Security Valuation

Bond, Equity and Preferred Stock

By
Sudarshan Kadariya

Basis for all valuation

approaches
The use of valuation models in
investment decisions (i.e., in decisions
on which assets are under valued and
which are over valued) are based upon
a perception that markets are inefficient
and make mistakes in assessing value
an assumption about how and when these
inefficiencies will get corrected
2

In an efficient market, the market price is

the best estimate of value. The purpose of
any valuation model is then the
justification of this value.

What is Value?
In

general, the value of an asset is the

equilibrium price that a buyer and a seller is
ready to transact.

Note

that if either the buyer or seller is not

both willing and able, then an offer does not
establish the value of the asset.

Types of value

Among the several types of value, the following

three are useful for valuation purpose:
o Book Value - The assets accounting value after
depreciation
o Market Value - The price of an asset in the market
determined competitively
o Intrinsic Value - The present value of the expected
future cash flows discounted at the required rate of
return
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Determinants of Intrinsic
Value

There are two primary determinants of the

intrinsic value of an asset as:
o The size and timing of the expected future cash flows
o The individuals required rate of return
(this is determined by a number of other factors such as risk/return
preferences, returns on competing investments, expected inflation, etc.)

Note that the intrinsic value of an asset can be,

and often is, different for each individual so
that the markets exist. (why??)
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Bonds
Bonds are long-term fixed income securities. It is a
trade-able instrument which is also termed as debt
securities. Both the bonds (?) and debentures (?)
are the debt securities. Most commonly, bonds pay
interest periodically (usually semiannually) and
then return the principal at maturity.
In India, debt securities issued by the government
and public sector are generally referred as bonds
whereas the debt securities that are issued by the
private sector joint stock companies are called
debentures. The terms - bonds and debentures are
often used interchangeably.
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Definitions of useful terms

Par

or Face Value

The amount of money that is paid to the bondholders at

maturity. For most bonds this amount is $1,000. It also
generally represents the amount of money borrowed by the
bond issuer.
Coupon

Rate

The coupon rate, which is generally fixed, determines the

periodic coupon or interest payments. It is expressed as a
percentage of the bond's face value. It also represents the
interest cost of the bond to the issuer. For example: if the
coupon rate is 12%, $120 is payable to bondholder.

Spot interest rate

Zero coupon bond is a special type of bond which does
not pay annual interests. This type of bonds is also
called pure discount or deep discount bond. The return
received from a zero coupon bond expressed on an
annualized basis is the spot interest rate. In other
words, spot interest rate is the annual rate of return on
a bond that has only one cash inflow to the investor.
For instance, if a bond with face value $1000 issued at
a discount for $797.19 for 2 years. The spot rate is
12%, an annual interest rate.

Coupon

Payments

The coupon payments represent the periodic interest

payments from the bond issuer to the bondholder. For
example: coupon payments is $1000 @12% = $120.
Since most bonds pay interest semiannually, generally
one half of the annual coupon is paid to the bondholders
every six months.
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 Maturity

Date

The maturity date represents the date on which the bond

matures, i.e., the date on which the face value is repaid.
The last coupon payment is also paid on the maturity
date.
Current

Yield

The current yield is the annual interest receivable on a

bond to its current market price. For instance, if the
market price is $800, coupon rate is 12% and the face
value is $1000 then the current yield equals
$120/$800 * 100 = 15% (Discount or Premium ??)
(If the current yield > coupon rate = bond is selling at discount,
(If the current yield< coupon rate = bond is selling at premium)

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THANK YOU

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Bond Valuation
Bonds

are valued using time value of money concepts.

Their

coupon, or interest, payments are treated like an

equal cash flow stream (annuity).

Their

face value is treated like a lump sum.

How many types of cash flows that provides to a bond

investments or the bondholder?
Periodic interest payments
Repayment of the face value

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Calculation
Maturity period: 10 years bond

Date of purchase: January 1, 2003

Face value: $1000

Coupon rate: 10%

Market rate of return: 12%.

Required: Calculate the price of this bond today.

Draw a timeline

$1000
+
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100

?
?

13

1.

First of all calculate the present value of the coupon stream

PV = $100/(1+.12)1 + $100/(1+.12)2 + $100/(1+.12)3 + $100/
(1+.12)4 + $100/(1+.12)5 + $100/(1+.12)6 + $100/(1+.12)7 +
$100/(1+.12)8 + $100/(1+.12)9+ $100/(1+.12)10

Or, we can find the PV of an annuity

PVA = $100 * {[1-(1+.12) -10]/.12}

(PVIFA12%,10 years = 5.650)

PV = $565.02
2.

Find the PV of the face value

PV = CFt / (1+r)t
PV = $1000/ (1+.12)10
PV = $321.97

3.

(PVIF 12%, 10 years = 0.3219)

Add the two values to get the total PV

Therefore, the price of bond today is $565.02 + $321.97 = $886.99
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Realized rate of return

If you purchased a bond for $800 5-years ago and sold

the bond today for $1200. The bond paid an annual
10% coupon. What is the realized rate of return?
n

PV = [CFt / (1+r)t]
t=0

$800 = [$100/(1+r) + $100/(1+r)2 + $100/(1+r)3 +

$100/(1+r)4 + $100/(1+r)5] + [$1200/(1+r)5]

To solve, you need to use a trail and error approach.

The realized rate of return on this bond is 19.3%.

931.8276 (15%) & 781.3143 (20%)

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Example
The following timeline illustrates a
typical bonds cash flows:

100

100

100

1,000
100 100
4

16

 The value of the bond is simply the

present value of the annuity-type
cash flow and the lump sum:
1

VB Pmt

1 k

kd

FV

1 k

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 Assume that you are interested in purchasing a

bond with 5 years to maturity and a 10% coupon
rate. If your required return is 12%, what is the
highest price that you would be willing to pay?

100

100

100

VB 100

0.12

0.12

1,000

0.12

1,000
100 100
4

927.90

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Interest rate risk facts

Bond prices are sensitive to the market
interest rate
If interest rates rise, the market value of
bonds fall in order to compete with newly
issued bonds with higher coupon rates.
Sensitivity to the interest rate change
become more severe for longer term bonds
Percentage change (rise) in price is not
symmetric with percentage decline.
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Some Notes About Bond Valuation

The value of a bond depends on several factors such
as time to maturity, coupon rate, and required return
We can note several facts about the relationship
between bond prices and these variables (ceteris
paribus):
o Higher required returns lead to lower bond prices, and
vice-versa
o Higher coupon rates lead to higher bond prices, and vice
versa
o Longer terms to maturity lead to lower bond prices, and
vice-versa
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THANK YOU

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Common stock & Stock

price
Common stock represents an ownership interest in a
corporation, but to the typical investor, a share of common
stock is simply a piece of paper characterized by two features
It entitles its owner to dividends, but only if the company has earnings
out of which dividend can be paid, and only if the management
chooses to pay dividends rather than retaining and reinvesting all the
earnings.
Stock can be sold at some future data, hopefully at a price greater
than the purchase price. If the stock is actually sold at a price above
its purchase price, the investor will receive a capital gain.

Stock price
Volatile, rapidly changes
Price swings are even larger for smaller companies
For large companies, it is relatively stable
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Common Stock Valuation

Just like with bonds, the first step in valuing
common stocks is to determine the cash flows
For a stock, there are two:
Dividend payments
The future selling price

Again, find the present values of these cash flows

and adding them together will give us the value

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D0
Dt
D1
D2
P0
Pt

:
:
:
:
:
:

P0

Terms used in stock valuations

Most recent dividend, which has already been paid
Dividend the stockholder expects to receive at the end of year t
First dividend expected, and will be paid at the end of this year
The dividend expected at the end of second year
Actual market price of stock
Expected price of stock at the end of year t ("P hat t")
The intrinsic or theoretical value of the stock today as seen by
the particular investor doing the analysis. It could differ among
investors depending on how optimistic they are regarding the
company

Certain
Uncertain
Uncertain
Uncertain
Certain
Uncertain
Uncertain

Expected growth rate in dividends as predicted by a investor.

: Different investors may use different g's to evaluate a firm's
stock.

Uncertain

ks

Minimum acceptable, or required rate of return, on the stock,

: considering both its riskiness and the return available on other
investments.

Certain

Expected rate of return which an investor who buys the stock

ks
: expects to receive. It could be above or below ks, but one would
buy the stock only if ks is equal or greater than ks.
Actual, or realized, after the fact rate of return, pronounced "k
ks
:
bar s."
D1/P0 : Expected dividend yield on the stock during the coming year.
(Pt P0)/P0 The expected capital gain yield on the stock during year t
The expected total return = exp.div. yield + exp. Capital gain
yield

Uncertain
Certain
Uncertain
Uncertain
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Common Stock Valuation: An

Example
Assume that you are considering the purchase of
a stock which will pay dividends of $2 next year,
and $2.16 the following year. After receiving the
second dividend, you plan on selling the stock for
$33.33. What is the intrinsic value of this stock if
your required return is 15%?
?

2.00

VCS
VCS

2.00

1.15

33.33
2.16

Dt
P^t
t 1

t
(1 ks) (1 ks )t
2

2.16 33.33

1.15

28.57

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Assumptions
In valuing the common stock, we have made
two assumptions:
o We know the dividends that will be paid in the future
(Di)
o We know the price that we will be able to sell the
stock in the future (Pi)

Both of these assumptions are unrealistic,

especially knowledge of the future selling price
Furthermore, suppose that when we intend to
hold the stock for twenty years, the calculations
would be very tedious!
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Further Assumptions
We cannot value common stock without making
some simplifying assumptions
If we make the following assumptions, we can
derive a simple model for common stock valuation:
Assumption 1: The holding period is infinite (i.e., you will never sell the stock)
Assumption 2: The dividends will grow at a constant rate

forever

Note that the second assumption allows us to

predict every future dividend, as long as we know
the most recent dividend
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The Dividend Discount Model

(DDM)
With these assumptions, we can derive a model which
is known as the Dividend Discount Model, or the Gordon
Model
This model gives us the present value of an infinite
stream of dividends that are growing at a constant rate:
VCS

D 0 1 g
D1

k CS g
k CS g

Where,
Ke = Kcs = Cost of equity
g = growth rate
Do = Recent dividend rate
D1 = One period dividend

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The DDM: An Example

Recall the previous example in which the
dividends were growing at 8% per year, and
your required return was 15%
The value of the stock must be:
VCS

1.85 1.08
.15.08

2.00
0.15.08

28.57

(Note that this is exactly the same value that we got earlier)

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The DDM Example (cont.)

In the earlier example, how did we know that the
stock would be selling for $33.33 in two years?
Note that the period 3 dividend must be 8% larger
than the period 2 dividend, so:
V2

2.16 1.08
.15.08

2.33
33.3 3
0.15.0 8

(Therefore, the selling price is equal to 33.33, considering 8% growth rate per
year)

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Preferred Stock Hybrid

stock

Preferred stock, like as bonds imposes a fixed

charge & the failure to make this fixed charge will
not lead to bankruptcy.

Preferred stock represents an ownership claim on

the firm that is superior to common stock in the
event of liquidation.

Typically, preferred stock pays a fixed dividend

periodically, and

the preferred stockholders are usually not entitled

to vote as are the common shareholders.
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Preferred Stock Valuation

Most preferred stocks are perpetuities, and the

value of a share of perpetual preferred stock is
found as the dividend divided by the required
rate of return.

Preferred stock is very much like common stock,

except that the dividends are constant (i.e., the
growth rate is 0%)

Therefore, we can use the DDM with a 0% growth

rate to find the value:
VP

D 0 1 0
k CS 0

D
k CS

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Preferred Stock: An
Example
Suppose

that you are interested in

purchasing shares of a preferred stock
which pays a $5 dividend every year. If
your required return is 7%, what is the
intrinsic value of this stock?
VP

5
71.43
0.07

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Bond valuation is less glamorous

than stock valuation. Why?

Two reasons:
First, the returns from investing from bonds
are less imperative and fixed.
Second, the bond prices fluctuate less than
the equity prices

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Bond Yields

Yield to
Maturity:
Same as
market
rate of
return at
maturity

Yield to Call:

Market rate of return at call which is

issuers option

When coupon>market interest

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Current
Yield:

Annual
interest
payment
divided
by bonds
current
price

Yield to Maturity: The Approximation Approach

The yield to maturity (YTM) is the average
annual rate of return that a bondholder will earn.
YTM is generally the same as the market rate of
interest, kd which can be solve as trial and error
or by interpolation.
For example, a 14-year, 10 percent coupon with
par value $1000 is offered at a market price
$1494.93. What rate of interest we earn if we
bought the bond and held it to maturity?
(Answer is 5%)

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The Approximation
Formula
F = Face Value = Par Value = $1,000
P = Bond Price
C = the semi annual coupon interest
N = number of semi-annual periods left to maturity

F-P
C
Semi - annual Yield to Maturity n
FP
2
YTM 2 semi - annual YTM
YTM (1 semi - annual YTM) 1
2

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Example

Find the yield-to-maturity of a 5 year 6%

coupon bond that is currently priced at
$850. (assume the coupon interest is paid semiannually.)
Therefore there is coupon interest of $30 paid semiannually i.e. ($1000 x 6% = $60 p.a. & $30 s.a.)
There are 10 semi-annual periods left until maturity
(i.e. nx2 = 5x2 = 10 periods)

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$1,000 $850
F-P
$30
C
$15 $30
10
n
Semi - annual Yield to Maturity

0.0486
FP
$1,850
$925
2
2
YTM 2 semi - annual YTM 0.0486 2 0.09273 9.3%

Realized rate of return YTM (1 semi - annual YTM) 2 1 (1.0486) 2 1 9.97%

The
Theapproximation
approximationapproach
approachonly
onlygives
givesus
usan
anapproximate
approximateanswer
answer

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THANK YOU

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