Valuing Bonds

and Stocks
Historical Context
• One of the earliest known bond was issued
around 2400 BCE in Mesopotamia (Iraq) with
payment using corn as currency.
• Much older than equity market.
• Used to finance wars and explorations.
Bonds Characteristics
• The face value is generally in denominations of
mutiples of 10s.
• Coupon is fixed percentage face of face value.
• Bond name is as per year of maturity and
coupon
• Price is specified as percentage of face value
(95.6% , 6% 2030)
• Zero Coupon bonds have no coupon and are
issued at discount
 • The internal rate of return of buying the bond and
holding till maturity

• Rate at which bond’s value is equal to its market

price

• Yields are generally quoted annually (APR).

Yield to Maturity • YTM > coupon as there is capital gain too

• Consider a bond being priced a 92.39% of its face

value and 3.5% coupon with 6 year maturity (YTM
Pricing Bonds • Suppose you buy a 100 USD face
value 4.25% bond with 4 year
maturity with same risk class as an
investment with yield 0.15%.
What is the price?

P = PV = 4.25/1.0015 +
4.25/1.0015^2 + 4.25/1.0015^3 +
4.25/1.0015^4 + 100/1.0015^4

= 116.3

General Formula:
Pricing Bonds

• Consider an 8 year, 12% coupon bond

with face value $100 on which interest is
payable semi-annually. Assume discount
rate 14%. What is the bond price?

• Bond is selling at a discount as price <

100 (Face value)
• If price > face value, it would be called
as premium
Pricing Bonds

• Consider the five-year, $1000 bond

with a 5% coupon rate and
semiannual coupons. If this bond is
currently trading for a price of
$957.35, what is the bond’s yield to
maturity?

• YTM is root of the below equation

• This would be converted to annual
= 3%*2 = 6%
• Yield and price are inversely related
Pricing Bonds
• Consider a bond with coupon rate 14%
issued 3 years ago for 1000. The original
maturity was 10 years. Interest rate fell
and investors now expect 10% from the
bond. What is its price?

• Bonds sells at a premium since yields fell

 Pricing Bonds
• Consider a 30 year zero coupon bond with yield 5%

P0 = 100/1.05^30 = 23.14

• Now reconsider this bond 5 years later, assuming that the yield stays
the same

P5 = 100/1.05^25 = 29.53

Price has risen, and it will converge to the face value with time.
 Pricing Bonds
• At maturity, bond price = face value
• If a bond is trading at discount, price will rise with time (yield > coupon, bond
sells at a discount)
• If a bond is trading at premium, price will fall with time (yield < coupon, bond
sells at a premium)
• A 10 year bond is issued with face value USD 1000 and pays USD 60 per year.
If after the bond issuance, the interest rate increases, what happens to the
following?
▶ Coupon rate – No change
▶ Price -- Falls
▶ YTM -- Rise
 Pricing Bonds
• In May 2008, US Treasury sold $9B of 4.375% bonds maturing in 2038 (30-year maturity).
Bonds were issued at price $96.38% and offered yield to maturity of 4.6%. Crisis struck in the
coming months and the demand boomed for safe assets such as 30 year US bonds. By December,
the price of the 4.375s of 2038 reached 138.05% and the yield fell to 2.5%. Suppose a bond was
bought in May and the buyer receives its first coupon payment of 4.375/2 = 2.187 in December.
What rate of return did the buyer get?

• Rate of Return = Change in investment value/initial investment

= (Coupon Income + Capital Gains)/Initial Investment

= (2.187 + (138.05 – 96.3))/96.3

= 45.5% in 6 months!
Yield to Maturity
Bond Duration

• Duration is measure of bond’s

sensitivity to interest rate.

• Duration/Macaulay Duration is the

weighted average of the times of
each of the cash payments, with
weights for each year being the PV
of cash flow at that time, divided
by total present value of bond.
 Pharmacy Industry

Valuing Stocks

Tourism Industry
Dividend Discount Model
• Imagine a 1 year investment horizon with expected dividends
D1 and price P1 and P0 in year 1 and 0 respectively.
• Re(Stock’s Return) = D1/P0 + (P1 – P0)/P0
• P0 (Price of Stock Today) = (D1 + P1)/(1+Re)

• Sujata home appliance is expected to provide a dividend of

INR 2/share and stock price one year in the future is expected
to be INR 18. If required rate of return is 12% what should be
the price today.

P0 = 2/1.12 + 18/1.12 = 17.86

Dividend Discount Model (2
Period)
• Now consider a two period model.
• Price in year 1 for year 2 would be:
P1 = (D2 + P2)/(1 + Re)

• Price as per discounted cash flow model:

P0 = (D1 + P1)/ 1 + Re

Substituting value of P1
P0 = D1/(1 + Re) + (D2 + P2)/(1 + Re)^2
Dividend Discount Model (N Periods)
• Consider an N period model:

• Stock Price for year 0 is defined as:

Dividend Growth Model

• Even though dividends are sticky in short term, they can be uncertain

• If dividends grow at a growth rate g:

• Re = D/P0 + g

• P0 = D/(Re – g)

• Valuation is similar to a perpetuity.

Constant Dividends

• ITC provides a dividend of INR 20/share and its growth rate is 0. With a
market capitalization rate of 15% its stock price is:

• P0 = 20/0.15 = 133.33
Dividends, Investment and Growth
• Consider the constant dividend growth model
P0 = D/(Re – g)
To increase its share price, the firm can:
 Increase dividends (D)
 Increase growth of dividends (g)

There is a trade-off, however

▶ Increasing growth requires investment
▶ This means taking away the surplus from dividends

Dividends are carved out of earnings

• ▶ Dividend payout rate of, say 60%
• ▶ Implies 60% earnings converted to dividends
• ▶ 40% earnings retained (‘plowback’) to grow the assets-in-place
Dividends, Investment and Growth
• Earnings either become: Dividends (payout)
and Retained (plowback)
• Part that is not payed out is plowed back
into the firm:
Payout Ratio = 1 – Plowback Ratio
• Thus, dividends can be calculated as:
D = Earnings * Payout Ratio = Earnings * (1 –
Plowback Ratio)
• Assuming growth occurs due to retained
earnings
Multi Stage Growth Model

Constant growth models are not true always:

• Small firms grow fast and rarely give dividends (Tech Firms, Startups)
• Old mature grow slow and pay more dividends (Utilities and Oil and Gas)

Two stage growth model:

• A growth tech company has: D = 0.50, P0 = 50, ROE = 25%, Plowback = 80%
• Year 3 onwards, ROE = 16% and Plowback = 50%
Multi Stage Growth Model
Earnings = ROE * BV
D = Payout * Earnings
BV(t) = BV(t-1) + Earnings(t-1) + D(t-1)
Multi Stage Growth Model
Quantifying Growth Opportunities

• Consider a firm which gives all earnings as dividends.

Pn = D/Re

• In practice, each stock price can be modelled as a sum of

 Price due to no-growth
 Net Present value of growth opportunities.
 P0 = D/r + NPVGO
Quantifying Growth Opportunities

• NPVGO is hard to estimate.

• It can be calculated as: P0 – E (Forecasted)/r

• For eg, Alphabet (Google’s holding company) has never paid a dividend. In
early 2018 its stock sold for $1130/share and forecasted earnings were
$41.54/share. What was the market’s estimate of Alphabet’s growth
opportunities, assuming its cost of equity as 8%?

• NPVGO = 1130 – 41.54/0.08 = 611 (55% of its valuation)

Is the stock market shortsighted?
Illustration

Sun Pharma stock on May 26, 2014 was INR 591.8. Its dividend per share was INR 10, and was
expected to increase by 19% per year for the next five years. Assume discount rate of 13%.
What part of the stock price is short term, and what part is long term?

Based on the information above, the stock price should be:

10 ∗ 1.19 10 ∗ (1.19)2 10 ∗
P ≡ PV + + . . . =
= (1.19)
1.135 58.55 1.132 1.135

The leftover part of the stock price must be attributable to

information beyond the five year horizon—not very myopic
behavior
Is the stock market shortsighted?
Myopia?
► Typically more than 80% of the stock price is attributable
to cash flow related information beyond five years
► Why are managers then obsessed with quarterly numbers?
► By itself quarterly earnings etc. are not so informative.
But they convey information about long term prospects of
the firm. From that perspective, their unexpected fall
could indicate major problems.
► Further, managements’ career outcomes could be tied
to quarterly/short term performance
► Together, the above two could explain managers’
obsession with short term performance
Problem
Chapter 4, #18
Consider the following 3 stocks:
1. A is expected to provide a dividend of $10/share forever
2. B is expected to pay a dividend of $5 next year, growing at 4% thereafter
3. C is expected to pay a dividend of $5. Then dividends will grow at 20%/year
from years 2–6, and then 0 afterwards

If market capitalization rate is 10% for each stock, which is most valuable?

Solution

D
PVA = 10 = = 100
r 0.10
D 5
PV B = = = 83.33
r−g 0.10 − 0.04
5 6 7.2 8.64 10.37 12.44 12.44 1
PVC = + + + + + + × = 104.50
1.10 1.102 1.103 1.14 1.15 1.16 0.10 1.16
v ˛ ¸ }
delayed p erpetuit y
Problem
Chap 4, #20
CSI is guaranteed a 10% book return on equity. At the end of the year, CSI needs to
pay $4 dividend. It reinvests 40% of its earnings and grows at 4%/year
1. What is the long-run rate of return from purchasing the stock at $100? What
part of the price is attributable to growth opportunities?
2. Now CSI needs to invest 80% of its earnings for five years. Starting in year 6, it
will resume 60% payout as dividends. What will be the stock price after this
announcement is made?

Solution
1. First, we find the cost of equity (discount rate). This is the long-run rate of
return
D
r = + g= +
4
P 100
0.04 = 8%
Now we find earnings

D
(1 − plowback)E = D ⇒ E = = 4/0.60 = 6.67
0.60
Problem
Solution: Chap 4, #20
1. Now we find NPVGO
E

NPVGO = P0 − 6.67
= 100 − = 16.63
r 0.08

Thus, 16.63% of the price is attributable to the value of growth opportunities

2. Increased plowback (80%) will mean that dividends drop

D = (1 − plowback)E = (1 − 0.80) × 6.67 = 1.33

ROE = 10%, hence growth rate for the years 2–6 will be

g = plowback × ROE = 0.80 × 0.10 = 0.08 = 8%

Year cash flows

Hence dividend 1 are2 3 4 5 6 7, 8, 9, . . .
Div 1.33 1.44 1.56 1.68 1.81 5.88 growth at 4%
E 6.67 7.20 7.78 8.40 9.07 9.80 growth at 4%
Problem
Solution: Chap 4, #20
Note the large increase in dividends and large decrease in
earnings in year 6 when plowback drops back to 40%
Forecasted stock price in year 5 will be
D6
5 5.88 = 147
P = =
r−g 0.08
− 0.04
Thus CSI’s price becomes
1.33 1.44 1.56 1.68
=
1.81 + 147
106.22
P0 = + + + +
1.08
Hence price rises 1.08
by $6.22
2 1.8
at 3the 1.08
announcement
4
of
increased
1.085 investment
Cost of Capital and WACC

• The cost of capital of any investment (project, business, or company) is

the rate of return the suppliers of capital would expect to receive if the
capital were invested elsewhere in an investment (project, business, or
company) of comparable risk

• The cost of capital reflects expected return

• The cost of capital represents an opportunity cost
Cost of Capital
It can be calculated two ways
> Weighted average of cost of equity and debt

WACC = wErE + wDrD (1 – tc)

> Company return as per CAPM

Ra = Rf + Ba(Rm – Rf)
Cost of Capital

• Consider the case of ABC corp. which has 60% equity and 40% debt. The expected equity return
is 12% and interest rate on debt is 8%. Consider the tax rate to be 50%

• WACC = 0.60(12) + 0.40(8)(1-0.5)

= 7.2 + 1.6
= 8.8%
• What if the the risk free rate was 3% and company beta was 1.2 and market return was 9%

Ra = 3 + (9-3)*1.2
= 3 + 7.2
= 10.2 %
Beta Calculation

• Suppose the beta for the company is not available.

• It can be calculated as the weighted average of equity and debt beta and
then used to find return via CAPM.
• Consider again ABC corp with its equity and debt beta as 1.6 and 0.5
respectively.

Ba = 0.6*1.6 + 0.4*0.5
= 0.96 + 0.2
= 1.16
CAPM Inputs

While there is disagreement among finance practitioners, the following would serve.

• The risk-free rate may be estimated as the yield on long-term bonds that have a
maturity of 10 years or more.

• The market risk premium may be estimated as the difference between the average
return on the market portfolio and the average risk-free rate over the past 10 to 30
years.

• The beta of the stock may be calculated by regressing the stock returns against
market returns.
CAPM Inputs

The two most widely used approaches to estimating cost of debt are:

– YTM on a bond outstanding from the firm. The limitation of this approach is that
very few firms have long term straight bonds that are liquid and widely traded

– Rating for the firm and estimating a default spread based upon the rating. While
this approach is more robust, different bonds from the same firm can have
different ratings. You have to use a median rating for the firm
CAPM Misconceptions

• The concept of cost of capital is too academic or impractical.

• The cost of equity is equal to the dividend rate or return on equity.
• Retained earnings are either cost free or cost significantly less that the
external equity.
• Share premium has no cost
Certainty Equivalent
• Instead of using risky cash flows, use risk free/certain cash flow.
• Then use risk free rate to discount the certain cash flows.
• Consider Project A with CF of 100 million for 3 years, with Rf = 6%
market risk premium = 8% and beta of 0.75 what is the PV of the
project?
Risk,DCF and CEQ
Now assume that the cash flows change, but are RISK FREE. What is the new
PV?
Risk,DCF and CEQ

Since the 94.6 is risk free, we call it a Certainty Equivalent

of the 100.