CHAPTER

10
Valuation and Rates
of Return

PowerPoint Presentation Prepared by Michel Paquet, SAIT

© 2018 McGraw-Hill Education Limited 10-1

 Chapter 10 - Outline

• Valuation: Concepts and Relation with Financing

and Investment Decisions
• Valuation (price, yield) of:
– Bonds
– Preferred Stock
– Common Stock
• Valuation Using the Price-Earnings Ratio
• Summary and Conclusions

© 2018 McGraw-Hill Education Limited 10-2

 Learning Objectives

1. Describe the valuation of a financial asset as

based on the present value of future cash
flows. (LO1)
2. Propose that the required rate of return in
valuing an asset is based on the risk involved.
(LO2)
3. Assess the current value (price) of bonds,
preferred shares (perpetuals), and common
shares based on the future benefits (cash
flows). (LO3)

© 2018 McGraw-Hill Education Limited 10-3

 Learning Objectives

4. Evaluate the yields on financial claims based

on the relationship between current price and
future expected cash flows. (LO4)
5. Describe the use of a price-earnings ratio to
determine value. (LO5)

© 2018 McGraw-Hill Education Limited 10-4

 Figure 10-1
The relationship between time value of
money, required return, cost of financing, and
investment decisions

LO1 © 2018 McGraw-Hill Education Limited 10-5

 Valuation Concepts
• A financial asset (security) is a claim against a
firm, government or individual for future
expected cash flows.
• Examples of financial assets are bonds,
preferred stocks and common stocks.
• Valuation of a financial asset is to determine the
present value of those future anticipated cash
flows using an appropriate discount rate.

LO1 © 2018 McGraw-Hill Education Limited 10-6

 Valuation Concepts - Yield

• An investment decision should be made by:

– comparing the price (or market value) of a financial
asset to its present value.
– determining the discount rate that equates the
market value of a financial asset with the present
value of its future expected cash flows.

• This discount rate is the market-determined

required rate of return (ROR) or yield.

LO2 © 2018 McGraw-Hill Education Limited 10-7

 Valuation: Concepts and Relation with
Financing and Investment Decisions
• Financial assets are issued by firms to attract
funds from investors.
• Therefore, the required or expected rate of
return or yield on these financial assets is the
cost of financing for issuing firms.
• In turn, the issuing firm must earn at least this
rate of return on its projects (the capital
budgeting decision) in order to add value to
shareholders’ wealth.

LO2 © 2018 McGraw-Hill Education Limited 10-8

 Yield
The Required Real Rate of Return:
– represents the opportunity cost of the investment
– in the early 1990’s, 5-7%, but now about 2 to 3%

Inflation Premium:
– a premium to compensate for the effects of inflation
– Since 2000 slightly less than 2%

Risk Premium:
– a premium associated with business and financial risk
– default, liquidity and maturity risk
– typically, 2-6%

The Required Rate of Return equals:

Real Rate of Return + Inflation Premium + Risk
Premium

LO2 © 2018 McGraw-Hill Education Limited 10-9

 Example of a Required Rate of Return

LO2 © 2018 McGraw-Hill Education Limited 10-10

 Valuation of Bonds
A bond contractually promises:
• a stream of annuity payments, “I” (called interest or coupon)
• And a final payment, Pn (called maturity, face or par value,
usually is $1,000)

LO3 © 2018 McGraw-Hill Education Limited 10-11

 Bond Calculation Example
What the price of a $1,000 bond that pays a $100 interest
payments for 20 periods and the required yield to maturity is
10%?

LO3 © 2018 McGraw-Hill Education Limited 10-12

 Bond Calculation Example Part 2
Find the price of a bond that pays 10% interest (coupon rate)
when the required rate of return (current yield) is 12%, and
the bond has 20 years remaining to maturity and a face value
of $1,000
Using a calculator:

LO3 © 2018 McGraw-Hill Education Limited 10-13

 Bond Calculation Example Part 3
• Calculating the price of the same bond using a
spreadsheet

LO3 and LO4 © 2018 McGraw-Hill Education Limited 10-14

 Relationship Between Bond Prices and
Yields
• Bond prices are inversely related to bond yields
If Yields decrease, the Price of Bonds increase
If Yields increase, the Price of Bonds decrease

• Distinguish between the bond yield and the

coupon rate, which equals coupon/par value.
• As interest rates in the economy change, the price
or value of a bond changes.

LO4 © 2018 McGraw-Hill Education Limited 10-15

 Table 10-1
Bond price sensitivity to yield to maturity

LO4 © 2018 McGraw-Hill Education Limited 10-16

 Table 10-2
Bond price sensitivity to time to maturity changes

LO4 © 2018 McGraw-Hill Education Limited 10-17

 Figure 10-2 Relationship between time to maturity and bond price*

*The relationship in the graph is not symmetrical in nature

LO4 © 2018 McGraw-Hill Education Limited 10-18
 Finance in Action
The Ups and Downs of Bond Prices

LO4 © 2018 McGraw-Hill Education Limited 10-19

 Semiannual Interest and Bond Prices
Most bonds in Canada and the United States pay
interest semiannually.

To make the conversion from an annual to semiannual

analysis, we follow three steps:

1. Divide the annual interest (coupon) rate by 2

2. Multiply the number of years by 2
3. Divide the annual yield to maturity by 2

LO4 © 2018 McGraw-Hill Education Limited 10-20

 Semiannual Interest and Bond Price
Example

LO4 © 2018 McGraw-Hill Education Limited 10-21

 Valuation of Preferred Stock
Preferred stock:
o usually represents a perpetuity (something with
no maturity date)
o has a fixed dividend payment
o is valued without any principal payment since it
has no ending life
o is considered a hybrid security
o owners have a higher priority of claim than
common shareholders
o price is based upon PV of future dividends

LO3 © 2018 McGraw-Hill Education Limited 10-22

 Valuation of Preferred Stock
• Cash flows from a preferred stock

LO3 © 2018 McGraw-Hill Education Limited 10-23

 Valuation of Preferred Stock

• Generally preferred stock is a perpetuity

• The Price (P) of preferred stock will then use the

formula for the present value of an infinite
stream of constant dividends (D) at a given
discount rate equal to K

Pp = D p
Kp

LO3 © 2018 McGraw-Hill Education Limited 10-24

 Valuation of Preferred Stock

• Determining the Required Rate of Return (Yield)

from the Market Price:

Dp
Kp 
Pp

LO3 © 2018 McGraw-Hill Education Limited 10-25

 Valuation of Common Stock
• Present value of a stream of future dividends

• Common stock dividends are variable:

1. No growth in dividends (valued like preferred stock)
2. Constant growth in dividends
3. Variable growth in dividends (Appendix 10B)

• Yield (Rate of Return) reflects the dividend yield on

the stock and the expected growth rate in the
dividend

LO3 © 2018 McGraw-Hill Education Limited 10-26

 Valuation of Common Stock

1. No Growth in Dividends
o similar to preferred stock
D0
P0 
Ke
2. Constant Growth in Dividends
i. the dividend growth rate, “g”, must be constant forever.
ii. the required rate of return, Ke, must exceed the growth rate, “g”

D1
P0 
Ke  g

LO3 © 2018 McGraw-Hill Education Limited 10-27

 Determining the Inputs for the Dividend
Valuation Model
• Dividends: annual reports or investment web sites
• The required rate of return, Ke can be estimated:
o Using the Capital Asset Pricing Model (CAPM) (examined in
Appendix 11A)
o Or by using the current yield for long-term Government of
Canada bond and a risk premium based on the level of risk
of the common shares
• The growth rate “g” is best estimated from the historical
growth rate in dividends projected in the future
o or “g” can be estimated from the growth in EPS, revenues
per share, or cash flow per share if one or the other of these
items are not available.

LO3 © 2018 McGraw-Hill Education Limited 10-28

 Determining the Required Rate of
Return from the Market Price
• The Required Rate of Return consists of 2
things:
1) dividend yield = D1/P0
2) anticipated growth in the future = g

D1
Ke  g
P0

LO4 © 2018 McGraw-Hill Education Limited 10-29

 The Price-Earnings Ratio Concept and
Valuation
The Price-Earnings (P/E) ratio represents a multiplier
applied to current earnings to determine the value
of a share of stock in the market.
The P/E ratio is influenced by:
o the earnings and sales growth of the firm
o the risk (or volatility in performance)
o the debt-equity structure of the firm
o the dividend policy
o the quality of management
o a number of other factors

LO5 © 2018 McGraw-Hill Education Limited 10-30

 Table 10-3
An example of stock quotations, March 2017

LO5 © 2018 McGraw-Hill Education Limited 10-31

 High vs. Low P/Es
A stock with a high P/E ratio:
o indicates positive expectations for the future of the
company
o means the stock is more expensive relative to earnings
o typically represents a successful and fast-growing
company
o is called a growth stock
A stock with a low P/E ratio:
o indicates negative expectations for the future of the
company
o may suggest that the stock is a better value or buy
o is called a value stock
LO5 © 2018 McGraw-Hill Education Limited 10-32
 Variable Growth in Dividends

Most common finance literature assumes

common share valuation with no growth or
constant growth in dividends

When the firm experiences very rapid growth

it is called supernormal growth

Appendix 10B discusses the valuation of a

supernormal growth firm

LO5 © 2018 McGraw-Hill Education Limited 10-33

 Summary and Conclusions

• Valuation of financial assets – bonds, preferred

stock, and common stock – is determining the
present value of future cash flows.
• The discount rate used in the valuation process
is called the rate of return or yield to maturity.
• The yield (ROR) is composed of a real rate of
return, an inflation premium, and a risk premium.

© 2018 McGraw-Hill Education Limited 10-34

 Summary and Conclusions
• The price, or current value, of a bond is equal to
the present value of interest (or coupon)
payments (It) over the life of the bond plus the
present value of the principal payment (Pn) at
maturity. The discount rate used is the yield to
maturity (Y).
• The value of preferred stock is the present value
of an infinite stream of level dividend payments.

© 2018 McGraw-Hill Education Limited 10-35

 Summary and Conclusions
• In general, the value of common stock is also
the present value of an expected stream of
future dividends. However, there are 3 possible
scenarios.
• The price-earnings (P/E) ratio is an easy rule of
thumb used to determine the value of a common
stock.

© 2018 McGraw-Hill Education Limited 10-36

 Appendix 10B
Variable Growth in Dividends
When the firm experiences very rapid growth
it is called supernormal growth.

Dividends from supernormal growth firm is

represented graphically as:

APP-10B © 2018 McGraw-Hill Education Limited 10-37

 Appendix 10B
Stock valuation of a supernormal growth firm

APP-10B © 2018 McGraw-Hill Education Limited 10-38

 Appendix 10B
Stock valuation of a supernormal growth firm

APP-10B © 2018 McGraw-Hill Education Limited 10-39

 Appendix 10 B
Stock valuation of a supernormal growth firm

APP-10B © 2018 McGraw-Hill Education Limited 10-40

 Figure 10B-1
Stock valuation under supernormal growth
analysis

APP-10B © 2018 McGraw-Hill Education Limited 10-41