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You are on page 1of 43

CHAPTER

How to Value

Bonds and Stocks

McGraw-Hill/Irwin

Corporate Finance, 7/e

5-2

Chapter Outline

5.1

5.2

5.3

5.4

5.5

5.6

5.7

How to Value Bonds

Bond Concepts

The Present Value of Common Stocks

Estimates of Parameters in the Dividend-Discount Model

Growth Opportunities

The Dividend Growth Model and the NPVGO Model

(Advanced)

5.8

Price Earnings Ratio

5.9

Stock Market Reporting

5.10 Summary and Conclusions

McGraw-Hill/Irwin

Corporate Finance, 7/e

5-3

First Principles:

Value of financial securities = PV of expected future

cash flows

Estimate future cash flows:

Size (how much) and

Timing (when)

The rate should be appropriate to the risk presented by the

security.

McGraw-Hill/Irwin

Corporate Finance, 7/e

5-4

of a Bond

A bond is a legally binding agreement between a

borrower and a lender:

Specifies the principal amount of the loan.

Specifies the size and timing of the cash flows:

In dollar terms (fixed-rate borrowing)

As a formula (adjustable-rate borrowing)

McGraw-Hill/Irwin

Corporate Finance, 7/e

5-5

of a Bond

Consider a U.S. government bond listed as 6 3/8 of December

2009.

The Par Value of the bond is $1,000.

Coupon payments are made semi-annually (June 30 and December 31 for

this particular bond).

Since the coupon rate is 6 3/8 the payment is $31.875.

On January 1, 2005 the size and timing of cash flows are:

$31.875

$31.875

$31.875

$1,031.875

6 / 30 / 09

12 / 31 / 09

1 / 1 / 05

6 / 30 / 05

McGraw-Hill/Irwin

Corporate Finance, 7/e

12 / 31 / 05

5-6

Identify the size and timing of cash flows.

Discount at the correct discount rate.

If you know the price of a bond and the size and

timing of cash flows, the yield to maturity is the

discount rate.

McGraw-Hill/Irwin

Corporate Finance, 7/e

5-7

Information needed for valuing pure discount bonds:

Time to maturity (T) = Maturity date - todays date

Face value (F)

Discount rate (r)

$0

$0

$0

$F

T 1

F

PV

T

(1 r )

McGraw-Hill/Irwin

Corporate Finance, 7/e

5-8

Find the value of a 30-year zero-coupon bond with

a $1,000 par value and a YTM of 6%.

$0

$0

$0

$1,000

0$ 0,1$

0 1229 30

29

30

F

$1,000

PV

$174.11

T

30

(1 r )

(1.06)

McGraw-Hill/Irwin

Corporate Finance, 7/e

5-9

Find the value of a 30-year zero-coupon bond with

a $1,000 par value and a YTM of 6%.

N

30

I/Y

PV

174.11

PMT

FV

McGraw-Hill/Irwin

Corporate Finance, 7/e

1,000

2005 The McGraw-Hill Companies, Inc. All Rights

510

Level-Coupon Bonds

Coupon payment dates and time to maturity (T)

Coupon payment (C) per period and Face value (F)

Discount rate

$C

$C

$C

$C $ F

T 1

= PV of coupon payment annuity + PV of face value

C

1

F

PV 1

T

r

(1 r ) (1 r )T

McGraw-Hill/Irwin

Corporate Finance, 7/e

511

Find the present value (as of January 1, 2004), of a 6-3/8 coupon Tbond with semi-annual payments, and a maturity date of

December 2009 if the YTM is 5-percent.

On January 1, 2004 the size and timing of cash flows are:

$31.875

$31.875

$31.875

$1,031.875

6 / 30 / 09

12 / 31 / 09

1 / 1 / 04

6 / 30 / 04

12 / 31 / 04

$31.875

1

$1,000

PV

1

$1,070.52

12

12

.05 2

(1.025) (1.025)

McGraw-Hill/Irwin

Corporate Finance, 7/e

512

Find the present value (as of January 1, 2004), of a

6-3/8 coupon T-bond with semi-annual payments, and

a maturity date of December 2009 if the YTM is

5-percent.

N

I/Y

PV

PMT

FV

McGraw-Hill/Irwin

Corporate Finance, 7/e

12

5

1,070.52

31.875 =

1,0000.06375

2

1,000

2005 The McGraw-Hill Companies, Inc. All Rights

513

1.

directions.

2.

When coupon rate > YTM, price > par value (premium bond)

When coupon rate < YTM, price < par value (discount bond)

3.

change than one with shorter maturity when interest rate (YTM)

changes. All other features are identical.

4.

higher coupon bond when YTM changes. All other features are

identical.

McGraw-Hill/Irwin

Corporate Finance, 7/e

514

When the YTM < coupon, the bond

trades at a premium.

Bond Value

$1400

1300

1200

bond trades at par.

1100

1000

800

0

0.01

0.02

0.03

0.04

0.05

0.06 0.07

6 3/8

0.08

0.09

0.1

Discount Rate

McGraw-Hill/Irwin

Corporate Finance, 7/e

Bond Value

515

bonds.

The long-maturity bond will have

much more volatility with respect to

changes in the discount rate

Par

Short Maturity Bond

Discount Rate

McGraw-Hill/Irwin

Corporate Finance, 7/e

Volatility

Bond Value

516

The low-coupon bond will have much more

volatility with respect to changes in the

discount rate

Discount Rate

Low Coupon Bond

McGraw-Hill/Irwin

Corporate Finance, 7/e

517

of Common Stocks

Dividends versus Capital Gains

Valuation of Different Types of Stocks

Zero Growth

Constant Growth

Differential Growth

McGraw-Hill/Irwin

Corporate Finance, 7/e

518

Assume that dividends will remain at the same level forever

Since future cash flows are constant, the value of a

zero growth stock is the present value of a

perpetuity:

Div1

Div 2

Div 3

P0

1

2

3

(1 r )

(1 r )

(1 r )

Div

P0

r

McGraw-Hill/Irwin

Corporate Finance, 7/e

519

Assume that dividends will grow at a constant

rate, g, forever. i.e.

Div1 Div0 (1 g )

2

3

..

.

forever, the value of a constant growth stock

is the present value of a growing perpetuity:

Div1

P0

r g

McGraw-Hill/Irwin

Corporate Finance, 7/e

520

Assume that dividends will grow at different rates

in the foreseeable future and then will grow at a

constant rate thereafter.

To value a Differential Growth Stock, we need to:

Estimate future dividends in the foreseeable future.

Estimate the future stock price when the stock

becomes a Constant Growth Stock (case 2).

Compute the total present value of the estimated

future dividends and future stock price at the

appropriate discount rate.

McGraw-Hill/Irwin

Corporate Finance, 7/e

521

Assume that dividends will grow at rate g1

for N years and grow at rate g2 thereafter

Div1 Div0 (1 g1 )

2

..

.

N

DivN 1 DivN (1 g2 ) Div0 (1 g1 ) (1 g2 )

..

.

McGraw-Hill/Irwin

Corporate Finance, 7/e

522

Dividends will grow at rate g1 for N years

and grow at rate g2 thereafter

2

Div0 (1 g1 ) Div0 (1 g1 )

Div0 (1 g1 )

DivN (1 g2 )

Div0 (1 g1 )N (1 g2 )

McGraw-Hill/Irwin

Corporate Finance, 7/e

N+1

2005 The McGraw-Hill Companies, Inc. All Rights

523

We can value this as the sum of:

an N-year annuity growing at rate g1

C

(1 g1 )

PA

1

T

r g1

(1 r )

growing at rate g2 that starts in year N+1

DivN 1

r g2

PB

N

(1 r )

McGraw-Hill/Irwin

Corporate Finance, 7/e

524

To value a Differential Growth Stock, we can use

DivN 1

C

(1 g1 )T r g2

P

1

T

N

r g1

(1 r )

(1 r )

McGraw-Hill/Irwin

Corporate Finance, 7/e

525

expected to grow at 8% for 3 years, then it will grow at

4% in perpetuity.

What is the stock worth? The discount rate is 12%.

McGraw-Hill/Irwin

Corporate Finance, 7/e

526

DivN 1

C

(1 g1 ) r g2

P

1

T

N

r g1

(1 r )

(1 r )

$2(1.08)3 (1.04)

(1.08)

.12 .04

$

2

(

1

.

08

)

1

P

3

3

.12 .08

(1.12)

(1.12)

$32.75

P $54 1 .8966

3

(1.12)

P $5.58 $23.31

P $28.89

McGraw-Hill/Irwin

Corporate Finance, 7/e

527

$2(1.08)

0

$2.16

0

$2(1.08)

2

$2.33

2

4 The constant

$2.62

$2.52

.08

3

growth phase

beginning in year 4

can be valued as a

growing perpetuity

at time 3.

$2.62

P3

$32.75

.08

$28.89

P0

2

3

1.12 (1.12)

(1.12)

McGraw-Hill/Irwin

Corporate Finance, 7/e

528

A common stock just paid a dividend of $2. The dividend is

expected to grow at 8% for 3 years, then it will grow at 4%

in perpetuity. What is the stock worth?

$28.89 = 5.58 + 23.31

First find the PV of the supernormal dividend stream then find

the PV of the steady-state dividend stream.

I/Y

3.70 =

PV

5.58

PMT

FV

McGraw-Hill/Irwin

Corporate Finance, 7/e

$2 =

0

1.12

1.08

1 100 I/Y

21.08

1.08

3

12

PV

23.31

PMT

FV

2(1.08)3 (1.04)

32.75 =

.08

529

Dividend-Discount Model

The value of a firm depends upon its growth rate,

g, and its discount rate, r.

Where does g come from?

Where does r come from?

McGraw-Hill/Irwin

Corporate Finance, 7/e

530

McGraw-Hill/Irwin

Corporate Finance, 7/e

531

The discount rate can be broken into two parts.

The dividend yield

The growth rate (in dividends)

error involved in estimating r.

McGraw-Hill/Irwin

Corporate Finance, 7/e

532

Growth opportunities are opportunities to invest

in positive NPV projects.

The value of a firm can be conceptualized as the

sum of the value of a firm that pays out 100percent of its earnings as dividends and the net

present value of the growth opportunities.

EPS

NPVGO

P

r

McGraw-Hill/Irwin

Corporate Finance, 7/e

533

the NPVGO Model (Advanced)

We have two ways to value a stock:

The dividend discount model.

The price of a share of stock can be calculated as the

sum of its price as a cash cow plus the per-share value

of its growth opportunities.

McGraw-Hill/Irwin

Corporate Finance, 7/e

534

NPVGO Model

Consider a firm that has EPS of $5 at the end of the first

year, a dividend-payout ratio of 30%, a discount rate of

16-percent, and a return on retained earnings of 20percent.

The retention ratio is .70 ( = 1 -.30) implying a growth rate in

dividends of 14% = .70 20%

From the dividend growth model, the price of a share is:

Div1

$1.50

$75

P0

r g .16 .14

McGraw-Hill/Irwin

Corporate Finance, 7/e

535

First, we must calculate the value of the firm as a

cash cow.

Div1 $5

$31.25

P0

r

.16

growth opportunities.

.20

3

.

50

3.50 .16

$.

875

$43.75

P0

r g

.16 .14

Finally,

McGraw-Hill/Irwin

Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

536

Many analysts frequently relate earnings per share to

price.

The price earnings ratio is a.k.a. the multiple

Calculated as current stock price divided by annual EPS

The Wall Street Journal uses last 4 quarters earnings

P/E ratio

EPS

Firms whose shares are in fashion sell at high multiples. Growth

stocks for example.

Firms whose shares are out of favor sell at low multiples. Value

stocks for example.

McGraw-Hill/Irwin

Corporate Finance, 7/e

537

Many analysts frequently relate earnings per

share to variables other than price, e.g.:

Price/Cash Flow Ratio

cash flow = net income + depreciation = cash flow

from operations or operating cash flow

Price/Sales

current stock price divided by annual sales per share

price divided by book value of equity, which is

measured as assets liabilities

McGraw-Hill/Irwin

Corporate Finance, 7/e

538

52 WEEKS

YLD

VOL

NET

HI

LO STOCKSYM DIV % PE 100s HI LO CLOSE CHG

52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75

Gap has

been as

high as

$52.75 in

the last

year.

Gap pays a

dividend of 9

cents/share

at $19.25, down

$1.75 from

yesterdays close

Given the

current price,

the dividend

yield is %

Gap has

been as low

as $19.06 in

the last year.

McGraw-Hill/Irwin

Corporate Finance, 7/e

Given the

current price, the

PE ratio is 15

times earnings

6,517,200 shares

traded hands in the

last days trading

539

52 WEEKS

YLD

VOL

NET

HI

LO STOCKSYM DIV % PE 100s HI LO CLOSE CHG

52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75

52-week low. Imagine how you would feel if within the

past year you had paid $52.75 for a share of Gap and now

had a share worth $19.25! That 9-cent dividend wouldnt

go very far in making amends.

Yesterday, Gap had another rough day in a rough year. Gap

opened the day down beginning trading at $20.50,

which was down from the previous close of $21.00 =

$19.25 + $1.75

Looks like cargo pants arent the only things on sale at Gap.

McGraw-Hill/Irwin

Corporate Finance, 7/e

540

5.10

formulae from previous chapters to value bonds

and stocks.

1. The value of a zero-coupon bond is

F

PV

T

(1 r )

C

2. The value of a perpetuity is

PV

r

McGraw-Hill/Irwin

Corporate Finance, 7/e

541

PV of the par value at maturity.

C

PV

r

1

F

1 T T

(1 r ) (1 r )

discounts the payments on the bond to the purchase price.

McGraw-Hill/Irwin

Corporate Finance, 7/e

542

Div

Zero growth in dividends P0

r

Div1

Constant growth in

P0

r g

dividends

DivN 1

Differential growth in dividends

g1 ) r g2

C

(

1

P

1

T

N

r g1

(1 r )

(1 r )

McGraw-Hill/Irwin

Corporate Finance, 7/e

543

g = Retention ratio Return on retained earnings

sum of its cash cow value plus the present

value of growth opportunities.

EPS

NPVGO

P

r

McGraw-Hill/Irwin

Corporate Finance, 7/e

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