Chapter 1

FINANCIAL ASSETS VALUATION

1. Definitions and Example of a Bond
2. How to Value Bonds
3. Bond Concepts
4. Valuation of Stocks
5. Growth Opportunities
6. EMH and anomalies (irregularities)
 Definitions
2

 Financial asset: a security that

represents a claim against the future
income or assets of issuer.
 Bond is a security sold by governments
and corporations to raise money from
investors today in exchange for promised
future payments.
 A bond is a legally binding agreement
between a borrower and a lender that
specifies the :
 Principal amount of the loan.
 Cont’d..........
3

Par or Face Value –

 The amount of money that is paid to the
bondholders at maturity. For most
bonds this amount is $1,000. It also
generally represents the amount of
money borrowed by the bond issuer.
Coupon Rate -
 The coupon rate, which is generally
fixed but can also be floating or zero,
determines the periodic coupon or
interest payments. It is expressed as a
 Cont’d........
4

Coupon Payments –
 The coupon payments represent the
periodic interest payments from the
bond issuer to the bondholder.
 Since most bonds pay interest semi-
annually, generally one half of the
annual coupon is paid to the
bondholders every six months.
Maturity Date -
 It represents the date on which the
bond matures, i.e., the date on which
 Cont’d........
5

Original Maturity -
 The time from when the bond was
issued until its maturity date.
Remaining Maturity -
 The time currently remaining until the
maturity date.
Call Date -
 For bonds which are callable, i.e., bonds
which can be redeemed by the issuer
prior to maturity.
 It represents the earliest date at which
 Cont’d...........
6

Call Price –
 The amount of money the issuer has to
pay to call a callable bond (there is a
premium for calling the bond early).
 When a bond first becomes callable, i.e.,
on the call date, the call price is often
set to equal the face value plus one
year's interest.
Required Return -
 The rate of return that investors
currently require on a bond.
 Cont’d..........
7

Yield to Maturity –
 The rate of return that an investor
would earn if he bought the bond at its
current market price and held it until
maturity.
 It represents the discount rate which
equates the discounted value of a
bond's future cash flows to its current
market price.
Yield to Call -
 The rate of return that an investor
 Theory of Valuation
8

 The value of an asset is the present value

of its expected returns.
 You expect an asset to provide a stream of
returns while you own it.
 To convert this stream of returns to a
value for the security, you must discount
this stream at your required rate of
return.
 This requires estimates of:
 The stream of expected returns, and
 The required rate of return on the
 Stream of Expected
9
Returns
 Form of returns
 Earnings
 Cash flows
 Dividends
 Interest payments
 Capital gains (increases in value)

 Time pattern and growth rate of returns

Required Rate of Return
10

 Required Rate of Return and Expected

Growth Rate of Valuation Variables
 Valuation procedure is the same for
securities around the world, but the
required rate of return (k) and expected
growth rate of earnings and other
valuation variables (g) such as book
value, cash flow, and dividends differ
among countries.
 Required Rate of Return
11
(k)
 The investor’s required rate of return must
be estimated regardless of the approach
selected or technique applied.
 This will be used as the discount rate and
also affects relative-valuation.
 The rate we use to discount a company's
future cash flows back to the present is
known as the company's required return,
or cost of capital.
 This is not used for present value of free
cash flow which uses the required rate of
return on equity (K).
 Required Rate of Return
12
(k)
 Three factors influence an investor’s
required rate of return:
 The economy’s real risk-free rate
(RRFR)
 The expected rate of inflation (I)
 A risk premium (RP)
Cont’d…..the Economy’s Real Risk-Free
Rate
13

 Minimum rate an investor should require

 Depends on the real growth rate of the
economy
 (Capital invested should grow as fast as

the economy)
 Rate is affected for short periods by
tightness or ease of credit markets
 Cont’d……the Expected Rate of
Inflation
14

 Investors are interested in real rates of

return that will allow them to increase
their rate of consumption

 The investor’s required nominal risk-free

rate of return (NRFR) should be
increased to reflect any expected
inflation.
NRFR  [1  RRFR][1  E (I)] - 1
Where:
E(I) = expected rate of inflation
 Investment Decision Process: A Comparison of
Estimated Values and Market Prices
15

 If Estimated Value > Market Price, Buy

 If Estimated Value < Market Price, Don’t

Buy
 Valuation of Alternative Investments
16

 Valuation of Bonds is relatively easy

because the size and time pattern of cash
flows from the bond over its life are
known.
1. Interest payments are made usually
every six months equal to one-half the
coupon rate times the face value of the
bond
2. The principal is repaid on the bond’s
maturity date
 Valuation of Bonds
17

 Example:
 In 2002, a $10,000 bond due in 2017

with 10% coupon

 Discount these payments at the investor’s
required rate of return (if the risk-free
rate is 9% and the investor requires a risk
premium of 1%, then the required rate of
return would be 10%)
 Valuation of Bonds
18

 Present value of the interest payments is

an annuity for thirty periods at one-half the
required rate of return:
$500 x 15.3725 = $7,686
 The present value of the principal is
similarly discounted:
$10,000 x .2314 = $2,314
Total value of bond at 10 percent = $10,000
 Valuation of Bonds
19

 The $10,000 valuation is the amount that an

investor should be willing to pay for this
bond, assuming that the required rate of
return on a bond of this risk class is 10
percent.

 If the market price of the bond is above this

value, the investor should not buy it because
the promised yield to maturity will be less
than the investor’s required rate of return.
 Valuation of Bonds
20

 Alternatively, assuming an investor requires

a 12 percent return on this bond, its value
would be:
$500 x 13.7648 = $6,882
$10,000 x .1741 = 1,741
Total value of bond at 12 percent = $8,623
Higher rates of return lower the value!
 Compare the computed value to the market
price of the bond to determine whether you
should buy it.
 Valuation of Preferred Stock
21

 The value is simply the stated annual

dividend divided by the required rate of
return on preferred stock (kp)
Dividend
V 
kp

Assume a preferred stock has a $100 par

value and a dividend of $8 a year and a
required rate of return of 9 percent
 Valuation of Preferred Stock
22

 The value is simply the stated annual

dividend divided by the required rate of
return on preferred stock (kp).

Dividend
V 
kp
Assume a preferred stock has a $100 par
value and a dividend of $8 a year and a
required rate of return
$8 of 9 percent
V
.09
 Valuation of Preferred Stock
23

 The value is simply the stated annual

dividend divided by the required rate of
return on preferred stock (kp)

Dividend
V 
kp
Assume a preferred stock has a $100 par
value and a dividend of $8 a year and a
required rate of return$8 of 9 percent
V   $88.89
.09
 Valuation of Preferred Stock
24

 Given a market price, you can derive its

promised yield
Dividend
kp 
Price
 Valuation of Preferred Stock
25

 Given a market price, you can derive its

promised yield
Dividend
kp 
Price

 At a market price of $85, this preferred

stock yield would be $8
kp   .0941
$85.00
 Approaches to the Valuation of
Common Stock
26

The price of a security should equal the

present value of the expected cash flows
an investor will receive from owning it -
the Law of One Price.
Two approaches have developed
1. Discounted cash-flow valuation
 PV of some measure of cash flow,
including dividends, operating cash
flow, and free cash flow.
2. Relative valuation technique
 Value estimated based on its price
 Approaches to the Valuation of
Common Stock
27

 The discounted cash flow approaches are

dependent on some factors, namely:
 The rate of growth and the duration of

growth of the cash flows

 The estimate of the discount rate
 Approaches to the Valuation of
Common Stock
28

Why and When to Use the Discounted

Cash Flow Valuation Approach?
 The DCF model of valuation is a
fundamental method.
 Financial ratios and multiples provide a

quick and easy way for investors to

determine the general value of a stock
compared to other investments in the
market.
 But, how do we go about estimating the

absolute value of any company?

 Approaches to the Valuation of
Common Stock
29

 Valuation methods based on DCF models

determine stock prices in a different and
more robust way.
 DCF models estimate what the entire
company is worth.
 Comparing this estimate, or "intrinsic
value," with the stock's current market
price allows for much more of an apples-
to-apples comparison.
 For example, if you estimate a stock is

worth £20 based on a DCF model, and it

Approaches to the Valuation of
Common Stock
30

 The measure of cash flow used

 Dividends

 Cost of equity as the discount rate

 Operating cash flow

 Weighted Average Cost of Capital

(WACC)
 Free cash flow to equity

 Cost of equity
 Dependent on growth rates and discount
rate
 Relative Valuation
31
Techniques
Why and When to Use the Relative
Valuation Techniques?
 Appropriate

1. You have a good set of comparable

entities – comparable companies that are
similar in terms of industry, size, and it is
hoped, risk

2. Aggregate market and the company’s

industry are not at a valuation extreme –
that is, they are not either seriously
 Relative Valuation
32
Techniques
 Prices can be standardized using a
common variable such as earnings, cash
flows, book value, or revenues.
 Earnings Multiples
 Price/Earning ratio (PE) and variants
 Value/EBIT
 Value/EBDITA
 Value/Cash flow
 Enterprise value/EBDITA
 Relative Valuation
33
Techniques
 Book Multiples
 Price/Book Value (of equity) PBV
 Revenues
 Price/Sales per Share (PS)
 Enterprise Value/Sales per Share
(EVS)
 Industry Specific Variables (Price/kwh,
Price per ton of steel, Price per click,
Price per labor hour)
Discounted Cash-Flow Valuation
Techniques
34

 The main idea behind a DCF model is relatively

simple: a stock's worth is equal to the present
value of all its estimated future cash flows.
t n
CFt
Where:
Vj  
t 1 (1  k )
t
Vj = value of stock j
n = life of the asset
CFt = cash flow in period t
k = the discount rate that is equal to the
investor’s required rate of return for asset j,
which is determined by the uncertainty (risk)
of the stock’s cash flows
 Valuation Approaches and Specific
35
Techniques
Approaches to Equity Valuation

Discounted Cash Flow Relative Valuation

Techniques Techniques
• PV of Dividends (DDM) • Price/Earnings Ratio
(PE)
•PV of Operating Cash Flow
•Price/Cash flow ratio
•PV of Free Cash Flow (P/CF)
•Price/Book Value Ratio
 The Dividend Discount Model (DDM)
36

 The value of a share of common stock is

the present value of all future dividends
D1 D2 D3 D
Vj     ... 
(1  k ) (1  k ) 2
(1  k ) 3
(1  k ) 
n
Dt
 
t 1 (1  k ) t
Where:
Vj = value of common stock j
Dt = dividend during time period t
k = required rate of return on stock j
 The Dividend Discount Model (DDM)
37

 If the stock is not held for an infinite

period, a sale at the end of year 2 would
imply:
D1 D2 SPj 2
Vj   
(1  k ) (1  k ) 2
(1  k ) 2
 The Dividend Discount Model (DDM)
38

 If the stock is not held for an infinite period,

a sale at the end of year 2 would imply:

D1 D2 SPj 2
Vj   
(1  k ) (1  k ) (1  k ) 2
2

 Selling price at the end of year two is the

value of all remaining dividend payments,
which is simply an extension of the original
equation
 The Dividend Discount Model (DDM)
39

 Stocks with no dividends are expected to

start paying dividends at some point.
 The Dividend Discount Model (DDM)
40

 Stocks with no dividends are expected to

start paying dividends at some point, say
year three...

D1 D2 D3 D
Vj     ... 
(1  k ) (1  k ) 2
(1  k ) 3
(1  k ) 
 The Dividend Discount Model (DDM)
41

 Stocks with no dividends are expected to

start paying dividends at some point, say
year three...

D1 D2 D3 D
Vj     ... 
(1  k ) (1  k ) 2
(1  k ) 3
(1  k ) 
Where:
D1 = 0
D2 = 0
 The Dividend Discount Model (DDM)
42

 Infinite period model assumes a constant

growth rate for estimating future dividends

D0 (1  g ) D0 (1  g ) 2
D0 (1  g ) n
Vj    ... 
(1  k ) (1  k ) 2
(1  k ) n
Where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k = required rate of return on stock j
n = the number of periods, which we assume
 The Dividend Discount Model (DDM)
43

 Infinite period model assumes a

constant growth rate for estimating
future dividends
D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) n
Vj    ... 
(1  k ) (1  k ) 2
(1  k ) n

D1
Vj 
kg
This can be reduced to:
 The Dividend Discount Model (DDM)
44

 Infinite period model assumes a

constant growth rate for estimating
future dividends
D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) n
Vj    ... 
(1  k ) (1  k ) 2
(1  k ) n

D1
Vj 
This can be reduced to: kg

1. Estimate the required rate of return (k)

 The Dividend Discount Model (DDM)
45

 Infinite period model assumes a

constant growth rate for estimating
future Ddividends
(1  g ) D (1  g ) 2
D (1  g ) n
Vj  0  0  ...  0

(1  k ) (1  k ) 2 (1  k ) n
D1
Vj 
kg
This can be reduced to:
1. Estimate the required rate of return (k)
2. Estimate the dividend growth rate (g)
 Infinite Period DDM and Growth
Companies
46

Assumptions of DDM:
1. Dividends grow at a constant rate
2. The constant growth rate will continue
for an infinite period
3. The required rate of return (k) is greater
than the infinite growth rate (g)
 Infinite Period DDM and Growth
Companies
47

Inconsistencies with infinite period DDM

assumptions

 Growth companies have opportunities to earn

return on investments greater than their
required rates of return.
 To exploit these opportunities, these firms

generally retain a high percentage of

earnings for reinvestment, and their
earnings grow faster than those of a typical
firm.
 Infinite Period DDM and Growth
Companies
48

 The infinite period DDM assumes

constant growth for an infinite period, but
abnormally high growth usually cannot be
maintained indefinitely
 Temporary conditions of high growth
cannot be valued using DDM.
 Valuation with Temporary Supernormal
Growth
49

 Combine the models to evaluate the years

of supernormal growth and then use DDM
to compute the remaining years at a
sustainable rate.
 Estimating a company's future cash flows

for a certain period--say five or 10 years--

and then estimating the value of all cash
flows after that in one lump sum.
 This lump sum is the perpetuity value

 To calculate the perpetuity value, take the

last cash flow estimated, increase it by the

rate at which you expect cash flows to
 Valuation with Temporary
Supernormal Growth
50

For example:
With a 14 percent required rate of return,
current dividend payment is 2.00 per share,
and dividend growth of:

Dividend
Year Growth
Rate
1-3: 25%
4-6: 20%
7-9: 15%
10 on: 9%
 Valuation with Temporary Supernormal
Growth
51

The value equation becomes

2.00 (1.25) 2.00 (1.25) 2 2.00 (1.25) 3
Vi   2

1.14 1.14 1.14 3
2.00 (1.25) 3 (1.20 ) 2.00 (1.25) 3 (1.20 ) 2
 4

1.14 1.14 5
2.00 (1.25) 3 (1.20 ) 3 2.00 (1.25) 3 (1.20 ) 3 (1.15)
 6

1.14 1.14 7
2.00 (1.25) 3 (1.20 ) 3 (1.15) 2 2.00 (1.25) 3 (1.20 ) 3 (1.15) 3
 8

1.14 1.14 9
2.00 (1.25) 3 (1.20 ) 3 (1.15) 3 (1.09 )
(. 14  .09 )

(1.14 ) 9
Computation of Value for Stock of Company
with Temporary Supernormal Growth
52

Discount Present Growth

Year Dividend Factor Value Rate
1 $ 2.50 0.8772 $ 2.193 25%
2 3.13 0.7695 $ 2.408 25%
3 3.91 0.6750 $ 2.639 25%
4 4.69 0.5921 $ 2.777 20%
5 5.63 0.5194 $ 2.924 20%
6 6.76 0.4556 $ 3.080 20%
7 7.77 0.3996 $ 3.105 15%
8 8.94 0.3506 $ 3.134 15%
9 10.28 0.3075 $ 3.161 15%
10 11.21 9%
a b
$ 224.20 0.3075 $ 68.943
$ 94.365
a
Value of dividend stream for year 10 and all future dividends, that is
$11.21/(0.14 - 0.09) = $224.20
b
The discount factor is the ninth-year factor because the valuation of the
remaining stream is made at the end of Year 9 to reflect the dividend in
Year 10 and all future dividends.
 Present Value of Operating Free
Cash Flows
53

 Free cash flow represents the cash a company

has left over after spending the money
necessary to keep the company growing at its
current rate.
 Derive the value of the total firm by
discounting the total operating cash flows prior
to the payment of interest to the debt-holders.
 Then subtract the value of debt to arrive at an
estimate of the value of the equity.

t n
OCF
V j  
t1 ( 1  WACC
t
) t
j
 Present Value of Operating Free
Cash Flows
54

t n
OCFt
Vj  
t 1 (1  WACC j )
t

Where:
Vj = value of firm j
n = number of periods assumed to be
infinite
OCFt = the firms operating free cash flow
in period t
 Present Value of Operating Free
Cash Flows
55

 Similar to DDM, this model can be used

to estimate an infinite period
 Where growth has matured to a stable

rate, the adaptation is

OCF
V  j
1
WACC  g j OCF
Where:
OCF1=operating free cash flow in period 1
gOCF = long-term constant growth of
operating free cash flow
 Present Value of Operating Free
Cash Flows
56

 Assuming several different rates of

growth for OCF, these estimates can be
divided into stages as with the
supernormal dividend growth model
 Estimate the rate of growth and the
duration of growth for each period
 Present Value of Free Cash Flows
to Equity
57

 “Free” cash flows to equity are derived

after operating cash flows have been
adjusted for debt payments (interest and
principle)
 The discount rate used is the firm’s cost
of equity (k) rather than WACC
 Present Value of Free Cash Flows
to Equity
58

n
FCF t
Vj  
t 1 (1  k j ) t

Where:
Vj = Value of the stock of firm j
n = number of periods assumed to be
infinite
FCFt = the firm’s free cash flow in period t
K j = the cost of equity
 Market Equilibrium
59

What is market equilibrium?

 In equilibrium, stock prices are stable.
 There is no general tendency for people
to buy versus to sell.
 The expected price must equal the
actual price.
 In other words, the fundamental
value must be the same as the price.
 Market Efficiency

60

 The Efficient market hypothesis (EMH) is a

theory that asserts:
 As a practical matter, the major financial

markets reflect all relevant information

at a given time.

 The idea that competition among investors

works to eliminate all positive-NPV trading
opportunities is referred to as the
efficient markets hypothesis.
 It implies that securities will be fairly
 Market Efficiency
61

 Market efficiency examines the

relationship between stock prices and
available information.
 Prediction of the EMH theory: if a market
is efficient, it is not possible to “beat the
market” (except by luck).
What Does “Beat the Market” Mean?
 The important question: is it possible
for investors to “beat the market?”
 “Beating the market” means
consistently earning a positive
 Market Efficiency

62

 Three Economic Forces that Can Lead to

Market Efficiency;
Investors use their information in a
rational manner:
Rational investors do not
systematically overvalue or undervalue
financial assets.
There are independent deviations from
rationality:
So, irrationality is just noise that is
diversified away.

 Forms of Market Efficiency

63

 Weak-form efficiency states that it should

not be possible to profit by trading on
information in past prices and volume
figures.
 Semi-strong form efficiency states that it
should not be possible to consistently profit
by trading on any public information, such
as news announcements or analysts’
recommendations.
 Strong form efficiency states that it should
not be possible to consistently profit even by
 Information Sets for Market
64 Efficiency
 Why Would a Market be Efficient?

65

 The driving force toward market

efficiency is simply competition and
the profit motive.
 Even a relatively small performance
enhancement can be worth a
tremendous amount of money (when
multiplied by the dollar amount
involved).
 This creates incentives to unearth
relevant information and use it.
 Some Implications of Market
Efficiency
66

I. Does Old Information Help Predict

Future Stock Prices?
 This is a surprisingly difficult question to

answer clearly.
 Researchers have used sophisticated

techniques to test whether past stock

price movements help predict future
stock price movements.
 Some researchers have been able to
show that future returns are partly
predictable by past returns.
 Some Implications of Market
Efficiency
67

II. Random Walks and Stock Prices

 If you were to ask people you know whether

stock market prices are predictable, many

of them would say yes.
 However, considerable research has
shown that stock prices change through
time as if they are random.
 That is, stock price increases are about as

likely as stock price decreases.

 When there is no discernable pattern to the

path that a stock price follows, then the

 Cont’d.....Random Walks & Stock
68
Prices
 How New Information Gets into
Stock Prices
69

 In its semi-strong form, the EMH states

simply that stock prices fully reflect publicly
available information.
 Stock prices change when traders buy and
sell shares based on their view of the future
prospects for the stock.
 But, the future prospects for the stock are
influenced by unexpected news
announcements.
 Prices could adjust to unexpected news in
three basic ways:
 How New Information Gets into
70
Stock Prices
 Informed Traders and Insider
Trading
71

 If a market is strong-form efficient, no

information of any kind, public or
private, is useful in beating the market.
 But, it is clear that significant
inside information would enable you
to earn substantial excess returns.
 This fact generates an interesting
question: Should any of us be able to
earn returns based on information that
is not known to the public?
72

END

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