CHAPTER

VALUATION PRINCIPLES
BOND AND STOCK VALUATION
1. Valuation of Bonds
• A bond is a long-term debt instrument issued by a
corporation or government.
• A bond pays a stated amount of interest to the investor,
period after period, until it is fully retired by the issuing
company.
• A bond has a face value – this is a stated value of a an
asset. In the case of a bond, the face value is usually $1,
000.
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• A bond has a stated maturity which is the time
when the company is obliged to pay the bond
holder the face value of the instrument.
• The coupon rate or nominal annual rate of
interest, is stated on the face of the bond.
 If for example, the coupon rate is 12% on a $1,
000 face value bond, the company pays the
holder $120 each year.
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• Calculating the value of bonds is relatively easy
because size and time pattern of their cash flow
over their life are known.
• Bond cash flows comes in two basic forms;
i. Interest payments every six months equals to
one-half the coupon rate times the face value
of the bond.
ii. The payment of the principle on bond’s maturity
date.
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Bond with a Finite Maturity
None Zero Coupon Bonds
• If a bond has a finite maturity, then we must
consider not only the interest stream but also the
terminal or maturity (face) value in valuing the
bond.
• The valuation equation of such a bond that pays
interest at the end of each year is;
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 Note: the intrinsic value of an interest-bearing
bond with a finite maturity is equal to the present
value of the interest payments plus the present
value of principal payment at maturity, all
discounted.

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Semi-Annual Compounding of Interest
• Although some bonds make interest payments
once a year, most bonds issued especially in the
united states pay interest twice a year.
• As a result, it is necessary to modify our bond
valuation equation to account for compounding
twice a year. the formula changes to;

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Preferred Stock
• A preferred stock is a type of stock that promises fixed
dividend, but at the discretion of the board of directors.
• Preferred stock enjoy preference over common stock in
the payment of dividends and claims on assets.
• Preferred stock have no stated maturity date and to a
larger extent they are like perpetual bonds due to the
fixed nature of payments.

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Common Stock Valuation
• Common stock are securities that represent the
ultimate ownership and risk position in a
corporation.
• Unlike bonds and preferred stock cash-flows,
which are contractually stated, much more
uncertainty surrounds the future stream of
returns connected with common stock.
• The valuation of common stock can be viewed
as the discounted value of all expected cash
dividends provided by the issuing firm until the 20
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• Dividend discount models are designed to
compute the intrinsic value of a share of common
stock under specific assumptions such as the
expected growth pattern of future dividends and
the appropriate discount rate to employ.
• The models are basically in three models –
constant growth (Gordon dividend valuation)
model, no growth model and growth phase model.

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 Note:not always are stocks expected
simply to maintain a constant dividend
forever. However, when a stable dividend is
expected to be maintained for long period
of time the equation can provide a good
approximation of value.

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Growth Phase Model
• When dividends growth is expected to differ
during various phases of the firm’s
development, the present value of dividends
for various growth phases can be
determined and summed up to produce the
stock’s intrinsic value.
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END

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