Security Valuation

DCF Approach to
Stock and Bond Valuation
 DCF Valuation
• In general, the value of a security is the sum of the present
values of the (expected) future cash flows that accrue to the
owner (or purchaser) of that security.
– Expected cash flows since we ultimately will have to be concerned
about risk.
– The presence of risk implies we must use a discount rate consistent
with market conditions and appropriate for the risk involved.
– Different discount rates may be appropriate for different cash flows
generated by the same asset.
– Discount all future cash flows to the present and the sum of the
present values equals the securities current value.
• Correct application of this approach may be used to value
all the securities you will come across. For some securities
(i.e. options and other derivatives) there are easier ways.
 Bond Valuation - Terminology
• Face or par value (F), is the promised payment at maturity.
• Coupon interest: The bond is quoted as a coupon rate of C per
year and usually makes actual payments of C/2 every 6 months.
C/F is defined as the coupon interest rate, a rate that is constant
over the life of the bond.
• Call provision, call protection, call premium.
• Default risk.
• Discount rate, r, the market determined appropriate rate of return.
• Yield to maturity (yield) is the single discount rate that equates
the present value of the bond’s promised payments and its market
price, V.
• Current yield is defined as C/V.
 Pure Discount Bonds
• Pure discount bonds are the simplest bonds possible. They
pay no interest and promise only to return the face value at
maturity.
• Wrinkle: in the bond market we always presume semi-
annual compounding.
• T-bills (up to a year in maturity) and Strips.
F
Valuation formula : V  ; T is years to maturity
(1  2 )
r 2T

– The value of a three year $1,000 face value treasury strip, when
the market rate is 6%, is
$1,000
V 6
 $837.48
(1.03)
 Level Coupon Bonds
• Level coupon bonds are the most common type of
bond. They pay a semiannual (fixed) coupon,
quoted as C per year, face of F, T years to
maturity, and an annual discount rate of r.
• We can think of there being two components of
this valuation:
– The coupon payments comprise an annuity.
– The lump sum payment of the face value at maturity is
like a pure discount bond.
 Level Coupon Bonds cont…
Yr 1 2 T-1 T
0

C/2 C/2 C/2 C/2 C/2 C/2 C/2 C/2

• The two pieces: +F
– Annuity of C/2 for 2T periods (a period is 6 months).
– Lump sum of F at the end of 2T periods.
C  1 1  F
P0 =
2  r / 2  (r / 2)(1  r / 2) 2T  2T
  (1+ r / 2 )
• Technical note: r is the stated annual discount rate (YTM) and we
are using semiannual compounding. This is the current value
assuming you receive the first coupon in 6 months.
 Bond Pricing Example
• Dupont issued 30-year bonds with a coupon rate
of 7.95%. These bonds currently have 28 years
remaining to maturity (the next coupon is to be
paid in 6 months) and they are rated AA. Newly
issued AA bonds with similar maturities currently
have a yield to maturity of 7.73%. The bonds have
a face value of $1000. What is the value of this
Dupont bond today?
 Bond Pricing Example cont…
• Annual coupon payment = 0.0795*$1000=$79.50
• Semiannual coupon payment = $39.75 = $79.50/2
• Semiannual discount rate = 0.0773/2 = 0.03865
• Number of semiannual periods = 28*2 = 56
 1 1 
V0 = 39.75  0.03865 (0.03865)(1  0.03865) 56  

 
1000
 $1025.06
(1  0.03865) 56

• Why is this more than $1,000?

 Bond Prices and Interest (Discount) Rates

 When The Discount Rate Is Equal To The Coupon Rate

The Bond Will Sell At Par
 When The Discount Rate Is Above The Coupon Rate The
Bond Will Sell At A Discount To Par
 When The Discount Rate Is Below The Coupon Rate The
Bond Will Sell At A Premium To Par
 At The Instant Before Maturity All Bonds Sell At Par
• Why Do These Relations Hold?
• What Feature Of A Bond Is The Primary Determinant
Of Its Price Sensitivity To Interest Rate Changes?
 Bond Prices and Time to Maturity
1600.00

1400.00

1200.00
Price

1000.00
7%
800.00
10%
600.00 13%
30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0
Years to Maturity

Discount Rates
What is the coupon rate? Or Yields to Maturity
 Term Structure of Interest Rates
• We have been talking (and we will commonly continue
to talk) as if the interest rate is constant across all future
periods.
• One look at the WSJ bond pages and you know I’m
lying to you.
• Its not only because I enjoy doing so.
• We shouldn’t leave this discussion without introducing
the term structure of interest rates.
• The term structure of interest rates is the structure of
yields on debt instruments which differ only in their
times to maturity.
The Yield Curve

http://finance.yahoo.com/bonds
The Yield Curve
 Measuring the Term Structure
• We have been dealing with “spot rates,” and thinking of
the same “spot rate” for each maturity (the same r for all
time periods). What do we do knowing they can differ?
• The formulas are the same, we just need to include a
subscript to denote different maturities. A T year zero:
1
F F 2T
P0  and rT  2  2
(1  rT
2 ) 2T
 P0 
• Knowing the face value and price you can calculate the
spot rates or knowing face and the spot rate you can
calculate the price of the zero’s with different maturities.
 Examples
• Suppose that a two year zero has a face of $1,000 and a
current price of $800. What is the two-year spot rate?
1
 $1,000 
4
r2  2   2  2(1.25)  2  11 .47%
1/ 4

 $800 
• Once we have computed all the spot rates (term structure)
we can find the current value of any stream of cash flows.
• A government bond that matures in 2 years promises to
pay a coupon of 6%. The spot rate for a ½ year cash flow
is 6% for a 1 year cash flow is 6.2%, for an 18 month cash
flow is 6.4% and for a 2 year cash flow is 6.5%. Find the
current value (price) of the bond.
$30 $30 $30 $1,030
P0  1
 2
 3
 4
 $990.95
(1.03) (1.031) (1.032) (1.0325)
 Yield to Maturity (or Call)
• The yield to maturity is the discount rate that equates the
bond’s current price with its stream of promised future cash
flows. It is useful in that it is a single descriptive interest
rate entirely intrinsic to the bond.
• This is the yield that you would receive for the maturity of
the bond if you held the bond to maturity (and were able to
reinvest the coupon payments at this rate).
– Introduces reinvestment risk.
• The yield to call is the discount rate that equates the bond’s
current price with its stream of promised cash flows until
the expected call date (a discussion for advanced classes).
– Given two bonds, equivalent in all respects except that one is
callable, which bond will have a higher price?
 YTM – Example
• On 9/1/95, PG&E bonds with a maturity date of
3/01/25 and a coupon rate of 7.25% were selling
for 92.847% of par, or $928.47 per $1,000 of face
value. What is their YTM?

• Semiannual coupon payment = 0.0725*1000/2 =

$36.25.
• Number of semiannual periods to maturity
= 30*2 – 1 = 59.
 YTM – Example cont…
 1 1  1000
$928.47 = $36.25  59 

 r / 2 ( r / 2 )(1  r / 2)  (1 + r / 2 )
59

• r/2 can only be found by trial and error. However,

calculators and spread sheets have algorithms to
speed up the search.
• Searching reveals that r/2 = 3.939% or a stated
annual rate (YTM) of r = 7.878%.
• This is an effective annual rate of:
(1.03939)  1  8.03%
2
 Reinvestment and YTM
• The yield to maturity as an approximation to the return of
bond. It’s calculation assumes you reinvest the coupons at
the YTM rather than the prevailing future spot rates.
• Take our 2 year 6% coupon bond with a current price of
$990.95 as an example.
• The spot rates were between 6% and 6.5%.
• The yield to maturity is 6.48979% or 3.2449% for 6 months.
• Now assume we “invest” the $30 coupons at this rate till the
maturity of the bond. The final value at maturity is
$30(1.032449)3 + $30(1.032449)2 + $30(1.032449) + $1030
= $1125.968 which is a return on $990.95 equal to the YTM
for 2 years compounded semiannually: $990.95(1.032449)4.
Common Stock Valuation - Terminology

• Dt =dividend per share of stock at time t.

• P0=market price of the stock at time 0 (now).
• Pt=market price of the stock at time t. (Prior to
date t, this would be the expected price.)
• g=expected growth rate in dividend payments.
• rs=required rate of return (the S is for stock).
• [P1 - P0]/P0= capital gain rate during period 1.
Common Stock Valuation - Terminology

• Dividend yield is the (past) annual dividend

over the current price.
• PE (price earnings ratio) is the current price
divided by the trailing year’s earnings (sum
of the last 4 quarters announced earnings).
• Get to know how to read the information
contained in the WSJ stock quotes, it can be
surprisingly informative.
 Common Stock Valuation
• What would you pay for a share of stock today?
• To answer this question, ask: why would you buy it?
• Suppose you have a one year holding period horizon.
D1 P1 D1  P1
P0   
1  rs 1  rs 1  rs
• D1 and P1 represent expectations.
• We can rearrange this to see that required return is
expected dividend yield plus the expected capital gain
yield: D1 P1  P0
rs  
P0 P0
Common Stock Valuation cont…
• What determines P1?
• An investor purchasing the stock at time 1 and
holding it until time 2 would be willing to pay:
D2  P2
P1 
(1  rs )
• Substitute this into the equation for P0 from the
last slide and find:
D1 D2 P2
P0   
(1  rs ) (1  rs ) (1  rs ) 2
2
Common Stock Valuation cont…
• Repeat this process N times and find:
D1 D2 D3 DN PN
P0     ....  
(1  rs ) (1  rs ) (1  rs )
2 3
(1  rs ) N
(1  rs ) N
• If we continue to apply the same logic (let N get really
big) we find that: 
P0   D t
t
t 1 (1 + r s )

• The current market value (price) of a share of stock is the

present value of all its expected future dividends.
 Stock Valuation if Dividends
Display Constant Growth (Forever)
• If the dividend payments on a stock are expected to
grow at a constant rate, g, and the discount rate is rs,
then the value of the stock at time 0 is
D1
P0 
rs  g
• g must be less than rs for this to be valid.
• If g = 0 this collapses to the perpetuity formula.
– If g is negative this also works for shrinking dividends.
• Labeled the Gordon growth model.
• Why would prices change?
 Example
• Geneva Steel just paid a dividend of $2.10.
Geneva’s (once per year) dividend payments are
expected to grow at a constant rate of 6%. The
appropriate discount rate is 12%. What is the
current price (or value) of Geneva Stock?

• D0 = $2.10  D1 = $2.10(1.06) = $2.226

$2.226
P0   $37.10
0.12  0.06
 Non-constant Growth in Dividends
• Firms often go through lifecycles.
– Fast growth.
– Growth that matches the economy.
– Slower growth or decline.

• A super normal growth stock is one that is

experiencing rapid growth. But, supernormal
growth is, by definition, only temporary.
 Valuation of Non-constant Growth Stocks

• Could just derive all expected dividend payments

individually and discount them. Tedious.

• Find the present value of the dividends during the period

of rapid growth.
• Project the stock price at the end of the rapid growth
period. This will be the discounted value of the
subsequent dividends. Discount this price back to the
present.
• Add these two present values to find the intrinsic value
(price) of the stock.
 Example
• Batesco Inc. just paid a dividend of $1. The
dividends of Batesco are expected to grow by 50%
next year (time 1) and 25% the year after that
(year 2). Subsequently, Batesco’s dividends are
expected to grow at 6% in perpetuity.

• The proper discount rate for Batesco is 13%.

• What is the fair price for a share of Batesco stock?

 Example cont…
• First, determine the dividends. Draw the timeline!
• D0 = $1 g1 = 50%
• D1 = $1(1.50) = $1.50 g2 = 25%
• D2 = $1.50(1.25) = $1.875 g3 = 6%
• D3 = $1.875(1.06) = $1.9875

0 g =50% 1 g2=25% 2 g =6% 3 g4=6% 4

1 3
......

1.50 1.875 1.9875 2.107

 Example cont…
• Supernormal growth period:
D1 + D2 1.50 1.875
Ps = 2 = + 2 = $2.796
(1 + rs ) (1 + rs ) (1.13) (1.13 )
• Constant growth period. Value at time 2:

D 3 1.9875
Pc = = = $28.393
• Discount Pc rtos -time
g3 00.13 - 0.06
and add to Ps:

P c 28.393
P0 =
• What if P s+
supernormal = 2.796 + = $25.03
2 growth lasted 5 yrs
2 at 50%?
(1+ r s ) (1.13 )
 Stocks That Pay No Dividends
• If investors value dividends, how much is a stock that pays
no dividends worth?
• A stock that will literally never pay dividends in any form
has a value of zero.
• In actuality, a company that has not paid dividends to date
can be worth a lot, if the company had good investment
opportunities or if it is accumulating assets that can be
liquidated and the proceeds eventually distributed.
– McDonald’s started in the 1950’s but paid its first dividend in
1975. The market value of McDonald’s stock was in excess of $1
billion prior to 1975.
– Anyone familiar with Intel’s history? Or Microsoft’s?
Valuing Operations Instead of Dividends
• Stocks can be (and often are) valued based on earnings and/or
operating cash flows instead of dividends.
• Let OCF denote operating cash flow (after taxes and after all accrual
and working capital corrections).
• Let F denote the net cash flow to the firm from future financings (new
debt and equity issues less any debt repaid or equity repurchased).
• Let I denote net new capital investment to be undertaken by the firm.
• Then using the cash flow identity, future dividends can be written as
Dt = OCFt + Ft – It.
• So if we can value the firm by discounting future dividends we can also
value it by discounting future operating cash flows, financing flows,
and requisite capital investments instead of dividends.
 Valuing Operations cont…
• We have been using the present value of the expected future
dividends as the current price of the stock.
• Given the cash flow identity we can also look at the present
value of the right hand side of the equality.
• The present value of the first term is the present value of the
cash flow that is expected to be generated by the firms
existing assets. Since we are concerned with equity, we
must remove cash flows assigned to existing debt.
• Let PVA denote the present value of all the future cash
flows expected to be generated by the firms existing assets.
• Let PVL denote the present value of the portion of these
expected future cash flows required to service the firm’s
existing debt.
 Valuing Operations cont…
• Let NPVGO represent the net present value of the firm’s
future investments, I. This is the present value of the
operating cash flows the new investments will create less
the present value of the cash outflows that will be required
to develop them.
• Let NPVF represent the net present value of the firm’s
future financing transactions, F. This is the present value
of the proceeds from future financings less the present
value of the resulting obligations --- interest and principal
for debt, added dividends for equity (a good starting point
is NPVF=0: why?).
• If we put it all together:
 Valuing Operations cont…
• The cash flow identity tells us that the discounted dividend model
must be equivalent to:
P0 = PVA - PVL + NPVGO + NPVF
• Equivalent, even though it does not directly involve dividend
projections at all!
• Observations regarding RWJ’s Chapter 5 discussion:
– They assume no future financings. (More generally, NPVF = 0 is usually a very
good approximation.)
– They assume no existing debt, so PVL = 0.
– They assume that existing assets generate cash flow as a perpetuity in the
amount of EPS per period. So, PVA = EPS/rs.
– So, with their special restrictions, we have:
P0 = EPS/rs + NPVGO.
 Xcorp Example
• Suppose that Xcorp’s current assets will produce
operating cash flows of $1 million per year in
perpetuity. The discount rate for Xcorp is 15%.
• What is the market value of Xcorp’s equity?
Time 0 1 2 3 4
......

$1 million $1 million $1 million $1 million

OCF1 $1 million
PVA    $6.67 million
rs 0.15
 XCORP Example cont…
• Now suppose that Xcorp has an R&D project that will
require cash infusions of $1 million in each of the next
three years. Subsequently, the project will generate
additional cash flow of $0.75 million per year in
perpetuity. Xcorp’s net cash flow including the project is:

0 1 2 3 4
......
• What is the market value of Xcorp’s equity with the
project?0 million 0 million 0 million 1.75 million
 XCORP Example cont…
• Xcorp’s cash flow can be divided up into two pieces:
• The cash flow from current assets (we know this value):
0 1 2 3 4
......

1 million 1 million 1 million 1 million

• Plus the cash flows from the new project:
0 1 2 3 4
......
-1 million -1 million -1 million 0.75 million
 XCORP Example concluded
• The NPV of the project at time 0 is:
1 1 1 1 0.75
NPVGO   2
 3
 3

1.15 (1.15) (1.15) (1.15) 0.15
 $1.004 million
• Xcorp’s value with the project is:
P0  PVA  NPVGO
 $6.667  $1.004  $7.671 million
• The value of the firm rises by the NPV of the project.
 The Discounted Dividend and NPV
Approaches Are Equivalent
• Fresno Corporation has 1 asset and 1 growth opportunity.
• The existing asset is a factory which generates operating cash
flow (OCF) of $100,000 per year. This will continue for 10
years only, with no salvage value.
• The growth opportunity would require an investment of $2
million at t=2, and will return $350,000 to Fresno in each year
from t=3 to t=10.
• The growth opportunity will be funded by selling $2 million in
zero coupon bonds at t=2. The bonds will be repaid at t=10.
• Fresno currently has 100,000 equity shares outstanding and pays
a dividend of $1 per share annually.
• For simplicity, assume that interest/discount rates are zero.
 Valuing Fresno’s Operations
• P0 = PVA - PVL + NPVGO + NPVF
– PVL = 0 (No existing debt).
– NPVF = 0 (Fair terms on the future financing)
– PVA = $100,000x10 = $1,000,000 (no discounting)
– NPVGO = $350,000x8 - $2,000,000 = $800,000

• P0 = $1,000,000 + $800,000 = $1,800,000

in total, or $18 per share.
 Valuing Fresno’s Dividends
• Fresno pays $100,000 per year in regular dividends. At t = 10 Fresno
will pay off its debt and pay out all remaining cash as a liquidating
dividend.
• We need to determine the size of the liquidating dividend, and obtain
the present value (no discounting) of the dividend stream.
Year BofY Cash OCF I F D EofYCash

1 0 100 0 0 100 0
2 0 100 -2000 2000 100 0
3 0 100 350 0 100 350
4 350 100 350 0 100 700
5 700 100 350 0 100 1050
6 1050 100 350 0 100 1400
7 1400 100 350 0 100 1750
8 1750 100 350 0 100 2100
9 2100 100 350 0 100 2450
10 2450 100 350 -2000 900 0
 Valuing Fresno’s Dividends cont…
• Fresno will pay 9 dividends of $100,000 each,
plus a liquidating dividend of $900,000.
• With a zero discount rate the present value of the
dividend stream is $1,800,000, or $18 per share.
• The equivalence in the two approaches does not
depend on the zero discount rate assumption only
on the cash flow identity.
• So, use whichever method is easier to implement!