Module 3

Valuing Securities
Efficient Market
• The efficient market hypothesis (EMH), also known as the efficient
market theory, posits that markets are efficient, meaning share
prices reflect all available information, both public and private. This
means that stocks trade at their fair value, so most investors will see
the best results from holding a low-cost, passive portfolio over the
long term.

• Efficient Market Hypothesis (EMH): Definition and Critiqu

e
Securities valuation
• Valuation is the analytical process of determining the current or
projected worth of an asset or company. Many techniques are used
for doing a valuation. Among other metrics, an analyst placing a
value on a company looks at the business's management, the
composition of its capital structure, the prospect of future earnings,
and the market value of its assets.
• Fundamental analysis is often employed in valuation although
several other methods may be employed such as the
capital asset pricing model (CAPM) or the dividend discount model
(DDM).
What Is Valuation? How It Works and Methods Used
 BOND VALUING

• Convexity in Bonds: Definition, Meaning, and Examples

Yield Curve: Bond Pricing
• Yields on different maturity bonds are not equal
• Consider cash flow of each bond as a stand-alone
zero-coupon bond
• Bond stripping and bond reconstitution offer
opportunities for arbitrage
• The value of the bond should be the sum of the
values of its parts

15-5
Prices and Yields to Maturities on
Zero-Coupon Bonds ($1,000 Face Value)

Maturity Yield to
Price
(years) Maturity (%)

1 5% $952.38 = $1,000/1.05

2 6 $890.00 = $1,000/1.062

3 7 $816.30 = $1,000/1.073

4 8 $735.03 = $1,000/1.084

Table 15.1
Prices and yields to maturity on zero-coupon bonds ($1,000 face value)

15-6
Valuing Coupon Bonds
• Value a 3 year, 10% coupon bond using
discount rates from Table 15.1:

$100 $100 $1100

Price   
1.05 1.06 2
1.073

• Price = $1082.17 and YTM = 6.88%

• 6.88% is less than the 3-year rate of 7%

15-7
Bond Pricing:
Two Types of Yield Curves

On-the-Run Yield
Pure Yield Curve
Curve
• Refers to the plot of
• Uses stripped or zero
yield as a function of
coupon Treasuries
maturity for recently
issued coupon bonds
• May differ
selling at or near par
significantly from the
value
on-the-run yield
• The one typically
curve
published by the
financial press

15-8
The Yield Curve under Certainty
• Consider two 2-year bond strategies:
1. Buy the 2-year zero offering a 2-year YTM of
6% and hold it until maturity
 Face value is $1,000, so it is purchased today for
$1,000/(1.06)2 = $890 and matures in two
years to $1,000
 Total 2-year growth factor is $1,000/$890 =
1.1236
2. Invest the same $890 in a 1-year zero-coupon
bond with a YTM of 5% and upon maturity
reinvest the proceeds in another 1-year bond

15-9
Two 2-Year Investment Programs

15-10
Spot Rates and Short Rates
• Spot rate
• The rate that prevails today for a time period
corresponding to the zero’s maturity

• Short rate
• Applies for a given time interval (e.g., one year)
• Refers to the interest rate for that interval
available at different points in time

15-11
Holding-Period Returns
• Multiyear cumulative returns on all competing
bonds should be equal
• What about HPRs over shorter periods, such as
one year?

• In a world of certainty, all bonds must offer

identical returns, or investors will flock to the
higher-return securities, bidding up their prices,
and reducing their returns

15-12
Short Rates vs Spot Rates

15-13
Forward Rates

• Yield Curve Under Certainty

• Buy and hold vs. rollover:

2
(1+y 2 ) =( 1+r1 ) × ( 1+r2 )
• (r2) is just enough to make rolling over a series of
1-year bonds equal to investing in the 2-year bond
• Therefore, short rate in year n:

(1+𝑟 𝑛 )=¿ ¿
yn = YTM of a zero-coupon bond with an n-
period maturity
15-14
Forward Rates (continued)

• The forward interest rate is a forecast of a

future short rate
• Rate for 4-year maturity = 8%
• Rate for 3-year maturity = 7%

1 f4 
1  y4 
4

1.084
1.1106
1  y3 3 1.07 3

f 4 11.06%

15-15
Interest Rate Uncertainty and
Forward Rates
• The investor wants to invest for 1 year
• Buy the 2-year bond today and plan to sell it
at the end of the first year for $1000/1.06 =
$943.40
or
• Buy the 1-year bond today and hold to
maturity

• What if next year’s interest rate differs from

6%?
• The actual return on the 2-year bond is
uncertain!

15-16
Interest Rate Uncertainty and
Forward Rates (continued)
• Investors require a risk premium to hold a
longer-term bond

• This liquidity premium compensates short-

term investors for the uncertainty about
future prices

15-17
Theories of Term Structure
• The Expectations Hypothesis Theory
• Simplest theory of the term structure
• States forward rate equals market consensus
expectation of future short interest rate
• f2 = E(r2) and liquidity premiums are zero
• Liquidity Preference Theory
• Long-term bonds are more risky
 f2 > E(r2)
• The excess of f2 over E(r2) is the liquidity premium
 Predicted to be positive
• Yield curve has an upward bias built into the long-
term rates because of the liquidity premium

15-18
Yield Curve Examples

Panel A:
• Constant Expected Short Rate
• Constant Liquidity Premium

15-19
Yield Curve Examples (continued)
Panel B:
• Declining Expected Short Rate
• Increasing Liquidity Premiums

15-20
Yield Curve Examples (continued)
Panel C:
• Declining Expected Short Rate
• Constant Liquidity Premiums

15-21
Yield Curve Examples (continued)
Panel D:
• Increasing Expected Short Rates
• Increasing Liquidity Premiums

15-22
Additivity: The Term Structure Prices
Bonds

• The principle of bundle pricing is often applied to the

pricing of bonds. A bond gives you a series of payments
over time. Each of these payments is a separate
financial package. If we can price each financial
package, then we should be able to price the bond.
• Pricing a bond by additivity—schematic. Bond C is priced by taking the IRR of Bond A
and applying it to the first-year payment of Bond C and by taking the IRR of Bond B and
applying it to the second year payment of Bond C. In the jargon of bond markets, both
Bond A and Bond B are known as zero-coupon bonds. A zero-coupon bond is a bond
with only two cash flows: the initial price of the bond and the final payoff.
 Computing the Yield to Maturity (YTM) of a Bond

The most common tool for the analysis of bonds is the yield to
maturity (YTM). YTM of the bond is the internal rate of return of the
bond’s cash flows. Suppose we observe the bond’s market price P
and we know its stream of future promised payments (coupons and
principal) C1, C2, ...., CN. Then the YTM is defined as the internal
rate of return of the bond price and its future payments, which is
the rate of return that sets the present value of the bond’s future
promised payments equal to its current price:

p 462
 The terminology:
• The XYZ bond has a face value and a coupon rate. The $10 million of bonds issued by
XYZ Corporation are issued as individual bonds of $1,000 face value; each such bond pays a
coupon rate of 7%. The periodic interest payments are based on the product of the coupon
rate and the face value. The XYZ bonds pay interest only once a year; since the coupon rate
is 7% and the face value is $1,000, this means that the coupon payments are $70
annually. (As you will see in Section 15.2, most corporate bonds pay interest semi-annually; if
this were true for the XYZ bonds, they would pay $35 on 15 December and 15 June of each
year until the redemption year (2021).)
• The XYZ bond has a principal repayment on the last day of the bond’s maturity (the
bond’s maturity date). On this day, 15 December 2016, a $1,000 face-value XYZ bond will
pay its holder a final repayment of the principal of $1,000 in addition to the interest payment
of $70 due for 2021.
• The bond’s offer price is the initial price at which it is sold to the public. The XYZ bonds
are offered at par value, meaning that the initial sale price is equal to the bond’s face value.
Valuing Stock
Valuation Methods
Valuation method 1: The efficient markets approach. In its
simplest form, the efficient markets approach states that the current
market stock price is correct. A somewhat more sophisticated use of
the efficient markets approach to stock valuation is that a stock’s
value is the sum of the values of its components.
Valuation method 2: Discounting the future free cash flows
(FCF). Sometimes called the discounted cash flow (DCF) approach
to valuation, this method values the firm’s debt and its equity
together as the present value of the firm’s future FCFs. The discount
rate used is the weighted average cost of capital (WACC). This
method is the valuation approach favored by most finance
academics and practitioners.
Valuation Methods
Valuation method 3: Discounting the future equity payouts.
A firm’s shares can also be valued by discounting the stream of
anticipated equity payouts at an appropriate cost of equity re.

Valuation method 4: multiples. Finally, we can value a firm’s

shares by a comparative valuation based on multiples. This very
common method involves ratios such as the price earnings (P/E)
ratio; earnings before interest, taxes, depreciation, and
amortization (EBITDA) multiples; and more industry-specific
multiples such as value per square foot of storage space or value
per subscriber.
Value Additivity: Meaning

The Value Additivity Principle is a financial principle that

says that the total value of a group of assets is equal to the
total value of all individual assets included in the group.

According to this principle, a portfolio’s total value would be a

summation of the values of all the securities/assets taken
together.
This principle also says that the Net Present Value (NPV) of a
group of independent projects would be equivalent to the NPV of
all the individual projects.
Page 511, Principle of Finance with Excel
 Valuation Method 2: The Price of a Share Is the Discounted
Value of the Future Anticipated Free Cash Flows
• Valuation method 1 of the previous section says that there is nothing to be gained by second-
guessing market valuations. In many cases, however, the finance expert will want to do a basic
valuation of a company and derive the value of a share from the discounted value of the future
anticipated free cash flows (FCF). This method often called the discounted cash flow (DCF)
method of valuation, was discussed and illustrated in Chapter 6. Figure 16.2 reminds you of the
definition of FCF, and Figure 16.3 gives a flow diagram of the FCF valuation method.
• Valuation 2: Example 1—A Basic Example
• It is 31 December 2015, and you are trying to value Arnold Corporation, which finished 2015
with a free cash flow of $2 million. The company has a debt of $10 million and cash balances of
$1 million. You estimate the following financial parameters for the company:
• The future anticipated growth rate of the FCF is 8%.
• The WACC of Arnold is 15%.
• Arnold Corp. has 2,000,000 shares outstanding.
P. 513
P 514
Valuation Method 3: The Price of a Share Is the Present Value of Its
Future Anticipated Equity Cash Flows Discounted at the Cost of Equity

We directly discount the value of the firm’s anticipated

payouts to its shareholders. As an example, consider
Haul-It Corporation, which has a steady record of paying
dividends and repurchasing shares. The company has 10
million shares outstanding. Here’s a spreadsheet with the
valuation model:
Valuation Method 4: Comparative Valuation—Using
Multiples to Value Shares
Based on the similarity between the two companies, SFL appears underpriced relative to
LS—its P/E ratio is less. A market analyst might recommend that anyone interested in
investing in the shoe store business should invest in SFL rather than LS.2