Chapter 8

VALUATION OF BONDS
AND STOCKS

 Centre for Financial Management , Bangalore

 OUTLINE
• Concepts of Value
• Basic Valuation Model
• Bond Valuation
• Bond Yields
• Valuation of Preference Stock
• Equity Valuation : Dividend Discount Model
• Equity Valuation : PE Ratio Approach
• Earnings-Price Ratio, Expected Return, and Growth
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 CONCEPTS OF VALUE

• Liquidation Value

• Going Concern Value

• Book Value

• Market Value

• Intrinsic Value

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 BASIC VALUATION MODEL
The value of any asset, real or financial, is equal to the
present value of the cash flows expected from it.

C1 C2 Cn
V0 = + + ………+
(1+k) (1+k)2 (1+k)n

V0 = value of the asset at time zero

Ct = cash flow expected at the end of year t
k = discount rate applicable to the cash flows
n = life of the asset
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 EXAMPLE
Year Cash flow
1 20
2 30
3 220
Discount rate = 16 percent
V0 = 20 x PV16%,1 + 30 x PV16%,2 + 220 x PV16%,3
V0 = 20 x 0.862 + 30 x 0.763 + 220 x 0.641
= 180.55
KEY INPUTS
 Cash Flows
 Timing
 Discount Rate
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 BASIC BOND VALUATION MODEL
n I F
V= +
t =1 (1+k d)t (1+k d)n

=
I x PVAkd,n + F x PVkd,n

Example
Rs.100 par .. 12 percent coupon
8 years maturity … Required return 14 percent

V = Rs.12 x PVA14%,8 + Rs.100 x PV14%,8

= Rs.12 x 4.639 + Rs.100 x 0.351

= Rs. 90.77
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 PRICE - YIELD RELATIONSHIP
PRICE

YEILD

PRICE CHANGES WITH TIME

VALUE OF
BOND PREMIUM BOND: rd = 11%

A
PAR VALUE BOND: rd = 13%

B
DISCOUNT BOND: rd = 15%

8 7 6 5 4 3 2 1 0
YEARS TO MATURITY
 BOND PRICE THEOREMS
1. BOND PRICES & YIELDS MOVE IN OPPOSITE
DIRECTIONS
2. BOND PRICES ARE MORE SENSITIVE TO YIELD
CHANGES THE LONGER THEIR MATURITIES
3. THE PRICE SENSITIVITY OF BONDS TO YIELD
CHANGES INCREASES AT A DECREASING RATE
WITH MATURITY
4. HIGH COUPON BOND PRICES ARE LESS SENSITIVE
TO YIELD CHANGES THAN LOW COUPON BOND
PRICES
5. WITH A CHANGE IN YIELD OF A GIVEN NUMBER OF
BASIS POINTS, THE ASSOCIATED PERCENT GAIN IS
LARGER THAN THE PERCENT LOSS.
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 BOND YIELDS
• CURRENT YIELD
ANNUAL INTEREST
PRICE
• YIELD TO MATURITY
C C C M
P = + + …. +
(1+r) (1+r) 2
(1+r) n
(1+r)n
8 90 1,000
800 =  +
t=1 (1+r)t (1+r)8
AT r = 13% … RHS = 808
AT r = 14% … RHS = 768.1
808 - 800
YTM = 13% + (14% - 13%) = 13.2%
808 - 768.1
C + (M - P) / n
YTM ≃
0.4M + 0.6 P
• YIELD TO CALL
n* C M*
P =  +
t=1 (1+r) t
(1+r)n
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 REALISED YIELD TO MATURITY
FUTURE VALUE OF BENEFITS
0 1 2 3 4 5

• INVESTMENT 850
• ANNUAL INTEREST 150 150 150 150 150
• RE-INVESTMENT
PERIOD (IN YEARS) 4 3 2 1 0
• COMPOUND FACTOR
(AT 16 PERCENT) 1.81 1.56 1.35 1.16 1.00
• FUTURE VALUE OF
INTERMEDIATE CASH FLOWS 271.5 234.0 202.5 174.0 150.0
• MATURITY VALUE 1000
• TOTAL FUTURE VALUE = 271.5 + 234.0 + 202.5 + 174.0 + 150.0 + 1000
= 2032
(1+r*)5 = 2032 / 850 = 2.391
r* = 0.19 OR
Centre19 PERCENT
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 DIVIDEND DISCOUNT MODEL
• SINGLE PERIOD VALUATION MODEL
D1 P1
P0 = +
(1+r) (1+r)
• MULTI - PERIOD VALUATION MODEL
 Dt
P0 = 
t=1 (1+r)t
• ZERO GROWTH MODEL
D
P0 =
r
• CONSTANT GROWTH MODEL
D1
P0 =
r-g
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 TWO - STAGE GROWTH MODEL

1 - 1+g1 n
1+r Pn
P0 = D1 +
r - g1 (1+r)n
WHERE
Pn D1 (1+g1)n-1 (1+g2) 1
=
(1+r)n r - g2 (1+r)n

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TWO - STAGE GROWTH MODEL : EXAMPLE
EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OF
VERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY AN
ABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6
YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISE
AT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15
PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OF
VERTIGO ?
THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE :
g1 = 20 PERCENT
g2 = 10 PERCENT
n = 6 YEARS
r = 15 YEARS
D1 = D0 (1+g1) = RS.2(1.20) = 2.40

PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THE

INTRINSIC VALUE ESTIMATE AS FOLLOWS :

1.20 6
1 -
1.15 2.40 (1.20)5 (1.10) 1
P0 = 2.40 +
.15 - .20 .15 - .10 (1.15)6

1 - 1.291 2.40 (2.488)(1.10)

= 2.40 + [0.497]
-0.05 .05

= 13.968 + 65.289
= RS.79.597
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 H MODEL

ga
gn

H 2H

D0
PO = [(1+gn) + H (ga + gn)]
r - gn
D0 (1+gn) D0 H (ga + gn)
= +
r - gn r - gn

VALUE BASED PREMIUM DUE TO

ON NORMAL ABNORMAL GROWH
 ILLUSTRATION: H LTD

D0 = 1 ga = 25% H=5
gn = 15% r = 18%
1 (1.15) 1 x 5(.25 - .15)
P0 = +
0.18 - 0.15 0.18 - 0.15
= 38.33 + 16.67 = 55.00
IF E = 2 P/E = 27.5

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 IMPACT OF GROWTH ON PRICE, RETURNS,
AND P/E RATIO

PRICE DIVIDEND CAPITAL PRICE

D1 YIELD GAINS EARNINGS
PO = YIELD RATIO
r-g (D1 / PO) (P1 - PO) / PO (P / E)

RS. 2.00
LOW GROWTH FIRM PO = = RS.13.33 15.0% 5.0% 4.44
0.20 - 0.05

RS. 2.00
NORMALGROWTH PO = = RS.20.00 10.0% 10.0% 6.67
FIRM 0.20 - 0.10

RS. 2.00
SUPERNORMAL PO = = RS.40.00 5.0% 15.0% 13.33
GROWTH FIRM 0.20 - 0.15

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 EARNINGS MULTIPLIER
APPROACH

P0 = m E1

DETERMINANTS OF m (P / E)
D1
P0 =
r-g
E1 (1 - b)
=
r - ROE x b
(1 - b)
P0 / E1 =
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 E / P, EXPECTED RETURN, AND GROWTH
1 2
……...
E1 = D1 E2 = D2
= 15 = 15
15
r = 15% P0 = = 100
0.15
INVESTMENT .. RS. 15 PER SHARE IN YEAR 1 … EARNS 15%
2.25
NPV PER SHARE = - 15 + = 0
0.15

RATE OF INCREMENTAL PROJECT'S IMPACT ON SHARE PRICE E1/P0 r

RETURN CASH FLOW NPV IN SHARE PRICE IN YEAR 0,
YEAR 1 IN YEAR 0 P0

0.05 0.75 -10 -8.70 91.30 0.164 0.15

0.10 1.50 -5 -4.35 95.65 0.157 0.15
0.15 2.25 0 0 0 0.15 0.15
0.20 3.00 5 4.35 104.35 0.144 0.15
0.25 3.75 10 8.70 108.70 0.138 0.15

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IN GENERAL, WE CAN THINK OF THE STOCK PRICE AS THE
CAPITALISED VALUE OF THE EARNINGS UNDER THE ASSUMPTION OF
NO GROWTH PLUS THE PRESENT VALUE OF GROWTH OPPORTUNITIES
(PVGO).

E1
P0 = + PVGO
r

MANIPULATING THIS A BIT, WE GET

E1 PVGO
= r 1 -
P0 P0

FROM THIS EQUATION, IT IS CLEAR THAT :

 EARNINGS-PRICE RATIO IS EQUAL TO R WHEN PVGO IS ZERO.
 EARNINGS-PRICE RATIO IS LESS THAN R WHEN PVGO IS
POSITIVE.
 EARNINGS-PRICE RATIO IS MORE THAN R WHEN PVGO IS
NEGATIVE.

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 STOCK MARKET

 Principal Exchanges

• The National Stock Exchange

• The Bombay Stock Exchange

 Veritable Transformation

• Screen-based Trading
• Electronic Delivery
• Rolling Settlement

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 STOCK MARKET INDICES

• Bombay Stock Exchange Sensitive Index (Sensex)

• Base year 1978-79  100

• 30 shares

• Value-weighted index of the free float

• S & P CNX Nifty

• Base period ; November 3, 1995  1,000

• 50 shares

• Value-weighted index

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 SUMMING UP
 The value of any asset, real or financial, is equal to the present value of the cash
flows expected from it
 The value of a bond is:
n I F
V= +
t =1 (1+k d)t (1+k d)n

 The yield to maturity (YTM) on a bond is the rate of return the investor earns
when he buys the bond and holds it till maturity. It is the value of k d in the
bond
valuation model. For estimating the YTM readily, the following approximation
may be used:

I + (F – P) / n
YTM ~
0.4 F + 0.6P

 According to the dividend capitalisation approach, the value of an equity share

is equal to the present value of dividends expected from its ownership plus the
present value of the resale price expected when the equity share is sold.
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 Most share valuation models are based on the assumption that dividends tend to
increase over time.
 If dividends are expected to grow at a constant rate, the following equity
valuation model, a very popular model, is obtained:
D1
P0 =
ks–g
 Conceptually, the dividend capitalisation approach is unassailable.
practitioners, however, seem to prefer the earnings capitalisation approach,
mainly because of its simplicity. The procedure typically employed while using
this approach consists of the following steps: (i) Estimate the earnings per
share.
(ii) Establish the price-earnings multiple. (iii) Develop a value anchor and a
value range.
 Sometimes analysts look at the book value per share and the liquidation value
per share as proxies for intrinsic value. However, these measures have serious
flaws.

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