VALUATION

Introduction to Business Finance

Muniba Abdullah, CFA
FIXED INCOME
 INTRODUCTION
• The fixed-income market is a key source of financing for businesses and
governments.
• Also called the debt market or bond market, represents a significant
investing opportunity for institutions as well as individuals.
 BOND PRICES AND TIME VALUE OF
MONEY
• Bond pricing is an application of discounted cash flow analysis.
• On a traditional (option-free) fixed-rate bond, the promised future cash
flows are a series of coupon interest payments and repayment of the full
principal at maturity.
• The coupon payments are on regularly scheduled dates.
 BOND PRICES AND TIME VALUE OF
MONEY
• The final coupon typically is paid together with the full principal on the maturity
date.
• The price of the bond at issuance is the present value of the promised cash flows.
• The market discount rate is used in the time-value-of-money calculation to
obtain the present value.
• The market discount rate is the rate of return required by investors given the risk
of the investment in the bond.
• It is also called the required yield, or the required rate of return.
 EXAMPLE
• For example, suppose the coupon rate on a bond is 4% and the payment is
made once a year. If the time-to-maturity is five years and the market
discount rate is 6%, the price of the bond is?

• This bond is described as trading at a discount because the price is below

par value.
 EXAMPLE
• Suppose that another five-year bond has a coupon rate of 8% paid
annually. If the market discount rate is again 6%, the price of the bond is?

• This bond is trading at a premium because its price is above par value.
 FINDINGS
• The coupon rate indicates the amount the issuer promises to pay the bondholders each
year in interest.
• The market discount rate reflects the amount investors need to receive in interest each
year in order to pay full par value for the bond.
• When the coupon rate is less than the market discount rate, the bond is priced at a
discount below par value.
• When the coupon rate is greater than the market discount rate, the bond is priced at a
premium above par value.
• When the coupon rate is equal to the market discount rate, the bond is priced at par value.
GENERAL FORMULA
 YIELD TO MATURITY
• If the market price of a bond is known, Equation 1 can be used to calculate its yield-to-maturity (sometimes
called the redemption yield or yield-to-redemption).
• The yield-to-maturity is the internal rate of return on the cash flows—the uniform interest rate such that when
the future cash flows are discounted at that rate, the sum of the present values equals the price of the bond.
• It is the implied market discount rate.
• The yield-to-maturity is the rate of return on the bond to an investor given three critical assumptions:
• The investor holds the bond to maturity.
• The issuer makes all of the coupon and principal payments in the full amount on the scheduled dates.
Therefore, the yield-to-maturity is the promised yield—the yield assuming the issuer does not default on any
of the payments.
• The investor is able to reinvest coupon payments at that same yield. This is a characteristic of an internal rate
of return.
 RELATIONSHIPS BETWEEN THE BOND
PRICE AND BOND CHARACTERISTICS
• The bond price is inversely related to the market discount rate. When the
market discount rate increases, the bond price decreases (the inverse
effect).
• For the same coupon rate and time-to-maturity, the percentage price
change is greater (in absolute value, meaning without regard to the sign of
the change) when the market discount rate goes down than when it goes
up (the convexity effect).
 RELATIONSHIPS BETWEEN THE BOND
PRICE AND BOND CHARACTERISTICS
• For the same time-to-maturity, a lower-coupon bond has a greater
percentage price change than a higher-coupon bond when their market
discount rates change by the same amount (the coupon effect).
• Generally, for the same coupon rate, a longer-term bond has a greater
percentage price change than a shorter-term bond when their market
discount rates change by the same amount (the maturity effect).
 CONSTANT YIELD TRAJECTORY
• But bond prices change as time passes even if the market discount rate remains the
same.
• As time passes, the bondholder comes closer to receiving the par value at maturity.
• The constant-yield price trajectory illustrates the change in the price of a fixed-income
bond over time.
• This trajectory shows the “pull to par” effect on the price of a bond trading at a
premium or a discount to par value.
• If the issuer does not default, the price of a bond approaches par value as its time-to-
maturity approaches zero.
 PRICING WITH SPOT RATES
• When a fixed-rate bond is priced using the market discount rate, the same
discount rate is used for each cash flow.
• A more fundamental approach to calculate the price of a bond is to use a
sequence of market discount rates that correspond to the cash flow dates.
• These market discount rates are called spot rates.
• Spot rates are yields-to-maturity on zero-coupon bonds maturing at the
date of each cash flow.
 EXAMPLE
• Suppose that the one-year spot rate is 2%, the two-year spot rate is 3%,
and the three-year spot rate is 4%. Then, the price of a three-year bond
that makes a 5% annual coupon payment is?
GENERAL FORMULA
EQUITY
 TYPES OF ANALYSIS
• Technical analysis uses such information as stock price and trading volume as
the basis for investment decisions.
• Fundamental analysis uses information about the economy, industry, and
company as the basis for investment decisions.
• Whereas technical analysts use information to predict price movements and
base investment decisions on the direction of predicted change in prices,
fundamental analysts use information to estimate the value of a security and to
compare the estimated value to the market price and then base investment
decisions on that comparison.
 APPROACHES FOR ANALYSIS
• Intrinsic value (synonym: fundamental value) of a security
• In a top-down approach, an analyst examines the economic environment,
identifies sectors that are expected to prosper in that environment, and
analyzes securities of companies from previously identified attractive
sectors.
• In a bottom-up approach, an analyst typically follows an industry or
industries and forecasts fundamentals for the companies in those
industries in order to determine valuation.
 ESTIMATED VALUE AND MARKET
PRICE
• By estimating value, the analyst is assuming that the market price is not necessarily the best
estimate of intrinsic value.
• If the estimated value exceeds the market price, the analyst infers the security is
undervalued.
• If the estimated value equals the market price, the analyst infers the security is fairly valued.
• If the estimated value is less than the market price, the analyst infers the security is
overvalued.
• The ability to benefit from identifying a mispriced security depends on the market price
converging to the estimated intrinsic value.
 MAJOR CATEGORIES OF EQUITY
VALUATION MODELS
• Present value models (synonym: discounted cash flow models). These
models estimate the intrinsic value of a security as the present value of the
future benefits expected to be received from the security.
• Multiplier models (synonym: market multiple models). These models are
based chiefly on share price multiples or enterprise value multiples.
• Enterprise value (EV) multiples have the form (Enterprise value)/(Value of a
fundamental variable).
 MAJOR CATEGORIES OF EQUITY
VALUATION MODELS
• Asset-based valuation models. These models estimate intrinsic value of a
common share from the estimated value of the assets of a corporation
minus the estimated value of its liabilities and preferred shares. The theory
underlying the asset-based approach is that the value of a business is equal
to the sum of the value of the business’s assets.
 PRESENT VALUE MODELS: THE
DIVIDEND DISCOUNT MODEL
• Sources of return:
• cash dividends received by an investor over his or her holding period and
• the change in the market price of equities over that holding period.
• A dividend is a distribution paid to shareholders based on the number of shares owned,
and a cash dividend is a cash distribution made to a company’s shareholders.
• Cash dividends are typically paid out regularly at known intervals; such dividends are
known as regular cash dividends.
• An extra dividend or special dividend is a dividend paid by a company that does not
pay dividends on a regular schedule
 PRESENT VALUE MODELS: THE
DIVIDEND DISCOUNT MODEL
• A stock dividend (also known as a bonus issue of shares) is a type of dividend
in which a company distributes additional shares of its common stock.
• A stock split involves an increase in the number of shares outstanding with a
consequent decrease in share price.
• A reverse stock split involves a reduction in the number of shares outstanding
with a corresponding increase in share price.
• A share repurchase (or buyback) is a transaction in which a company uses
cash to buy back its own shares.
 DATES FOR DIVIDENDS
• Declaration date, the day that the company issues a statement declaring a specific dividend.
• Ex-dividend date (or exdate), the first date that a share trades without (i.E., “Ex”) the
dividend.
• Holder-of-record date (also called the owner-of-record date, shareholder-of-record date,
record date, date of record, or date of book closure), the date that a shareholder listed on
the company’s books will be deemed to have ownership of the shares for purposes of
receiving the upcoming dividend
• Payment date (or payable date), which is the day that the company actually mails out (or
electronically transfers) a dividend payment to shareholders.
THE DIVIDEND DISCOUNT MODEL:
DESCRIPTION
 THE DIVIDEND DISCOUNT MODEL:
DESCRIPTION

• The expected value of a share at the end of the investment horizon—in

effect, the expected selling price—is often referred to as the terminal stock
value (or terminal value).
• This general form of the DDM applies even in the case in which the investor
has a finite investment horizon.
 FCFE
• A free-cash-flow-to-equity (FCFE) valuation model - FCFE is a measure
of dividend paying capacity.
• The calculation of FCFE starts with the calculation of cash flow from
operations (CFO). CFO is simply defined as net income plus non-cash
expenses minus investment in working capital. FCFE is a measure of cash
flow generated in a period that is available for distribution to common
shareholders.
QUESTIONS?