Chapter 9 : Stock and

Bond Valuation-

Chapter Outline :
definition and understanding bond and stock;
bond features, prices, bond risk, bond indenture,
bond values and yield; Basic concep, t of
valuation of stock and bond; long term debt, call
provision, types of bond and shares / stocks;
valuation of bond and stocks. Inflation and
interest rates the Fisher Effect.
9.1 Definition and understanding
Bond and Stock
Governments and corporations borrow money by
selling bonds to investors. The money they collect
when the bond is issued,or sold to the public, is
the amount of the loan.
When you own a bond, you generally receive a
fixed interest payment each year until the bond
matures. This payment is known as the
coupon because, most bonds used to have
coupons that the investors clipped off and
mailed to the bond issuer to claim the interest
payment. At maturity, the debt is repaid: the
borrower pays the bondholder the bond’s face
value (equivalently, its par value).
Defining Stock and Bond
Stocks and bonds are financial instruments for
investors to obtain a return and for companies to raise
capital. Stocks of a company are offered at the time of
an IPO (Initial Public Offering) or later equity sales. The
company offers investors an ownership stake by selling
stocks. Stocks can be either common stock or preferred
stock. Preferred stock is further divided into participating
and non-participating preferred stock.
 Definition of bond

In contrast, bonds are loans offered at a

fixed interest rate. When a company
believes that it can raise capital cheaper
by borrowing money from banks,
institutional investors or individuals, they
may choose to offer interest-paying
corporate bonds.
Bond characteristics:

Every bond has certain characteristics:

 A definite maturity date when the bond issuer

promises to repay the bondholder who owns the
security at the time.
 A promise to pay taxable or tax-exempt interest at a
stated “coupon” rate in defined intervals over the life
of a bond.
 A yield, or return on investment, which is a function of
the bond’s coupon rate and the price the investor
pays, which may be more or less than the bond’s face
value depending on a variety of factors.
 A credit rating indicates the likelihood that the issuer
will be able to repay its debt.
 Stock Vs Bond

Stocks offer an ownership stake in the company and bonds are akin
to loans made to the company.

With bonds, an investor is promised a fixed return. While

bonds are "safer" than stocks because of lower volatility, it
should be noted that there is always a chance that company
will be unable to repay bond-holders. In that sense, bonds
are not "risk-free".

However, when a company declares bankruptcy,

stockholders are the first to bear losses. Creditors (including
bond-holders) are next.
 Debt Versus Equity

Bonds are debt, whereas stocks are equity. This is the

important distinction between the two securities. By
purchasing equity (stock) an investor becomes an owner in a
corporation. Ownership comes with voting rights and the right
to share in any future profits.
On the other hand, by purchasing debt (bonds) an investor
becomes a creditor to the corporation (or government). The
primary advantage of being a creditor is that you have a
higher claim on assets than shareholders do: that is, in the
case of bankruptcy, a bondholder will get paid before a
shareholder.
However, the bondholder does not share in the profits if a
company does well - he or she is entitled only to
the principal plus interest.
Basic Concept of the Stock
Valuation

Example 10.1
Consider a situation in which we are
valuing a share of common stock that
we plan to hold for only one year.
What will be the value of the stock
today if it pays a dividend of $2.00, is
expected to have a price of $75 and
the investor’s required rate of return
is 12%?
8 FIN3000, Liuren Wu
9.2 bond features, indenture, bond
values, and yield
Basic Features of Bonds
In order to better understand more complicated
topics, the CFA Institute requires CFA candidates
to have the ability to describe the basic features of
a bond. These features include:
1. Maturity
Maturity is the time at which the bond matures and the
holder receives the final payment of principal and interest.
The "term to maturity" is the amount of time until the bond
actually matures. There are 3 basic classes of maturity:
 Contd.

 A. Short-Term Maturity - One to five years in length

 B.Intermediate-Term Maturity - Five to twelve years in
length
 C. Long-Term Maturity - Twelve years or more in
length
 Contd.

2. Par Value
Par value is the dollar amount the holder will
receive at the bond's maturity. It can be any
amount but is typically $1,000 per bond. Par
value is also known as principle, face, maturity
or redemption value. Bond prices are quoted as
a percentage of par.
3. Yield or Return
A yield, or return on investment, which is a
function of the bond’s coupon rate and the price
the investor pays, which may be more or less
than the bond’s face value depending on a
variety of factors.
 Contd.

4. A promise- to pay taxable or tax-exempt

interest at a stated “coupon” rate in defined
intervals over the life of a bond.
 Bond Indenture

A bond indenture is the contract between a bondholder

and the issuer. It is a legal document that states what the
issuer can and cannot do, and states the bondholders
rights. Since there tends to be a ton of legalese involved,
the contract is managed by the corporate trustee who
polices the actions of the issuer to ensure the rights of the
bondholder are upheld. Within the indenture, there
are affirmative and negative covenants:
 Contd.

 Affirmative Covenants

Affirmative covenants are what the issuer promises to do for the

investor. These promises include things such as paying interest
and principle in a timely manner; paying taxes and other
expenses when due; maintaining the assets backing the bond and
issuing reports to the trustee to ensure compliance.

 Negative Covenants

Negative convents are the restraints put on a borrower. These

restraints include issuing additional securities or taking on
additional debt that may harm the current bondholders. This is
generally done without meeting certaintests and/or ratios or
receiving permission from the current bondholders.
 Risks of Bond Investing

While generally considered safer and more stable

than stocks, bonds have certain risks:

 Interest rate risk: when interest rates rise, bond prices fall. If
you need money and have to sell your bond before maturity in a
higher rate environment, you will probably get less than you
paid for it. Interest rate risk declines as the maturity date gets
closer.

 Credit risk: if the issuer runs into financial difficulty or declares

bankruptcy, it could default on its obligation to pay the
bondholders.
Contd.

 Liquidity risk: if the bond issuer’s credit rating falls or

prevailing interest rates are much higher than the coupon
rate, it may be hard for an investor who wants to sell
before maturity to find a buyer. Bonds are generally more
liquid during the initial period after issuance as that is when
the largest volume of trading in that bond generally occurs.

 Call risk or reinvestment risk: If a bond is callable, the

issuer can redeem it prior to maturity, on defined dates for
defined prices. Bonds are usually called when interest rates
are falling, leaving the investor to reinvest the proceeds at
lower rates.
Bond Yields and Prices

Yield is a figure that shows the return you get

on a bond. The simplest version of yield is
calculated using the following formula:
Bond yield = coupon amount/price. When you
buy a bond at par, yield is equal to the interest
rate. When the price changes, so does the yield.
 Contd.

Let's demonstrate this with an example. If

you buy a bond with a 10% coupon at its
$1,000 par value, the yield is 10%
($100/$1,000). Pretty simple stuff. But if the
price goes down to $800, then the yield goes
up to 12.5%. This happens because you are
getting the same guaranteed $100 on an
asset that is worth $800 ($100/$800).
Conversely, if the bond goes up in price to
$1,200, the yield shrinks to 8.33%
($100/$1,200).
 Bond Prices

The theoretical fair value of a bond is the present

value of the stream of cash flows it is expected to
generate. Hence, the value of a bond is obtained by
discounting the bond's expected cash flows to the
present using an appropriate discount rate. the factors
that influence the bond price are : bond’s face value,
coupon rate or interest rate, maturity, issuers and yield.
 Contd.
However, the factor that influences a bond
more than any other is the level of prevailing
interest rates in the economy. When interest
rates rise, the prices of bonds in the market
fall, thereby raising the yield of the older bonds
and bringing them into line with newer bonds
being issued with higher coupons.
 Yield To Maturity

YTM is a more advanced yield calculation that shows the

total return you will receive if you hold the bond to
maturity. It equals all the interest payments you will
receive (and assumes that you will reinvest the interest
payment at the same rate as the current yield on the
bond) plus any gain (if you purchased at a discount) or
loss (if you purchased at a premium).

YTM is more accurate and enables you to compare bonds

with different maturities and coupons.
 Contd.

YTM is more accurate and enables us

to compare bonds with different
maturities and coupons.
Relationship between bond prices and
Yield

As interest rates change, so do bond prices.

The relationship of yield to price can be summarized as
follows: when price goes up, yield goes down and vice
versa. Technically, you'd say the bond's price and its yield
are inversely related.
Here's an example : How high yields and high prices both
be good when they can't happen at the same time. It
depends on our point of view. If you are a bond buyer, you
want high yields. For example:
 Contd.

A buyer wants to pay $800 for the $1,000 bond,

which gives the bond a high yield of 12.5%. On
the other hand, if you already own a bond,
you've locked in your interest rate, so you hope
the price of the bond goes up. This way you can
cash out by selling your bond in the future.
9.4 Types of bond and shares /
stocks
There are many types of corporate bonds and
stocks that can be offered in order to finance
corporate activity. Each corporation chooses the
particular type of bond or stock that it offers
depending on a variety of factors. These include
general financial market conditions, the financial
strength of the corporation, the length of time
during which the funds are needed, and so on.
 Contd.

On the other side of the coin, investors choose among available

types of bonds and stocks depending on their investment goals.
Some investors are seeking safety, while others are seeking high
current yields and are willing to take more risk. The most
important types of corporate bonds.

Types of Corporate Bonds

 Debenture Bonds- Bonds for which no specific assets of
the corporation are pledged as backing. Rather, they are
backed by the general credit rating of the corporation,
plus any assets that can be seized if the corporation
allows the debentures to go into default.
 Contd.

 Mortgage Bonds- Bonds that pledge specific

property. If the corporation defaults on the bonds,
the bondholders can take the property.
 Convertible Bonds- Bonds that can be exchanged
for a specified number of shares of common stock
under certain conditions.
 Callable Bonds- Bonds that may be called in and
the principal repaid at specified times or under
conditions specified in the bond when it is issued.
 Types of Stocks

o Common Stock- Voting shares that represent

ownership interest in a corporation. Common
stock has the lowest priority with respect to
payment of dividends and distribution of assets
upon the corporation's dissolution.

o Preferred Stock- Shares of stock that have

priority over common-stock shares as to
payment of dividends and distribution of assets
upon dissolution. Dividend payments are usually
a fixed percentage of the face value of the
share.
 Contd.

o Cumulative Preferred Stock - Required dividends not

paid in a given year must be paid in a subsequent year
before any common-stock dividends are paid.
o Participating Preferred Stock- The owner is entitled to
receive the preferred-stock dividend and additional
dividends after payment of dividends on common stock.
o Convertible Preferred Stock- Preferred shareholders with
the option to convert their shares into a specified
number of common shares either in the issuing
corporation or, sometimes, in anothercorporation.
 Contd.

o Redeemable, or Callable, Preferred Stock-

Preferred shares issued with the express
condition that the issuing corporation has the
right to repurchase the shares as specified.
9.5 Valuation of bond and stocks.

Bond valuation is the determination of the fair price of

a bond. As with any security or capital investment, the theoretical
fair value of a bond is the present value of the stream of cash
flows it is expected to generate. Hence, the value of a bond is
obtained by discounting the bond's expected cash flows to the
present using an appropriate discount rate. In practice, this
discount rate is often determined by reference to similar
instruments, provided that such instruments exist. Various related
yield-measures are calculated for the given price.
 Stocks Valuation

The process of calculating the fair market value of

a stock by using predetermined formulas that factors in
various economic indicators.
Stock valuation can be calculated using a number of
different methods. The most common methods used
are the Discounted cash Flow method, the P/E
method, and the Gordon model. Whichever method is
chosen must be done accurately so that the price of
stock can be valued properly.
 Stock Valuation

Parameters of Stocks
1.Current Price
2.Future Price
3.Future dividend stream
4.Market capitalization rate
Cost of Equity Capital

Expected Return - The percentage yield that

an investor forecasts from a specific
investment over a set period of time.
Sometimes called the market
capitalization rate.

Div1  P1  P0
Expected Return  r 
P0
Cost of Equity Capital

Example: If Red Hen Feathers is selling for

$100 per share today and is expected to sell
for $110 one year from now, what is the
expected return if the dividend one year
from now is forecasted to be $5.00?

5  110  100
Expected Return   .15
100
Cost of Equity Capital

The formula can be broken into two

parts:
Dividend Yield
+ Capital Appreciation

Div1 P1  P0
Expected Return  r  
P0 P0
Stock Valuation

Stock Price using Dividend Discount

Model:
Computation of today’s stock price,
depending on the present value of all
expected future dividends.

Div1 Div2 Div H  PH

P0   ...
(1  r ) (1  r )
1 2
(1  r ) H

H - Time horizon for your investment.

Stock Valuation

Example
Current forecasts are for Wahoo Company to pay
dividends of $3, $3.24, and $3.50 over the next three
years, respectively. At the end of three years you
anticipate selling your stock at a market price of $94.48.
What is the price of the stock given a 12% expected
return?
3.00 3.24 3.50  94.48
PV   
(1  .12) (1  .12)
1 2
(1  .12) 3

PV  $75.36
 Stock Valuation

Stock Price using Perpetuity Model (growth):

Computation of today’s stock price,
depending on current dividend and
growth assumption.
Div1 EPS1
P0  or
rg rg
Ex: What is the price of a share of stock that pays $12 per share
and is assumed to grow at 3% per year, if the market capitalization
rate is 6%? What happens to share price if ‘g’ falls to 2%?
Stock Valuation Terminology

Return Measurements

Div 1
Dividend Yield 
P0

Return on Equity  ROE

EPS
ROE 
Book Equit y Per Share
Stock Valuation Terminology

 If a firm elects to pay a lower dividend, and

reinvest the funds at a relatively high rate of
return, the stock price may increase
because future dividends may be higher.

Payout Ratio - Fraction of earnings paid out

as dividends
Plowback Ratio - Fraction of earnings
retained by the firm
Stock Valuation Terminology

Present Value of Growth Opportunities

(PVGO) - Net present value of a firm’s
future investments

Sustainable Growth Rate –

Steady rate at which a firm can grow:
plowback ratio X return on equity
 Bond Valuation

Parameters of bonds
1. Face value FV = 1000
2. Coupon rate coup = .05
3. Frequency of payment m=1
4. Interest payment C = 50
5. Maturity date T=5
6. Yield to maturity r = .06

7. Price PV = ?
Market price
T Pmt  FaceValue

PB 
t 1 (1r )
t
(1 r )
T
Problems for practices

Bond valuation-
 Review Questions

 Briefly discuss about various types of bonds and

shares / stocks
 What Causes Stock Prices to Go Up and Down?
 What is Bond Indenture?
 State various types of Risks in Bond Investing.
 What type of facilities a bond holder enjoy
during the time of bankruptcy ?
 Define bond price, bond yield, and bond
maturity.
 Discuss in brief about bond and stock valuation.
Exercises on stock valuation
 See exercises from Brigham and
Houston
 Ch-08 (Starter problem 8.1to 8.6)