Valuation of Bond and Stocks

Chapter 6 & 7
Basic Valuation

• From the time value of money, we realize that the

value of anything is based on the present value of
the cash flows the asset is expected to produce in
the future.
Basic Valuation

Asset ^
CF ^
CF ^
CF
value = V =
1 2 N
+ ++
(1 + k ) 1
(1 + k ) 2
(1 + k )
N

N ^
CF
=∑ t

t =1 (1 + k ) t

^t = the cash flow expected to be generated by

CF
the asset in period t
Valuation of Financial Assets - Bonds

•Bond is a long-term debt instrument

•Value is based on present value of:
• stream of interest payments
• principal repayment at maturity
Valuation of Financial Assets - Bonds

• kd = required rate of return on a debt instrument

• N = number of years before the bond matures
• INT = dollars of interest paid each year (Coupon
rate X Par value)
• M = par or face value of the bond to be paid off at
maturity
Valuation of Financial Assets - Bonds

Bond INT INT INT M

= Vd = + ++ +
value (1 + k d )1 (1 + k d )2 (1 + k d )N (1 + k d )N
N INT M
+
= ∑ (1 + k
d) (1 + k d )N
t
t =1
Valuation of Financial Assets - Bonds

• Genesco 15% coupon, 15 year, $1,000 bonds valued

at 15% required rated of return
• INT= 1000 X .15 = 150
• M = 1000
• Kd= 15%
• EP = MP - Buy
Valuation of Financial Assets - Bonds

• Numerical solution:

 1 
Bond 1 − (1.15)15   1 
= $150   + $1,000  15 
value  0.15   (1.15) 
 
 
Vd = $150 (5.8474) + $1,000 (0.1229)
= $877.11 + $122.89 = $1,000
Changes in Bond Values over Time

• If the market rate associated with a bond (kd) equals

the coupon rate of interest, the bond will sell at its
par value
Changes in Bond Values over Time
• If interest rates in the economy fall after the bonds are
issued, kd is below the coupon rate. The interest payments
and maturity payoff stay the same, causing the bond’s value
to increase (investors demand lower returns, so they are
willing to pay higher prices for bonds).
 Changes in Bond Values over Time

• Current yield is the annual interest payment on a

bond divided by its current market value

Current INT
yield =
Vd

 Ending  −  Beginning 
 bond value   bond value  V
d,End − Vd,Begin
Capital gains
yield =     =
 Beginning  Vd,Begin
 bond value 
 
Changes in Bond Values over Time

•Discount bond
• A bond that sells below its par value, which occurs
whenever the going rate of interest rises above the
coupon rate
•Premium bond
•A bond that sells above its par value, which occurs
whenever the going rate of interest falls below the
coupon rate
Changes in Bond Values over Time

• An increase in interest rates will cause the price of

an outstanding bond to fall
• A decrease in interest rates will cause the price to
rise
• The market value of a bond will always approach its
par value as its maturity date approaches, provided
the firm does not go bankrupt
Time path of value of a 15% Coupon, $1000 par
value bond when interest rates are 10%, 15%, and
20%
Year k d = 10% k d = 15% k d = 20%
0 $1,380.30 $1,000.00 $766.23
1 $1,368.33 $1,000.00 $769.47
2 $1,355.17 $1,000.00 $773.37
3 $1,340.68 $1,000.00 $778.04
4 $1,324.75 $1,000.00 $783.65
5 $1,307.23 $1,000.00 $790.38
6 $1,287.95 $1,000.00 $798.45
7 $1,266.75 $1,000.00 $808.14
8 $1,243.42 $1,000.00 $819.77
9 $1,217.76 $1,000.00 $833.72
10 $1,189.54 $1,000.00 $850.47
11 $1,158.49 $1,000.00 $870.56
12 $1,124.34 $1,000.00 $894.68
13 $1,086.78 $1,000.00 $923.61
14 $1,045.45 $1,000.00 $958.33
15 $1,000.00 $1,000.00 $1,000.00
Changes in Bond Values over Time

• Time path of value of a 15% Coupon, $1000 par

value bond when interest rates are 10%, 15%, and
20%
Bond Value
$1,500
Kd < Coupon Rate
$1,250
Kd = Coupon Rate
$1,000
$750
$500 Kd > Coupon Rate
$250
$0
1 3 5 7 9 11 13 15
Years
Yield to Maturity

• YTM is the average rate of return earned on a bond if it is held to

maturity

Annual Accrued
Approximate yield interest + capital gains
=
to maturity Average value of bond

 M - Vd 
INT +  
=  N 
 2 (Vd ) + M 
 3 
 
Bond Values with Semiannual Compounding

INT
2N
2 M
Vd = ∑ t
+ 2N
t =1  kd   kd 
1 +  1 + 
 2  2 
Valuation of Financial Assets - Equity (Stock)

•Common stock
•Preferred stock
•hybrid
• similar to bonds with fixed dividend amounts
• similar to common stock as they are the
owners and have no fixed maturity date
Stock Valuation Models

• Expected Dividends as the Basis for Stock Values

Value of Stock = Vs = Pˆ 0 = PV of expected future dividends

D̂1 D̂ 2 D̂ ∞
= + ++
(1 + k s ) (1 + k s )
1 2
(1 + k s )∞

∞
D̂ t
=∑
t =1 (1 + k s )
t
 Stock Valuation Models
• Stock Values with Zero Growth
• A zero growth stock is a common stock whose future
dividends are not expected to grow at all

D D D
P̂0 = + ++
(1 + k s ) (1 + k s )
1 2
(1 + k s )∞

D D
P̂0 = k̂ s =
ks P0
Stock Valuation Models

•Normal, or Constant, Growth

• Growth that is expected to continue into the
foreseeable future at about the same rate as that
of the economy as a whole
• g = a constant
 Stock Valuation Models
• Normal, or Constant, Growth
• (Gordon Model)
• Growth that is expected to continue into the
foreseeable future at about the same rate as that
of the economy as a whole
• g = a constant
D 0 (1 + g ) D 0 (1 + g ) D 0 (1 + g )
1 2 ∞
P̂0 = + ++
(1 + k s )1
(1 + k s )2
(1 + k s )∞

D 0 (1 + g ) D̂1
= =
ks − g ks − g
DCF Approach

• Here P0 is the current price of the stock; Dt is the

dividend expected to be paid at the end of year t;
and ks is the required rate of return. If dividends is
expected to grow at a constant rate, then

D̂1
P0 =
Ks − g
Expected Rate of Return on a Constant
Growth Stock

D̂ 1
k̂ s = + g
P0

= Dividend yield + Capital gain