My summary notes on Valuation of Long Term Securities.

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My summary notes on Valuation of Long Term Securities.

© All Rights Reserved

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First Trimester 2016 interest payment divided by the bond’s face value.

By Alfredo M. Ofrecio III

The coupon rate, or nominal annual rate of interest, is stated

on the bond’s face. If, for example, the coupon rate is 12

Course Overview: percent on a $1,000-face-value bond, the company pays the

1. Introduction to Financial Management holder $120 each year until the bond matures.

2. Valuation

3. Financial Analysis and Planning The term coupon rate comes from the detachable coupons

4. Capital Management and Investment that are affixed to bearer bond certificates, which, when

5. Cost of Capital, Capital Structure and Dividend presented to a paying agent or the issuer, entitle the holder

Policy to receive the interest due on that date. Nowadays, registered

6. Zero Base Budget Setup bonds, whose ownership is registered with the issuer, allow

the registered owner to receive interest by check through the

mail.

PART 3. VALUATION

PERPETUAL BONDS

“The Valuation of Long-Term Securities” Consol. (Consolidated Annuities) A bond that never matures; a

perpetuity in the form of a bond.

Chapter Overview:

A. Distinctions Among Valuation Concepts

B. Bond Valuation

C. Preferred Stock Valuation Where I = annual coupon and K = discount rate

D. Common Stock Valuation

E. Rates of Return (or Yields) BONDS WITH FINITE MATURITY

1. Nonzero Coupon Bonds.

If a bond has a finite maturity, then we must consider not only

A. DISTINCTIONS AMONG VALUATION CONCEPTS the interest stream but also the terminal or maturity value

(face value) in valuing the bond.

Liquidation Value versus Going-Concern Value

Liquidation value. The amount of money that could be realized if In this case, the present value of the bond is in excess of its

an asset or a group of assets (e.g., a firm) is sold separately from its $1,000 par value because the required rate of return is less

operating organization. than the coupon rate. Investors would be willing to pay a

Going-concern value. The amount a firm could be sold for as a premium to buy the bond. In the previous case, the required

continuing operating business. rate of return was greater than the coupon rate. As a result,

the bond has a present value less than its par value. Investors

These two values are rarely equal, and sometimes a company is would be willing to buy the bond only if it sold at a discount

actually worth more dead than alive. from par value. Now if the required rate of return equals the

Book value. (1) An asset: the accounting value of an asset –

the asset’s cost minus its accumulated depreciation; (2) a

firm: total assets minus liabilities and preferred stock as listed

on the balance sheet.

Because book value is based on historical values, it may bear coupon rate, the bond has a present value equal to its par

little relationship to an asset’s or firm’s market value. value, $1,000.

2. Zero-Coupon Bonds. A zero-coupon bond makes no periodic

Market value. The market price at which an asset trades in an interest payments but instead is sold at a deep discount from

open marketplace. its face value.

Market Value versus Intrinsic Value Why buy a bond that pays no interest? The answer lies in the

Intrinsic value. The price of a security should be if properly fact that the buyer of such a bond does receive a return. This

priced based on all factors bearing on valuation – assets, return consists of the gradual increase (or appreciation) in the

earnings, future prospects, management, and so on. value of the security from its original, below-face-value

purchase price until it is redeemed at face value on its

The intrinsic value of a security is its economic value. If maturity date.

markets are reasonably efficient and informed, the current

market price of a security should fluctuate closely around its

intrinsic value.

B. BOND VALUATION

3. Semiannual Compounding of Interest.

government.

the face value is usually $1,000.

time when the company is obligated to pay the bondholder

C. PREFERRED STOCK VALUATION

the face value of the instrument.

Preferred stock. A type of stock that promises a (usually) fixed dividend, The logical question to raise at this time is: Why do the stocks

but at the discretion of the board of directors. It has preference over of companies that pay no dividends have positive, often

common stock in the payment of dividends and claims on assets. quite high, values? The answer is that investors expect to sell

the stock in the future at a price higher than they paid for it.

Most preferred stock pays a fixed dividend at regular intervals. Instead of dividend income plus a terminal value, they rely

only on the terminal value. In turn, terminal value depends

Preferred stock has no stated maturity date and, given the fixed nature on the expectations of the marketplace viewed from this

of its payments, is similar to a perpetual bond. It is not surprising, then, terminal point.

that we use the same general approach as applied to valuing a perpetual

bond to the valuation of preferred stock.4 Thus the present value of The ultimate expectation is that the firm will eventually pay

preferred stock is dividends, either regular or liquidating, and that future

investors will receive a company-provided cash return on

their investment. In the interim, investors are content with

Where Dp is the stated annual dividend per share of preferred stock and the expectation that they will be able to sell their stock at a

kp is the appropriate discount rate. subsequent time, because there will be a market for it. In the

meantime, the company is reinvesting earnings and, everyone

hopes, enhancing its future earning power and ultimate

D. COMMON STOCK VALUATION dividends.

Common stock. Securities that represent the ultimate ownership (and 2. Dividend Discount Models

risk) position in a corporation.

Dividend discount models are designed to compute the

It is a subject of considerable controversy, and no one method for intrinsic value of a share of common stock under specific

valuation is universally accepted. Still, in recent years there has assumptions as to the expected growth pattern of future

emerged growing acceptance of the idea that individual common stocks dividends and the appropriate discount rate to employ.

should be analyzed as part of a total portfolio of common stocks that Merrill Lynch, CS First Boston, and a number of other

the investor might hold. investment banks routinely make such calculations based on

their own particular models and estimates.

Investors are not as concerned with whether a particular stock goes up

or down as they are with what happens to the overall value of their a. Constant Growth. If this constant rate is g, then it

portfolios. This concept has important implications for determining the becomes where D is the present dividend per share.

required rate of return on a security.

discounted value of all the cash distributions made by the firm Thus the dividend expected at the end of period n is

to the investor. In a similar fashion, the value of a share of equal to the most recent dividend times the

common stock can be viewed as the discounted value of all compound growth factor, (1 + g)n. However,

expected cash dividends provided by the issuing firm until the assuming that ke is greater than g (a reasonable

end of time. assumption because a dividend growth rate that is

always greater than the capitalization rate would

imply an infinite stock value), Eq. (4.13) can be

reduced to:

The critical assumption in this valuation model is that

Where Dt is the cash dividend at the end of time period t and dividends per share are expected to grow perpetually at a

ke is the investor’s required return, or capitalization rate, for compound rate of g. For many companies this assumption

this equity investment. This seems consistent with what we may be a fair approximation of reality.

have been doing so far. But what if we plan to own the stock

for only two years? In this case, our model becomes b. Conversion to an Earnings Multiplier Approach

The idea is that investors often think in terms of

how many dollars they are willing to pay for a dollar

of future expected earnings. Assume that a

company retains a constant proportion of its

earnings each year; call it b. The dividend-payout

Where P2 is the expected sales price of our stock at the end ratio (dividends per share divided by earnings per

of two years.

future selling price, which itself is based on expected future

dividends that gives value to the stock.

from the issuing company. Consequently, the foundation for

the valuation of common stock must be dividends. These are

construed broadly to mean any cash distribution to share) would also be constant. Therefore,

shareholders, including share repurchases.

c. No Growth.

price of a security caused by changes in interest rates is referred to as

interest-rate (or yield) risk.

d. Growth Phases. (or yield) risk only if a security is sold prior to maturity and the level of

interest rates has increased since time of purchase.

E. RATES OF RETURN (OR YIELDS) 5) For a given change in market required return, the price

of a bond will change by a greater amount, the longer its

If we replace intrinsic value (V) in our valuation equations with the maturity.

market price (Po) of the security, we can then solve for the market

required rate of return. This rate, which sets the discounted value of In general, the longer the maturity, the greater the price fluctuation

the expected cash inflows equal to the security’s current market price, associated with a given change in market required return.

is also referred to as the security’s (market) yield.

The closer in time that you are to this relatively large maturity value

Depending on the security being analyzed, the expected cash inflows being realized, the less important are interest payments in determining

may be interest payments, repayment of principal, or dividend the market price, and the less important is a change in market required

payments. return on the market price of the security. In general, then, the longer

the maturity of a bond, the greater the risk of price change to the

It is important to recognize that only when the intrinsic value of a investor when changes occur in the overall level of interest rates.

security to an investor equals the security’s market value (price) would

the investor’s required rate of return equal the security’s (market) 6) The Coupon Effect. For a given change in market

yield. required rate of return, the price of a bond will change

by proportionally more, the lower the coupon rate. In

Market yields serve an essential function by allowing us to compare, on other words, bond price volatility is inversely related to

a uniform basis, securities that differ in cash flows provided, maturities, coupon rate.

and current prices.

The reason for this effect is that the lower the coupon

1. Yield to Maturity (YTM) on Bonds rate, the more return to the investor is reflected in the

principal payment at maturity as opposed to interim

Yield to maturity (YTM). The expected rate of return on a bond if interest payments. Put another way, investors realize

bought at its current market price and held to maturity. their returns later with a low-coupon-rate bond than

with a high-coupon-rate bond. In general, the further in

The market required rate of return on a bond (Kd) is more the future the bulk of the payment stream, the greater

commonly referred to as the bond’s yield to maturity. the present value effect caused by a change in required

return.9 Even if high- and low-coupon-rate bonds have

It is also known as the bond’s internal rate of return (IRR). the same maturity, the price of the low-coupon-rate

bond tends to be more volatile.

If we now substitute actual values for I, MV, and P0, we can solve

for kd, which in this case would be the bond’s yield to maturity.

a. Interpolation.

Solving for kd/2 in this equation would give us the semiannual yield to

b. Behavior of Bond Prices. maturity. The practice of doubling the semiannual YTM has been

1) When the market required rate of return is more than adopted by convention in bond circles to provide the “annualized”

the stated coupon rate, the price of the bond will be less (nominal annual) YTM or what bond traders would call the bond-

than its face value. Such a bond is said to be selling at a equivalent yield. The appropriate procedure, however, would be to

discount from face value. The amount by which the face square “1 plus the semiannual YTM” and then subtract 1: that is,

value exceeds the current price is the bond discount.

2) When the market required rate of return is less than the

stated coupon rate, the price of the bond will be more

than its face value. Such a bond is said to be selling at a 2. Yield on Preferred Stock

premium over face value. The amount by which the Substituting current market price (P0) for intrinsic value (V) in preferred

current price exceeds the face value is the bond stock valuation we have

premium.

3) When the market required rate of return equals the

stated coupon rate, the bond will equal its face value.

Such a bond is said to be selling at par.

The rate of return that sets the discounted value of the expected cash

dividends from a share of common stock equal to the share’s current

market price is the yield on that common stock. If, for example, the

4) If interest rates rise so that the market required rate of

constant dividend growth model was appropriate to apply to the

return increases, the bond’s price will fall. If interest

common stock of a particular company, the current market price (P0)

rates fall, the bond’s price will increase. In short, interest

could be said to be

rates and bond prices move in opposite directions – just

like two ends of a child’s seesaw.

should lead to variability in bond prices. This variation in the market

From this last expression, it becomes clear that the yield on common

stock comes from two sources. The first source is the expected dividend

yield, D1/P0; whereas the second source, g, is the expected capital gains

yield. Yes, g wears a number of hats. It is the expected compound annual

growth rate in dividends. But, given this model, it is also the expected

annual percent change in stock price (that is, P1/P0 − 1 = g) and, as such,

is referred to as the capital gains yield.

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