VALUATION OF BONDS AND

STOCKS
LEARNING OBJECTIVES
• After going through this chapter, one should be able to:
• Distinguish between various valuation concepts
• Estimate the value of a bond
• Calculate various measures of bond yield
• Read bond and stock quotations
• Value a preference share
• Calculate the value of a stock
• Show the relationship between E/P ratio, expected return, and growth
A. VALUATION CONCEPTS
• Liquidation Value versus Going Concern Value: The liquidation value
is the amount that can be realised when assets representing part or
the whole of a firm are sold. In contrast, the going concern value
represents the amount that can be realised if the firm is sold as a
continuing operating entity
• In general, security valuation models assume a going concern.
• When the going concern assumption is not appropriate, like in the
case of an impending bankruptcy, the liquidation value of assets is
more relevant.
• Book Value versus Market Value: The book value of a firm’s equity is equal to
the book value of its assets minus the book value of its liabilities.
• The market value of an asset is simply the market price at which the asset
trades in the market place.
• Often the market price is greater than the book value.
• Market Value versus Intrinsic Value: The market value of a security is the
price at which it trades in the financial market. The intrinsic value is the
present value of the cash flow stream expected from the security, discounted
at a rate of return appropriate for the risk associated with the security, i.e.
intrinsic value is economic value.
•
B. BOND VALUATION
• A bond represents a contract under which a borrower promises to pay
interest and principal on specified dates to the holders of the bond.
• Bonds are issued by central government (Treasury Bonds) and usually
pay interest semi annually.
• Public sector undertakings issue PSU bonds
• Private sector bonds are issued by private sector companies.
Terminology

• Par Value : the value stated on the face of the bond. It represents the
amount the firm borrows and promises to repay upon maturity.
• Coupon Rate and Interest: The specified rate is “coupon rate”. The
interest payable is simply: par value x coupon rate.
• Maturity Period: Bonds typically run for periods of 1 to 20 years. At
the time of maturity the par value is payable to the bond holder.
Valuation Model

• The value of a bond is equal to the present value of the cash flows
expected from it
• To determine the value of a bond we require: 1. An estimate of
expected cash flows and 2. An estimate of the required return.
• The following assumptions will be made:
• The coupon rate is fixed for the term of the bond
• The coupon payments are made at specified intervals, i.e. annually, or
semi-annually, etc
• The bond will be redeemed at par on maturity
• Given the above assumptions. The value of the bond is:
• P=∑ C + M (1.1)
• (1+r)t (1+r)n
• where P = value in $, n the number of years to
maturity, C = the annual coupon payment, r = the periodic required return,
M = is the maturity value, and t = the time when the payment is received.
• Since the stream of coupon payments is an ordinary annuity, the following
formula can be applied for the present value of the bond:
• P = C X PVIFAr,n + M x PVIFr,n (1.1a)
• Example: Consider 10-year, 12% coupon bond with a par value of $1
000. Assume the required yield on this bond is 13%. The cash flows
for this bond are as follows:
• 10 annual coupon payments of $120
• $1 000 principal repayment 10 years from now.
• The value of the bond is: P = 120 x PVIFA 13%, 10 yrs + 1000 x PVIF 13%, 10 yrs
• = 120 x 5,426 + 1 000 x 0,295
• = 651,10 + 295 = $946,10
Bond Values With Semi-annual Interest

• Where the interest payment is semi-annually, the following

applies:
• The annual interest payment, C, must be divided by 2 to obtain
the semi-annual interest payment.
• The number of years to maturity is multiplied by 2 to get the
number of half-yearly payments.
• The discount rate has to be divided by 2 to get the discount rate
applicable to half-yearly periods.
• With above modifications the bond valuation becomes:
• P = ∑ C/2 + M
• (1+ r/2)t (1+r/2)2n (1,2)
• = C/2 (PVIFAr/2,2n) + M(PVIFr/2,2n)
• Where P is the value of the bond, C/2 is the semi-annual interest
payment, r/2 is the discount rate applicable to a half-year period, M is
the maturity value, and 2n is the maturity period expressed in terms
of half-year periods.
• Example: Consider an 8-year, 12 percent coupon bond with a par
value of $100 on which interest is payable semi-annually. The
required return on this bond is 14%.
• The value of the bond is: P =
• (1.07)t (1,07)16
• =6(PVIFA 7%,16) + 100 (PVIF7%,16)
• = $6(9,447) + $100 (0,339) = $90,60
Relationship between Coupon Rate, Required Yield,
and Price
• A bond’s price varies inversely with yield. As the required yield decreases,
the present value of the cash flows increases, hence the price increases.
• Conversely, when the required yield increases, the present value of the
cash flow decreases.
• Example: Consider a bond carrying a coupon rate of 14% issued 3 years
ago for $1 000. The original maturity of the bond was 10 years, so its
residual maturity now is 7 years. The interest rate has fallen in the last 3
years and investors now expect a return of 10 % from this bond. The
price of this bond would be: Po = ∑ 140 + 1 000 = $1 194,70
• (1.10)t (1.10)7
• Why has the price increased? The fact that the required return has fallen to 10%
means that if you had $1 000 to invest, you can buy new bonds like this one,
except that these new bonds would pay $100, rather than $140 by way of
interest. Naturally, as an investor you would prefer $140 to $100, so you would
be willing to pay more than $1 000 for the bond to enjoy its higher coupons. All
investors would behave similarly and consequently the price of the bond would
be bid up to $1 194,70
• Now what happens when the interest rate rises after the bond has been issued?
Assume that because of a rise in interest rates, investors now expect a return of
18% from the above bond. The price would be: Po = ∑ 140 + 1 000
= $848,50
• (1,18)t (1.18)7
• To sum the relationship between the coupon rate, the required yield,
and the price is as follows:
• Coupon rate ˃ Required yield Price ˃ Par (Premium bond)
• Coupon rate = Required yield Price – Par
• Coupon rate ˂ Required yield Price ˂ Par (Discount bond)
BOND YIELDS

• Current Yield: relates the annual coupon interest to the market price.
It is expressed : Current Yield = Annual Interest
Price
For example, the current yield of a 10 year, 12% coupon bond with a
par value of $1 000 and selling for $950 is 12,63%
i.e. Current yield = 120 = 0,1263
950
The current yield ignores the time value of money. Hence it is an
incomplete and simplistic measure of yield.
• Yield to Maturity: The yield to maturity (YTM) of a bond is the
interest rate that makes the present value of the cash flows
receivable. It is the interest rate r which satisfies the equation:
P = C + C + …+ C + M (1.3)
(1+r) (1+r)2 (1+r)n (1+r)n
The computation of YTM requires a trial and error procedure. However if one is not inclined to the
trial and error procedure, the following formula can be used to find the approximate YTM.
YTM ≈ C + (M - P) /n (1.4)
0.4M + 0,6P
• Example : Consider a $1 000 par value bond, carrying a coupon rate
of 9%, maturing after 8 years. The bond is currently selling for $800.
What is the YTM on this bond?
YTM = 90 + (1 000 – 800)/8 = 13,1%
0,4x1 000 + 0,6x800
• The YTM considers the current coupon income as well as the capital
gain or loss the investor will realise by holding the bond to maturity.
In addition, it takes into account the timing of the cash flows
C. VALUATION OF PREFERENCE STOCK

• Preference stock generally pays regular, fixed dividends.

• The preference stock may be perpetual or redeemable. While the former has
no maturity period, the latter is expected to be redeemed after its limited life.
• If we assume that the preference stock pays fixed annual dividends during its
life and the principal amount on maturity, its value is given as: Po = ∑
D + M (1.5)
(1+rp)
t
(1+rp)n
where Po = the current price, D = the annual dividend, n = the residual life of
the preference stock, rp = the required rate of return, and M = the maturity
value.
• Since the stream of dividends is an ordinary annuity, the following
formula can be applied to determine the present value :
• Po = D x PVIFArp,n + M x PVIFrp,n
• Example: Consider an 8 year, 10% preference stock with a par value of $1 000.
The required return is 9%. The value of the preference stock is:
P = 100 x PVIFA9%,8yrs + 1 000 x PVIF9%,8yrs
= 100 x 5,535 + 1 000 x 0,502 = $1 055,50
EQUITY VALUATION

• DIVIDEND DISCOUNT MODEL

• According to the dividend discount model, the value of an equity
share is equal to the present value of dividends expected from its
ownership plus the present value of the sale price expected when the
equity share is sold.
Single-period Valuation Model

• If an investor expects to hold the share for one year, the price of the
share will be:
Po = D1 + P1 (1.6)
(1+r) (1+r)
Where Po = current price of the share; D1 = the dividend expected a year hence; P1 = the
price of the share expected a year hence; and r = the required rate of return.
Example: Cornet's equity share is expected to provide a dividend of $2,00 and
fetch a price of $18,00 a year hence. What price would it sell for now if the
investor’s required rate of return is 12%?
• The current price will be: Po = 2,00 + 18,00 = $17,86
(1,12) (1,12)
What happens if the price is expected to grow at a rate of g % annually?
If the current price, Po becomes Po(1+g) a year hence, we get:
Po = D1 + Po(1+g) (1.7)
(1+r) (1+r)
Simplifying equation 1.7 we get : Po = D1 (1.8)
r-g
• The expected dividend of Econet share is $2,00. The dividend per
share of Econet has grown over the past five years at the rate of 5%
per year. The growth rate will continue in future. Further the market
price of the share, too, is expected to grow at the same rate. What is
the fair estimate of the intrinsic value of the Econet share if the
required rate of return is 15%?
• Applying equation 1.8, we get : Po = 2,00 = $20,00
0,15 – 0.05
Expected Rate of Return

• What rate of return can an investor expect, given the current market
price and forecast values of dividend and share price? The expected
rate of return is : r = D1 / Po + g (1.9)
• Example: The expected dividend per share of Edgars is $5,00. The
dividend is expected to grow at the rate of 6% per year. If the price
per share now is $50,00, what is the expected rate of return?
• The expected rate of return is : r = 5/50 + 0,06 = 16%
Multi-period Valuation Model

• Since equity shares have no maturity period, they may be expected to

bring a dividend stream of infinite duration. Hence the value of an
equity share may be put as: Po = D1 + D2 + …+ D∞ = ∑ Dt (1.10)
(1+r) (1+r)2 (1+r)∞ (1+r)t
Where D1 is the dividend expected a year hence, D2 is the dividend
expected two years hence, ….D∞ is the dividend expected at the end of
infinity, and r is the expected rate of return.
• For practical applications, the following assumptions are made:
• The dividend per share remains constant forever, implying that the growth
rate is still nil (the zero growth model)
• The dividend per share grows at a constant rate per year forever (the
constant growth model)
• The dividend per share grows at a constant rate for a finite period, followed
by a constant normal rate of growth forever thereafter (the two stage model)
• The dividend per share, currently growing at above-normal rate, experiences
a gradually declining rate of growth for a while. Thereafter, it grows at a
constant normal rate (the H model)
Zero Growth Model

• If we assume that the dividend per share remains constant year after
year at a value of D, equation 7.10 becomes :
• Po = D + D +…+ D +…..∞ (1.11)
(1+r) (1+r)2 (1+r)n
On simplification, the above equation becomes:
Po = D (1.12)
r
Constant Growth Model

• The model assumes that the dividend per share grows at a constant
rate (g) : Po = D1 + D1(1+g) + …. D1(1+g)n + …. (1.13)
(1+r) (1+r)
Applying the formula for the sum of a geometric progression, the above
simplifies to : Po = D1 (1.14)
r-g
What Drives Growth?

• The two major drivers of growth are ploughback ratio and return on
equity (ROE).
• Consider that Edgars has an equity (net worth) base 100 at the
beginning of the year 1. It earns a return on equity of 20%. It pays
out 40% of its equity earnings and ploughs back 60% of its equity
earnings. The growth rate is a product of: Ploughback ratio x Return
on equity = 0.6 x 20% = 12%
• H Model: this is based on the following assumptions:
• While the current dividend growth rate, ga is greater than gn, the long-run growth
rate declines linearly for 2H years.
• After 2H years the growth rate becomes gn
• At H years the growth rate is exactly halfway between ga and gn
• P0 = D0[(1+gn) + H(ga-gn)]
r – gn
Where P0 is the intrinsic value, D0 is the current div, r is the rate of return, gn is the
normal long-run growth rate, ga is the current growth rate, and H is one-half of the
period during which ga will level off to gn
• Example: The current dividend on an equity share of International
Computers Ltd is $3,00. The present growth rate is 50%. However,
this will decline linearly over a period of 10 years and then stabilise at
12%. What is the intrinsic value per share of International Computers
Limited, if the investors require a return of 16%?
• D0 = $3,00; ga = 50%; H = 5 years; gn = 12%; r = 16%
• P0 = 300[(1,12)+5(0,50-0,12)] = $226,50
0,16-0,12
THE P/E RATIO APPROACH

• The value of stock under this approach is estimated as follows:

P0 = E1 x P0/E1
Where P0 is the estimated price, E1 is the estimated earnings per share,
P0/E1 is the justified price-earnings ratio.
The determinants of the P/E ratio can be derived from the dividend
discount model, which is the foundation for valuing equity stocks:
P0 = D1
r-g
• In this model, D1 = E1(1-b). b stands for the ploughback ratio and g =
ROE x b
• Making substitutions we get: P0 = E1 (1 – b)
r – ROE x b
Dividing both sides by E1, we get : P0/E1 = (1 – b)
r –ROE x b
The above equation indicates that the factors that determine the P/E
ratio are:
• The dividend payout ratio, (1 – b)
• The required rate of return, r
• The expected growth rate, ROE x b
• P/E Ratio and Ploughback Ratio: If ROE is greater than r, an increase in b
leads to an increase in P/E; if ROE is equal to r an increase in b has no effect
on P/E; if ROE is less than r an increase in b leads to a decrease in P/E
• P/E Ratio and Interest Rate: When interest rates increase, required rates of
return on all securities, including equity stocks, increase, pushing security
prices downward. When interest rates fall security prices rise. Hence there
is an inverse relationship between P/E ratios and interest rates.
• P/E Ratio and Risk: Other things being equal, riskier stocks have
lower P/E multiples. This can be seen by examining the formula for
the P/E ratio of the constant growth model:
• P/E = 1 – b
r–g
Riskier stocks have higher required rates of return, r , and hence lower
P/E multiples. This is true in all cases, not just the constant growth
model.
• P/E Ratio and Liquidity: Other things being equal, stocks which are
highly liquid command higher P/E multiples and stocks which are
highly illiquid command lower P/E multiples. Investors value liquidity
just the way they value safety and hence are willing to give higher P/E
multiples to liquid stocks.