stock gives voting 1. Preferred stock gives no
rights to shareholders voting rights to shareholders

2. Promises a unfixed 2. Promises a fixed dividend

dividend. in perpetuity.
3. Common shareholders are 3. Preferred shareholders are
paid dividends after preferred paid dividends before common
shareholders. shareholders.
4. Common stockholders are 4. Preferred shareholders are
last in line for the company’s paid out before common
assets. shareholders when the
company must liquidate assets.
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 5.3. Stock valuation & Investment

5.3.1. Dividend Discounted Model (DDM)

Apply Dividend Discounted Model into 03
scenarios:

v Zero growth model ;

v Constant growth model ;
v Non-constant growth model ;

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 5.3.1. Discounted dividend model
COMMON STOCK VALUATION
FOR 1-YEAR INVESTMENT
Expected return identification (r)

Common stock value for 1-year investment

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 5.3.1. Discounted dividend model
COMMON STOCK VALUATION
FOR n-YEAR INVESTMENT

n-year later:

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 5.3.1. Discounted dividend model
COMMON STOCK VALUATION - DDM

Investors buy stocks and hold for dividends:

(P0: intrinsic value of the stock)

Common stock valuation process:

Step 1: Estimating the expected dividends in the future

Step 2: Calculating the discount rate (r)

Step 3: Determining present value of the expected

dividends with the discount rate estimated.
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 5.3.1. Discounted dividend model
INVESTMENT DECISIONS - STOCKS

ØThe intrinsic value of a stock (P) > the

market value of a stock (MP) à should buy
this stock.

ØThe intrinsic value of a stock (P) < the

market value of a stock (MP) à should sell
this stock

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 5.3.1. Discounted dividend model

DISCOUNT RATE
CAPM formula:

r = rf + β * (rm – rf)

r : expected return of the stock ;

rf : risk-free rate ;
rm : expected return of the market portfolio;
β : Beta coefficient.

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 5.3.1. Discounted dividend model
ZERO GROWTH STOCK VALUATION

v A company will pay constant annual

dividends in perpetuity.
v Normally used to value preferred
dividend stock

D = D1 = D2 = … = Dn = … = D∞

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 5.3.1. Discounted dividend model
ZERO GROWTH STOCK VALUATION

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 5.3.1. Discounted dividend model

EXAMPLE 13

The company A has just paid annual dividend of 3,000

VND /share. The company intends to maintain this
amount of annual dividend in many years. The risk-free
rate is 7%, the expected market return is 12% and the
Beta coefficient is 0.8. The current market price of stock
A is 20,000 VND/share. Please calculate the intrinsic
value of stock A and recommend your investment
decision ?

125
 5.3.1. Discounted dividend model
CONSTANT GROWTH STOCKS (GORDON)
Assumptions:
Ø The dividends grow at a constant growth rate (g = constant).
Øg<r

D0 is the dividend just paid, then the next dividend is D1

The intrinsic value of a constant growth stock:

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 5.3.1. Discounted dividend model
CONSTANT GROWTH STOCKS (GORDON)

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 5.3.1. Discounted dividend model
CONSTANT GROWTH STOCKS (GORDON)
Estimating the growth rate
Assumptions:
Ø The growth rate in dividends is also the growth rate in
earnings under the assumption that the dividend payout
ratio remains constant (g=constant)
Ø The future retention ratio is equal to the past retention ratio
Ø The expected return on current retained earning is equal to
the past return on equity which is known as ROE
Ø Earning next year = Earning this year + Retained Earning
this year * Return on Retained Earning
Ø g = Retention Ratio * ROE

(RR - Retention ratio is the proportion of earnings kept back in

the business as retained earnings)
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 5.3.1. Discounted dividend model

EXAMPLE 14

The DHG company has just paid annual dividend of 1,000

VND/share. The return on equity (ROE) is always 20%.
The ratio of dividend to earning is always 60%. The risk-
free rate is 7%, the expected market return is 12%
and the Beta coefficient is 1. The current market price
of DHG stock is 40,000 VND/share. Please calculate
the intrinsic value of DHG stock and recommend your
investment decision ?

128
 5.3.1. Discounted dividend model
NON-CONSTANT GROWTH STOCKS

Assumption: Dividend is expected to grow at

non-constant rate in some period before
heading to the normal growth

Ø Step 1: Find the present values of all the non-

constant growth dividends.
Ø Step 2: Compute price of stock at the end of
non-constant growth period based on the
normal growth. Then discount its price to
present value
Ø Step 3: Sum all the present values in step 1
and step 2 129
 5.3.1. Discounted dividend model
EXAMPLE 15

Example:
BID has just paid annual dividend of 4,000 VND/share. In the
next 2 years, the dividend growth will be expected at
15%/year. From year 3, shareholders anticipates that
dividend will rise at 5%/year. The discount rate is 12%. What
is the intrinsic value of stock BID?

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 5.3.1. Discounted dividend model

EXAMPLE 16

The CVT company has just paid annual dividend of 2,000

VND/share. In next 2 years, the dividend growth will be
expected at 10% /year (g1). From year 3, the dividend
growth will be expected at 5% /year (g2). The discount
rate is 12%. Please calculate the intrinsic value of the
CVT stock:

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 5.3.1. Discounted dividend model
EXAMPLE 17

The HPG company has just paid annual dividend of 3,000

VND/share. In next 2 years, the dividend growth will be
expected at 15% /year. In year 3, the dividend growth will be
10% /year. From year 4, the dividend growth will be
expected at 5% /year. The discount rate is 12%. Please
calculate the intrinsic value of the HPG stock ?

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 5.3.1. Discounted dividend model

LIMITATIONS OF DDM
Ø The DDM can not apply when the valuing firm
retains most its earnings rather than distributes
them as dividend.

Ø The DDM may result in an inaccurate valuation

of a firm because of potential errors in
determining:
+ The dividends in the future ;
+ The discount rate (required rate of return by
investors).
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 5.3.1. Discounted dividend model

LIMITATIONS OF DDM
Ø Growth in some companies is always non-
constant
Ø Some firms do not pay dividends (e.g.
Apple, Google, Ebay until quite recently, and
Amazon has never paid a dividend)
Ø The payout is sometimes financed through
stock purchases
ü Works best when a firm has a fixed payout
ratio (dividend/earnings)
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5.3.2. PRICE-EARNINGS (P/E) METHOD

P = P/E comparison * EPS expected

Ø P: the intrinsic value of a common stock

Ø P/E comparison is the mean P/E ratio of all
publicly traded competitors in the respective
industry ;
Ø EPS expected: the expected earnings per share
next year (year 1).

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 5.3.2. P/E Method

LIMITATIONS OF P/E METHOD

Ø The P/E method may result in an inaccurate
valuation of a firm because of potential
errors in determining:

+ The forecast of the firm’s future earnings ;

+ The choice of the industry to derive the

P/E comparison ratio (Ex: a company operates in
several different kinds of industries, a
company has unique business…).

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 5.3.2. P/E Method

EXAMPLE 18

The current market price of the HSG steel

company is 33,000 VND/share. The expected
EPS will be 3,500 VND/share next year. The
mean P/E ratio of the steel industry is 12. Please
calculate the intrinsic value of HSG stock and
recommend your investment decision:

135