CHAPTER 5:

BONDS AND STOCK

VALUATION
Concept of Bonds

When a business issues a bond, the money received is then considered a loan
and needs to be paid over a period of time. Bonds are commonly issued by the
government and corporations commonly in order to raise needed funds or
capital.
 ADVANTAGES AND DISADVANTAGES OF
BONDS

Advantages:
Bonds become an attractive source of financing because
of the following advantages.
1.Investor will receive regular income through the interest earned from the
bonds over the period of time.
2.Full amount of investment will be received by the investor on the maturity
date of the bonds.
 However certain precaution need to be exercised as
investing in bonds also have some disadvantages such
as:
1.Since bond investment normally covers long period of time like 5or 10
years, the interest received might not be even enough to cover inflation, thus
instead of gaining profit it might even result to a loss.
2.The risk of companies not being able to return the money to investors. This
could happen if the money borrowed is not put into profitable projects.
 EFFECT OF BONDS IN THE
ECONOMY
At the time of recession or when the economic conditions
decline, the government may opt to issue bonds in order to generate
enough funds for its projects. A bond investment during this period
might be attractive as the government may offer better interest rates
to attract the general public or individual investor to buy the bonds.
CONCEPTS OF STOCKS

Stock prices are dictated based on earnings

generated by the company. If the borrow profits are
alight or are inclined to rise in the future, companies
will raise stocks price.
ADVANTAGES AND DISADVANTAGES OF
STOCKS
ADVANTAGE:
1.Contribution to economic growth- When company performances results to profit, it
affects the growth of the economy. In the same way what if the economy grows, it
generates enough purchasing power which allows people to have enough money to spend
and thus results to businesses to grow and generate profits.
2. Beats inflation- Dividends received from stocks range from 10%-12% which are
normally higher to an average inflation rate that range between 3%-5%.
3.Accessibility- stocks can be bought in capital markets through a broker, a financial
planner, or online
4. Return on Investment – investors would normally buy stocks when prices are low
and later sell them when the prices are high.
5. Liquidity and conversion to cash – stocks maybe sold at any given time as it does
not carry a maturity date.
 DISADVANTAGE:
1.Investment Risk- when a company performs poorly, stock price will decrease and thus
investor is at risk of losing on the investment made,
2.Priority for Payment – when the company goes bankrupt, stockholders will receive
payment only after all third party creditors had been paid.
3.Time Requirement- is needed to do research, read financial statements and annual
reports, follow company’s developments in the news and monitor the stock market in order
to arrive to a decision on which compony to buy stocks.
4.Stock prices volatility- Depending on the individual intention, this could result to some
emotional high since stock’s prices have a tendency to go high or low.
5.You complete against professionals-Institutional investors and traders have more time
and knowledge to invest.
VALUATION OF BONDS AND STOCK

Bond valuation is a process to calculate the theoretical

fair value of a particular bond. Bond valuation would involve
calculation of the present value of the bond’s future interest
payments and the bond value when it reaches the maturity
period which is also known as par or face value. Bond value
valuation is needed in order to determine the rate of return
and make decision if bond investment would be advisable .
YIELD MEASURES
There are different types of yield measures that may be used to represent the
approximately return to a bond. These include:
A. Yield to maturity (YTM)
The discount rate used in the bond pricing formula is also known as the
bond’s yield to maturity (YTM) or yield. This equals the rate of return earned
by a bond holder (known as the holding period return) if:
* the bond is held to maturity
* the coupon payments are reinvested at the yield to maturity
A bond’s YTM is the unique discount rate at which the market price of the
bond equals the present value of the bond’s cash flows.
B. Yield to call (YTC)
For a bond that is callable, the yield to call may be
used as measured of return instead of the yield to
maturity. The process is similar to computing yield
to maturity, except that the maturity date of the bond
is replaced with the next call date.
C. Current yield
The current yield is simpler measure of the
rate of return to a bond than the yield to
maturity. Current yield is measured as the
ratio of the bond’s annual coupon payment
to the bond’s market price.
Common Stock Valuation Models
~ can be done either through absolute and relative valuation models
~Under absolute valuation, the focus will be on dividends, cash flow and
growth rate of a single
RELATIVE VALUATION MODELS
~involve calculating multiples or ratios, such as the price-to-earnings multiple,
and comparing them to the multiples of other comparable firms.

The focus of this lesson will be the absolute valuation methods since it is
most commonly used by most companies.
Absolute Valuation Model
1. Dividend Discount Method (DDM)
~ it determine the worthiness of the business based on the dividends paid to
shareholders.
~ used since dividends represent the actual cash flows going to the shareholder,
thus valuing the present value of these cash flows should give you a value for
how much the shares would be worth.
~ under this model, the dividends should be actually paid.
2. Discounted Cash Flow Method (DCF)
~ it suited for companies that don’t pay a dividend or payment is irregular.
~ uses a firm’s discounted future cash flows to determine the value of the firm.
~uses the free cash flows which are forecast for five to ten years, and then a
terminal value is calculated for all of the cash flows beyond the forecast period.
Preferred Stock Valuation
The nature of preferred stocks is that it pays a fixed amount of dividend and
this can be use to calculate the value by discounting each of this payments to
the present day.

Consideration
If the company earnings are not adequate it might result to a cut off in the
payment of preferred stocks dividends. This risk of a cut payment needs to be
accounted for. This risk increases as the dividend payment compared to
earnings gets higher.