WEEK 6,7

VALUATION OF SECURITIES

Securities valuation for some of the more exotic financial instruments (such as
mortgage-backed securities) is a specialized field which departs from the
traditional valuation methods used to determine the value of business assets.
A valuation can be useful when trying to determine the fair value of a security, which
is determined by what a buyer is willing to pay a seller, assuming both parties enter
the transaction willingly. When a security trades on an exchange, buyers and sellers
determine the market value of a stock or bond.
BONDS
Bonds are debt securities that represent a loan made by an investor to a borrower.
When you buy a bond, you are essentially lending money to the issuer in exchange
for periodic interest payments and the return of the principal amount at maturity.
Bonds are commonly used by governments, municipalities, and corporations to raise
capital for various purposes.
Types of Bonds:
 Government Bonds: Issued by national governments to finance public
spending. Examples include U.S. Treasuries, German Bunds, and Japanese
Government Bonds (JGBs).
 Corporate Bonds: Issued by corporations to raise capital for various
purposes, such as expansion or debt refinancing.
 Municipal Bonds: Issued by state or local governments to fund public
projects, such as infrastructure development.
 Agency Bonds: Issued by government-sponsored entities, such as Fannie
Mae or Freddie Mac in the United States.
 Zero-Coupon Bonds: Bonds that do not pay periodic interest but are issued
at a discount to face value, with the investor receiving the face value at
maturity.
 Convertible Bonds: Bonds that can be converted into a predetermined
number of common stock shares.

BOND CHARACTERISTICS

Bonds have various characteristics that differentiate them from other financial
instruments. Understanding these characteristics is essential for investors, as they
impact the risk and return profile of bond investments. Here are some key bond
characteristics:

1. Face Value (Par Value):

 The face value, also known as par value, is the nominal value of the bond. It
represents the amount the issuer promises to repay to the bondholder at
maturity. Face value is typically $1,000 or multiples thereof.
2. Coupon Rate:
 The coupon rate is the fixed or floating interest rate that the issuer agrees to
pay to the bondholder, expressed as a percentage of the face value. For
 example, a bond with a 5% coupon rate on a $1,000 face value will pay $50 in
annual interest.
3. Coupon Payments:
 Coupon payments are the periodic interest payments made by the issuer to
the bondholder. These payments are typically made semiannually or annually
and are based on the coupon rate and face value.
4. Maturity Date:
 The maturity date is the date on which the face value of the bond becomes
due, and the issuer is obligated to repay it to the bondholder. Bonds can have
short-term (e.g., less than one year), medium-term (e.g., 1-10 years), or long-
term (e.g., more than 10 years) maturities.
5. Yield to Maturity (YTM):
 The yield to maturity is the total return anticipated on a bond if it is held until it
matures. It includes both the annual coupon payments and any capital gain or
loss if the bond is bought at a price different from its face value.
6. Market Price:
 The market price of a bond is the current trading price in the secondary
market. It can be influenced by various factors, including changes in interest
rates, credit risk, and overall market conditions.
7. Bond Indenture:
 The bond indenture is the legal document outlining the terms and conditions
of the bond, including the rights and obligations of the issuer and the
bondholder. It specifies details such as coupon payments, maturity date, and
any covenants.
8. Callable and Non-Callable Bonds:
 Callable bonds give the issuer the option to redeem the bond before its
maturity date. This introduces call risk for the bondholder, as the issuer may
choose to call the bond if interest rates decline.
9. Convertible Bonds:
 Convertible bonds give bondholders the option to convert their bonds into a
predetermined number of common stock shares. This provides the potential
for capital appreciation if the issuer's stock price rises.
10. Credit Rating:
 Credit rating agencies assign credit ratings to bonds based on the issuer's
creditworthiness. Higher credit ratings indicate lower default risk, while lower
ratings suggest higher risk.
11. Coupon Frequency:
 The frequency of coupon payments can be semiannual, annual, or, in the
case of zero-coupon bonds, none at all.
12. Inflation Protection:
 Inflation-protected bonds, such as Treasury Inflation-Protected Securities
(TIPS), adjust their principal value based on changes in the Consumer Price
Index (CPI) to provide investors with protection against inflation.

Q.BOND PRICES AND YIELDS

 Bond prices and yields have an inverse relationship, meaning that as one goes up,
the other generally goes down. This relationship is crucial for investors to understand
when evaluating bond investments. Here's how bond prices and yields interact:

1. Interest Rates and Bond Prices:

 The most significant factor influencing bond prices is changes in interest
rates. When interest rates rise, the prices of existing bonds in the market tend
to fall, and when interest rates decline, bond prices tend to rise.
 The reason for this inverse relationship is that existing bonds with fixed
coupon rates become less attractive in a rising interest rate environment.
Investors can earn higher yields by purchasing newly issued bonds with
higher coupon rates.
2. Discount and Premium Bonds:
 Bonds can be traded at three different price levels: at par, at a premium, or at
a discount.
 At Par: The bond is trading at its face value, and the yield equals the
coupon rate.
 At a Premium: The bond is trading at a price higher than its face
value, and the yield is lower than the coupon rate.
 At a Discount: The bond is trading at a price lower than its face value,
and the yield is higher than the coupon rate.
3. Yield to Maturity (YTM):
 The yield to maturity is the total return an investor can expect to receive if the
bond is held until it matures. YTM takes into account the bond's current
market price, coupon interest, and the time remaining until maturity.
 When bond prices rise, yields fall, and when bond prices fall, yields rise. This
is because the yield is inversely related to the bond's price.
4. Example Scenario:
 Consider a bond with a face value of $1,000, a fixed annual coupon rate of
5%, and a maturity of 10 years. If interest rates in the market rise after the
bond is issued, causing similar newly issued bonds to have a higher coupon
rate, the existing bond's price in the secondary market would likely fall.
 As a result, the bond might start trading at a discount, say $900. Now, the
investor buying the bond at $900 would receive $50 annually in coupon
payments (5% of $1,000), effectively yielding more than 5% on their
investment. This higher yield compensates for the lower bond price.
5. Duration:
 Duration is a measure of a bond's sensitivity to changes in interest rates. It
helps estimate the potential impact of interest rate movements on the bond's
price.
 The longer the duration, the more sensitive the bond's price is to changes in
interest rates.
6. Risk and Reward:
 Investors should be aware that while bonds provide a fixed income stream
through coupon payments, changes in interest rates can introduce price
volatility. Understanding the relationship between bond prices and yields is
essential for managing interest rate risk.

Q.STOCKS AND THE STOCK MARKET
 Q.STOCKS AND THE STOCK MARKET

Stocks and the stock market play a central role in the world of finance. Here's an
overview of key concepts related to stocks and the stock market:

Stocks (Equities):

1. Definition:
 Stocks, also known as equities or shares, represent ownership in a company.
When you own a stock, you own a piece of the company and become a
shareholder.
2. Ownership and Voting Rights:
 Shareholders are entitled to certain ownership rights, including the right to
vote on major company decisions, such as the election of the board of
directors. The number of votes typically corresponds to the number of shares
owned.
3. Types of Stocks:
 Common Stock: The most common type of stock, providing ownership and
voting rights. Common shareholders have a residual claim on the company's
assets and earnings after all debts and preferred stock obligations are
satisfied.
 Preferred Stock: These shares have preference over common stock in terms
of dividend payments and liquidation proceeds. However, preferred
shareholders usually don't have voting rights.
4. Dividends:
 Some companies pay dividends to their shareholders, which are a portion of
the company's profits distributed to stockholders. Not all stocks pay dividends,
and dividend payments are at the discretion of the company's board of
directors.
5. Stock Symbols:
 Each publicly traded company is identified by a unique stock symbol or ticker
symbol. This symbol is used for trading and tracking the company's stock on
stock exchanges.

The Stock Market:

1. Definition:
 The stock market is a marketplace where buyers and sellers trade stocks. It
provides a platform for companies to raise capital by issuing stocks and for
investors to buy and sell stocks.
2. Exchanges:
 Stocks are bought and sold on stock exchanges. Examples include the New
York Stock Exchange (NYSE), NASDAQ, London Stock Exchange (LSE), and
Tokyo Stock Exchange (TSE).
3. Stock Indices:
 Stock indices, such as the S&P 500, Dow Jones Industrial Average (DJIA),
and NASDAQ Composite, track the performance of a group of stocks and
serve as benchmarks for the overall market.
4. Bulls and Bears:
 A "bull market" refers to a period when stock prices are rising, and investor
confidence is high. In contrast, a "bear market" occurs when stock prices are
falling, and pessimism prevails.
5. Market Participants:
 Investors: Individuals, institutional investors, and funds that buy and hold
stocks for various investment objectives.
 Traders: Individuals or institutions engaged in short-term buying and selling
of stocks to capitalize on price fluctuations.
 Market Makers: Entities that facilitate trading by buying and selling stocks in
the secondary market.
6. Initial Public Offering (IPO):
 When a private company offers its shares to the public for the first time, it is
known as an initial public offering (IPO). This allows the company to raise
capital by selling shares to investors.
7. Market Capitalization (Market Cap):
 Market cap is the total value of a company's outstanding shares and is
calculated by multiplying the stock price by the number of shares. It is used to
categorize companies as large-cap, mid-cap, or small-cap.
8. Stock Brokerages:
 Investors typically buy and sell stocks through brokerage accounts. Online
brokerages have become increasingly popular, providing investors with easy
access to stock markets.

Q.BOOK VALUES

Book value is a company’s equity value as reported in its financial statements. The
book value figure is typically viewed in relation to the company’s stock value (market
capitalization) and is determined by taking the total value of a company’s assets and
subtracting any of the liabilities the company still owes.

The company’s balance sheet also incorporates depreciation in the book value of
assets. It attempts to match the book value with the real or actual value of the
company. Book value is typically shown per share, determined by dividing
all shareholder equity by the number of common stock shares that are outstanding.

Importance of Book Value

Book value is considered important in terms of valuation because it represents a fair

and accurate picture of a company’s worth. The figure is determined using historical
company data and isn’t typically a subjective figure. It means that investors and
market analysts get a reasonable idea of the company’s worth.

Book value is primarily important for investors using a value investing

strategy because it can enable them to find bargain deals on stocks, especially if
they suspect that a company is undervalued and/or is poised to grow, and the stock
is going to rise in price.

Stocks that trade below book value are often considered a steal because they are
anticipated to turn around and trade higher. Investors who can grab the stocks while
costs are low in relation to the company’s book value are in an ideal position to make
a substantial profit and be in a good trading position down the road.

Q.LIQUIDATION VALUE

Liquidation value is the net value of a company's physical assets if it were to go out
of business and the assets sold. The liquidation value is the value of company real
estate, fixtures, equipment, and inventory. Intangible assets are excluded from a
company's liquidation value.

Understanding Liquidation Value

There are generally four levels of valuation for business assets: market value, book
value, liquidation value, and salvage value. Each level of value provides a way for
accountants and analysts to classify the aggregate value of assets. Liquidation
value is especially important in the case of bankruptcies and workouts.

Liquidation value does not include intangible assets such as a company's

intellectual property, goodwill, and brand recognition. However, if a company is sold
rather than liquidated, both the liquidation value and intangible assets determine the
company's going-concern value. Value investors look at the difference between a
company's market capitalization and its going-concern value to determine whether
the company's stock is currently a good buy.

Not every asset can be sold for what was paid for it or what is still due on the note to
buy that asset. Businesses look at the recovery rate on an asset-by-asset basis.
Cash would have a 100% recovery rate. Accounts receivable, inventory, and plant
equipment would have a lower recovery rate. These rates tallied together will
provide an estimated recovery value of a company in case of liquidation.

Q.MARKET VALUE

MARKET VALUE

Market value (also known as OMV, or "open market valuation") is the price an asset
would fetch in the marketplace, or the value that the investment community gives to
a particular equity or business.

Market value is also commonly used to refer to the market capitalization of a

publicly traded company, and is calculated by multiplying the number of
its outstanding shares by the current share price.

Market value is easiest to determine for exchange-traded instruments such as

stocks and futures, since their market prices are widely disseminated and easily
available, but is a little more challenging to ascertain for over-the-counter
instruments like fixed income securities. However, the greatest difficulty in
 determining market value lies in estimating the value of illiquid assets like real
estate and businesses, which may necessitate the use of real estate appraisers and
business valuation experts respectively.

Understanding Market Value

A company’s market value is a good indication of investors’ perceptions about its
business prospects. The range of market values in the marketplace is enormous,
ranging from less than $1 million for the smallest companies to hundreds of billions
for the world’s biggest and most successful companies.

Market value is determined by the valuations or multiples accorded by investors to

companies, such as price-to-sales, price-to-earnings, enterprise value-to-EBITDA,
and so on. The higher the valuations, the greater the market value.

Q.VALUING COMMON STOCK

VALUING common stock involves estimating the intrinsic value of a share of stock,
which is the present value of its expected future cash flows. Investors use various
methods to Valuing assess the worth of a stock, and two common approaches are
the Dividend Discount Model (DDM) and the Discounted Cash Flow (DCF) model.
Additionally, some investors consider relative valuation metrics and qualitative
factors. Here's an overview of these valuation methods:

1. Dividend Discount Model (DDM):

 The DDM is suitable for valuing stocks that pay dividends. It calculates the
present value of expected future dividend payments.
 The formula for the Gordon Growth Model, a version of the DDM for
perpetuity, is:
Stock Price=Dividend per ShareDiscount Rate−Dividend Growth RateStock P
rice=Discount Rate−Dividend Growth RateDividend per Share
 Here, the Discount Rate is the required rate of return for the investor, and the
Dividend Growth Rate is the expected annual growth rate of dividends.
2. Discounted Cash Flow (DCF) Model:
 The DCF model is a more general approach that values a stock based on the
present value of its expected future cash flows, including dividends, buybacks,
and the future sale of the stock.
 Here, Cash Flow�Cash Flowt represents the expected cash flow in year �t,
�r is the discount rate, and �n is the number of years into the future.
3. Relative Valuation:
 Investors often compare a stock's valuation with its peers or industry averages
using relative valuation metrics. Common ratios include the Price-to-Earnings
(P/E) ratio, Price-to-Sales (P/S) ratio, and Price-to-Book (P/B) ratio.
 For example, the P/E ratio is calculated as
Stock PriceEarnings per Share (EPS)Earnings per Share (EPS)Stock Price. A
lower P/E ratio might suggest that a stock is undervalued relative to its
earnings.
Q.SIMPLIFYING THE DIVIDEND DISCOUNT MODEL

What Is the Dividend Discount Model (DDM)?

The dividend discount model (DDM) is a quantitative method used for predicting the
price of a company's stock based on the theory that its present-day price is worth
the sum of all of its future dividend payments when discounted back to their present
value.

It attempts to calculate the fair value of a stock irrespective of the prevailing market
conditions and takes into consideration the dividend payout factors and the market
expected returns. If the value obtained from the DDM is higher than the current
trading price of shares, then the stock is undervalued and qualifies for a buy, and
vice versa.

Understanding the DDM

A company produces goods or offers services to earn profits. The cash flow earned
from such business activities determines its profits, which gets reflected in the
company’s stock prices. Companies also make dividend payments to stockholders,
which usually originate from business profits. The DDM model is based on the
theory that the value of a company is the present worth of the sum of all of its future
dividend payments.

DDM Formula
Based on the expected dividend per share and the net discounting factor, the
formula for valuing a stock using the dividend discount model is mathematically
represented as,

Value of Stock=EDPS(CCE−DGR)
where:EDPS=expected dividend per shareCCE=cost of capital equityDGR=dividen
d growth rate

Since the variables used in the formula include the dividend per share and the net
discount rate (represented by the required rate of return or cost of equity and the
expected rate of dividend growth), the value comes with certain assumptions.

Since dividends, and their growth rate, are key inputs to the formula, the DDM is
believed to be applicable only to companies that pay out regular dividends;

however, it can still be applied to stocks that do not pay dividends by making
assumptions about what dividend they would have paid otherwise.

growth stock and income stocks:

Growth Stocks:
As the name implies, growth companies by definition are those that have substantial
potential for growth in the foreseeable future. Growth companies may currently be
growing at a faster rate than the overall markets, and they often devote most of their
current revenue toward further expansion. Every sector of the market has growth
companies, but they are more prevalent in some areas such as technology,
alternative energy, and biotechnology.

 SP-500 trailing P/E of 26.9.12

Income Stocks:
Investors look to income stocks to bolster their fixed-income portfolios with dividend
yields that typically exceed those of guaranteed instruments such as Treasury
securities or CDs.

There are two main types of income stocks. Utility stocks are common stocks that
have historically remained fairly stable in price but usually pay competitive
dividends. Preferred stocks are hybrid securities that behave more like bonds than
stocks. They often have a call or put features or other characteristics, but also pay
competitive yields.

Although income stocks can be an attractive alternative for investors unwilling to risk
their principal, their values can decline when interest rates rise.

the concepts of growth stocks and income stocks through a case study.

Case Study: XYZ Corporation

Background: XYZ Corporation is a well-established company in the technology

sector. The company has been in operation for over a decade and has a strong track
record of innovation. Recently, it has launched a groundbreaking product that is
expected to revolutionize the industry.

Growth Stock Perspective:

1. Financials: XYZ Corporation has been reinvesting a significant portion of its profits
into research and development. The company is not focused on paying out dividends
to shareholders but rather on expanding its product line and market share. The
revenue and earnings growth of XYZ Corporation have been impressive over the past
few years.

2. Stock Price Appreciation: Investors interested in growth stocks are attracted to

XYZ Corporation because of the potential for significant stock price appreciation. As
the company continues to innovate and capture market share, the stock price is
expected to rise, providing capital gains for investors.

3. Volatility: Growth stocks, including XYZ Corporation, often experience higher

volatility in their stock prices compared to more stable income stocks. This volatility
can present both opportunities and risks for investors.
Income Stock Perspective:

1. Dividend Payments: Contrastingly, an income-oriented investor may prefer

stocks that provide a regular stream of income in the form of dividends. XYZ
Corporation, despite its success and profitability, has opted to pay a portion of its
earnings back to shareholders in dividends. The dividend yield may not be as high as
some traditional income stocks, but it provides a steady income stream.

2. Stability and Lower Volatility: Income stocks are generally considered more
stable and less volatile than growth stocks. XYZ Corporation's dividend payments can
act as a cushion during market downturns, providing investors with a more reliable
income source.

3. Capital Preservation: Income investors are often more concerned with preserving
capital and generating a consistent income stream rather than achieving high capital
appreciation. XYZ Corporation's dividend payments contribute to this goal.

Conclusion:

In this case study, XYZ Corporation illustrates the duality of growth and income
stocks. Investors need to carefully consider their investment objectives, risk tolerance,
and time horizon when choosing between these two approaches. While growth
stocks like XYZ Corporation offer the potential for high returns through capital
appreciation, income stocks prioritize stability and regular income through dividends.
A well-diversified portfolio may include a combination of both growth and income
stocks based on an investor's unique financial goals and risk preferences.