ESSEC

BBA PROGRAMME

Finance I

CLASS HANDOUT

SESSION 5

Rick Marchese

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 Bond and Stock Valuation

Outline

- Principles of Bond and Stock Valuation

- Bond Valuation

- Stock Valuation

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 Principle of Bond and Stock Valuation

- Principles:

o Value of financial securities = PV of expected future

cash flows

- To value bonds and stocks we need to:

o Estimate future cash flows:

• Size (how much) and

• Timing (when)

o Discount future cash flows at an appropriate effective

rate:

• The rate should be appropriate to the risk of the

cash flow presented by the security. It is investors’

required rate of return.

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 Bond Valuation

- A bond is a financial security issued by a corporation or

government entity that shows proof of indebtedness by the

issuer and calls for payments to the owner.

- Features of bonds:

o Maturity (fixed lifetime): The date when the issuer of the

bond makes the last payment.

o Coupons (fixed payments before and on maturity).

o Face value, (or par value, or principal).

o Risk characteristics (Government, Corporate, Credit rating)

- Example: Consider a Government of Canada bond:

o Maturity Date: December 31, 2009.

o The Par Value of the bond is $1,000.

o Coupon Rate: 6%, and coupons are paid semi-annually

(June 30 and December 31 for this particular bond).

On January 1, 2002 the size and timing of cash flows are:

$30 $30 $30 $30 + $1,000

!
1 / 1 / 02 6 / 30 / 02 12 / 31 / 02 6 / 30 / 09 12 / 31 / 09

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 Bond Valuation

- Valuation of Bonds:

1) Pure Discount Bond (zero coupon bonds or zeros): Single

payment at the maturity.

T-year discount bond:

$0 $0 $0 $F
!

0 1 2 T -1 T

F
PV =
(1 + r )T , where F is the Face Value, r is the

appropriate discount rate and T is Time to Maturity which

is equal to maturity date minus today’s date.

• Exercise:

Find the value of a 30-year zero-coupon bond with a $1,000

par value and a discount rate of 6%.

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 Bond Valuation

2) Level-Coupon Bonds: A constant cash flow stream, C, for T

periods, plus the face value, F, at T.

C is the Coupon Payment = Face Value × Coupon Rate

$C $C $C $C + $ F
!

0 1 2 T -1 T

1 1 𝐹 𝐹
𝑃𝑉 = 𝐶 : − A + = 𝐶 × 𝑎 (𝑇, 𝑟 ) + .
𝑟 𝑟(1 + 𝑟)! (1 + 𝑟)! (1 + 𝑟)!

= PV of Coupon Payments + PV of Face Value

• Exercise:

Find the present value (as of January 1, 2002) of Canadian

Government Bond if the interest rate is 5-percent, semi-

annually compounded.

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 Bond Valuation

- Bond Concept:

• Bond prices and market interest rates move in opposite

directions.

• If discount rate r is constant:

§ When coupon rate = r, price = par value.

§ When coupon rate > r, price > par value (premium bond)

§ When coupon rate < r, price < par value (discount bond)

• Exercise:

C = $100, F = $1000, T = 2, What is the value of the bond

when r = 10%, 12%, or r = 8%?

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 Bond Valuation

- The Term Structure of Interest Rates:

• So far we have assumed that the interest rate is constant

for all time to maturity.

• In reality, (annualized) interest rates for different periods

are different. This is called a non-flat term structure.

• Suppose r0 ,1 , r0 , 2 , r0 , 3 …are interest rates today for 1 period

to T periods. They are called the spot rates (interest rate

fixed today on a loan made today).

• Term structure refers to the relationship between the spot

rates and time to maturities.

Yield

6% r0,3
•
r0,2
5% •

r0,1
•

3%

1yr 2yr 3yr 4yr

Maturity
• Term structure changes over time.
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 Bond Valuation

– Example:

o Consider two zero-coupon bonds. Bond A expires in one year

and Bond B expires in two years. Both have face value of

$1,000. The one-year interest rate, r0,1, is 10%. The two-year

interest rate, r0,2, is 12%.

o Consider a two-year, 10% annually paid coupon bonds with

face value $1,000. The one-year interest rate, r0,1, is 10%.

The two-year interest rate, r0,2, is 12%.

– Generally, given the spot rates, a coupon bond is priced as:

C C C C+F
P0 (C) = + + ! + +
(1 + r0,1 ) (1 + r0,2 ) 2 (1 + r0,T-1 ) T-1 (1 + r0,T ) T

– Exercise:
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 Bond Valuation

Suppose that we observe 4 pure discount bonds with face

value $1000. A six-month discount bond is priced at $950. A
one year discount bond is priced at $920. An eighteen-month
discount bond is priced at $880. A two-year discount bond is
priced at $830. Consider a 10%, two-year coupon bond. The
face value of the coupon bond is F = $1000. The coupon is paid
semi-annually. What is the price of the coupon bond?

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 Bond Valuation

– Yield to Maturity (YTM), is a single measure of per period

return, earned from holding a bond to maturity. It is the

number y that equates the price of the bond to the present

value of its cash–flows

C C C C+F
P0 (C) = + + ! + +
(1 + y) (1 + y)2 (1 + y)T-1 (1 + y)T

Exercise: 2-year coupon bond: r0,1 = 8%, r0,2 = 10%, F = $1000,

C= $100. What’s the price and YTM of the bond?

YTM is not a good measure of return because it assumes that

the investor will be able to reinvest each coupon received at

the rate equal to YTM throughout the life of the bond.

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 Stock Valuation

- Dividends versus Capital Gains:

• Suppose you buy a stock and hold it for one year. The cash

payoff to stocks comes in two forms:

o Cash dividends.

o Capital gains or losses from period t−1 to t : 𝑃" − 𝑃"#$

• The price now is given by the PV of the dividend plus the

D1 + P1
PV of the price expected next year: P0 = , where
1+ r

P0 = current price (of one share),

P1 = expected price next year,

D1 = expected dividend per share next year.

r = the expected return on this stock = required rate of

return for investment of similar risk.

Note: r is not the interest rate. Since dividends and

capital gains are risky, we discount them usually at

higher rates. r is investors’ required rate of return.

D2 + P2
• P1 should obey the same relation: P1 =
1+ r

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 Stock Valuation

D1 D2 P2
P0 = + +
Plug it back: 1 + r (1 + r ) 2 (1 + r ) 2

"! +"
• Keep doing this: 𝑃! = ∑()*$ ( )!
+(
$%& $%& )"

&
If 𝑃! grows at a slower rate than (1 + 𝑟)! , 𝑃% = ∑+ !
"-$ ($())!

This says P0 is equal to the present value of all expected

future dividends.

- Valuation of Different Types of Stocks:

1. Zero Growth: Assume that dividends will remain at the same

level forever: Div1 = Div2 = Div3 = ! = Div

Div1 Div2 Div3 Div

P0 = + + + ! =
(1 + r )1 (1 + r ) 2 (1 + r )3 r

Exercise: ABC Corp. is expected to pay $0.75 dividend per

annum, starting a year from now, in perpetuity. If stocks of

similar risk earn 12% annual return, what is the price of a

share of ABC stock?

2. Constant Growth: Assume that dividends will grow at a

constant rate, g, forever. i.e.

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 Stock Valuation

Div1 = Div0 (1 + g )
Div2 = Div1 (1 + g ) = Div0 (1 + g ) 2
Div3 = Div2 (1 + g ) = Div0 (1 + g )3

𝐷𝑖𝑣$
𝑃% =
𝑟−𝑔

If dividends grow at a constant rate g, the resulting formula is

known as the Gordon Growth Model of stock valuation.

Exercise: XYZ Corp. has a common stock that paid its annual

dividend this morning. It is expected to pay a $3.60 dividend

one year from now, and following dividends are expected to

grow at a rate of 4% per year forever. If stocks of similar risk

earn 16% effective annual return, what is the price of a share

of XYZ stock?

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 Stock Valuation

3. Differential Growth: Assume that dividends will grow at

different rates in the foreseeable future and then will grow at

a constant rate thereafter.

e.g.: Dividends will grow at rate g1 for N years and grow at

rate g2 thereafter

Div N (1 + g 2 )
Div0 (1 + g1 ) Div 0 (1 + g1 ) Div 0 (1 + g1 )
2 N
= Div0 (1 + g1 ) N (1 + g 2 )

0 1
…
2 N N+1 …

⎛ Div N+1 ⎞
⎜ ⎟
Div1 ⎡ (1+ g1 ) N ⎤ ⎝ r − g2 ⎠
P0 = ⎢1− ⎥+
r − g1 ⎣ (1+ r) N ⎦ (1+ r) N

Exercise: A common stock just paid a dividend of $2. The

dividend is expected to grow at 8% for 3 years, then it will

grow at 4% in perpetuity. If stocks of similar risk earn 12%

effective annual return, what is the stock worth?

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 Stock Valuation

- Growth Opportunities

• Consider a firm with a level stream of earning per share (EPS)

in perpetuity.

If the company pays all these earnings out to the shareholder

as dividend, i.e., EPS = DIV , this kind of company is called

cash cow.

DIV1 EPS
The value of the firm’s one share is : =
r r

– But paying out all earning as dividend may not be optimal

since firms may have growth opportunities (investing in

profitable projects).

Example: ABC co. expects to earn $1million per year in

perpetuity. There are 100,000 shares outstanding. If the firm

spends $1million at date 1 to buy a new machine, the earnings

in every subsequent period will be increased by $210,000. The

firm’s discount rate is 10%. What is the value per share before

and after deciding to buy the new machine?

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 Stock Valuation

– The value per share of a firm can be conceptualized as the

sum of the value per share of a firm that pays out 100-percent

of its earnings as dividends and the net present value per

share of the growth opportunities.

EPS
P= + NPVGO
r

– Firm’s per share value will be increased if NPVGO is positive.

Exercise: In the example above, suppose the earning in every

subsequent period can be increased by $90,000 instead of

$210,000. What is the value of the firm after buying the

machine?

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 Stock Valuation

The NPVGO is positive if the return of the retained earning is

above the cost of capital (discount rate).

– The firm can have more than one growth opportunity.

– Estimation of g:

Consider a firm that will experience earnings growth only if

its net investment is positive. If it does not issue stocks or

bonds to raise capital, the firm must retain some of its

earnings to grow. This leads to div t = pt ´ EPSt , where p is the

dividend payout ratio and EPS is Earning per Share. Retained

Earning at t=(1−pt) × EPS. , and 1−p is called retention ratio.

If we assume that the retention ratio is constant and the

return on the firm’s investments is the historical ROE (return

on equity: Net income divided by average common

shareholders’ equity), then g = Retention ratio × ROE.

- Exercise:

Ontario Book Publishers (OBP) just reported earnings of $1.6

million, and it plans to retain 28-percent of its earnings. If

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 Stock Valuation

OBP’s historical ROE was 12-percent, what is the expected

growth rate for OBP’s earnings?

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 Stock Valuation

- Example: Consider a firm that has EPS of $100 at the end of

1st year, a payout ratio of 50-percent (the firm pays out 50% of

its earning as dividend every year starting at the end of the 1st

year), a discount rate of 10-percent, and a return on retained

earnings of 12-percent. What’s the share price of the firm?

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 Stock Valuation

- Price Earnings Ratio

Price per share P0

P/E ratio = = , is the multiple.
Annual EPS E0

• Measure of how “expensive” is the stock, per unit of earning

• From the NPVGO model:

NPVGO 1
P/E ratio = + The model says:
EPS r.

o If EPS and r are the same for two firms, the higher

NPVGO, the higher P/E ratio. E.g., Growth stocks have

high multiples

o The P/E ratio is negatively related to r since P is

negatively related to r.

o P/E ratio is affected by the firm’s accounting method. A

firm with conservative accounting has higher P/E ratio.

– From the Gordon Growth model:

(1 + g ) p
P/E ratio = Similarly, P/E ratio is high when
r-g .

ο Payout ratio is high

ο Growth rate is high

ο r is low (stock’s risk is low)

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