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How To Value Bonds and Stocks
How To Value Bonds and Stocks
Consider a bond with a 10% annual coupon rate, 15 years to maturity, and a par value of $1,000. The
current price is $Will the yield be more or less than 10%? N = 15; PV = ; FV = 1,000; PMT = 100 .CPT I/Y =
11%The students should be able to recognize that the YTM is more than the coupon since the price is
less than par./
4 5.1 Definition of a BondA bond is a legally binding agreement between a borrower and a lender
that specifies the:Par (face) valueCoupon rateCoupon paymentMaturity DateThe yield to maturity is
the required market interest rate on the bond.
7 Pure Discount BondsMake no periodic interest payments (coupon rate = 0%)The entire yield to
maturity comes from the difference between the purchase price and the par value.Cannot sell for
more than par valueSometimes called zeroes, deep discount bonds, or original issue discount bonds
(OIDs)Treasury Bills and principal-only Treasury strips are good examples of zeroes.
10 Level Coupon BondsMake periodic coupon payments in addition to the maturity valueThe
payments are equal each period. Therefore, the bond is just a combination of an annuity and a
terminal (maturity) value.Coupon payments are typically semiannual.Effective annual rate (EAR) =(1
+ R/m)m – 1m is the number of compounding periods during a year.
16 5.3 Bond ConceptsBond prices and market interest rates move in opposite directions.When
coupon rate = YTM, price = par valueWhen coupon rate > YTM, price > par value (premium
bond)When coupon rate < YTM, price < par value (discount bond)
17 YTM and Bond ValueWhen the YTM < coupon, the bond trades at a premium.13001200Bond
ValueWhen the YTM = coupon, the bond trades at par.110010006
3/88000.010.020.030.040.050.060.070.080.090.1Discount RateWhen the YTM > coupon, the bond
trades at a discount.
25 Case 1: Zero GrowthAssume that dividends will remain at the same level foreverSince future
cash flows are constant, the value of a zero growth stock is the present value of a perpetuity:
26 Case 2: Constant GrowthAssume that dividends will grow at a constant rate, g, forever,
i.e.,.Since future cash flows grow at a constant rate forever, the value of a constant growth stock is
the present value of a growing perpetuity:. .
27 Constant Growth Example
Suppose Big D, Inc., just paid a dividend of $.50. It is expected to increase its dividend by 2% per
year. If the market requires a return of 15% on assets of this risk level, how much should the stock
be selling for?P0 = .50(1+.02) / ( ) = $3.92The biggest mistake that students make with the DGM is
using the wrong dividend. Be sure to emphasize that we are finding a present value, so the dividend
needed is the one that will be paid NEXT period, not the one that has already been paid.
35 With Cash Flows …The constant growth phase beginning in year 4 can be valued as a growing
perpetuity at time 3.This type of problem generally separates the “A” students from the rest of the
class.
37 Where does R come from?The discount rate can be broken into two parts.The dividend yieldThe
growth rate (in dividends)In practice, there is a great deal of estimation error involved in estimating
R.
38 Using the DGM to Find R Start with the DGM: Rearrange and solve for R:
Point out that D1 / P0 is the dividend yield and g is the capital gains yield.You could also use this
point to introduce the CAPM as a method for computing required return.
43 5.8 Price-Earnings RatioMany analysts frequently relate earnings per share to price.The price-
earnings ratio is calculated as the current stock price divided by annual EPS.The Wall Street Journal
uses last 4 quarter’s earnings
45 Quick QuizHow do you find the value of a bond, and why do bond prices change?What is a
bond indenture, and what are some of the important features?What determines the price of a share
of stock?What determines g and R in the DGM?Decompose a stock’s price into constant growth and
NPVGO values.Discuss the importance of the PE ratio.