Chapter 6 – Valuation of bonds and shares

Presentation by: James Williams

 Price and value

 Price is the amount of money needed to acquire an

asset.
 Value is the worth of an asset to an individual.
 Price and value can be quite different amounts.
 How are security prices set?

 Securities are tradable instruments that represent

an ownership interest or the right to receive payment
on a debt.
 An important characteristic normally found in
securities is that they are easily interchangeable.
 The price of a security is easy to observe when it is
traded in an active market.
 A bid is the price a trader is willing to pay for a
security.
 An offer is a price a trader is willing to accept to sell
a security.
 How are security prices set?

 The number of bids for a security (at a certain price)

indicates the demand for that security at that price.
 The number of offers for a security (at a certain
price) indicates the supply of that security at that
price.
 The market price represents the most widely held
view of the value of the security at that point in time.
 Principles of security valuation

 Book value is the accounting measure of an asset’s

worth.
 The book value of a share is given by equation 6.1:

 Book value does not provide us with a good

representation of future cash flows.
 Principles of security valuation

 The cash flows of a security can come from

dividends, coupon payments, redemption by the
issuer or from the sale of the security on the
secondary market.
 Coupon payments are the regular interest payments
received by the holder of a bond.
 Intrinsic value of a security is the PV of expected
future cash flows discounted at the investor’s
required rate of return.
 A higher (lower) discount rate will lead to a lower
(higher) intrinsic value calculation.
 Principles of security valuation

 The amount of uncertainty about cash flows varies

between securities.
 For instance, ordinarily it is much simpler to forecast
the cash flows associated with debt instruments than
it is to forecast the cash flows associated with
ordinary shares.
 An investors’ required return, the amount and timing
of the security’s cash flows and the level of risk
associated with these cash flows are the key
elements in determining a security’s value.
 Principles of security valuation

 The basic security valuation model is given in

equation 6.2:
 Valuing bonds

 A bond normally pays a regular income stream (the

coupon) and has a face value that is repaid to the
holder at maturity.
 The coupon is the stated rate of interest paid on the
bond.
 Valuing bonds

Zero coupon bonds

 As the name suggests, zero coupon bonds pay no

coupons but rather pay a lump sum (face value) at
maturity.
 In this sense, a zero coupon bond is similar to a
discount security.
 The purchase price at the time of issue will be at a
deep discount to the face value of the bond.
 A deep discount is a purchase price for a security
that is well below its face value.
 Valuing bonds

Zero coupon bonds

 Equation 6.3 shows us that the intrinsic value of a

zero coupon bond is equal to the PV of the maturity
cash flow.
 Valuing bonds
Zero coupon bonds

Example 6.2
 The inputs for this problem are as follows:
F = $100000; rb = 0.05/2 and; n = 3*2.
 Valuing bonds
Coupon bonds
 The cash flows of a fixed interest coupon bond
form an annuity plus a single sum when the face
value is repaid.
 Fixed interest means that the coupon received on
the bond stays the same over the bond’s life.
 The abovementioned cash flow pattern is used in
equation 6.4 to calculate a coupon bond’s value:
 Valuing bonds

Coupon bonds

 The first part of equation 6.4 calculates the PV of the

annuity that is made up of coupon payments.
 The last half calculates the PV of the face value of
the bond.
 Valuing bonds
Coupon bonds
Example 6.3
 The inputs for this problem are as follows:
F = $100000; Ct = $2500 rb/m = 0.06/2; t = 1,2,3,4
and; nm = 2*2.
 Valuing preference shares

 Preference shares are hybrid securities that have

features of both debt and equity.
 We can value the cash flows associated with a
typical preference share as a perpetuity.
 The formula for calculating the intrinsic value of a
preference share is given in equation 6.5:
 Valuing preference shares

Example 6.4

 The inputs for this problem are as follows: D = $0.5

and; rp = 8%.
 Valuing ordinary shares

Dividend discount model

 As for bonds and preference shares, the intrinsic

value of an ordinary share is the present value of the
future cash flows using the investor’s required rate
of return.
 Equation 6.6 gives the dividend discount model used
for computing the intrinsic value of an ordinary
share.
 Valuing ordinary shares

Dividend discount model

Example 6.5
 The inputs for this problem are as follows:
D1 = $0.35; D2 = $0.37; D3 = $0.42; D4 = $0.45;
P = $65 and; re = 0.11/2.
 Valuing ordinary shares

Constant growth model

 A major problem with valuing an ordinary share is

associated with its infinite life.
 If we make the assumption of a constant growth rate
in dividends, we can use equation 6.7 to calculate
the value of a share:
 Valuing ordinary shares

Constant growth model

Example 6.7
 The inputs for this problem are as follows:
D = $0.15; g = 0.02/2 and; re = 0.06/2.
 Valuing ordinary shares

Applying dividend valuation models

 The dividend discount and constant growth valuation

models can not be applied to all companies.
 These models are applicable to the valuation of blue
chip companies as opposed valuing companies
which exhibit unpredictable variability in dividends.
 Blue chip companies are well established and have
a good track record for financial stability and a fairly
predictable pattern of dividend payments.
 Price-earnings ratio
• Market capitalisation is the total dollar value of all
issued shares. Market value is used to determine
the dollar value per share.
 Earnings per share is the total forecast earnings of
the firm divided by the number of ordinary shares on
issue.
 The Price-earnings ratio compares the price per
share to the forecast EPS:
 Price-earnings ratio

 Analysts pay a lot of attention to earnings results

and devote considerable resources to developing
earnings forecasts.
 Earnings indicate profitability, but before we can
compare the profitability of two firms we need to
take the size of each of the operations into
consideration.
 Calculating the EPS standardises the total earnings
for companies and puts them on a more comparable
per share footing:
 Price-earnings ratio

 It is important to note that a change in the historical

PE of a company can be due solely to a change in
the general level of prices in the share market rather
than with changes in the value of a company.
 Analysts use a PE multiple based on the
PEs of comparable firms and make adjustments for
differences attributable to risk and gearing and any
other factors they consider relevant.