Lecture 3

FM212 - Principles of Finance
Asset Pricing
Lecture 3 – Introduction to Bonds and
Common Stocks
James Clark FM212 - Principles of Finance 1

Key Topics
Bond Terminology
Zero-coupon Bonds
Coupon Bonds
Yield to Maturity (YTM)
Stock and Stock Market Terminology
Gordon Growth Formula
A Simple Model of Growth

Lecture 3 – Introduction to Bonds and Common Stocks
Introduction to Bonds
Bonds are often called fixed-income securities. They are so named as the cash
flows they deliver to an investor, as well as the dates that these cash flows will
arrive, tend to be known (fixed) in advance.
A bond is a security issued by a borrower (i.e. the issuer) and purchased by

an investor. The bond issuer is raising money (borrowing). Upon issue, the
investor is obliged to pay the issuer the bond price and expects to
see this money repaid (with interest) over time.
The bond contract obligates the issuer to make pre-specified payments to the
bondholder at pre-specified future dates. Different payment schedules will give
different bond types.

Bond Terminology
Par Value The nominal value of the bond that is repaid to the
bondholder at maturity. It is also known as the
principal or face value. Generally assumed to be 100 or
1000 units of currency.
Coupon The periodic payment of interest on a bond. Generally

fixed (can have floating rate bonds). For annual coupon
bonds calculated from par value X coupon rate. Paid
semi-annually in the US.
Coupon Rate The annual coupon payment expressed as a percentage

of the bond's par value.
Maturity Date The specified date on which the par value of the bond
must be repaid.
Bond Terminology
Zero-coupon A bond that pays no annual interest (coupons) but is

Bond sold below par so all the compensation is paid to
the zero coupon bondholder in the form of capital
appreciation. Also known as a pure discount bond.
Coupon Bond A bond that pays regular coupon interest payments

up to maturity, when the par value is also paid.
Discount Bonds do not have to trade at their par value. A bond

trading below it’s par value is said to be trading at a
discount.
Premium A bond trading above it’s par value is said to be

trading at a premium.

Zero-coupon Bonds
t=0 Maturity date t=n
PV Par value
The zero-coupon bond is the building block from which other bond structures
are built. A n-year zero-coupon bond has the following basic structure:
A n-year zero-coupon bond promises the purchaser a single payment, called

the face value or par value, n years from the current date.
The date of the payment is called the maturity date and n is the time to
maturity.

Zero-coupon Bonds
t=0 t=5
£9750 £10,000
Example
A 5 year zero has a face value of £10,000 and is priced at £9750.
If an investor was to purchase the bond then:

The investor would suffer an immediate cash outflow of £9750
The investor would would be promised a cash inflow of £10,000, 5 years
from today.

Coupon Bonds
t=0 t=1 t=2 t=3 t= n-1 t=n
PV C C C C C + Par value
Coupon bonds are more complicated structures. A n-year coupon bond has the
following basic features:
At regular intervals until maturity the bondholder receives a coupon payment.

These payments could be made annually, semi-annually or quarterly.
These coupon payments are usually the same at every payment date.
The ratio of the total annual coupon payment to the face value is called the
coupon rate.
On the maturity date, the bondholder receives both a coupon payment and
the par value.
Coupon Bonds
t=0 t=1 t=2
PV £6 £106
Example
A 2 year 6% coupon bond with annual coupons and a face value of £100.
If an investor was to purchase the bond then:

The investor would suffer an immediate cash outflow of the price (PV)
of the bond.
The investor would be promised a cash inflow of £6 (coupon) at the end
of every year until the maturity date of 2 years.
The investor would also be promised a cash inflow of £100 (face value)
at the maturity date of 2 years.
A Real World Example – UK Gilts
Consider the 4.5% Treasury Gilt 2019 issued by the UK government. This is a
bond issued by the government to fund its activities. It has the following
features:
Every year until maturity, an investor receives an annual coupon of £4.50

for every £100 of the bond that they hold.
Coupon payments are semi-annual, so the £4.50 total annual coupon is paid
in 2 instalments:
£2.25 on March 7th every year
£2.25 on September 7th every year.
The bond matures on March 7th 2019, and on that date a holder of £100 of
the bond issue will receive £100 face value plus the £2.25 coupon due on
that date.
When it issues a bond, the government sets the coupon rate to reflect current
market interest rates.
Size of Bond Markets
In general, we hear much less about bond markets than we do equity (or
housing) markets in the financial media. Is this because bond markets are
unimportant or small? Clearly, as the table below shows, they are very large.
Table 1: US bond markets: outstanding debt (SIFMA, Q1 2017)

Size of Bond Markets
How about bond markets relative to equity markets?
Use the Russell 3000 index of US stocks to measure US stock market

capitalisation.
The Russell 3000 is over 98% of the US stock universe in market

capitalisation terms.
In Feb 2017 the Russell 3000 companies were worth $25.6 trillion
Obviously: bond markets are around 50% larger in size than equity markets.

It is much more common to talk about bonds using their yield to maturity rather
than their price.
Yield to Maturity
The YTM is the constant, hypothetical discount rate that, when used to compute
the PV of a bond’s cash flows, gives you the bond’s market price as the answer.
We talk about YTMs rather than prices as prices can be very different across
bonds due to differing coupon rates, but yields are annual discount rates and
thus much more easily compared.
A higher bond price must mean a lower YTM and vice versa.

Example
Consider a 2 year 6% coupon bond with annual coupons and a face value of
£100. Assume the market price of the bond is £102.
What is the bond’s YTM?
The YTM is the discount rate, y, that solves the following equation:
£6 £106
£102 = +
1 + y (1 + y )2
The solution is, roughly, y = 4.9% (which can be calculated using excel, a financial
calculator, trail and error or in this specific case the quadratic formula).
If the bond’s price was to rise then the YTM would fall and vice versa.

Example
Assume that today is January 2018. A German Government bond (Bund) pays
a 5.375% annual coupon, every year for 6 years. The face value of the bond is
€100. Its YTM is 3.8%.
What is the market price of the bond?
Jan 2018 Jan 2019 Jan 2020 Jan 2021 Jan 2022 Jan 2023 Jan 2024
PV €5.375 €5.375 €5.375 €5.375 €5.375 €105.375

We can thus compute the price of the bond from:
€5.375 €5.375 €5.375 €5.375 €5.375 €105.375

PV = + + + + +
1+ y (1 + y ) (1 + y ) (1 + y ) (1 + y ) (1 + y )
2 3 4 5 6
Since we know that the yield to maturity, y is 0.038, the price of the bond is:
€5.375 €5.375 €5.375 €5.375 €5.375 €105.375

€108.31 = + + + + +
1.038 (1.038 ) (1.038 ) (1.038 ) (1.038 )
2 3 4 5
(1.038)
6

Yields, Bond Prices and Coupon Rates
Coupon rates are fixed at the issue date of a bond, while prices and thus YTMs
can vary through the bond’s lifetime.
Bond prices are sensitive to interest rate movements. They go down when
interest rates go up, and vice-versa.
Bond prices are negatively related to interest rates
If interest rates go up, cash flows are discounted more heavily, and the price
(PV) goes down.
If interest rates go down, cash flows are discounted less heavily, and the price
(PV) goes up.
Yields, Bond Prices and Coupon Rates
Bonds Trading at a Premium
If the coupon rate on a bond is greater than the YTM, then the price of the
bond will be above par (or face value).
Bonds Trading at a Discount
If a bond’s coupon rate is below the YTM, then the bond’s price will be
below par.
So, for example, in a world of positive interest rates, zero coupon bonds must
always be priced below par.

Stockholders are the owners of the firm. They have the right to vote on
company policy and strategy (at AGMs and EGMs), whereas bond holders do
not. They are entitled to the residual cash flows from the firm’s operations.
Common Stock Security representing a share in the ownership of a

corporation.
Initial Public The first sale of stock in a corporation to the public.

Offering (IPO)
Secondary A market, often a stock exchange, in which previously

Market issued shares are traded amongst investors.
Dividends Payments made by companies to shareholders. These

are usually ex-ante uncertain (unlike bond coupons).
Dividend Yield Ratio of annual dividend to share price.
P/E Ratio Share price divided by earnings per share.
There are various ways to measure the aggregate value of the company to its
shareholders.
Market Value The total stock market value of the firm’s stock (i.e.
price per share multiplied by number of shares
outstanding).
Book Value Accounting value of the firm’s equity as reflected on

the company’s balance sheet.
Liquidation The amount that would be available to shareholders if

Value the firm was liquidated and all creditors paid off.
Measuring Expected Returns to Holding a Single Share
You buy a share today, defined as time t=0, in a corporation that has a current
price of P0. You know that at the end of one year, t=1, the firm will pay you a
dividend D1 and after the payment of the dividend you will be left with a share
worth P1. You don’t know with certainty the values of D1 and P1 today.
You wish to estimate the percentage one-year return you will obtain from
holding the stock.
As the future dividend and the future price are unknown, you must estimate
them. Your expected return is
E0 [ D1 + P1 − P0 ] E0 ( D1 ) E0 ( P1 − P0 )
E (r ) = = + .
P0 P0 P0
Expected Expected capital

dividend yield appreciation
Constant Expected Returns and Stock Prices
Now we’re going to turn this equation round.
Assume for the particular stock we’re looking at, investors demand a constant
expected return of E(r) over time. Using our previous equation we can
separate the last term:
E0 ( D1 ) E0 ( P1 − P0 )
E (r ) = +
P0 P0
E0 ( D1 ) E0 ( P1 )
E (r ) = + −1
P0 P0

Rearranging the first equation below we obtain an equation for P0:
E0 ( D1 ) E0 ( P1 ) E0 [ D1 + P1 ]
E (r ) = + −1 ⇒ P0 =
P0 P0 1+ E (r )
If investors require a return of E(r) and expect dividends of D1 and a future price
of P1 at t=1 then using PV techniques, investors must think that the stock today
is worth P0.
Now think about the E(P1)term on the RHS of the preceding equation. By the
same logic we just used:
E0 [ D2 + P2 ]
E ( P1 ) =
1+ E (r )
So we can rewrite our pricing equation as:
 E0 [ D2 + P2 ] 
E0  D1 + 
 1+ E (r ) 
P0 =
1+ E (r )
E0 ( D1 ) E0 ( D2 ) E0 ( P2 )
P0 = + +
1 + E ( r ) 1 + E ( r )  2
1 + E ( r ) 
2
 
Then applying the same logic to substitute out E0(P2) and E0(P3) and so
on ........

If we make the assumption that

E0 ( Pt )
1 + E ( r ) 
t
tends to zero as t tends to infinity then we obtain the stock pricing equation
below:
∞
E0 ( Dt )
P0 = ∑
1 + E ( r ) 
t
t =1
The stock price is just the present value of an infinite stream of dividends.
Prices will be greater when expected dividends are greater.
Prices will be lower when the expected return required by investors E(r)
rises.
Constant Dividends, Expected Returns and Stock Prices
t=0 t=1 t=2 t=3 t= 4 t=n→∞
PV=P0 D D D D
Assume that we expect all future dividends to be constant at a level of D. The
the price of the stock becomes: ∞
D
P0 = ∑
1 + E ( r ) 
t
t =1
This is just a perpetuity and we know that its PV is equal to

D
P0 =
E (r)
where D is the constant future dividend and starts one period after the
valuation point.
Stock Prices when Dividends Grow at a Constant Rate
t=0 t=1 t=2 t=3 t= 4 t=n→∞
PV=P0 D D(1+g) D(1+g)2 D(1+g)3
Assume that we expect dividends to grow at a constant rate in the future.

Denote next period’s expected dividend by D and the growth rate by g, so that
the stream of expected dividends will be D, D(1 + g), D(1 + g)2 ......
Then the stock price is

D (1 + g )
t −1
∞
P0 = ∑
1 + E ( r ) 
t
t =1

t=0 t=1 t=2 t=3 t= 4 t=n→∞
PV=P0 D D(1+g) D(1+g)2 D(1+g)3
This is just a perpetuity with growth and we know that it can be evaluated as
D
P0 =
E (r ) − g
The formula is often called the Gordon Growth Formula for stock pricing. It
implies that stock prices are higher when dividends or their growth rates are
higher and stock prices fall when required returns rise.
Example I
Assume that you wish to value a stock. You estimate that it will pay a dividend
of £2 in one year and that the dividends will grow at a rate of 5% per annum
thereafter. You require an annual return of 9% for holding a stock of this risk
level.
t=0 t=1 t=2 t=3 t= 4 t=n→∞
PV=P0 £2 £2(1.05) £2(1.05)2 £2(1.05)3
£2
P0 = = £50
0.09 − 0.05
Example II
Assume a stock currently has a market price of £75. You believe that it will pay
a dividend of £3 at the end of the year and that dividends will grow at an annual
rate of 5% thereafter. What is the market’s required return on this stock?
t=0 t=1 t=2 t=3 t= 4 t=n→∞
P0=£75 £3 £3(1.05) £3(1.05)2 £3(1.05)3
£3
£75 =
E ( r ) − 0.05
Example II
Rearranging the equation
£3
E ( r ) = 0.05 + = 0.09
£75
The market’s required return on this stock is 9%.

Stock Prices, Earnings and Dividends
Dividends must be paid out of a firm’s net earnings.

If a firm chooses to invest more today and pays a lower dividend, that might
raise stock prices as it allows the firm to make greater dividend payments in
future.
Payout ratio is the ratio of dividends to earnings.
Plowback ratio is the proportion of earnings retained by the firm and used
for investment.
Return on equity is a measure of the amount of earnings that a pound of
equity (book value) creates. Thus it is:
EPSt
ROE =
Book value of Equity per sharet −1
The rate at which a firm’s earnings can grow is governed by its ROE and by its
plowback ratio. Earnings growth is:
g = ROE × Plowback Ratio

Intuition
Assume constant ROE and plowback ratio.

Plowback tells us how much of current earnings is retained for investment
purposes.
ROE tells us how much each pound of equity contributes to earnings.
Put them together than you get growth in earnings, g.
Change in Earnings = New Investment × ROE
We assume that the new investment comes from reinvesting earnings only and
hence depends on earnings and the plowback ratio.
New Investment = Earnings × Plowback Ratio
Change in Earnings
Earnings Growth Rate =
Earnings
For the equation above plug in for the change in earnings.

New Investment × ROE

Earnings
Plug in for the new investment from the equation on the previous slide.
Earnings × Plowback Ratio × ROE

Earnings
Cancel through earnings.
Earnings Growth Rate = Plowback Ratio × ROE

If the payout ratio i.e. (1 – plowback ratio), and ROE are constant then the
growth in earnings is constant and is the same as growth in dividends.
Dividend Growth Rate = ROE × Plowback Ratio
So, if you plowback earnings into investment projects, this will enable your
dividends to grow faster. Growth will be greater when the ROE of your
investments is larger.

Firm 1
t=0 t=1 t=2 t=3 t= 4 t=n→∞
P0 £8.33 £8.33 £8.33 £8.33
Firm 1 earns £8.33 per share every year and pays out all of this to investors. It’s
required rate of return is 15%. We can calculate the price of the share using the
perpetuity formula:
£8.33
P0 = = £55.56
0.15
Firm 2
t=0 t=1 t=2 t=3 t= 4 t=n→∞
P0 £8.33(0.6) £8.33(0.6)(1.1) £8.33(0.6)(1.1)2 £8.33(0.6)(1.1)3
Firm 2 has an identical required return to Firm 1 and an identical earnings

forecast for next year (i.e. £8.33). Instead of paying all of its earnings as
dividends, it commits to plowing back 40% of them. It’s ROE is 25%.
Given the assumption of constant ROE and plowback ratio the constant growth
rate in dividends is:
g = ROE × Plowback Ratio =0.25 × 0.4=0.1

Firm 2
t=0 t=1 t=2 t=3 t= 4 t=n→∞
P0 £8.33(0.6) £8.33(0.6)(1.1) £8.33(0.6)(1.1)2 £8.33(0.6)(1.1)3
We can calculate the price of the share using the perpetuity with growth
formula:
£8.33 ( 0.6 )
P0 = = £100
0.15 − 0.1

Intuition for Firms I and II
The firm that plows back earnings has a greater stock price.
This is because its ROE is greater than the required return so retaining
earnings generates returns that are above the discount rate.
If the ROE was equal to the required return, the two firms would be worth
the same amount. If the firm’s new investments earn the same return, ROE,
as the required rate of the return then the NPV of the investment is zero.
The difference in value between the firm that plows back earnings and the
firm that does not is called the Present Value of Growth Opportunities
(PVGO).
In our case the PVGO is £44.44 per share.

Using the definition of the PVGO, we have the following:
EPS1
P0 = + PVGO
E (r)
The stock price is equal to the present value of earnings under the assumption
that all earnings are paid as dividends (the first term) plus the present value of
growth opportunities (the second term).
EPS1 PVGO
Divide by P0: 1= +
E ( r ) × ( P0 ) P0

EPS1 E ( r ) × PVGO
Multiply by E(r): E (r ) = +
P0 P0
Rearrange: EPS1  PVGO  Percentage value

= E ( r ) × 1 −  of PVGO to price
P0  P0 
This tells us that E/P ratios are not a good measure of required returns. They will
dramatically understate required returns for firms with large PVGO. Lesson,
don’t use E/P ratios to estimate required returns unless you adjust for growth.

Summary Key Topics
Bond Terminology
Zero coupon Bonds
Coupon Bonds
Gordon Growth Formula

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FM212 - Principles of Finance

James Clark FM212 - Principles of Finance 1

Yield to Maturity (YTM)

Stock and Stock Market Terminology

Gordon Growth Formula

A Simple Model of Growth

James Clark FM212 - Principles of Finance 2

A bond is a security issued by a borrower (i.e. the issuer) and purchased by

James Clark FM212 - Principles of Finance 3

Coupon The periodic payment of interest on a bond. Generally

Coupon Rate The annual coupon payment expressed as a percentage

Zero-coupon A bond that pays no annual interest (coupons) but is

Coupon Bond A bond that pays regular coupon interest payments

Discount Bonds do not have to trade at their par value. A bond

Premium A bond trading above it’s par value is said to be

James Clark FM212 - Principles of Finance 5

t=0 Maturity date t=n

A n-year zero-coupon bond promises the purchaser a single payment, called

James Clark FM212 - Principles of Finance 6

A 5 year zero has a face value of £10,000 and is priced at £9750.

If an investor was to purchase the bond then:

James Clark FM212 - Principles of Finance 7

t=0 t=1 t=2 t=3 t= n-1 t=n

At regular intervals until maturity the bondholder receives a coupon payment.

t=0 t=1 t=2

If an investor was to purchase the bond then:

A Real World Example – UK Gilts

Every year until maturity, an investor receives an annual coupon of £4.50

Size of Bond Markets

Table 1: US bond markets: outstanding debt (SIFMA, Q1 2017)

James Clark FM212 - Principles of Finance 11

Size of Bond Markets

How about bond markets relative to equity markets?

Use the Russell 3000 index of US stocks to measure US stock market

The Russell 3000 is over 98% of the US stock universe in market

James Clark FM212 - Principles of Finance 12

Yield to Maturity (YTM)

James Clark FM212 - Principles of Finance 13

Yield to Maturity (YTM)

What is the bond’s YTM?

James Clark FM212 - Principles of Finance 14

Yield to Maturity (YTM)

What is the market price of the bond?

PV €5.375 €5.375 €5.375 €5.375 €5.375 €105.375

James Clark FM212 - Principles of Finance 15

Yield to Maturity (YTM)

We can thus compute the price of the bond from:

€5.375 €5.375 €5.375 €5.375 €5.375 €105.375

€5.375 €5.375 €5.375 €5.375 €5.375 €105.375

James Clark FM212 - Principles of Finance 16

Yields, Bond Prices and Coupon Rates

Bond prices are negatively related to interest rates

Yields, Bond Prices and Coupon Rates

Bonds Trading at a Premium

Bonds Trading at a Discount

James Clark FM212 - Principles of Finance 18

Stock and Stock Market Terminology

Common Stock Security representing a share in the ownership of a

Initial Public The first sale of stock in a corporation to the public.

Secondary A market, often a stock exchange, in which previously

Dividends Payments made by companies to shareholders. These

Stock and Stock Market Terminology

Dividend Yield Ratio of annual dividend to share price.