2

The Fundamental Value of Stocks

and Bonds

The fundamental value of an investment is the present value PV0 of its expected, future cash
flows. Given a risk-free rate of 4%, an investment A that pays a cash flow (CFA ) of USD
100 000 at the end of one period with certainty is worth USD 96 154 today as an investor
receives USD 100 000 at the end of one period if he/she invests USD 96 154 today at a
risk-free rate of 4%:
1 100 000
PV0 = CFA × t = = 96 154 ⇔
1 + iA ) 1.041
CFA = PV0 × 1 + iA )t = 96 154 × 1.041 = 100 000

If investment A currently traded below its fundamental value of USD 96 154 – for example,
at USD 90 000 – an arbitrageur could borrow USD 90 000 at 4%, invest it in investment
A and realize a risk-less profit of USD 6400 before transaction costs at maturity [USD
100 000 − 90 000 × 1.04]. If investment A traded above its fundamental value – for example,
at USD 105 000 – an arbitrageur could borrow investment A at a small borrowing fee from
the owner of the asset, sell it for USD 105 000 in the market and invest the proceeds of the
short sale at the risk-free rate. At maturity the investor would realize a risk-free profit of USD
9200 before borrowing fees and transaction costs [USD 105 000 × 1.04 − USD 100 000]. As a
result of these arbitrage transactions, the price of the asset which trades below its fundamental
value would increase and the price of the asset which trades above its fundamental value
would fall until all arbitrage opportunities are eliminated and the market price equals its
fundamental value (arbitrage-free pricing).
The expected returns which are foregone by investing in an asset rather than in a com­
parable investment are called opportunity cost of capital. The opportunity cost i of a risky
asset B is simply the sum of the risk-free rate rf plus a risk premium 1 which adequately
reflects the uncertainty of future cash flows generated by asset B:

iB = rf + 1B

A US dollar, euro or yen received today is worth more than the same amount of money
received tomorrow in the eyes of most investors. Investors are usually only willing to forgo
current consumption and invest in a risk-free asset if they receive interest on the investment.
If the interest rate increases, people are typically more willing to delay consumption into
the future. Classical economists postulate that the interest rate is the price that brings
consumption and investment into equilibrium. However, investors not only have to decide
how much to consume and how much to save but also if they want to hold wealth in the
6 Equity Valuation

form of cash or to purchase long-term assets. According to Keynes, the risk-free rate rf can
be viewed as reward for parting with liquidity.1
Common sense suggests that risk-free investments yield lower returns than risky assets.
Risk-averse investors are willing to invest in risky assets only if they can expect to receive
a risk premium 1 in addition to the risk-free rate which adequately reflects the uncertainty
of future cash flows of that asset. By definition, the risk premium of a risky asset B is the
difference between the expected return i on asset B less the risk-free rate.2

'B = iB − rf

The fundamental value of a risky investment depends on the expected returns (opportunity
costs) that investors can achieve elsewhere on a comparable investment with the same
characteristics. The fundamental value decreases (increases) if the opportunity costs increase
(decrease). The price of identical assets with the same expected return and risk should be
equal in competitive financial markets. If prices of identical assets were different, arbitrageurs
would simply buy the cheap and short sell3 the more expensive but otherwise identical
asset to capture a risk-free arbitrage profit. Arbitrage ensures that assets trade very close to
fundamental values in equilibrium, i.e. after all arbitrage opportunities are eliminated.
Cash flows and discount rates must be consistent: Nominal cash flows must be discounted
at nominal discount rates, cash flows in real terms at real discount rates. Let us assume that the
real risk-free rate is 1.5%, the expected inflation rate 2.5%, the risk premium 4% and that the
expected cash flow of asset B at the end of period 1 is USD 100 000. The nominal opportunity
cost of capital of asset B is simply the sum4 of the real risk-free rate rf real , the expected
inflation rate rinf and the risk premium 'B . The fundamental value of asset B is 92 593:

1 100 000 100 000

PV0 B = CF1 B × h )= = = 92 593
1 + rf real + rinf + 1B 1 + 0.015 + 0.025 + 0.04) 1.08

Implicitly, we have assumed that investors compare characteristics of assets and have a
preference for high returns, low risk and liquidity. In other words, we have assumed that
greed, fear and impatience generally dominate investment decisions. A brief look at how
bonds are priced in financial markets shows that the present value approach describes
realistically how assets are priced in competitive financial markets. If the present value rule
holds, the price of a bond PB equals the present value of its future cash flows ct :5
c1 B c2 B cT B
PB = + +. . . +
1 + yB ) 1 1 + yB ) 2 1 + yB )T

1
Keynes (1997), p. 167.
2
The annualized, historical geometric average of equity risk premia relative to bills over the 105-year period from 1900 to 2004
was 5.5% for the United States, 6.4% for Japan, 3.6% for Germany, and 4.3% for the United Kingdom. Dimson et al. (2005), p. 39.
3
Short selling (building a short position) a stock is simply the opposite of buying it (building a long position): A short seller of a
stock borrows it from the owner of the asset and sells it in the market hoping that the price declines so that she can buy it back at
a lower price. The short seller of a stock not only realizes the price difference, but also has to pay borrowing fees and dividends, if
any, to the owner of the stock and receives interest on the proceeds of the short sale.
4
Discounting the expected cash flow in the amount of USD 100 000 by the product of one plus the real rate of interest multiplied
by one plus the inflation rate and one plus the risk premium leads almost to the same result:

USD 100 000/ 1.015∗ 1.025∗ 1.04) = USD 92 422.

5
Fabozzi (1997), pp. 25–105.
 The Fundamental Value of Stocks and Bonds 7

The yield y is the interest rate that makes the present value equal to the price of the bond.
The yield-to-maturity is the yield that an investor would realize if she holds the bond until
maturity. By convention, the yield-to-maturity of a semi-annual bond with k = 2 payments
per year is expressed by doubling the semi-annual discount rate i. Table 2.1 shows that
a bond that pays semi-annually USD 2.5 over five years (10 periods) and USD 100 at
maturity T should trade at USD 100 (par value) if the yield of identical bonds (opportunity
cost) is 5% and at USD 99.56 if the required yield is 5.1%.

Table 2.1 Present value calculation to value bonds

Scenario 1: y = 5% Scenario 2: y = 5.1%

t Cash flows c PV = c/ 1 + i)t PV × t Cash flows c PV = c/ 1 + i)t PV × t

1 2.5 2.4390 2.4390 2.5 2.4378 2.4378

2 2.5 2.3795 4.7591 2.5 2.3772 4.7544
3 2.5 2.3215 6.9645 2.5 2.3181 6.9543
4 2.5 2.2649 9.0595 2.5 2.2605 9.0419
5 2.5 2.2096 11.0482 2.5 2.2043 11.0213
6 2.5 2.1557 12.9345 2.5 2.1494 12.8967
7 2.5 2.1032 14.7221 2.5 2.0960 14.6720
8 2.5 2.0519 16.4149 2.5 2.0439 16.3510
9 2.5 2.0018 18.0164 2.5 1.9931 17.9375
10 102.5 80.0728 800.7284 102.5 79.6833 796.8328
k 100.0000 897.0866 99.5635 892.8997

In reality, differences between bond prices and the present values of future cash flows to
bond holders are usually very small. Otherwise, arbitrageurs would try to capture a risk-free
profit by buying undervalued bonds and short selling overvalued bonds. Yield changes are
the main value driver of bonds. The modified duration quantifies the sensitivity of a bond
to small yield changes. The Macaulay duration and the modified duration in scenario 1 are
4.485 and 4.37:
n ct
t
t=1 1 + i)t 897.0866 DMacaulay 4.485433
DMacaulay = = = 4.485433 ⇒ DMOD = = = 4.37
n ct 2 × 100 1 + i) 1.025
k
t=1 1 + i)t
If the yield-to-maturity y increases by 10 basis points (0.1% or 0.001) from 5% to 5.10% the
price of the bond should approximately fall by −0.437% (from USD 100 to USD 99.56):6
DP
= −DMOD × Dy = −4.37 × 0.001 = −0.00437 = −0.437%
P
The present value rule also applies to equities. The fundamental value of a stock is simply
the sum of future cash flows to equity holders discounted at the opportunity costs of equity.
However, there are at least four important differences between stocks and bonds:

6
Modified duration gives only an initial approximation of the percentage price change of a bond due to small yield changes. As
the price/yield relationship of a bond is not linear, investors also have to consider the second derivative (convexity) if large yield
changes are considered. Fabozzi (1997), pp. 90–94.
8 Equity Valuation

(1) The future cash flows of stocks are more uncertain than those of bonds: Coupon payments
are usually constant and can be predicted with a high degree of confidence. Cash flows
to equity holders cannot be predicted with the same high degree of confidence. Scenario
analysis and Monte Carlo simulations are therefore essential tools for equity analysts
who want to take the uncertainty of future cash flows into consideration.
(2) Equity holders do not receive a redemption value at maturity: They are the owners of a
company and therefore, theoretically, entitled to receive cash flows until infinity. As it
is not practically possible to discount cash flows until infinity, equity analysts usually
discount cash flows over a finite period of time t = 1 . . . T , the so-called competitive
advantage period, and calculate a terminal value which captures the value of expected
cash flows after the competitive advantage period. The fundamental value of a stock is
the sum of the discounted cash flows to equity holders during the competitive advantage
period and the discounted value of the terminal value. The terminal value is – in contrast
to the redemption value of a bond – a purely theoretical construct.
(3) In contrast to the opportunity costs of debt, the opportunity costs of equity cannot be
readily observed in financial markets: Financial economists have constructed various
models to estimate the costs of equity. The most widely used model to quantify the
costs of equity is the Capital Asset Pricing Model. The CAPM describes how assets are
priced under equilibrium conditions.
(4) The number of value drivers is more plentiful for stocks than for bonds: Yield changes
are clearly the most important value driver for bonds. The duration quantifies the price
sensitivity of a bond to small yield changes. Opportunity costs are also an important
value driver for equities. However, there are several other value drivers which have
a strong impact on the value of equities, including sales growth, operating margins,
capital expenditures and change in net working capital, to name just the most prominent
value drivers of stocks. Building a model to price equities is more complicated than
valuing bonds.
The fundamental value quantifies the present value of future cash flows. It expresses how
much an investment is worth in equilibrium assuming that no arbitrage opportunities exist.
Some investors argue that equity valuation models are not helpful in making investment
decisions as market prices often deviate from their fundamental values for an extended period
of time. Of course, market prices can deviate from their fundamental values for a long time.
It is not sufficient to simply select overvalued and undervalued stocks. Investors are well
advised only to buy undervalued and short sell overvalued stocks if they have valid reasons
to believe that a stock price will move to its fundamental value over time.7 Some investors
claim that fundamental values are extremely sensitive to highly subjective inputs. They are
right as fundamental values are never objective, but depend on subjective expectations of an
uncertain future. Investors should also be aware that financial analysts and their employers
have their own interests.
Valuation models are most useful if investors (a) are able to identify stock prices which
deviate significantly from their fundamental values and (b) have valid reasons to believe
that the prices of these stocks will move to their fundamental values over time. Believers
in efficient market theory often claim that stock prices always fully reflect all available

7
These reasons are often called “catalysts”. In chemistry a catalyst is a substance that accelerates a reaction. In the parlance of
finance the word catalyst is often used for information that triggers or accelerates stock price adjustments.
 The Fundamental Value of Stocks and Bonds 9

information.8 However, valuation models are useful not only for active fund managers, but
also for believers in efficient markets. If market prices equal fundamental values, believers
in efficient markets can apply DCF models to analyze what expectations are implied in
current market prices.9
Fundamental values are based on the premise that a company will employ its assets to
generate cash flows, will continue its operations and will not liquidate its assets. In reality,
the going-concern assumption does not always hold. The going-concern assumption does
not hold for companies involved in mergers, acquisitions or restructurings. A hedge fund
manager who short sells a stock believing that it is trading well above its fundamental value
suffers a large loss if a financial or strategic investor buys this company and pays a large
control premium. The fundamental value reflects only the value of the cash-generating,
operating assets of a firm. Often companies hold an excess amount of cash on their balance
sheets not needed to continue the firm’s operation. Fundamental values do not reflect the
value of excess cash and other non-operating assets which are not utilized to generate
operating cash flows. DCF valuation is a useful exercise to understand what an investment is
worth in equilibrium. Like every model, DCF models are based on simplifying assumptions.
Trading on the basis of fundamental values can be painful if the no-arbitrage argument or
the going-concern assumption does not hold. In summary:
(1) Virtually every sophisticated equity valuation model used by leading investment banks
today is a discounted cash flow (DCF) model. The fundamental value of an investment
derived by DCF models is the present value of its expected, future cash flows.
(2) Investors compare assets and have preferences for high returns, low risk and liquidity.
The expected return which is foregone by investing in a specific asset rather than in a
comparable investment is called opportunity cost of capital. The fundamental value of
an asset depends on its opportunity cost of capital.
(3) While the present value rule applies both to bonds and equities, several important
differences exist: Cash flows to equity holders are more uncertain; equity holders do not
receive a redemption value at maturity; the opportunity costs of equity cannot readily
be observed in the markets and therefore must be modeled; interest rate sensitivity
measured by duration is the key value driver of bonds, the value drivers of equities are
more plentiful.
(4) When applying DCF models, investors have to estimate the expected cash flows during
the competitive advantage period, the terminal value and the opportunity cost of capital.
The opportunity cost of capital consists of the risk-free rate plus a risk premium, which
adequately reflects the uncertainty of future cash flows. Cash flows and opportunity
costs should be consistent.
(5) Fundamental values are calculated assuming that a company will employ its operating
assets to generate cash flows, will continue its operation and will not liquidate its assets.
The going concern assumption does not hold if companies are involved in mergers,
acquisitions or restructurings. The fundamental value does not reflect the value of non-
operating assets which are not utilized to generate operating cash flows.

8
The so-called efficient market hypothesis is not a theoretical system of sentences which are logically related but a definition
formulated by Eugene F. Fama: “A market in which prices always ‘fully reflect’ available information is called ‘efficient’.” Fama
(1970), p. 383. Financial economists do not agree how quickly stock prices react on new information and whether investors always
interpret information rationally. The work on efficient capital markets is summarized in Fama (1991) and Malkiel (2003).
9
Rappaport and Mauboussin (2001), pp. 7–14.