Security Valuation

Stock and Bond Valuation

 DCF Valuation
• In general, the value of a security is the sum of the present
values of the (expected) future cash flows that accrue to
the owner of that security.
– Expected cash flows since we have to be concerned about risk.
– The presence of risk implies we must use a discount rate consistent
with market conditions and appropriate for the risk involved.
– Different discount rates may be appropriate for different cash
flows.
– Discount all future cash flows to the present and the sum of the
present values equals the securities current value.
• Correct application of this approach may be used to value
all the securities you will come across. For some securities
(i.e. options, a topic for later) there are easier ways.
 Bond Valuation - Terminology
• Face or par value (F), is the amount the bond promises to
pay at its maturity date.
• Coupon interest: The bond is quoted as a coupon rate of C
per year and usually makes actual payments of C/2 every 6
months. C/F is defined as the coupon interest rate, a rate
that is constant over the life of the bond.
• Call provision, call protection, call premium.
• Default risk.
• Discount rate, r, the market determined appropriate rate of
return of this type of security.
• Yield to maturity (yield) is the discount rate that equates
the bond’s promised payments to its market price, V.
• Current yield C/V
 Pure Discount Bonds
• Pure discount bonds are the simplest bonds
possible. They pay no interest and promise only
to return the face value at maturity.
• T-bills (up to a year in maturity) and Strips.
F
Valuation formula : V  ; T is periods to maturity
(1  r ) T

– The value of a three year $1,000 face value strip, when

the market rate is 6% is
$1,000
V 3
 $839.62
(1.06)
 Consol Bonds
• Consol bonds do not have a maturity, they make
periodic interest payments, forever.
• Who but the English?
C
Valuation formula : V
r
– If a consol bond you are buying from a cockney broker
pays ₤50 per year and the interest rates in London are
7%, how much will you pay?
£50
V  £714.29
0.07
 Level Coupon Bonds
• Level coupon bonds are the most common
bonds. They pay a semiannual coupon,
quoted as C per year, face of F, T years to
maturity, and an annual discount rate of r.
• There are two components of this valuation:
– The coupon payments comprise an annuity.
– The lump sum payment of face value at
maturity.
 Level Coupon Bonds cont…
1 2 T-1 T
0

C/2 C/2 C/2 C/2 C/2 C/2 C/2 C/2

F
• The two pieces:
– Annuity of C/2 for 2T periods (6 months).
– Lump sum of F at the end of 2T periods.
C  1 1  F
P0 =  r / 2  (r / 2)(1  r / 2) 2T  2T
2   (1+ r / 2 )
• Technical note: r is the stated annual discount rate and we are
using semiannual compounding. This is the current value
assuming you receive the first coupon 6 months from today.
 Bond Pricing Example
• Dupont issued 30-year bonds with a coupon rate
of 7.95%. These bonds currently have 28 years
remaining to maturity and are rated AA. Newly
issued AA bonds with similar maturities are
currently yielding 7.73%. The bonds have a face
value of $1000. What is the value of this Dupont
bond today?
 Bond Pricing Example cont…
• Annual coupon payment = 0.0795*$1000=$79.50
• Semiannual coupon payment = $39.75 = $79.50/2
• Semiannual discount rate = 0.0773/2 = 0.03865
• Number of semiannual periods = 28*2 = 56
 1 1 
V 0 = 39.75  56 

 0.03865 (0.03865)(1  0.03865) 
1000
 $1025.06
(1  0.03865 )56
 Bond Prices and Interest (Discount) Rates

n When The Discount Rate Is Equal To The Coupon Rate

The Bond Will Sell At Par
n When The Discount Rate Is Above The Coupon Rate The
Bond Will Sell At A Discount To Par
n When The Discount Rate Is Below The Coupon Rate The
Bond Will Sell At A Premium To Par
n At The Instant Before Maturity All Bonds Will Sell At Par
• Why Do These Relations Hold?
• What Feature Of A Bond Is The Primary Determinant
Of Its Price Sensitivity To Interest Rates?
 Bond Prices and Time to Maturity
1600.00

1400.00

1200.00
Price

1000.00
7%
800.00
10%
600.00 13%
30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0
Years to Maturity

Discount Rates
What is the coupon rate?
 Bond Prices and Interest (Discount) Rates
2000.00
1800.00
1600.00
1400.00
1200.00
Price

1000.00
800.00 5

600.00 10

400.00 30

200.00
0.00
5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Discount Rate
Years to maturity
What is the common coupon rate of these bonds?
Why is the long maturity bond more volatile?
 Yield to Maturity (or Call)
• The yield to maturity is the discount rate that equates the
bond’s current price with its stream of promised future
cash flows.
• This is the yield that you would receive if you held the
bond to maturity (and were able to reinvest the coupon
payments at this rate).
• The yield to call is the discount rate that equates the bond’s
current price with its stream of promised cash flows until
the expected call date.
• Given two bonds, equivalent in all respects except that one
is callable, which bond will have a higher price?
 YTM – Example
• On 9/1/95, PG&E bonds with a maturity date of
3/01/25 and a coupon rate of 7.25% were selling
for 92.847% of par, or $928.47 per $1,000 of face
value. What is their YTM?

• Semiannual coupon payment = 0.0725*1000/2 =

$36.25.
• Number of semiannual periods to maturity
= 30*2 – 1 = 59.
 YTM – Example cont…
 1 1  1000
$928.47 = $36.25  59 

 r / 2 ( r / 2)(1  r / 2)  (1 + r / 2 )
59

• r/2 can only be found by trial and error. However,

calculators and spread sheets have algorithms to
speed up the search.
• Searching reveals that r/2 = 3.939% or a stated
annual rate of r = 7.877%.
• This is an effective annual rate or annual YTM of:
(1.03939) 2  1  8.03%
 Term Structure of Interest Rates
• We have been talking (and we will frequently
continue to talk) as if the interest rate were
constant across all future periods.
• One look at the WSJ bond pages and you know
I’m lying to you.
• Its not just because I enjoy doing so.
• We shouldn’t leave this discussion without
introducing the term structure of interest rates.
• The term structure of interest rates is the structure
of yields on debt instruments which differ only in
their times to maturity.
 Measuring the Term Structure
• We have been dealing with “spot rates,” and thinking of
the same “spot rate” for each maturity.
• The formulas are the same, we just need to allow a
subscript to differentiate different maturities.
1
F FT
P0  and rT     1
(1  rT )T  P0 
• Knowing the face value and price you can calculate the
spot rates or knowing face and the spot rate you can
calculate the price of the zero’s with different maturities.
 Examples
• Suppose that a two year zero has a face of $1,000 and a
current price of $800. What is the two-year spot rate?
1
 $1,000 
2
r2     1  (1.25)  1  11.8%
1/ 2

 $800 
• Once we have computed all the spot rates we can find the
current value of any stream of cash flows.
• A government bond that matures in 4 years promises to
pay an annual coupon of 6%. The spot rate for year 1 is
6%, for year 2 is 6.5%, for year 3 is 7%, and for year 4 is
7.5%. How do we find the value of this bond?
$60 $60 $60 $1,060
P0   2
 3
 4
 $952.21
1.06 (1.065) (1.07) (1.07.5)
 Forward Rates
• An idea you need to be aware of is forward rates.
• Suppose that the one year spot rate is 5% and the two year
spot rate is 10%. If you want to invest for two years but
buy a one year bond how can we think about your
investment?
P0 P0(1+r2)2
t=0 t=1 t=2

P0 P0(1+r1) P0(1+r1)(1+E(r1,2))

• Because there is a rate that applies for now till one year from now and
a rate that applies for now till two years from now, there is implicitly
defined a rate between one year from now and two years from now.
 Forward Rates – Example
• If the one year spot rate is r1 = 5% and the two
year spot rate is r2 = 10% then we define the
forward rate between the end of year one till the
end of year two, f1,2 by the equation:
(1  r1 )(1  f1,2 )  (1  r2 ) 2

• We won’t dwell on these rates but you need to

know about them because they can be handy.
• How would you estimate what the price of a
coupon bond will be one year from now?
 Preferred Stock Valuation
• Preferred Stock
– Preferred stock has a fixed dividend payment.
– Preferred dividends can be omitted without
placing the firm in default.
– Preferred stock has no maturity date.
• Does preferred stock have the same risk as
the firm’s debt?
• Preferred stock looks like a perpetuity.
Preferred Stock Valuation cont…
• Preferred stock is typically valued as a
perpetuity. Given the promised dividend
payment, Divp, and the discount rate, rp, the
value of a share of preferred stock is:
Div p
Pp 
rp
 Preferred Stock Example
• On 8/24/01 Sears preferred stock had a
dividend of $2.22 per share and was selling
at $26.25 per share. What rate of return
were investors requiring on Sears preferred
stock?
Div p $2.22
rp    8.46%
Pp $26.25
Common Stock Valuation - Terminology

• Dt =dividend per share of stock at time t.

• P0=market price of the stock at time 0 (now).
• Pt=market price of the stock at time t. (Prior to
date t, this would be the expected price).
• g=expected growth rate in dividend payments.
• rs=required rate of return.
• D1/P0=dividend yield during period 1.
• [P1 - P0]/P0= capital gain rate during period 1.
Common Stock Valuation - Terminology

• Dividend yield is the annual dividend over

the current price.
• PE (price earnings ratio) is the current price
divided by the sum of the last 4 quarters
announced earnings.
• Get to know how to read the information
contained in the WSJ stock quotes, it can be
surprisingly informative.
 Common Stock Valuation
• What would you pay for a share of stock today?
• To answer this question, ask: why would you buy it?
• Suppose you have a one year holding period horizon.
D1 P1 D1  P1
P0   
1  rs 1  rs 1  rs
• D1 and P1 represent expectations.
• Note also that we can rearrange this to see that return is
dividend yield plus the capital gain yield.
D1 P1  P0
rs  
P0 P0
• Before date 1 this is the expected return, at or after date 1
this is the realized return.
Common Stock Valuation cont…
• What determines P1?
• An investor purchasing the stock at time 1 and
holding it until time 2 would be willing to pay:
D2  P2
P1 
(1  rs )
• Substitute this into the equation for P0 from the
last slide and find:
D1 D2 P2
P0   
(1  rs ) (1  rs ) (1  rs ) 2
2
Common Stock Valuation cont…
• Repeat this process N times and find:
D1 D2 D3 DN PN
P0     .... 
(1  rs ) (1  rs ) (1  rs )
2 3
(1  rs ) N
(1  rs ) N
• If we continue to apply the same logic (let N get really big)
we find that: 
P0   D t
t
t 1 (1 + rs )
• The current market value (price) of a share of stock is the
present value of all its expected future dividends.
 Stock Valuation if Dividends
Display Constant Growth (Forever)
• If the dividend payments on a stock are expected
to grow at a constant rate, g, and the discount rate
is rs, then the value of the stock at time 0 is
D1
P0 
rs  g
• g must be less than rs for this to be valid.
• If g = 0 this collapses to the perpetuity formula.
– If g is negative this works for shrinking dividends.
• Labeled the Gordon growth model.
• Why would prices change?
 Example
• Geneva Steel just paid a dividend of $2.10.
Geneva’s dividend payments are expected to grow
at a constant rate of 6%. The appropriate discount
rate is 12%. What is the current price of Geneva
Stock?

• D0 = $2.10  D1 = $2.10(1.06) = $2.226

$2.226
P0   $37.10
0.12  0.06
 Aside: Estimating the Required
Return from the Current Price
• We are focusing on valuation – determination of the price.
• Suppose you observe a price that you consider reliable, and instead
wish to infer rs. Rearrange the constant growth valuation formula to
obtain:
D1
rs  g
P0
• Example: US East stock currently sells for $22. Its most recent
dividend was $1.50, and dividend growth of 6% is expected.
D1  $1.50(1.06)  $1.59
$1.59
rs   0.06  0.0723  0.06  13.23%
$22
• This method is often used in utility regulation. Leaves us wondering:
what is g? (Seems to be an important question.)
Estimating the Growth Rate: Illustration

• A common starting point for estimating the growth rate is

to assume:
– The firm’s ROE is constant over time and across projects.
– The proportion of the firm’s income paid out as dividends (payout
ratio) is also constant.
– The firm will have no future financings.
• Then, income and dividends will both grow at the same
rate as owner’s equity, and owners equity will grow only
due to retained earnings.
• The growth rate will be ROE(1 – payout ratio) = SGR.
• Very sensitive to the assumptions, don’t use this method if
they are not representative of actual conditions.
 Common Stock Valuation Example
• In early 1996 (from a case used in another class).
• ROE = 13%, payout ratio = 45%
– Implying g = 0.13(1 – 0.45) = 0.0715.
– 1995 dividend was $1.64.
– Thus, D1 = $1.64(1.0715) = 1.757.
– Calculating rs = 0.11, we have
$1.757
P0   $45.64
0.11  0.0715
(The actual price was $45 per share, explaining my
choice of examples more than anything.)
 Non-constant Growth in Dividends
• Firms often go through lifecycles.
– Fast growth.
– Growth that matches the economy.
– Slower growth or decline.

• A super normal growth stock is one that is

experiencing rapid growth. But, supernormal
growth is, by definition, only temporary. Why?
 Valuation of Non-constant Growth Stocks

• Could just derive all expected dividend payments

individually and discount them. Tedious.

• Find the present value of the dividends during the period of

rapid growth.
• Project the stock price at the end of the rapid growth
period. This will be the discounted value of the
subsequent dividends. Discount this price back to the
present.
• Add these two present values to find the intrinsic value
(price) of the stock.
 Example
• Batesco Inc. just paid a dividend of $1. The
dividends of Batesco are expected to grow by 50%
next year (time 1) and 25% the year after that
(year 2). Subsequently, Batesco’s dividends are
expected to grow at 6% in perpetuity.

• The proper discount rate for Batesco is 13%.

• What is the fair price for a share of Batesco stock?

 Example cont…
• First, determine the dividends.
• D0 = $1 g1 = 50%
• D1 = $1(1.50) = $1.50 g2 = 25%
• D2 = $1.50(1.25) = $1.875 g3 = 6%
• D3 = $1.875(1.06) = $1.9875

0 g =50% 1 2 g =6% 3 4
1 g2=25% 3 g4=6%
......

1.50 1.875 1.9875 2.107

 Example cont…
• Supernormal growth period:
D1 + D2 1.50 1.875
Ps = 2 = + 2 = $2.796
(1 + rs ) (1 + rs ) (1.13) (1.13)

• Constant growth period. Value at time 2:

D 3 1.9875
Pc = = = $28.393
rs - g3 0.13 - 0.06
• Discount Pc to time 0 and add to Ps:
P c 28.393
P0 = P s + 2
= 2.796+ 2
= $25.03
(1+ r s ) (1.13 )
• What if supernormal growth lasted 5 yrs at 50%?
 Stocks That Pay No Dividends
• If investors value dividends, how much is a stock that pays
no dividends worth?
• A stock that will literally never pay dividends in any form
has a value of zero.
• In actuality, a company that has not paid dividends to date
can be worth a lot, if the company had good investment
projects or if it has assets that can be liquidated.
– McDonald’s started in the 1950’s but paid its first dividend in
1975. The market value of McDonald’s stock was in excess of $1
billion prior to 1975.
– Anyone familiar with Intel’s history?
Valuing Operations Instead of Dividends

• Stocks can be (and often are) valued based on earnings and/or

operating cash flows instead of dividends. Let OCF denote operating
cash flow (after taxes and after all working capital corrections).
• Let F denote the net cash flow to the firm from financings (new debt
and equity issues less any debt repaid or equity repurchased).
• Let I denote net new capital investment taken by the firm.
• Then using the cash flow identity, dividends can be stated as
Dt = OCFt + Ft – It.
• So we can value the firm by discounting future operating cash flows,
financing flows, and requisite capital investments instead of dividends.
• An “NPV” approach.
 Valuing Operations cont…
• Let NPVGO represent the net present value of the firm’s future
investments (growth options). This is the present value of the
operating cash flows those investments will create less the present
value of the capital outflows that will be required to develop them.
• Let NPVF represent the net present value of the firm’s future financing
transactions. This is the present value of the proceeds from financings
less the present value of the resulting obligations --- interest and
principal for debt, dividend dilution for equity (a good starting point is
NPVF=0: why?).
• Let PVA denote the present value of the future cash flows from the
firms existing assets.
• Let PVL denote the present value of the future cash flows associated
with the firm’s existing liabilities.
– All should be stated on a per share basis if we want the price per share.
 Valuing Operations cont…
• The following valuation approach is equivalent to the
discounted dividend approach:
P0 = PVA - PVL + NPVGO + NPVF
• Equivalent, even though it does not directly involve
dividend projections at all!
• Observations regarding RWJ’s Chapter 5 discussion:
– They assume no future financings. (More generally, NPVF = 0 is
probably a very good approximation).
– They assume no existing debt, so PVL = 0.
– They assume that existing assets pay a perpetuity in the amount of
EPS per period. So, PVA = EPS/rs.
• So, with their special restrictions, we have:
P0 = EPS/rs + NPVGO.
 XCORP Example
• Suppose that Xcorp’s current assets produce net
cash flows of $1 million per year in perpetuity.
The discount rate for Xcorp is 15%.
• What is the market value of Xcorp?
0 1 2 3 4
......

1 million 1 million 1 million 1 million

CF1 $1 million
PVA    $6.67 million
rs 0.15
 XCORP Example cont…
• Now suppose that Xcorp has an R&D project that
will require cash infusions of $1 million in each of
the next three years. Subsequently, the project
will generate additional cash flow of $0.75 million
per year in perpetuity. Xcorp’s net cash flow
including the project is:
0 1 2 3 4
......

0 million 0 million 0 million 1.75 million

• What is the market value of Xcorp with the
project?
 XCORP Example cont…
• Xcorp’s cash flow can be divided up into two pieces:
• The cash flow from current assets:
0 1 2 3 4
......

1 million 1 million 1 million 1 million

• Plus the cash flows from the new project:
0 1 2 3 4
......
-1 million -1 million -1 million 0.75 million
 XCORP Example concluded
• The NPV of the project at time 0 is:
1 1 1 1 0.75
NPVGO   2
 3
 3

1.15 (1.15) (1.15) (1.15) 0.15
 $1.004 million
• Xcorp’s value with the project is:
P0  PVA  NPVGO
 $6.667  $1.004  $7.671 million
 The Discounted Dividend and NPV
Approaches Are Equivalent
• Fresno Corporation has one asset and one growth
opportunity.
• The existing asset is a factory which generates operating
cash flow of $100,000 per year. This will continue for 10
years only, with no salvage value.
• The growth opportunity would require an investment of
$2 million at t=2, and will return $350,000 to Fresno in
each year from t=3 to t=10.
• The growth opportunity will be funded by selling $2
million in zero coupon bonds at t=2. The bonds will be
repaid at t=10.
• Fresno currently has 100,000 equity shares outstanding.
• For simplicity, we will assume that interest/discount rates
are zero.
 Valuing Fresno’s Operations
• P0 = PVA - PVL + NPVGO + NPVF
– PVL = 0 (No existing debt).
– NPVF = 0 (Fair terms on the future financing)
– PVA = $100,000x10 = $1,000,000 (no discounting)
– NPVGO = $350,000x8 - $2,000,000 = $800,000

• P0 = $1,000,000 + $800,000 = $1,800,000

in total, or $18 per share.
 Valuing Fresno’s Dividends
• Fresno pays $100,000 per year in regular dividends. At t = 10 Fresno
will pay off its debt and pay out all remaining cash as a liquidating
dividend.
• We need to determine the size of the liquidating dividend, and obtain
the present value (no discounting) of the dividend stream.
Year BofY Cash OCF I F D EofYCash

1 0 100 0 0 100 0
2 0 100 2000 2000 100 0
3 0 450 0 0 100 350
4 350 450 0 0 100 700
5 700 450 0 0 100 1050
6 1050 450 0 0 100 1400
7 1400 450 0 0 100 1750
8 1750 450 0 0 100 2100
9 2100 450 0 0 100 2450
10 2450 450 0 -2000 900 0
 Valuing Fresno’s Dividends cont…
• Fresno will pay 9 dividends of $100,000 each,
plus a liquidating dividend of $900,000.
• With a zero discount rate the present value of the
dividend stream is $1,800,000, or $18 per share.
• Does the fact that the discounted dividend
approach gives the same answer as the present
value of operations approach rely on the zero
discount rate assumption?
• So, use whichever method is easier to implement!
 Price – Earnings (P/E) Ratios
• The investment community relies heavily on P/E
ratios.
– P/E’s are one of the items reported for every NYSE and
NASDAQ stock in daily newspapers.
– Some analysts do simple valuation by obtaining the
product of earnings per share and the “P/E multiplier”
• Using the RWJ framework,
P0 = EPS/rs +NPVGO,
so the ratio of price to earnings per share is:
P0/EPS = 1/rs + NPVGO/EPS
 P/E Ratios – Example
• If NPVGO = 0 and r = .15, then P/E = 1/.15 = 6.67

• If NPVGO = 0 and r = .08, then P/E = 1/.08 = 12.50.

• If the Net Present Value of Future Investments is five times as

large as current EPS and r = .08, then P/E = 1/.08 + 5 = 17.50

• So, high P/E’s require either low discount rates or lots of good
future investments (relative to current earnings), i.e. earnings
growth. Note, though, that earnings growth obtained through
negative NPV investment won’t help. P/E ratios should not help
anyone “pick stocks.”
• Is the current P/E ratio in U.S. markets high or low by historical
standards?
 Residual Income Valuation and “EVA”

• A long overlooked, but recently rediscovered, approach to

valuation is the “residual income” approach.
– Let BVt denote the book value of equity (per share) at time t.
– Let NIt denote the net income per share for the interval ending at
time t.
– Let DIVt denote the dividend per share at time t.
• The “clean surplus” accounting relation is:
BVt = BVt-1 + NIt – DIVt, or
DIVt = NIt – BVt .
• Does this always hold?
 Residual Income and EVA cont…
• Substitute the “clean surplus” relation into the
“share price is the present value of all future
dividends” expression and rearrange it:

( ROEt  rs ) Bt 1
P0  B0  
t 1 (1  rs ) t

– Where ROE is return on equity, Nit/Bt-1.

– Where rs is the discount rate for equity, (Bt – Bt-1)/Bt-1.
• Why would they call this a “residual income”
approach?
 Residual Income – Example
• Jensen company currently has a book value per
share of $20. It earns a return on equity of 15%,
and its cost of equity capital (discount rate) is
10%. For simplicity, assume that book value and
ROE will remain constant forever. (This is solely
so we can compute present values based on level
perpetuities.)
(0.15  0.10)20 1
P0  20   20   $30
0.10 0.10
– The key to pushing share price above book value is…
 EVA Analysis
• The residual income approach underlies
“economic value added” techniques that are
currently popular.

• EVA = Income – Opportunity Cost of Invested Capital.

• Which is just “residual income.”
• In the previous example, EVA is:
.15(20) - .10(20) = 3 – 2 = $1
(per share, per period)
Valuation Techniques: Summary
• Financial assets (and some real assets) can be valued by
discounted cash flow techniques: compute the present
value of all expected future cash flows to be given off by
the asset.
• For bonds, this is mainly a matter of time value mechanics
and the selection of the appropriate discount rate.
• For stocks, DCF techniques can be implemented either by
discounting the forecasted dividend stream, or by
discounting future flows to equity. The important issues
are the firm’s inherent ability to generate cash flows and
the riskiness of these cash flows.