CAPITAL MARKETS
Capital Markets
a. Fixed-Income
b. Equity
Risks in the Capital Market
1. Stock prices keep fluctuating over a wide range unlike the bank deposits or government bonds. There are two factors
why the stock price fluctuates:
✓ Internal factors
o Profitability
o Having a good liquidity and reasonable leverage position
o Dividends
o Competent management which affects the company’s operating efficiency
o Good corporate plans that improve the business prospects of the company
✓ External factors
o Macroeconomics
o Press Release/News
o Industry where the company operates
o General market sentiment
o Flow of foreign funds invested in the Philippine stock market
2. Risk in the bond market arises due to interest rate changes. There is an inverse relationship between the price of the
bonds and effective interest rate.
✓ Effective interest rate: ↑ ; Market price of bonds: ↓
✓ Effective interest rate: ↓ ; Market price of bonds: ↑
CAPITAL MARKETS
a. Fixed-Income Market
- The fixed-income market is more commonly referred to as the debt securities market or the bond market.
o Fixed income market = Debt securities
➢ Fixed-Income Instruments
✓ Mortgages - loans to individuals in which the individual use their property as collateral.
✓ Bonds - units of corporate debt issued by companies and securitized as tradeable assets.
✓ Term Loans - contract under which a borrower agrees to make a series of interest and principal payments on
specific dates to the lender.
➢ Key Features of a Bond
✓ Par value - Face amount; paid at maturity. Assume $1,000.
✓ Coupon interest rate - Stated interest rate. Multiply by par to get $ of interest. Generally fixed.
✓ Maturity - Years until bond must be repaid. Declines.
✓ Issue date - Date when bond was issued.
✓ Effective interest - The discount rate used to compute the amortization of bonds.
➢ Advantages and Disadvantages
• Advantages
✓ Receive income through the interest payments
✓ Hold the bond to maturity and get all your principal back
✓ You can profit if you resell the bond at a higher price
• Disadvantages
✓ Bonds pay out lower returns than stocks
✓ Companies can default on your bonds
✓ Bond yields can fall
b. Equity Market
- Market in which shares of companies are issued and traded, either through exchanges or over-the-counter markets.
➢ Equity Market Instruments
✓ Common stocks
✓ Preferred stocks
➢ Advantages and Disadvantages
• Advantages
✓ Dividend ✓ Rights Shares
✓ Capital Gain ✓ Bonus Shares
✓ Limited Liability ✓ Liquidity
✓ Exercise Control ✓ Stock Split
• Disadvantages
✓ Dividend is not ✓ Fluctuation in market price
fixed/controllable ✓ Limited Control
✓ High Risk ✓ Residual Claim
➢ Equity Instruments Valuations – The following methods are used in the computation of shares:
✓ Dividend Growth Model / Gordon Growth Model
𝟏𝑫 𝑫𝟎 (𝟏+𝒈)
P𝐫𝐢𝐜𝐞 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬 = 𝒓−𝒈 or 𝑷= 𝒓−𝒈
𝐷1 = Dividend rate next year = Past dividends x (1 + Growth rate)
R = Rate of return / Cost of capital
G = Growth rate
The following are the assumptions in the GGM:
• The company’s business model is stable
• The entity grows at a constant, unchanging rate
• Has stable financial leverage
• The free cashflow is paid as dividends
✓ Zero-Growth Valuation Model
𝑫𝟎 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
𝑷= 𝒓
or 𝑷= 𝒓
• It is used under the assumption that the dividend rate is constant forever.
• You can use either the earnings per share or the dividend rate in the formula. Earnings per share is an
alternative because it somehow reflects the dividend received of each stockholder for the year.
✓ Discounted Cash Flow Model - A valuation methodology that measures the intrinsic value of a company based
on the present value of its future cash flows.
Steps in DCF Model
1. Determine and discount (compute for the PV) the unlevered free cash flows.
2. Determine and discount the terminal value.
3. Get the enterprise value.
4. Add non-operating assets and deduct any debts.
5. Divide by number of shares outstanding.
• Unlevered Free Cash Flows - Cash flow available to all equity holders and debt holders after all operating
expenses, capital expenditures, and investments in working capital have been made.
Earning before tax
Less: Income tax
Earning after tax
Add: Depreciation and Amortization
Less: Change in working capital
Less: Capital Expenditure
Unlevered Free Cash Flow
• Terminal Value - Value of your company from your last projected year until the end of time.
Method: Perpetual Growth DCF TV
- This method assumes the business will continue to generate Free Cash Flow (FCF) at a normalized state
forever (perpetuity).
𝑭𝑪𝑭𝒏 𝒙 (𝟏 + 𝒈)
𝑻𝑽 = 𝑾𝑨𝑪𝑪 – 𝒈
FCFn = Undiscounted last cashflow forecast
WACC = Weighted Average Cost of Capital / Cost of capital / Rate of Return
➢ Advantages and Disadvantages
• Advantages
✓ Theoretically the most sound method if the analyst is confident in his assumptions
✓ Not significantly influenced by temporary market conditions or non-economic factors
✓ Especially useful when there is limited or no comparable information
• Disadvantages
✓ Valuation obtained is very sensitive to a large number of assumptions/forecasts and can vary over
a wide range
✓ Often very time-intensive relative to some other valuation techniques
✓ Involves forecasting future performance, which is very difficult