Topic 3 Valuing Shares and Bond

MFA 8033
FINANCIAL
MANAGEMENT
1
TOPIC 3
VALUING SHARES AND BONDS
2
TOPIC LEARNING OUTCOME
 Identify different types of bonds,

common shares and preferred of
stocks.
 Estimate value of common and
preferred stocks as well as bond.
 Compute investor’s required rate of
return
3
VALUING BONDS
4
Bonds
A bond is a debt instrument issued by

governments or corporations to raise money
The successful investor must be able to:

• Understand bond structure
• Calculate bond rates of return
• Understand interest rate risk
• Differentiate between real and nominal returns
6-5
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
Bond Basics
When governments or companies issue bonds, they
promise to make a series of interest payments and
then repay the debt.
1. Bond: Security that obligates the issuer to make
specified payments to the bondholder.
: Debt contract
: borrower will pay interest every period;
principal is paid at the end of a loan term
2. Face Value: Payment at the maturity of the bond.
~ $1,000
3. Coupon: The interest payments paid to the
bondholder.
2. Coupon Rate: Annual interest payment as a
percentage of face value. 6-6
Key Features of a Bond
• Par value:
– Face amount
– Principal is re-paid at maturity
– Assume $1,000 for corporate bonds
• Coupon interest rate:

– Stated interest rate
– Usually = YTM at issue
– Multiply by par value to get coupon payment
6-7
• Par value:
– Face amount
– Principal is re-paid at maturity
– Assume $1,000 for corporate bonds
• Coupon interest rate:

– Stated interest rate
– Usually = YTM at issue
– Multiply by par value to get coupon payment
6-8
 Maturity:
 Years until bond must be repaid
 Yield to maturity (YTM):

 The market required rate of return for bonds of similar
risk and maturity
 The discount rate used to value a bond
 Return if bond held to maturity
 Usually = coupon rate at issue
 Quoted as an APR
6-9
Bond Pricing
coupon coupon (coupon  par )

PV    .... 
(1  r )1
(1  r ) 2
(1  r ) t
6-10
Interest Rates and Bond Prices
Cash flows to an investor in the 1.25%

coupon bond maturing in 2018
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

6-11
without the prior written consent of McGraw-Hill Education.
Example
What is the price of a 1.25 % annual coupon
bond, with a $1,000 face value, which matures
in 3 years? Assume a required return of
1.194%.
12.50 12.50 1,012.50

PV   
1.01194 1.01194 1.01194
1 2 3
PV  $1,001.64

6-12
Bond prices are quoted as a percentage of par

Par value × Price % = $ Price
$ 1,000 × Price % = $ 1,001.64
Price % = 100.164%

6-13
(6 of 17)
The financial calculator functions used for the time
value of money can be used for bond calculations as
well
• Notice how the keys map with the bond

terminology
• *These keys MUST reference the same time
period (i.e., annual, semi-annual, quarterly,
monthly, etc.)
6-14
Example
What is the price of a 1.25 % annual coupon bond,
with $1,000 face value, which matures in 3 years?
Assume a required return of 1.194%.
To get the final answer, push PV and you will get -

$1,001.64. Ignore the minus sign and that is the
answer
6-15
Example
Q: How did the calculation change, given
semi-annual coupons versus annual coupon
payments?
– Twice as many payments, cut in half, over the
same time period.

6-16
Cash flows to an investor in the 1.25% coupon

bond maturing in 2018. The bond pays
semiannual coupons, so there are two
payments of $6.25 each year.

6-17
(10 of 17)
Example (continued)
What is the price of the bond if the required
rate of return is 0.597% AND the coupons are
paid semi-annually?
6.25 6.25 6.25 1,006.25

PV    
1.00597 1
1.00597 2
1.00597 5
1.005976
PV  $1,001.65
Price %  100.165 %

6-18
Example
What is the price of the bond if the required rate
of return is 0.175% AND the coupons are paid
semi-annually?
To get the final answer, push PV and you will get

-$1,001.65. Ignore the minus sign and that is
the answer
6-19
Bond Prices & Interest Rates
As interest rates change, so do bond prices.
What is the present value of a 4% coupon bond with face

value $1,000 that matures in 3 years? Assume a discount rate of 5%.
What is the present value of this same bond at a discount rate of 2%?
6-20
Bond Prices & Interest Rates
 Remember:
As interest rates increase present values
decrease ( r → PV  )
As interest rates increase, bond prices

decrease and vice versa
6-21
Bond Pricing
A bond is a package of two investments: an

annuity and a final repayment.
PVBond  PVCoupons  PVParValue

PVBond  coupon  ( Annuity Factor )  par value  ( Discount Factor )
1  (1  r ) t
where Annuity Factor 
r
1
and Discount Factor 
(1  r )t
6-22
Bond Pricing: Example
What is the value of a 3-year annuity that pays $90

each year and an additional $1,000 at the date of the
final repayment? Assume a discount rate of 4%.
1  (1  .04) 3 1
PVBond  $90   $1, 000 
.04 (1  .04)3
 $1,138.75
6-23
Valuing a Discount Bond with Annual
Coupons
 Coupon rate = 10% Using the calculator:
5 N
 Annual coupons 11 I/Y
 Par = $1,000 100 PMT
 Maturity = 5 years 1000 FV
CPT PV -963.04
 YTM = 11%
 1 
Using the formula: 1 
 (1.11)5  1000
B = PV(annuity) + PV(lump sum) B  100  5
B = 369.59 + 593.45 = 963.04  0.11  (1.11)
 
Note: When YTM > Coupon rate  Price < Par = “Discount Bond”
6 6-24
-
Valuing a Premium Bond with Annual
Coupons
 Coupon rate = 10% Using the calculator:
20 N
 Annual coupons 8 I/Y
 Par = $1,000 100 PMT
 Maturity = 20 years 1000 FV
CPT PV -1,196.36
 YTM = 8%
Using the formula:
B = PV(annuity) + PV(lump sum)  1 
 1 
B = 981.81 + 214.55 = 1196.36 (1.08) 20  1000
B  100  20
 0.08  (1.08)
 
Note: When YTM < Coupon rate  Price > Par = “Premium Bond”
6 6-25
-
Example (continued)
Q: How did the calculation change, given semi-
annual coupons versus annual coupon
payments?
Time Periods
• Paying coupons twice a year, instead of once,
doubles the total number of cash flows to be
discounted in the PV formula.
Discount Rate
• Since the time periods are now half years, the
discount rate is also changed from the annual
rate to the half year rate.
6-26
The value of the 1.25% bond falls as interest

rates rise

6-27
Bond Yields (1 of 4)
• Current Yield
– Annual coupon payments divided by bond price
• Yield To Maturity
– Discount rate for which the present value of the
bond’s payments equals the price
• Calculating Yield to Maturity (YTM = r)
– If you are given the price of a bond (PV) and
the coupon rate, the yield to maturity can be
found by solving for r
PV 
cpn

cpn
 ... 
cpn  par 
1  r  1  r 
1 2
1  r t
6-28
Bond Yields
Example
What is the YTM of a 10.0% annual coupon
bond, with a $1,000 face value, which
matures in 3 years? The market price of the
bond is $1,200.
100 100 1,100

PV   
1  r  1
1  r 2
1  r 3
PV  $ 1,200.00
r  YTM  2.94 %

6-29
Bond Yields
Example (continued)
What is the YTM of a 10.0 % annual coupon bond,
with a $1,000 face value, which matures in 3
years? The market price of the bond is $1,200.
To get the final answer, push i and you will get

2.94%
NOTE: You must enter the price as a negative or
your calculator when generate an error.
6-30
Bond Yields
Example (continued)
What is the current yield of a 10.0 % annual
coupon bond, with a $1,000 face value, which
matures in 3 years? The market price of the bond
is $1,200.
100
Current yield   .083 or 8.3 %
$ 1,200
• WARNING
– Calculating YTM by hand can be very tedious
– It is highly recommended that you learn to use
the “IRR,” “YTM,” or “i” functions on a financial
calculator
6-31
Bond Rates of Return (1 of 4)
• Rate of Return
– Total income per period per dollar invested
total income
Rate of return 
investment
coupon income  price change
Rate of return 
investment
Example
A bond increases in price from $963.80 to
$1,380.50 and pays a coupon of $21.875 during
the same period. What is the rate of return?
21.875  1380.50 - 963.80
Rate of return   .455
963.80
ROR  45.5%
6-32
Bond Rates of Return

6-33
Nominal and Real Rates of Interest
In the presence of inflation, an investor’s real

interest rate is always less than the nominal
interest rate
1  no min al rate
1  real rate 
1  inf lation rate
Example
If you invest in a security that pays 8% interest
annually and inflation is 4%, what is your real
interest rate?
1.08
1  real rate 
1.04
Re al int erest rate  .0385 or 3.85%
6-34
Default Risk
• Default or Credit Risk

– The risk that a bond issuer may default on its
bonds
• Default premium
– The additional yield on a bond that investors
require for bearing credit risk
• Investment grade
– Bonds rated Baa or above by Moody’s or BBB
or above by Standard & Poor’s
• Junk bonds
– Bond with a rating below Baa or BBB
6-35
VALUING SHARES
36
Stocks Valuation
This chapters introduces valuations techniques

for equity (stocks).
The Dividend Discount Model provides an

excellent measure of a stock’s intrinsic value.
7-37
Stock Valuation
• Common stock valuation is more difficult
to value because:
1.The promised CFs are not known in
advance
2.The life of investment is forever – no
maturity
3.Not easy to observe the market rate of
return
7-38 8-38
Cash Flows for Stockholders
 If you buy a share of stock, you can
receive cash in two ways
1. The company pays dividends
2. You sell your shares, either to another
investor in the market or back to the
company
 As with bonds, the price of the stock is
the present value of these expected cash
flows
7-39 8-39
The Stock Market
1. Primary Market (PM) vs. Secondary
Market (SM)
• PM : Market for the of new securities by
corporations.
• SM: Market in which previously issued
securities are traded among investors.
Eg: Bursa Malaysia, NYSE
2. Initial Public Offering- First offering of
stock to the general public.
3. Primary Offering- The corporation sells
shares in the firm.
Stocks and the Stock Market
• Bid Price
– The prices at which investors are willing to
buy shares
• Ask Price
– The prices at which current shareholders are
willing to sell their shares
6-41
Terminology
Investors use a number of methods to
determine the quality of a company’s
shares.
1. Market Cap – the total value of its
outstanding shares of stock
2. P/E Ratio – Ratio of stock price to
earnings per share
3. Dividend Yield – how much dividend
income you would receive for every RM
invested
7-42
Basic Terminology: Example
You are considering investing in a firm whose
shares are currently selling for $50 per share
with 1,000,000 shares outstanding. Expected
dividends are $2/share and earnings are
$6/share.
What is the firm’s Market Cap? P/E Ratio?
Dividend Yield?
Market Capitalization  $50 1, 000, 000  $50, 000, 000
$50
P/E Ratio   8.33
$6
$2
Dividend Yield   .04  4%
$50
7-43
Measures of Value
Three ways to value a firm:
Book Value
– Net worth of the firm according to the balance
sheet.
Liquidation Value
– Net proceeds that could be realized by selling
the firm’s assets and paying off its creditors.
Market Value
– The value of the firm as determined by investors
who would be willing to purchase the company.
7-44
Going-Concern Value
The difference between a company’s actual

value and its book or liquidation value is
called its going-concern value.
• Refers to three factors:

1. Extra earning power
2. Intangible assets
3. Value of future investments
7-45
Price and Intrinsic Value
7-46
Price and Intrinsic Value
Example:
What is the intrinsic value of a share of
stock if expected dividends are $2/share
and the expected price in 1 year is
$35/share? Assume a discount rate of
10%.
7-47
Expected Return
7-48
Expected Return: Example
What should be the price of a stock in one year if it

sells for $40 today, has an expected dividend per
share of $3, and an expected return of 12%?
7-49
The Dividend Discount Model
Div1 Div2 DivH  PH

P0    ... 
(1  r ) (1  r )
1 2
(1  r ) H
where :
H  Time Horizon
Divi  Dividend in the ith period.
r  Required Rate of Return
7-50
Consider three cases:
1. No growth
2. Constant Growth
3. Non-constant Growth
7-51
• Case 1: No Growth
What should the price of a share of stock be if dividends are

projected at $5/share, the discount rate is 10%, and growth is 0%?
7-52
• Case 2: Constant Growth
Example: What should the price of a share of stock be if the firm

will pay a $4 dividend in 1 year that is expected to grow at a
constant rate of 5%? Assume a discount rate of 10%.
7-53
• Case 3: Non-constant Growth
Div1 Div2 DivH PH

P0    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H
PV of dividends from PV of stock price

year 1 to horizon at horizon
7-54
Non constant Growth Dividend
Discount Model
Example:
A firm is expected to pay $2/share in dividends next
year. Those dividends are expected to grow by 8% for
the next three years and 6% thereafter. If the
discount rate is 10%, what is the current price of this
security?
7-55
Required Rates of Return
Estimating Expected Required Rates of Return:
Example: What rate of return should an investor expect on a share

of stock with a $2 expected dividend and 8% growth rate that sells
today for $60?
7-56
Simplifying the Dividend Discount
Model
If we forecast no growth, and plan to hold out
stock indefinitely, we will then value the stock
as a PERPETUITY
Div1 EPS1
Perpetutiy  P0  or
r r

Assumes all earnings are
paid to shareholders

6-57
Model
If a firm elects to pay a lower dividend, and
reinvest the funds, 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
• Sustainable Growth Rate
– The firm’s growth rate if it plows back a
constant fraction of earnings, maintains a
constant return on equity, and keeps its debt
ratio constant
6-58
Sustainable Growth Rate
If a firm earns a constant return on its equity and

plows back a constant proportion of earnings,
then the growth rate g is:
g  Return on Equity  Plowback Rate = ROE  b
earnings  dividends
where : b 
earnings
Example: Suppose a firm that pays out 35% of earnings as dividends and
expects its return on equity to be 10%. What is the expected growth rate?
g  .10  (1  .35)  .065  6.5%

7-59
Valuing Growth Stocks
Present Value of Growth Opportunities

(PVGO) –
Where:
EPS = Earnings per share
PVGO = Present Value of Growth Opportunities
7-60
Valuing Growth Stocks: Example
Suppose a stock is selling today for $55/share and

there are 10,000,000 shares outstanding. If earnings
are projected to be $20,000,000, how much value are
investors assigning to growth per share? Assume a
discount rate of 10%.
7-61
Model
Growth can be derived from applying the return
on equity to the percentage of earnings plowed
back into operations
g = sustainable growth rate
= ROE × plowback ratio
• Present Value of Growth Opportunities (PVGO)
– Net present value of a firm’s future
investments

6-62
Model
Example
Aqua America has an ROE of 12.5% and a book
value per share of $9.86. It intends to
plowback 40% of its earnings and the
opportunity cost of capital is 7.8%. What is the
stock price?
EPS  $9.86  .125  $1.233
Growth rate  .40  .125  .05 or 5.0%
Div1  $1.233  .60  $0.74
0.74
P0   $26.43
.078  .05
6-63
Model
Example (continued)
If Aqua America decides not to reinvest any
earnings, what is the value of the stock and
what is the PVGO of the firm that is lost?
EPS  $9.86  .125  $1.233
1.233
P0   $15.81
.078
PVGO  26.43  15.81  $10.62

6-64
Methods of Analysis
Investors have many strategies for trying to

beat the market consistently.
1. Technical Analysis
2. Fundamental Analysis
7-65
Technical Analysis
Technical analysts try to achieve superior

returns by spotting and exploiting
patterns in stock prices.
• Problem with this approach:

– Prices follow a “random walk”
– Security prices change randomly with no
predictable trends or patterns
7-66
Random Walk Theory
• Security prices change randomly, with no

predictable trends or patterns
• Statistically speaking, the movement of stock
prices is random
– Skewed positive over the long term

6-67
Random Walk Theory
Scatter plot of NYSE Composite Index over two

successive weeks. Where’s the pattern?

6-68
Random Walk Theory
Cycles disappear once identified

6-69
Fundamental Analysis
Fundamental analysts are paid to

uncover stocks for which price does
not equal intrinsic value.
• Don’t just look at stock prices

• Also analyze fundamental information,
such as accounting performance,
earnings prospects, other items of news
• Eg: announcement of a takeover – stock price
of the target company will jump up on the day
the public becomes aware 7-70
Efficient Market Hypotheses
Is the Malaysian stock market a highly efficient
market?
Degrees of efficiency:
 Weak-form Efficiency
- Describe a market in which prices already
reflect all the information contained in past
prices.
 Semistrong-form Efficiency
- Describe a market in which prices reflect not
just the information contained in past prices
but all publicly available information
 Strong-form Efficiency
- A market where prices impound all available
7-71
Efficient-Market Theory
Impact of leaked information
Days Relative to Announcement Date

6-72
Behavioral Finance
Some believe that deviations in prices from
intrinsic value can be explained by
behavioral psychology, in two broad areas:
1. Attitudes toward risk--People generally dislike
incurring losses, yet they are more apt to take
bigger risks if they are experiencing a period of
substantial gains.
2. Beliefs about probabilities--Individuals

commonly look
back to what has happened in recent periods and
assume this is
representative of futureCopyright
outcomes. 7-73 Inc. All rights reserved
© 2018 by The McGraw-Hill Companies,
Islamic Equity Market
• Islamic equity market in Malaysia showed

tremendous progress
• The number of Shari’ah compliant shares
has increased significantly from 371 in 1997
to 881 in April 2015 (87% traded in the main
market)

THANKS…

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MFA 8033

VALUING SHARES AND BONDS

 Identify different types of bonds,

A bond is a debt instrument issued by

The successful investor must be able to:

• Coupon interest rate:

• Coupon interest rate:

 Yield to maturity (YTM):

 Return if bond held to maturity

 Usually = coupon rate at issue

coupon coupon (coupon  par )

Cash flows to an investor in the 1.25%

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

12.50 12.50 1,012.50

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

Bond prices are quoted as a percentage of par

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

• Notice how the keys map with the bond

To get the final answer, push PV and you will get -

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

Cash flows to an investor in the 1.25% coupon

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

6.25 6.25 6.25 1,006.25

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

To get the final answer, push PV and you will get

As interest rates change, so do bond prices.

What is the present value of a 4% coupon bond with face

As interest rates increase, bond prices

A bond is a package of two investments: an

PVBond  PVCoupons  PVParValue

What is the value of a 3-year annuity that pays $90

The value of the 1.25% bond falls as interest

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

100 100 1,100

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

To get the final answer, push i and you will get

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

In the presence of inflation, an investor’s real

• Default or Credit Risk

This chapters introduces valuations techniques

The Dividend Discount Model provides an

The difference between a company’s actual

• Refers to three factors:

What should be the price of a stock in one year if it

Div1 Div2 DivH  PH

Consider three cases:

What should the price of a share of stock be if dividends are

Example: What should the price of a share of stock be if the firm

• Case 3: Non-constant Growth

Div1 Div2 DivH PH

PV of dividends from PV of stock price

Estimating Expected Required Rates of Return:

Example: What rate of return should an investor expect on a share

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

If a firm earns a constant return on its equity and

g  .10  (1  .35)  .065  6.5%

Present Value of Growth Opportunities

Suppose a stock is selling today for $55/share and

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution

Investors have many strategies for trying to

Technical analysts try to achieve superior

• Problem with this approach: