Group 5

BOND AND
STOCK
VALUATION
01. INTRODUCTION AND
PROJECT'S AIMS

02. BOND VALUATION

Definition & Characteristics

Methods & Examples

TABLE OF
STOCK VALUATION
03. Definition & Characteristics

Methods & Examples CONTENT

INTRODUCTION

Investors rely on bond and

stock valuation to make
informed decisions about
the value and potential
returns of these financial
instruments.
AIMS OF OUR
PRESENTATIONS

Introduction to the
fundamental concepts
and tools used to value
stocks and bonds
Provide a practical
understanding of how
these concepts are
applied in real-world
scenarios.
Help students with their
future investing plans
VALUATION OF BONDS AND STOCKS
First Principle
Value of financial securities = PV of expected future cash flows

To value bonds and stocks we need to:

Estimate future cash flows: size (how much) and timing (when)

Discount future cash flows at an appropriate rate

Jacoby, Stangeland and Wajeeh, 2000

BOND VALUATION
Definition, Methods and Illustrations
 BOND FEATURES
WHAT IS A BOND THE ISSUER
PROMISES TO DEFAULT
debt issued by a
corporation or a
make regular coupon an issuer who fails to pay
governmental body.
A bond represents a loan
payments every is subject to legal action
made by investors to the period until the bond on behalf of the lenders
issuer. matures, and (bondholders).
In return for his/her pay the face (par)
money, the investor value of the bond
receives a legal claim on when it matures.
future cash flows of the
borrower.
WHAT IS BOND
VALUATION?
Bond valuation is a method to
calculate the present value of the
expected future returns, earnings, or
cash flow from a bond investment.
An investor who invests in a debt
instrument such as a bond uses the
valuation method to determine
whether the cost of the bond is
worth the returns over time.

Source: Bond Valuation

(wallstreetmojo.com)
 PURE-DISCOUNT
(ZERO-COUPON)
BONDS

A zero-coupon bond will not pay any coupon payments or timely

interest to the investor or bondholder.

In the case of a zero coupon bond, the bond price is lowered, or the
bond issuer issues the bond at a discounted rate to its face value.

At maturity, the investor receives a guaranteed full amount or par

value of the bond. As a result, the difference amount between the
purchase price of the bond and the par value at maturity becomes the
interest earned by the investor.
CALCULATION OF ZERO- COUPON BOND
Value of a pure discount bond:

Where,
‘n’ = Number of years/ number of a coupon payment cycle
P (v) = Present value of the coupon rate
F (v) = Future Value
‘r’. = Market interest rate, ‘ Discount rate,’ or ‘Yield to maturity.’
 EXAMPLES

Q1: Consider a zero-coupon bond, with a face value of $1,000,

maturing in 5 years. Suppose that the appropriate discount
rate is 8%.

1. What is the current value of the bond?

2. Suppose 6 months have past. What is the bond value now?

 ANSWER

1. Use the above P(v) equation to solve:

P(v) = F(v) / (1 + r)^n = 1,000 / (1.08)^5 = 680.583 $

2. Since 6 months (0.5 year) have passed, n comes down to 4.5

Again, use the above P(v) equation to solve:

P(v) = F(v) / (1 + r)^n = 1,000 / (1.08)^4.5 = 707.283 $

=> As we get closer to maturity, the z.c. bond value

increases P(v), since we have to wait less time to receive
$1,000
 LEVEL-COUPON BONDS

A level-coupon bond is a bond with a stream of coupon payments that

remain the same throughout the life of the bond
 CALCULATION OF LEVEL-COUPON BONDS
Value of a level-coupon bonds = PV of coupon payment annuity + PV of
face value

Where:
T: coupon payment dates and time to maturity
C: coupon payment per period
F: bond face-value
r: YTM
 CALCULATION OF LEVEL-COUPON BONDS
Discount rate

Calculating coupon payment per period:

C=Fxc
Where:
c: annual coupon rate (%)
 EXAMPLES

Consider a coupon bond paying a 4% coupon rate annually, with a face

value of $1,000, maturing in 10 years.

1. Calculate the periodic coupon payment

2. Suppose that the appropriate discount rate is 6%. What is the current
value of the bond?
 SOLUTION

1. The periodic coupon payment is:

C = F x c = 1000 x 4% = $40
2. Current value of the bond
PV = C/r * [1 - 1/(1+r)^T] + F/(1+r)^T
= 40/0.06 * [1 - 1/(1+0.06)^10] + 1000/(1+0.06)^10
= $852.79
 CANADIAN BONDS
Canadian bonds usually pay coupons every six months (semiannually)

Consider a GofC bond paying semiannual coupons at an annual rate of

6%, with a face value of $1,000, maturing in 8 years. The bond’s YTM is
7% per year compounded semiannually. What is the value of the bond?

Calculating periodic coupon payment

C = F x c = 1000 x 6%/2 = $30
Calculating PV
PV = C/r * [1 - 1/(1+r)^T] + F/(1+r)^T
= 30/0.07 * [1 - 1/(1+0.07)^10] + 1000/(1+0.07)^10
= $939.53
 DISCOUNT, PREMIUM, PAR BONDS

For the above example, when the discount rate is 6% and coupon rate is
4% (c < r) the value of the bond is $852.80, less than its face value (PV <
F). In this case we say that the bond is priced at discount.
 DISCOUNT, PREMIUM, PAR BONDS
Recalculate the PV of the above bond with discount rates of 2% and 4%.
r = 2% (c > r)
PV = C/r * [1 - 1/(1+r)^T] + F/(1+r)^T
= 40/0.02 * [1 - 1/(1+0.02)^10] + 1000/(1+0.02)^10
= $1179.65
We see that when c > r, the bond is priced at premium (PV > F).
r = 4% (c = r)
PV = C/r * [1 - 1/(1+r)^T] + F/(1+r)^T
= 40/0.04 * [1 - 1/(1+0.04)^10] + 1000/(1+0.04)^10
= $1000
We say that when c = r, the bond is priced at par (PV = F)
SOME TIPS ON BOND PRICING
Bond prices and market interest rates move in opposite directions.
 EXAMPLE 1: DISCOUNT BOND

This coupon rate is below the market interest rate and a rational
investor would only be willing to purchase this bond at a discount to
its face value because its coupon return is lower than the current
market interest rate.

The bond is generating a return lower than the market, and

investors would purchase the bond only if it was issued at a
discount.
 EXAMPLE 2: PREMIUM BOND

This coupon rate is above the market interest rate. In such a

scenario, a rational investor would be willing to purchase the bond
at a premium to its face value because its coupon return is higher
than the current interest rate.

The bond is generating a return higher than the market interest

rate and, therefore, investors will purchase the bond at a premium.
 EXAMPLE 3: PAR BOND

The coupon rate is equal to the market interest rate and a investor
would only want to purchase the bond at par to its face value
because its coupon return is the same as the current interest rate.

Since the bond is generating a return equal to the market interest

rate, investors would not offer a premium or require a discount –
the bond is priced at par.
Discount Bond
Coupon rate < market rate (r)
=> price < par value

Premium Bond
Coupon rate > market rate (r)
=> price > par value

Par Bond
Coupon rate = market rate (r)
=> price = par value
=> Uncommon in the market
The relationship between
YTM and bond price

The YTM is the implied market discount

rate given the price of the bond.

A bond's price moves inversely with its

YTM. An increase in YTM decreases the
price and a decrease in YTM increases the
price of a bond.
ROLES OF YTM
YTM can be quite useful for estimating
whether buying a bond is a good
investment. An investor will determine
a required yield (the return on a bond
that will make the bond worthwhile).

Once an investor has determined the

YTM of a bond they are considering
buying, the investor can compare the
YTM with the required yield to
determine if the bond is a good buy.
ROLES OF YTM

It is possible to compare
bonds with various maturities
and coupons since YTM
expresses the value of various
bonds in the same annual
terms regardless of the term
to maturity of the bond.
 STOCK
VALUATION
DIVIDEND DISCOUNT
MODEL
 -The dividend discount model (DDM) is a quantitative
method used for predicting the price of a company's stock
assuming that the sum of all of its future dividend payments
when discounted back, equals to their present value.

-Based on the number of

periods that need to be
calculated, there are
variants based on the
Gordon-growth model:
One-period
discount model
-Where:P is the present value (PV) of stock
D1 is next year’s expected dividend
P1 is the expected selling price at
period’s end
r is the expected rate of return

-Used by investors to estimate a fair price

when they intend to sell the purchased
stock at a target selling price.
Example

You purchase a stock for $90

intend to sell it at $100/share after a year
cost of equity of 5%.
The company will pay out a $5 dividend during this period.
=> So what is the present value of the stock you bought?
Is the stock under or overvalued?
 P = (D1+P1) / (1 + r)
=100+5/1+0.5
= $70.
The present value (PV) = $70 < the current price = $90
=> Overvalued
Multi-period
discount model
This model calculates dividend payouts for a stock over multiple holding periods
for investors who plan to purchase and sell the stock at different times during its
growth trajectory and business cycles.

Ideal for holding periods that are longer than a year, calculated each time an
investor purchases the stock.
We have the formula:

Where: PV is the present value (PV) of stock

D1, D2, …, Dn is the dividend paid each year
Pn is the stock’s selling price at the end
r is the expected rate of return
n is the amount of periods
Example
Suppose that you purchase a company's stock for $10.
It pays out a dividend of $3 that increases by 10% in the first year and
5% the following years.
Investors in the company expect a rate of return of 5% and plan to hold
the stock for three years at which time the price is estimated to be $15.
=>Then what is the PV of the stock?
PV = 3 / (1+0.05) + 3.3 / (1+0.05)^2 + 3.63/
(1+0.05)^3 + 15/ (1+0.05)^3
= 21.94
 Drawbacks
The model does not take into account changes and assumes that companies
will pay dividends in perpetuity. This is an erroneous assumption because:
- Organizations work in dynamic business environments that are subject to
multiple forces, such as regulation and competition so companies’ dividend
payouts change with conditions in the economy that affect their business.
- New companies and startups that do not have a sufficient track record of
payouts in the past may make the model less accurate.

The formula is sensitive to inputs. If the expected rate of dividend growth

changes, then the end result can be completely different.
Constant dividend
assumption
It is assumed that
dividend does not change
GORDON GROWTH MODEL

- Formula used to determine the intrinsic value of a

stock based on a future series of dividends that grow
at a constant rate.
- Assumes that dividends grow at a constant rate in
perpetuity and solves for the present value of the
infinite series of future dividends.
FORMULA
P = Current stock price
g = Constant growth rate expected for
dividends, in perpetuity
r = Required rate of return on investments in
equity
D1​= Value of next year’s dividends​
EXPLANATION
Assume that dividends will grow at a constant rate, g, forever, i. e.,
Since future cash flows grow at a constant rate forever, the value
of a constant growth stock is the present value of a growing
perpetuity:

V0 = Current stock price

D0 = The most recent dividend paid
g = Constant growth rate expected for dividends, in perpetuity
r = Required rate of return on investments in equity
 Dividends are assumed to
continue growing at a constant
ASSUMPTIONS rate forever.

The growth rate is assumed to be

less than the required return on
equity (g < r):

If the growth rate were higher than the

rate demanded by holders of the firm’s
equity (g > r), in the long run the firm
would grow impossibly large.
EXAMPLES
Q1. ABC Corp. has a common
stock that paid its annual
dividend this morning. It is
expected to pay a $3 dividend
one year from now, and
following dividends are expected
to grow at a rate of 5% per year
into the foreseeable future
(forever) in perpetuity. If stocks
of similar risk earn 15% effective
annual return, what is the price
of a share of ABC stock?
A1. The stock price is given by the the present value of the
perpetual stream of growing dividends:

0 1 2 3

$3 $3 $3

P0 = D1/(r-g)
= 3/(15%-5%)
= $30
Q2. In the previous example,
assume that ABC’s common
stock that paid its quarterly
dividend two months ago. It is
expected to pay a $0.75
dividend in one month, and
following quarterly dividends are
expected to grow at a rate of
1.25% per quarter into the
foreseeable future. Recall that
the effective annual required
rate of return on ABC stock is
15%. What is the price of a share
of ABC stock now?
A2. Timeline of the quarterly dividends:

0 1 month 4 months 7 months

$0.75 $0.75 $0.75
DISCOUNTED CASH
FLOW MODEL
 Discounted cash flow (DCF) refers to a valuation method
that estimates the value of an investment using its
expected future cash flows.

A DCF model is based on

the idea that a company’s
value is determined by how
well the company can
generate cash flows for its
investors in the future.
How to calculate DCF?
We have the following formula:
 Example of DCF

You were offered a private deal to buy a stake in a local business which will
return you $225000/year and a 10% growth rate for 5 years

Considering they use 8% of the free cash flow as weighted average cost of
capital. How much should you be willing to pay for that deal?
DCF = ($208,328 + $212,182 + $216,112 + $220,114 + $224,205)

DCF = $1,080,941
 When to use it?
DCF analysis is most useful
when future cash flows are
predictable, an appropriate
discount rate for risk is used,
and objectivity is needed to
select the best potential
investment.
Can be applied to a variety of
investments and capital
projects.
Avoid!
It is still estimation, as there
will be many factors can
impact the cash flow
forecast:
Inflation rate
New competitors
Geopolitical events
Take it with a grain of salt.
THANK YOU
Any questions?