Bond & Stock Valuations

Kiran Thapa

Bond Valuation

Bond valuation is the process of determining the fair

price of a bond.

The value of a bond is a function of

Amount and timing of expected cash flows,
Riskiness of the cash flows, and
Investor's required rate of return

Bond's value, also called intrinsic value.

contd.

Bond Price can be calculated as:

V0 = C PVIFAy, n + M PVIFy, n

The basic decision rule can be stated as follows:

IF

THEN

REASON

V0 >P0

Buy

Under valued

V0 <P0

Dont Buy

Over valued

V0 =P0

Indifferent

Correctly Priced

Where, V0 = Present value of the bond,

determined by using the appropriate
discount rate; P0 = Market price of the bond.

Bond Valuation
Valuation of Perpetual Bond

Perpetual bond are issued for infinite period.

The perpetual bond, also known as consol bond,

Pays a specified amount of interest every year forever

and never returns the face value or principal.

For example, the British government issued perpetual

bonds called consol to refinance the debt that was
issued to support the Napoleonic wars.

contd.

The value of a perpetual bond would equal to the

present value of an infinite stream of interest payments,
denoted as C, which is discounted at investors required
rate of return, y.

Mathematically

On simplification,

Where, C=interest payment, y=cost of debt

contd.

Valuation of Redeemable Bond

Redeemable bond has finite maturity period.

Firm will pay annual fixed amount of coupon interest

and repay the principal after maturity.

The value of a bond (V0) is the present value of its

periodic stream of interest payments plus the present
value of its maturity value.

contd.

Mathematically,

contd.

Valuation of Zero Coupon Bond

A zero coupon bond, as the name suggests, pays no

interest on a periodic basis.

Since a zero coupon bond does not earn interest, it is

sold at a discount from its face value.

Mathematically,

Bond Yields

Bond yields and interest rates are the similar concept.

Interest rates measure the price paid by a borrower to

a lender for the use of resources over some time period,
i.e. interest rates are the price for loanable funds.

The price differs from case to case, based on the

demand and supply for these funds, resulting in a wide
variety of interest rates.

contd.

Coupon Yield

The coupon yield is simply the coupon interest payment

stated as a percentage of the face value.

Coupon yield remains constant over the life of the

bond.

This yield is also known as nominal yield and

calculated as follows.

This yield ignores time value of money and capital

gain or losses

contd.

Current Yield

The current yield describes the yield on a bond based

on the coupon rate and the current market price of the
bond (not on its face value or par value).

It is the amount of coupon interest payment stated as a

percentage on market price of bond.

This yield ignores time value of money and capital

gain or losses

contd.

Holding Period Return

The period during which an investor owns an

investment is called its holding period, and the return
for that period is the holding period return (HPRt).

Holding period return includes the return in the form

of appreciation in the value and current income of the
bond.

It is calculated as follows:

Where, P0 = Beginning or purchase price P1=Ending

contd.
Yield to Maturity

Yield to maturity is the annualized rate of return from

the bond investment, if the bond is held until maturity.

It is the interest rate that equates the present value of

the bond's payments with the current market price of
the bond.

Yield to maturity evaluates both the interest income

and price appreciation.

Other things being equal, higher the yield to maturity

of an issue, the more attractive it is to the investor.

contd.

Assumptions:

The bond will be held until maturity, and

Coupons are immediately reinvested at yield to

maturity

The bond will not be called or redeemed by the issuer

before the maturity and

All cash flows (interest and principal) will occur as

indicated in the indenture (i.e., the issuer will not
default on the contractual obligation).

contd.

Computation of Yield to Maturity

Using Approximate Method

contd.

Using Trial And Error Method

Step 1: Calculate approximate yield to

maturity.

Step 2: Calculate the value of bond (or total

present value of bond) at low and high rate
using bond valuation formula.
V0 = C PVIFAy, n + M PVIFy,n

Step 3: Calculate the net present value at

low and high rate.
NPV = V0 Market price

contd.

Step 4: Interpolate the values calculated at

low and high rate. The interpolation formula
is:

Decision rule:
IF

THEN

REASON

y > Minimum required rate of

return

Buy

Undervalued

y < Minimum required rate of

return

Dont
Buy

Overvalued

contd.

Yield To Call(YTC)

Yield to call is the annualized rate of return that an

investor would earn if he/she bought a callable bond at
its current market price and held it until the call date
given that the bond was called on the date.

Yield to call is also known as yield to first call. Yield to

call is computed under the assumption that

The bond will be held to the call date.

Coupons are reinvested at the yield to call rate.

The issuer calls the bond on the call date

contd.

Computation of Yield to Call

Using Approximate Method

contd.

Using Trial And Error Method

Step 1: Calculate approximate yield to call.

Step 2: Calculate the value of bond (or total present

value of bond) at low and high rate using bond
valuation formula.
V0 = C PVIFAy, nc + Pc PVIFy,nc

Step 3: Calculate the net present value at low and

high rate.
NPV = V0 Market price

Step 4: Interpolate the values calculated at low and

high rate. The interpolation formula is:

Interest Rate Risk

The risk in bond prices due to fluctuations in interest

rates.

Interest rate risk consists of price risk and

reinvestment risk.

As interest rate increases, bond prices decline (price

risk) but the future value of reinvested coupons
increase (reinvestment rate risk), and vice versa.

It is noted that reinvestment effect does not exist for

zero coupon bonds.

Preferred Stock

Preferred stock is a hybrid security having some

characteristics of debt and some of equity.

Preferred dividends are similar to interest payments on

bonds in that they are fixed in amount and generally
must be paid before common stock dividends can be
paid.

Preferred stocks may be issued with or without a

maturity period.

contd.

Valuation of Perpetual Preferred Stock

Perpetual preferred stock has infinite period.

The value of a stock of perpetual preferred stock is

found as the dividend divided by the required rate of
return.
P0 =Dp / kp

Where, DP = Preferred stock dividend; P0 = Value of

preferred stock; kP = Required rate of return on
preferred stock.

contd.

Valuation of Redeemable Preferred Stock

Redeemable preferred stock has finite maturity period.

The value of a stock of redeemable preferred stock is

the present value of its dividend payments plus the
present value of its par, or face value.

Common Stock

Common stock represent the ownership interest.

Common stock holder are the true owner of the

corporation.

Common stock holder has limited liability, residual

claim, and voting right.

Common stock are entitled to received dividend that

varies with the earning

Common Stock Valuation

Known as the capitalization of income method.

The capitalization of income method of valuation states

that the intrinsic value of any asset is equal to the sum
of the discounted cash flows that the investors expect to
receive from that asset.

Intrinsic value (P0) of an asset is equal to the sum of the

present values of the assets expected cash flows:

Where Ct= expected cash flow associated with the asset at time t;
ks =appropriate discount rate or capitalization rate

contd.

To use this model, an investor must estimate the

following:

Estimate an appropriate required rate of return.

Estimate the amount and timing of the future stream

of cash flows.

Use these two components in a present value model

to estimate the value of the security,

Which is then compared to the current market price

of the security.

Dividend Discount Model

DDM define as an intrinsic value of a share as
the value of future dividend
Assumptions

The dividends must be paid out of retained earnings.

The appropriate discount rate remains fixed.
The internal rate of return remains constant.
The retention ratio remains fixed.
The growth of earnings (g) is assumed constant.
The growth rate of earnings is smaller than the
appropriate discount rate.
Taxes are assumed to be nonexistent.
The firms stream of earnings is assumed to be
perpetual; that is, there is no finite holding period.

contd.

The Zero Growth Model

If the firms future dividends are expected to remain

constant forever, then zero growth model is used to
determine the value of common stock.

The stock price would be equal to the annual dividends

divided by the required rate of return.

Mathematically,

contd.

The Constant Growth Model

If a firms future dividend payments per share are

expected to grow at a constant rate per period forever.

The dividend at any future time period t can be

forecast as follows:
Dt = D0 (1 + g)t

Where D0 is the dividend in current period (t = 0).

The expected dividend in period 1 is D 1 = D0 (1 + g)1,
the expected dividend in period 2 is D2 = D0 (1 + g)2,
and so on.

contd.

This model is work on the following assumptions.

The investor buys and holds the share forever.

The dividends from the share grow at a constant rate.

The required rate of return is greater than the dividend

growth rate.

contd.

Using this model, the current price (P0) is

determined as follows:

Where,
P0 is the intrinsic or theoretical or value of the stock
today,
D1 is expected dividend,
ks is required rate of return demanded by investor
on common stock, and g constant dividend growth
rate (steady state growth rate)

contd.

Limitations:

The model can be used only if the dividend growth rate

is expected to remain constant every year forever.

If the dividend growth rate is more than the required

rate of return, the model can not be used since the value
of the stock will become negative.

If the dividend growth rate is equal to the required rate

of return, the model can not be used since the value of
the stock will become infinity.

Growth Rate in Constant Growth

Model

USING HISTORICAL DIVIDENDS:

We can use the estimated growth rate as a proxy for the
companys expected future dividend growth rate.
Dt = D0 (1 + g)t
Where
D = Dividend at time t
t

G = Expected growth rate in dividends.

contd.

USING HISTORICAL EARNINGS:

We can estimate the dividends growth rate based on
the earnings growth (using the point-to-point
estimation method from before).
Et = E0 (1 + g)t
Where
E = Earnings per share at time t
t

G = Expected growth rate in Earnings.

contd.

USING RETURN ON EQUITY (ROE):

This is also known as the sustainable growth method.

It is based on three assumptions:

the company wants to grow as fast as possible;

management does not want to (or cannot) issue any

new equity; and

the company want to maintain both its capital

structure and dividend policies.

contd.

The following equation shows how the growth

rate can be estimated:

Multiple Growth Model

Known as non-constant growth model or variable growth

model.

In evaluating a firm with an initial pattern of supernormal

growth, we first take the present value of the dividends
during the exceptional growth period.

We determine the price of the stock at the end of

supernormal growth period by taking the present value of
the normal, constant dividends.

We discount this price to the present and add it to the

present value of the supernormal dividends.

contd.

The current price of the stock is:

P0 = PV of dividends + PV of terminal value

Mathematically,

Where,
Horizon value
g is supernormal growth rate; g is normal or
s
c
constant growth rate and Pn is the horizon value.

Any queries?

?
Thank You

Problems
Problem 1
Chaudhari Industries 15-year, Rs 1,000 par
value bonds pay 8 percent interest annually.
The market price of the bonds is Rs 1,085, and
your required rate of return is 10 percent. a.
a.Compute the bonds yield to maturity.
b. Should you purchase the bond?

Problems
Problem 2
Six years ago, The Singer Company sold a 20year bond issue with a 14 percent annual
coupon rate and a 9 percent call premium.
Today, Singleton called the bonds. The bonds
originally were sold at their face value of Rs
1,000. Compute the realized rate of return for
investors who purchased the bonds when they
were issued and who surrender them today in
exchange for the call price.

Problems
Gandak Motors common stock currently pays an
annual dividend of Rs. 1.80 per share. The required
return on the common stock is 12 percent. Estimate the
value of the common stock under each of the following
dividend growth rate assumptions:
a. Dividends are expected to grow at an annual rate of
zero percent to infinity.
b. Dividends are expected to grow at a constant annual
rate of 5 percent to infinity.
c. Dividends are expected to grow at an annual rate of 5
percent for each of the next 3 years followed by a
constant annual growth rate of 4 percent in years 4 to
infinity.

problems
Everest Bank wishes to estimate the value of its
outstanding preferred stock. The preferred issue has an
Rs.80 par value and pays an annual dividend of Rs.6.40
per share. Similar-risk preferred stocks are currently
earning a 9.3 percent annual rate of return.
a. What is the market value of the outstanding preferred
stock?
b. If an investor purchases the preferred stock at the
value calculated in a, how much would she gain or lose
per share if she sells the stock when the required return
on preferred has risen to 10.5 percent? Explain.