VALUATION OF STOCKS & BONDS BFINMA2: FINANCIAL

MANAGEMENT P-2
WHAT IS A BOND?
- A long-term debt instrument in which a borrower agrees to
make payments of principal and interest, on specific dates, to
the bondholders.
KEY FEATURES OF A BOND
Par value – face amount of the bond, which is paid at maturity.
Coupon interest rate – stated interest rate (generally fixed) paid by
the issuer. Multiply by par to get peso payment of interest.
Issue date – when the bond was issued.
Maturity date – years until the bond must be repaid.
Yield to maturity - rate of return earned on a bond held until
maturity (also called the “promised yield”).
Required return- is the actual rate received by the bondholder and is
sometimes referred to as discount rate, effective rate or market rate
of return.
OTHER TYPES (FEATURES) OF BONDS
Convertible bond – may be exchanged for common stock of
the firm, at the holder’s option.
Warrant – long-term option to buy a stated number of
shares of common stock at a specified price.
VALUATION OF BONDS
Is the process of determining the amount of the security at the time the
bond is issued.

−𝑛
1 − (1 − 𝑖)
𝑉𝐵 = Face value (1 + 𝑖)−𝑛 +Interest payment
𝑖
EXAMPLE
On January 1, 2018, Mahal Co. sold face value bonds
worth P500,000 with a required return of 12%. The
bond will mature 10 years with 12% interest payable
annually every January 1. What is the value of the bond?
BOND DISCOUNT
 If the selling price of the bond is less than its par value.
The required rate of return exceeds the nominal rate.
EXAMPLE
On January 1, 2018, Ayaw Nya Co. sold face value
bonds worth P500,000 with a required return of 12%.
The bond will mature 10 years with 10% interest
payable annually every January 1. What is the value of
the bond?
BOND PREMIUM
 If the selling price of the bond is more than its par value.
The required rate of return is less than the nominal rate.
EXAMPLE
On January 1, 2018, Humanap Ng Iba Corp. sold face
value bonds worth P500,000 with a required return of
12%. The bond will mature 10 years with 15% interest
payable annually every January 1. What is the value of
the bond?
FACTORS AFFECTING THE CHANGES IN THE PRICES
OF BONDS:
Required return
Time
REQUIRED RETURN AND BOND PRICE
EXAMPLE
Maghanap Ng Iba Inc. issued a bond with a par value of
P100,000. The coupon rate is 10% with interest payable
every year for 10%. Determined the value of the bond
using the following required rate of return: 6%, 7%, 8%,
9%,10%,11%,12%,13%,14% and 15%.
IMPACT OF TIME ON THE BOND PRICE
A P1,000 par value bond pays a 10% annual interest.
Determine the value of the bond that will mature in 2 years
whose required return is the following: 6%, 10% and 14%.
BY WAY OF CONCLUSION:
If the required rate of return (effective rate) is higher than the
coupon rate (nominal rate), then the longer the maturity, the lower
the price of the bond.
If the required rate of return (effective rate) is lower than the
coupon rate (nominal rate), then the longer the maturity, the higher
the price of the bond.
SEMI-ANNUAL PAYMENT OF INTEREST
On January 1, 2018, Lumaban Inc. sold face value bonds worth
P1,000,000 with a required rate of return of 9%. The bonds will
mature in 20 years with a 6% interest payable annually every
January 1 and July 1. Determine the value of the bond.
YIELD TO MATURITY (YTM)
Is the expected rate of return of the bond if it is held by the
bondholder from the time of purchase until the time of maturity.
YTM will always equal to the coupon rate if the selling price is
equal to the par value of the bond.
YTM considers not only the interest payments made by the issuer
but also the capital appreciation of the bond from the time it was
purchased until the date it matures.
YIELD TO MATURITY (YTM)
EXAMPLE
A bond selling in the market for P1,050,000 will mature in
10 years and pay interest semi-annually. The par value of
the bond is P1,000,000 with a coupon rate equivalent to
6%. What is the bonds yield to maturity?
SIMPLE APPROACH IN OBTAINING YTM

𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒 −𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐵𝑜𝑛𝑑

𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡+
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑃𝑒𝑟𝑖𝑜𝑑𝑠
𝑌𝑇𝑀 = 𝑃𝑎𝑟 𝑣𝑎𝑙𝑢𝑒+𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
2
EXAMPLE
On January 1, 2018, X Mo Co. issued 10%, 5-year bond
with a face value of P100,000 at P97,500. Compute the
yield to maturity.
YIELD TO CALL (YTC)
Is a provision entitling the issue to the right to call the bond
before the maturity date.
It is clearly stated in the bond indenture.
The call provision helps a firm to reduce its coupon payments
when the interest rate declines in the market.
CURRENT YIELD
Is the current ratio of the interest received per year divided by
the current market price of the bond.
Is not a good indicator of the investor’s expected rate of return
because it fails to recognize the capital gain or loss in the value
of the bond per year.

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐵𝑜𝑛𝑑
WHAT IS COMMON OR ORDINARY STOCK?
 are shares that represent a normal equity ownership in a company.
VALUATION OF COMMON STOCKS
It is measured by a shareholder as the present value of an
expected stream of future dividends in addition to the present
value of the future price of stocks at the time of sale.
GENERAL COMMON STOCK VALUATION MODEL
For an investor holding a common stock for one year, the value of his/her stock
is the present value of both the expected cash dividend to be received in one
year and the expected market price per share of the stock at the end of the
year (Shim, 2007).

𝑃0 = 𝐷𝑡 (1 + 𝑘𝑒 )−𝑛 + 𝑃𝑡 (1 + 𝑘𝑒 )−𝑛
Where:
𝑃0 - price of stock at year zero
𝐷𝑡 - dividend per share at the end of year t
𝑘𝑒 - required rate of return on the share
n – number of periods
EXAMPLE
Mr. Kupido purchased common stock X at the beginning of the
year. The dividend at the end of the year is expected to be P2.50
per share and the market price is expected to be P60. If the
investor’s required rate of return is 15%, what is the value of the
common stock?
THE GROWTH FACTOR
Growth is realized through infusion of new capital.
Capital increases by means of issuing bonds or new shares of stocks
The growth factor is attributed to two sources, namely external (i.e.
issuance of bonds and stocks) and internal (i.e. reinvestment of the firm’s
partial or entire net income)
There are three kinds of growth:
No Growth
Constant Growth
Variable Growth
NO GROWTH
This valuation assumes that the dividends are not growing at all. Thus, the amount of
dividends declared is constant.

𝐷1
𝑃0 =
𝑘𝑒
EXAMPLE
Nagpalaya Inc.’s common stock has paid a P5 dividend for so
long that investors are now convinced that the stock will
continue to pay that annual dividend forever. If the next
dividend is declared in 1 year and the investors require a
10% return on the stock, what is the stock’s expected price at
year 0? What is the price immediately after the next dividend
payment?
CONSTANT GROWTH MODEL (GORDON'S GROWTH
MODEL)
When valuing stocks with a constant growth, a certain percentage of net
income is reinvested in the firm and it is expected that dividends will grow
at a constant rate.
To be valid, the growth rate must be less than the required rate of return.

𝐷1
𝑃0 =
𝑘𝑒 − 𝑔
Note that for the model to be valid, the following conditions should be met:
The firm must have a constant dividend growth rate (g).
The discount rate (𝑘𝑒 )must not be less than the growth rate (g).
EXAMPLE
Nilayuan Corp. expects the dividends for the year to be P10 a
share. The required return is 13%. The growth rate is expected
to be constant at 8%. What is the price per share?
VARIABLE GROWTH MODEL
It is used if the firm is expected to grow at a rapid rate for few
years and then revert to the normal growth rate.
This situation occurs when a firm develops a new product that is
expected to be highly successful and profitable.
EXAMPLE
A firm paid a dividend over the last 12 months of P1.67 (represents the current
dividend). Dividends are expected to grow by 20% each year over the supernormal
growth period of three years. On its 4th year, the dividend expected to grow at a
normal constant rate (g) of 5%. The required return is 9%.
VALUATION OF PREFERRED STOCKS
Valuing a preferred stock is similar to valuing a bond.
By nature, a preferred stock receives a fixed dividend before a
common stock does.
It does not consider growth like common stock.
𝐷1
𝑃𝑝 =
𝑘𝑝
Where:
𝑃𝑝 - value of the preferred stock
𝑘𝑝 - required rate of return
EXPECTED RATE OF RETURN ON STOCKS
The expected rate of return is the rate of estimated income derived from investing
stock.
It is obtained by adding the dividend and the price of the stock after a year less
the purchase price of the stock over the purchase price.

𝐷1 + 𝑃1 − 𝑃0
𝐸𝑟 =
𝑃0
EXAMPLE
Consider a stock that sells for P50. The company expected
to pay a P3 cash dividend at the end of the year, and the
stock’s market price at the end of the year is expected to be
P55 a share. What is the expected return?
OTHER VALUATION TECHNIQUES
There are other ways of valuing stock, namely:
Price/Earnings ratio
Book value ratio
Liquidation value per share
PRICE/EARNING (P/E) RATIO
It reflects the amount that an investor is willing to pay for each peso earning.
In this technique, the P/E ratio and the earnings per share are already known by the
company.
If it decides to sell the stock to an interested party, it will use the formula of the P/E
ratio to determine the market price per share.

𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

𝑃/𝐸=  Market Price per Share = 𝐸𝑃𝑆 𝑥 𝑃/𝐸
𝐸𝑃𝑆
EXAMPLE
A firm has an EPS of P15. It is expected that the
company’s stock should sell at 5 times its earnings. What is
the market price per share?
BOOK-VALUE RATIO
In this technique, the price of the share is determined by dividing the
shareholders’ equity less the preferred shares by the common shares
outstanding.
This approach does not measure the true value of the stocks
accurately.
The figures used in this model are obtained from the financial
statement whose value are recognized at historical cost.
The earning potential of the firm is ignored and its relationship with
the market value is not shown.
EXAMPLE
The asset of a firm total P10,000,000 and its liabilities total
P3,500,000. Overall, the firm has outstanding shares of
325,000 common stocks and no preferred stocks. What is the
value of the stocks?
LIQUIDATION VALUE PER SHARE (LVPS)
It is the expected liquidating value of all the assets less the
liabilities and the preferred shareholders’ equity divided by the
common shares outstanding.
This valuation model is more realistic that the book value because
it takes consideration the market value of asset.
However, LVPS tends to ignore the earning power of the firm.
EXAMPLE
A firm has a current value (expected to be liquidating value) of
all its assets of P15million while its total liabilities is P11million
and the total preferred equity amounts to P2.5million. The firm
has currently 200,000 shares outstanding. What is the value of
the stocks?
CORPORATE VALUATION MODEL
It is used as a substitute of the discounted dividend model to
determine the firm’s value, especially if the firm has no history of
dividend declaration.
Based on the free cash flow, this method considered a strong
analytical tool because it concentrates on the cash generation
potential of the business.
This uses the fturue free cash flow of the company discounted by
the firm’s WACC after deducting the long-run growth rate of free
cash flow.
 CORPORATE VALUATION MODEL
The free cash flow is computed as follows:
𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇 1 − 𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 + 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

The market value of the company:

𝐹𝐶𝐹𝑛
𝑀𝑉 =
𝑊𝐴𝐶𝐶−𝑔𝐹𝐶𝐹
Where:
FCFn = free cash flow for n periods
WACC= weighted average cost of capital
𝑔𝐹𝐶𝐹 = long-run growth rate of free cash flow
EXAMPLE
May Bukas Pa Co. forecasts that it will have the free cash flows: Year
1- P(20million); Year 2- P48milllion; Year 3- P52million. If the
weighted average cost of capital is 14% and the free cash flows are
expected to continue growing at the same rate after year 3 as from
years 2 to 3, what is the year 0 value of operations (in millions)?
THANK YOU!  /NABergonia2018