Valuation of Bonds and Shares

Valuation of Bonds

Bond

Types of Bonds Bonds with Maturity Pure Discount Bonds Perpetual Bonds
Issuers of Bonds 1. Central Government 2. State Government 3. Municipalities 4. PSUs 5. Private Sector Companies

A long-term debt instrument (a legal contract) in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.

Bond Yields

Coupon rate Current yield Yield to maturity Yield to call

Terminology
Par Value The Value Stated on the face of Bond is called as Face Value. Coupon Rate Bond carries a specific interest rate which is called the coupon rate. Maturity Period The maturity of a bond indicates the length of time until the bond issuer returns the par value to the bond holder and terminates or redeems the bond. Current Yield The current yield on a bond refers to the ratio of the annual interest payment to the current market price . Bonds with Call Option The bonds issued by some companies give the right to the company to redeem entire/part of the bond issue prior to maturity are called as callable bond or bond with call option. Yield to Maturity This is the rate of return that investors earn if they buy the bond at a specific price and hold it until maturity. Yield to Call This is the rate of return that investors earn if they buy the bond with a call option at a specific price and hold it till the company exercises its call option.

 Yield to Maturity: The yield-to-maturity (YTM) is the annualized rate

of return on the investment that the investor expects to earn from the date of investment to the date of maturity. YTM is bonds internal rate of return.

YTM = Lo + (m p) /n

0.4(m) + 0.6(p) Where, I = Annual Interest m = Maturity Value p = Price of Bond n = Number of years to maturity

Valuation of Bonds Contd

Current Yield
Current yield is the annual interest divided by the

bonds current value.

It is calculated as:

Annual Pmt CY Current Value

CY

Valuation of Bonds Contd

Yield to Call:

The yield to call is the average annual rate of return that a bondholder will earn under the following assumptions: The bond is held to maturity The interest payments are reinvested at the YTM

YTC = FV + m p
n n1 0.4(m) + .0.6(p)

Where, FV = Face Value m = Maturity Value p = Price of Bond n = Number of years to maturity n1= Called Year

Valuation of Bonds Contd

Pure Discount Bonds: A pure discount bond makes a single payment at the

maturity date of the bond.

Value of pure discount bond = PV of the amount on maturity

Valuation of Bonds Contd

Perpetual Bonds:
A perpetual bond, is a bond with no maturity date.

Therefore, it may be treated as equity, not as debt.

PV = A

r
Where PV = Present Value of the Perpetuity, A = the

Amount of the periodic payment, and r = yield , discount rate or interest rate.

Valuation of Preference Share

Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preference shares represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, preference shares pay a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible. also called preferred stock.
div

Po = Preference

( PAVF

Kp, n)

+ Pn (PVF

Kp, n)

Where, Kp = Cost of Preference Share or expected rate of return.

Pn = Maturity value of Preference shares at the end of n number of year.

Valuation of Equity
The valuation of ordinary or equity shares is relatively more difficult.
The rate of dividend on equity shares is not known;

also, the payment of equity dividend is discretionary. The earnings and dividends on equity shares are generally expected to grow, unlike the interest on bonds and preference dividend.

Dividend Discount Models

A procedure for valuing the price of a stock by using
predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

Dt Vo t t 1 (1 k )
V0 = Value of Stock Dt = Dividend k = required return

No Growth Model
D Vo k
D is the constant dividend k is the required rate of return Stocks that have dividends that are expected to

remain constant

Constant Growth Model

D0 (1 g ) V0 kg
Dividends are expected to grow at a constant

percent per period. D0 is most recent dividend, D0(1+g) is next dividend g = constant perpetual growth rate k = required rate of return

Estimating Dividend Growth Rates

g ROE b
g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate. The

proportion of the firms earnings that is reinvested in the business.

= (1- dividend payout rate)

Multi-Period Dividend-Discount Model

P D D D ... V (1 k ) (1 k ) (1 k )
1 2 N 0 1 2

N N

PN = expected sales price of stock at time N N = number of years the stock is to be held

Multi-Period Earnings-Discount Model

(1 b) E N P N (1 b) E1 (1 b) E 2 ... V0 1 2 N (1 k ) (1 k ) (1 k )
PN = expected sales price of stock at time N N = number of years the stock is to be held

P/E Ratio and Growth Opportunities

D1 E 1(1 b) P0 k g k (b ROE ) P0 1 b E 1 k (b ROE )

b = retention ration ROE = Return on Equity

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