Professional Documents
Culture Documents
IPM - Written Report - Tinio PDF
IPM - Written Report - Tinio PDF
AND PORTFOLIO
MANAGEMENT
CHAPTER 11:
An Introduction to Security
Valuation
Written Report
Submitted by:
Part 3 introduces the two major approaches to the investment process and
this chapter will explain the specifics and logic of the top-down (three-step)
approach. This chapter also tackles the investment decision process and digs down
in different valuation techniques such as the valuation of bonds, preferred stocks
and common stocks using two primary approaches. These two approaches will be
tackled in detail discussing the available techniques that an individual can conduct,
the conditions to best use each approach, how to apply each approach and the
required inputs in applying each approach.
After detailing the concepts and applications of the two approaches, the discussion
will continue to the latter part of the investment decision process tackling the other
factors that must be considered in the decision making. At the end of this chapter,
you should be able to conclude what are the factors that an investment manager
must consider during the investment decision process by using the two major
approaches and decide whether a specific investment is good or bad.
II. Discussion
Two approaches in Investment Process
As introduced earlier, there are the two major approaches of the investment process,
namely: (1) Top-down, three-step approach and (2) Bottom-up, stock valuation,
stock picking approach. In order understand how it works, we must first identify
what are the three steps of the investment process. Exhibit 11.1 entitled “Overview
of Investment Process” of Reilly and Brown’s Investment and Portfolio Management
(referred to as “the Book”) summarizes the three step process.
VALUATION
Valuation of Bonds:
Valuation of Bonds is relatively easy because the size and time pattern of cash flows
from the bond over its life are known. Important details are provided in detail in
each investment agreements and below are the usual required details in valuing
bonds:
1. Interest payments usually periodic so we must divide the applicable nominal
rate per period.
2. Payment of principal on the bond’s maturity date
For example*:
In 2018, a P100,000 bond due in 2023 with 10% coupon. Discount these payments at
the investor’s required rate of return (if the risk-free rate is 9% and the investor
requires a risk premium of 1%, then the required rate of return would be 10%)
(1) Present value of the interest payments is an annuity for thirty periods at one-half
the required rate of return and (2) the present value of the principal is similarly
discounted
(1) P5,000 x 15.3725 = P76,862.50
(2) P100,000 x 0.231375 = P23,137.50
Total value of bond at 10 percent = P10,000
The value is simply the stated annual dividend divided by the required rate of
return on preferred stock (kp).
Dividend
V=
kp
For example*:
Assume a preferred stock has a $100 par value and a dividend of $8 a year and a
required rate of return of 9 percent
$8
V= = $88.89
.09
*This example is taken from the Book.
Exhibit 11.2 below introduces the specific techniques under the two approaches:
Summary of the two approaches is below:
III. Summary and Conclusion
As per Reilly and Brown, we apply the valuation theory to a range of investments,
including bonds, preferred stock, and common stock. Because the valuation of
common stock is more complex and difficult, we suggest two alternative approaches
(the present value of cash flows and the relative valuation approach) and several
techniques for each of these approaches. Notably, these are not competitive
approaches, and we suggest that both approaches be used. Although we suggest
using several different valuation models, the investment decision rule is always the
same: If the estimated intrinsic value of the investment is greater than the market
price, you should buy the investment or hold it if you own it; if the estimated
intrinsic value of an investment is less than its market price, you should not invest in
it and if you own it, you should sell it. We conclude with a review of factors that you
need to consider when estimating the value of stock with either approach—your
required rate of return on an investment and the growth rate of earnings, cash flow,
and dividends. Finally, we consider some unique factors that affect the application
of these valuation models to foreign stocks.