Valuation of Bond and Stock

Financial Management
Professor Banikanta Mishra, XIMB, XUB, India
 What is a Bond*?

A commitment by a borrower/issuer

to make payments to a lender/investor

on pre-specified dates

according to pre-specified rules.

*Debt, Debenture, Loan, Borrowing

07/24/21 Professor Banikanta Mishra 2

 CF of the Typical Bond

Maturity Date
t=0 t=1 t=2 t=3 … t=T

Coupon C1 C2 C3 … CT

Face-Value FV

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 Notations Used
C = Level of Fixed Coupon (or Interest) Payment Per Period
(Unadjusted )Annual Coupon Payment =
C * Number of Payments Per Year
[If $55 every six months, annual coupon payment = $110]

FV= Face Value or Par Value or Maturity Value

(Not necessarily equal to issue-price or current-price)

CR = Coupon Rate = (Unadjusted) Annual Coupon Payment / FV

R (often referred to as Rd or kd or rd) = RRR of the Bond

Should equal ERR of the bond if fairly priced
Should equal YTM or EAR of the Bond for annual coupon-payment

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 Fixed Rate Bond
t=0 t=1 t=2 t=3 … t=T

FV & C
specified
C C C … C

FV

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 Floating Rate Bond
At t=0 was set the FV = $200,000 and Coupon Rate Rule = 3-m LIBOR + 20 bp*

t=0 t = 1Q t = 2Q
Interest Interest
Set Payment
Date Interest
Reset
Interest
Payment
Interest
Reset
Interest
Paid
3-m LIBOR =5.0% $2,600
Interest
Paid
3-m LIBOR = 5.8% $3,000
[*bp = one-hundredth of 1% = 0.01%]

07/24/21 Professor Banikanta Mishra 6

 Our Focus: Fixed Rate Bond

We will focus on the typical fixed-rate bond with

$1,000 Face-Value,

Fixed Maturity Date,

Fixed, Level Coupon Payment

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 Fundamental Principle of
Security Valuation

Price of any security should equal

the Present Value of

All Expected Future Cash-flows

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 Valuing the Typical Bond
t=0 t=1 t=2 t=3 … t=T

PV =

C x PVIFAR,T C C C … C

+
FV
(1  R )T FV

C = Coupon Payment Per Period, R = RRR or Yield or Discount-Rate Per Period,

T = Maturity in Periods (E.g. If Coupon Paid Quarterly, T is No of Quarters)

07/24/21 Professor Banikanta Mishra 9

 Bond Valuation: Example
t=0 t=1 t=2 t=3 … t=5

PV =

110 x PVIFA10%,5 110 110 110 … 110

+
1,000
(1  10%)5 1,000

=$1,037.91 5 N; 10 I/Y; 110 PMT; 1,000 FV; CPT PV  1037.91

07/24/21 Professor Banikanta Mishra 10

 Discount-Rate (R) and Bond Price
We assume annual coupon-payments => CR (Coupon Rate) = 11% and R = YTM*

t=0 t=1y t=2y t=3y … t=5y

Coupon 110 110 110 … 110
Face Val 1000
 1000 
P0= PV = [110 x PVIFAR,5] +  5
 (1  R ) 
R P0
10% 1037.90 => If CR > R (or YTM), then P0 (Price) > FV (Par) PREMIUM
11% 1000.00 => If CR = R (or YTM), then P0 = FV PAR
12% 963.95 => If CR < R (or YTM), then P0 < FV DISCOUNT
(*YTM = Yield to Maturity)
07/24/21 Professor Banikanta Mishra 11
 Price Across Time
ow Price Changes Over Time

R t=0 t=1y t=2y t=3y t=4y t=5y

Coupon 110 110 110 110 11
Face Val 1000

% 1037.91 1031.70 1024.87 1017.36 1009.09 1000

% 1000.00 1000.00 1000.00 1000.00 1000.00 1000
% 963.95 969.63 975.98 983.10 991.07 1000

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 Interest-Rate Sensitivity of Bond Price
t=0 t=1y t=2y t=3y t=4y t=5y
Coupon 110 110 110 110 11
Face Val 1000

R P0 P0

9.8% 1045.72 1010.93

9.9 1041.81 1010.01
0.0 1037.91 1009.09  Ceteris paribus, bond with higher maturity is more sensitive
0.1 1034.03 1008.17
0.2 1030.17 1007.26

Coupon 110
Face Val 1000
07/24/21 Professor Banikanta Mishra 13
 ERR: Buy at t=0, Sell at t=1
t=0 t=1
Buy the Bond Sell the Bond
Cash Outflow Cash Inflow
P0 P1
+C
P1 + C
P1  C  P0  C   P1  P0 
ERR    
P0 P
 0  P0 
Current Yield Capital Gains Yield
CuY CGY

07/24/21 Professor Banikanta Mishra 14

 ERR on Our Bond
t=0 t=1
Buy the Bond Sell the Bond
Cash Outflow Cash Inflow
1037.91 1031.70
+ 110.00
1141.70

1031.70  110  1037.91  110   1031.70  1037.91

ERR     
1037.91  1037.91  1037.91

10.60% -0.60%
Current Yield Capital Gains Yield
As expected, ERR = RRR = 10% CuY CGY

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Actual (or Realized) Rate of Return
t=0 t=1
Buy the Bond at $1037.91 Receive $110 Coupon
(ERR = R = 10%)
R = 10%
Sell the Bond at $1031.70
Actual ROR = (110 + 1031.70 – 1037.91) / 1037.91 = 10.00% =ERR
R = 11%
Sell the Bond at $1000.00
Actual ROR = (110 + 1000.00 – 1037.91) / 1037.91 = 6.95% < ERR
R= 9%
Sell the Bond at $1064.79
Actual ROR = (110 + 1064.79 – 1037.91) / 1037.91 = 13.19% > ERR
07/24/21 Professor Banikanta Mishra 16
 Multi-period ERR: Buy at t=0, Sell at t=2
Computing ERR using the IRR Approach
t=0 t=1 t=2
Buy the Bond Get C Get C
Sell the Bond

P0 C C + P2
Find the R for which
C C  P2
P0 (1 =R ) +
(1  R ) 2

 For our Bond, find R __

110 110  1024.87
1037.91 (1 =R ) (1+ R ) 2
BY T&E, get R = 10% => ERR = IRR = 10% (As expected, ERR = RRR)
07/24/21 Professor Banikanta Mishra 17
 Yield To Maturity (YTM)
APR (not EAR) obtained when the bond is held till maturity
YTM = Number of Periods (or Coupon Payments) per Year x Yield per Period
If coupon-payment is annual, then
YTM = Yield per Period
(For the above example in the previous slide, 10%)
In this case, this is also the bond’s EAR (Effective Annual Rate)
If coupon-payment is semi-annual, then
YTM = 2 * Yield per Period
(For the above example in the previous slide, 2 x 10% = 20%)
And, so on …
Suppose coupon-payment in above example is semi-annual.
What then is the bond’s EAR?

EAR = [(1 + 10%)2 – 1] = 21% > YTM = 20%

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 A Staring Point for T&E Method
For the T&E Approach (if financial calculator is not available)
a good starting-value of R saves time.
The Approximate Yield formula provides a good starting-value
FV  P0
Annual Coupon 
Approximate Yield  T
FV  2 P0
3
So, for the bond in the previous slide, which is of five year maturity with
$110 annual-coupon and $1,000 FV and is selling now for $1,037.91 ,
a good starting-value of R for the T&E approach (to find IRR  Yield) is as follows:

1,000  1,037.91
110 
Approx Yield  5  9.9896%
1,000   2 x 1037.91
3
07/24/21 Professor Banikanta Mishra 19
 YTM: Another Example
IBM KG 5.700% coupon bond maturing in Sep 2017
was selling on 9/21/07 for 100.723% of Face Value.
What is its YTM?
We can take its FV to be $100. N = 2017 – 2007 = 10.
-100.723 PV; 5.70 PMT; 10 N; 100 FV; CPT I/Y  5.6036
So, its YTM = 5.6036% = EAR
What are YTM and EAR if its coupon is semiannual?
-100.723 PV; 2.85 PMT; 20 N; 100 FV; CPT I/Y  2.8023
YTM = 2 x 2.8023% = 5.6046%
EAR = (1 + 2.8023%)2 – 1 = 5.6831%
07/24/21 Professor Banikanta Mishra 20
 RRR or Cost of Debt
R= RF + Risk Premium

ERR on TB of Same Maturity

(Get from the Yield Curve)

Default Risk Premium

= f (Bond Rating)
+
Taxability Premium
= f (Taxability)
+
Liquidity Risk Premium
= f (Frequency of Trading)
+
Maturity Risk Premium
= f (Maturity: If Too High)

07/24/21 Professor Banikanta Mishra 21

 Determinants of Credit-Rating
Profitability Ratio
(EBIT / Total Assets)
Activity Ratio
(Sales / Total Assets)
Leverage Ratio
(Market Value of Equity / Book Value of Debt)
Growth Ratio
(Retained Earnings / Total Assets)
Liquidity Ratio
(Working Capital / Total Assets)

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 Basic Stock Valuation Model
t=0 t=1 t=2 ... t=T

Dividends  D1 D2 ... DT

D1 D2 DT
PV = (1  R ) + (1  R ) 2 + … + (1  R ) T

If Ds vary across time in a random way, valuing is difficult.

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 What if Ds Follow a Pattern?
Suppose D = D-1 x (1 + g)

t=0 t=1 t=2 ... t=T

Dividends  D1 D1(1+g) ... D1(1+g)T-1

T 1
D1 D1 (1  g ) D 1 (1  g )
PV = (1  R ) + (1  R ) 2 + … + (1  R )
T

D1  
T
 1 g 
or Po  1    
R  g  1 R  

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 Standard DDM
Dividend Discount Model (DDM)
Since T is typically ∞,
the Standard DDM simplifies to
D1
P0  PV 
R g
or in general ,
D t 1
Pt 
R g
(In this model, when T = ∞, we would have R > g)

07/24/21 Professor Banikanta Mishra 25

Constant Growth Model
R = 15% (Given)
you are here
t=-2 t=-1 t=0 t=1 t=2 t=3
7.70 8.26 9.09 10.00 11.00 12.10 …
Actual Past Data Estimated Future Data
Based on Historical Growth Rate*

10.00 11 .00
P0  P1 
15%  10% 15%  10%
 200.00  220.00

220.00  200.00
Growth   10%  g
200.00
(*Average of dividend growth-rates from –2 to –1 and –1 to 0 =10% = g)

07/24/21 Professor Banikanta Mishra 26

Zero Growth Model
R = 20% (Given)
you are here
t=-2 t=-1 t=0 t=1 t=2 t=3
10.0 10.1 9.90 10.0 10.0 10.0 …
Actual Past Data Estimated Future Data
Based on Historical Growth Rate*

10.00 10.00
P0   50.00 P1   50.00
20%  0% 20%  0%

Expected Growth-Rate in Price = 0% = g

D1
In this mod el , P0 
R
(*Average of dividend growth-rates from –2 to –1 and –1 to 0 = 0% = g)

07/24/21 Professor Banikanta Mishra 27

 Pure Growth Model
R = 10% (Given)
you are here

t=-2 t=-1 t=0 t=1 t=2 t=T

0 0 0 0 0 DT*
Actual Past Data Estimated Future Data
(Proper g does not exist) (Based on Historical Data)

DT DT
P0  P1 
(1  R ) T (1  R ) T 1

Note that the Expected Grow-Rate in Price = R

P1 220
If Expected P1 = 220, then P0 =   200.00
1  R 1  10%
*No Dividend expected till T; Dividend from T+1 onwards
DT is the value at T of all expected future dividends to be paid from T+1 onwards
07/24/21 Professor Banikanta Mishra 28
 Dividend-Yield and Capital-Gains Yield
D1
P0 
Rg
D1
 R  g
P0

DY Growth (Rate of Dividends)

As we saw earlier, in Constant/Zero Growth Model,

Growth (or g) = CGY (the expected increase in share-price)

So, RETURN in the DDM Model

partly comes from Dividend Yield
and partly from Capital Gains Yield
(Same/similar as in the case of bonds.)

07/24/21 Professor Banikanta Mishra 29

 ERR: Buy at t=0, Sell at t=1
t=0 t=1
Buy the Stock Sell the Stock
Cash Outflow Cash Inflow
P0 P1
+ D1
P1 + D1
P1  D1  P0  D1   P1  P0 
ERR    
P0 P
 0  P0 

Dividend Yield Capital Gains Yield

DY CGY

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 One-Period ERR: Example
t=0 t=1
Buy the Stock Sell the Stock
Cash Outflow Cash Inflow
200.00 220.00
+10.00
230.00

220.00  10.00  200.00  10.00   220.00  200.00 

ERR     
200.00  200.00   200.00

5% 10%
Dividend Yield Capital Gains Yield
As expected, ERR = RRR = 15% DY CGY

07/24/21 Professor Banikanta Mishra 31

 Multi-period ERR: Buy at t=0, Sell at t=2
Computing ERR using the IRR Approach
t=0 t=1 t=2
Buy the Stock Get D1 Get D2
Sell the Stock

P0 D1 D2 + P2
Find the R for which
D1 D 2  P2
P0 (1 =R ) (1+ R ) 2
 For our Stock, find R __
10.00 11  242.00
200.00 (1 =R ) (1+
 R )2

BY T&E, get R = 15% => ERR = IRR = 15% (As expected, ERR = RRR)
07/24/21 Professor Banikanta Mishra 32
 g > 0: Constant Growth Model
CGY = (PT – PT-1 )/ PT-1 = g => Prices and dividends grow at the same rate
Part of the return (ERR) comes from Dividend-Yield and part from CGY
(In our example, DY = 5% and CGY = 10%)
In this model, R > CGY = g, since R = g + DY

g = 0: Zero Growth (or Constant Dividend) Model

CGY = (PT – PT-1 )/ PT-1 = g = 0 => Prices and dividends remain constant
All of return (ERR) comes from Dividend-Yield
(In our example, DY = 20% and CGY = 0%)
In this model, R > CGY = g = 0, since R = g + DY = DY > 0

Pure Growth Model

CGY = (PT – PT-1 )/ PT-1 = R (no clear “g” in this model)
All return (ERR) comes from CGY, that is, the Growth in Prices
(In our example, DY = 0% and CGY = 10%)
In this model, R = CGY; DY = 0, g is not properly defined here
07/24/21 Professor Banikanta Mishra 33
 Estimating g from Retention-Ratio

Pay-out Ratio = Dividends / Net Income

Retention-Ratio = Retained-Earnings / Net Income

(= 1 – Payout-Ratio)

ROE (Return on Equity) = Net Income / Book Equity

(= EPS / Book-Value Per Share)

Retention-Ratio x ROE = Dividend Growth Rate

(This is the Sustainable Growth Formula)

07/24/21 Professor Banikanta Mishra 34

 Cost of Equity:
Constant/Zero Growth Model
R is the Cost of Equity
(ignoring cost of raising equity)

We know that,
D1
P0 
Rg
D
 R  1  g
P0
DY = Dividend Yield,
CGY = Capital Gains Yield DY CGY

07/24/21 Professor Banikanta Mishra 35

 Cost of Equity:
Pure Growth Model

 R = CGY

where, CGY = Capital Gains Yield

(or Growth-Rate in Prices)

07/24/21 Professor Banikanta Mishra 36

Constant Growth Model: Finite Life
R = 8% < g = 10%
FINAL
t=0 t=1 t=2 t=3 t=4
Dividends  10.00 11.00 12.10 13.31
(g = 10%)

P= 38.08 31.12 22.61 12.32 0.00

=>
CGY= -18.3% -27.3% -45.5% -100.0% -

DY= 26.3%* 35.3% 53.5% 108.0% -

R= 8% 8% 8% 8%
(=CGY+ DY)

(* 10.00 / 38.08 = 26.3%)

07/24/21 Professor Banikanta Mishra 37
 Differential Growth
Dividends would grow at a rate of
10% for four years and
6% thereafter for ever
(RRR for the stock is given to be 8%)

t=0 t=1 t=2 t=3 t=4 t=5 t=6 … t=∞

PV= 38.08 10 11 12.10 13.31

   
 
4
 10 1   1  10 % 
   
 (8%  10%)   1  8%   
   

PV= 538.08 V4=732 14.64 14.96 ... …

732

(1 8%) 4

Stock Price = 38.08 + 538.08 = 576.16

07/24/21 Professor Banikanta Mishra 38
 What if Dividends Declining?
If dividends are declining and expected to decline
we still use the standard model
Typically, unless it is a dying firm,
dividends would decline and stabilize at a low level
So, we would follow the Differential Growth model.

t=0 t=1 t=2 t=3 t=4 t=5 t=6 … t=∞

PV= 48.02 20.00 16.00 12.80 10.24 Expected to fall by 20% per year
   4 
   @R

10 1   1 20 %
   = 10%
  10%  (20%)   1  10%   
   
Expected to stabilize at $10 for ever

PV= 68.30 V4=100 10.00 10.00 ... …

100

(1  10%)4 Stock Price = 48.02 + 68.30 = 116.32
07/24/21 Professor Banikanta Mishra 39
 Delayed Dividends
A company has just started operation.
It would not pay any dividend for four years.
But, from the end of FIFTH year onwards,
it would give a flat $10 per share for ever.

If the RRR for such a share is 10%,

What should be its price now?
What should be DY and CGY if we buy it now and sell it at t=1?

What would be its price at t=4?

What should be DY and CGY if we buy it at t=4 and sell it at t=5?

t=0 t=1 t=2 t=3 t=4 t=5 t=6 … t=∞

P0= 68.30 P1=75.13 V4=100 10.00 10.00 ... …
100 100
  P4=100 P5 = 100
(1  10%) 4 (1  10%) 3
DY = 0% CGY = 0%
75.13 68.30 10
CGY   10%  RRR DY   10%  RRR
68.30 100
07/24/21 Professor Banikanta Mishra 40
 Delayed Growing Dividends
A company has just started operation.
It would not pay any dividend for four years.
But, from the end of FIFTH year onwards,
it would start with $10 per share and increase it at a rate of 5% per year.

If the RRR for such a share is 10%,

What should be its price now?
What should be DY and CGY if we buy it now and sell it at t=1?

What would be its price at t=4?

What should be DY and CGY if we buy it at t=4 and sell it at t=5?

t=0 t=1 t=2 t=3 t=4 t=5 t=6 … t=∞

P0= 136.60 P1=150.26 V4=200 10.00 10.50 ... …
200 200
  P4=200 P5 = 210
(1  10%)4 (1  10%) 3
DY = 0% CGY = 5%
150.26  136.60 10
CGY   10%  RRR DY   5%
136.60 200
07/24/21 Professor Banikanta Mishra 41
 Valuing a Preferred Stock
Since it typically promises
a constant dividend per share,

It is valued as a level-perpetuity,
with the RRR
lower than that of the RRR for equity
(but, of course, higher than RRR of debt)

Moreover,
RRR for a Cumulative Preferred would be
lower than that for a Non-Cumulative one

If a Cumulative Preferred Share is

expected to pay $7 per share (for eever0
and its RRR is 14%,

then its P = $7 / 14% = $50

07/24/21 Professor Banikanta Mishra 42