Chapter 5

Report
5-0
CHAPTER
5
How to Value
Bonds and Stocks
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Chapter Outline
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
Definition and Example of a Bond
How to Value Bonds
Bond Concepts
The Present Value of Common Stocks
Estimates of Parameters in the Dividend-Discount Model
Growth Opportunities
The Dividend Growth Model and the NPVGO Model
(Advanced)
Price Earnings Ratio
Stock Market Reporting
Summary and Conclusions
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Valuation of Bonds and Stock
First Principles:
Value of financial securities = PV of expected future
cash flows
To value bonds and stocks we need to:
Estimate future cash flows:
Size (how much) and
Timing (when)
Discount future cash flows at an appropriate rate:
The rate should be appropriate to the risk presented by the
security.
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5.1 Definition and Example
of a Bond
A bond is a legally binding agreement between a
borrower and a lender:
Specifies the principal amount of the loan.
Specifies the size and timing of the cash flows:
In dollar terms (fixed-rate borrowing)
As a formula (adjustable-rate borrowing)
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5.1 Definition and Example
of a Bond
Consider a U.S. government bond listed as 6 3/8 of December
2009.
The Par Value of the bond is $1,000.
Coupon payments are made semi-annually (June 30 and December 31 for
this particular bond).
Since the coupon rate is 6 3/8 the payment is $31.875.
On January 1, 2005 the size and timing of cash flows are:
$31.875 $31.875
$31.875
$1,031.875
6 / 30 / 09
12 / 31 / 09

1 / 1 / 05
6 / 30 / 05
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5.2 How to Value Bonds
Identify the size and timing of cash flows.
Discount at the correct discount rate.
If you know the price of a bond and the size and
timing of cash flows, the yield to maturity is the
discount rate.
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Pure Discount Bonds
Information needed for valuing pure discount bonds:
Time to maturity (T) = Maturity date - today’s date
Face value (F)
Discount rate (r)
$0
$0
$0
$F
T 1
T

0
1
2
Present value of a pure discount bond at time 0:
F
PV 
T
(1  r )
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Pure Discount Bonds: Example
Find the value of a 30-year zero-coupon bond with
a $1,000 par value and a YTM of 6%.
$0
$0
$0
$1,000
$0
29

0
1
2
29
30
F
$1,000
PV 

 $174.11
T
30
(1  r )
(1.06)
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Pure Discount Bonds: Example
Find the value of a 30-year zero-coupon bond with
a $1,000 par value and a YTM of 6%.
N
30
I/Y
6
PV
174.11
PMT
FV
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Level-Coupon Bonds
Information needed to value level-coupon bonds:
Coupon payment dates and time to maturity (T)
Coupon payment (C) per period and Face value (F)
Discount rate
$C
$C
$C
$C  $F
T 1
T

0
1
2
Value of a Level-coupon bond
= PV of coupon payment annuity + PV of face value
C
1 
F
PV  1 

T 
r  (1  r )  (1  r )T
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Level-Coupon Bonds: Example
Find the present value (as of January 1, 2004), of a 6-3/8 coupon Tbond with semi-annual payments, and a maturity date of
December 2009 if the YTM is 5-percent.
On January 1, 2004 the size and timing of cash flows are:
$31.875 $31.875
$31.875
$1,031.875
6 / 30 / 09
12 / 31 / 09

1 / 1 / 04 6 / 30 / 04
12 / 31 / 04
 $1,000
$31.875 
1
PV 
1

 $1,070.52

12 
12
.05 2  (1.025)  (1.025)
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Level-Coupon Bonds: Example
Find the present value (as of January 1, 2004), of a
6-3/8 coupon T-bond with semi-annual payments, and
a maturity date of December 2009 if the YTM is
5-percent.
N
I/Y
PV
PMT
12
5
– 1,070.52
31.875 =
1,000×0.06375
2
FV
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5.3 Bond Concepts
1.
Bond prices and market interest rates move in opposite
directions.
2.
When coupon rate = YTM, price = par value.
When coupon rate > YTM, price > par value (premium bond)
When coupon rate < YTM, price < par value (discount bond)
3.
A bond with longer maturity has higher relative (%) price
change than one with shorter maturity when interest rate (YTM)
changes. All other features are identical.
4.
A lower coupon bond has a higher relative price change than a
higher coupon bond when YTM changes. All other features are
identical.
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YTM and Bond Value
When the YTM < coupon, the bond
trades at a premium.
Bond Value
$1400
1300
1200
When the YTM = coupon, the
bond trades at par.
1100
1000
800
0
0.01
0.02
0.03
0.04
0.05
0.06 0.07
6 3/8
0.08
0.09
0.1
Discount Rate
When the YTM > coupon, the bond trades at a discount.
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Bond Value
Maturity and Bond Price Volatility
Consider two otherwise identical
bonds.
The long-maturity bond will have
much more volatility with respect to
changes in the discount rate
Par
Short Maturity Bond
C
Discount Rate
Long Maturity Bond
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Bond Value
Coupon Rate and Bond Price
Volatility
Consider two otherwise identical bonds.
The low-coupon bond will have much more
volatility with respect to changes in the
discount rate
High Coupon Bond
Discount Rate
Low Coupon Bond
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5.4 The Present Value
of Common Stocks
Dividends versus Capital Gains
Valuation of Different Types of Stocks
Zero Growth
Constant Growth
Differential Growth
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Case 1: Zero Growth
Assume that dividends will remain at the same level
forever
Div1  Div2  Div3  
Since future cash flows are constant, the value of a
zero growth stock is the present value of a
perpetuity:
Div1
Div 2
Div 3




1
2
3



(1 r )
(1 r )
(1 r )
Div
P0 
r
P0 
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Case 2: Constant Growth
Assume that dividends will grow at a constant
rate, g, forever. i.e.
Div1  Div0 (1  g )
2




Div2 Div1 (1 g ) Div0 (1 g )
3



Div3  Div
(
1
g
)
Div
(
1
g
)
0
.2
..
Since future cash flows grow at a constant rate
forever, the value of a constant growth stock
is the present value of a growing perpetuity:
Div1
P0 
r g
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Case 3: Differential Growth
Assume that dividends will grow at different rates
in the foreseeable future and then will grow at a
constant rate thereafter.
To value a Differential Growth Stock, we need to:
Estimate future dividends in the foreseeable future.
Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.
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Case 3: Differential Growth
Assume that dividends will grow at rate g1
for N years and grow at rate g2 thereafter
Div1  Div0 (1  g1 )
2




Div2 Div1 (1 g1 ) Div0 (1 g1 )
..
.
N




DivN DivN 1 (1 g1 ) Div0 (1 g1 )
DivN 1  DivN (1  g2 )  Div0 (1  g1 )N (1  g2 )
..
.
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Case 3: Differential Growth
Dividends will grow at rate g1 for N years
and grow at rate g2 thereafter
2


Div0 (1 g1 ) Div0 (1 g1 )
…
0
1
2
Div0 (1  g1 )N
DivN (1  g2 )
 Div0 (1  g1 )N (1  g2 )
…
…
N
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Case 3: Differential Growth
We can value this as the sum of:
an N-year annuity growing at rate g1
T


C
(1 g1 ) 
PA 
1 
T 
r  g1  (1  r ) 
plus the discounted value of a perpetuity
growing at rate g2 that starts in year N+1
 DivN 1

r  g2

PB 
(1  r )N
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Case 3: Differential Growth
To value a Differential Growth Stock, we can use
 DivN 1

T


C
(1 g1 )   r  g2

P
1 

T
N



r g1  (1 r )  (1 r )



Or we can cash flow it out.
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A Differential Growth Example
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.
What is the stock worth? The discount rate is 12%.
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With the Formula
 DivN 1

T


C
(1 g1 )   r  g2

P
1 

r  g1  (1  r )T  (1  r )N



 $2(1.08)3 (1.04) 




3



(1.08)
.12 .04
$
2
(
1
.
08
)





1
P

3 
3

.12 .08  (1.12) 
(1.12)
(
$32.75 )
P  $54 [1 . 8966]
(1.12)3
P  $5.58  $23.31
P  $28.89
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A Differential Growth Example (continued)
$2(1.08)
0
1
$2.16
0
2
$2(1.08)
2
$2.33
$2(1.08)3 $2(1.08)3 (1.04)
…
3
$2.62
$2.52 
.08
4 The constant
growth phase
beginning in year 4
can be valued as a
growing perpetuity
at time 3.
$2.62
P3 
 $32.75
.08
$2.16 $2.33 $2.52  $32.75


 $28.89
P0 
2
3
1.12 (1.12)
(1.12)
1
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A Differential Growth Example (continued)
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. What is the stock worth?
$28.89 = 5.58 + 23.31
First find the PV of the supernormal dividend stream then find
the PV of the steady-state dividend stream.
N
N
3
1.12
I/Y
3.70 =
PV
– 5.58
PMT
FV
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$2 =
0
1.08
3
–1 ×100 I/Y
2×1.08
12
PV
– 23.31
PMT
0
1.08
FV
2×(1.08)3 ×(1.04)
32.75 =
.08
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5.5 Estimates of Parameters in the
Dividend-Discount Model
The value of a firm depends upon its growth rate,
g, and its discount rate, r.
Where does g come from?
Where does r come from?
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Where does g come from?
g = Retention ratio × Return on retained earnings
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Where does r come from?
The discount rate can be broken into two parts.
The dividend yield
The growth rate (in dividends)
In practice, there is a great deal of estimation
error involved in estimating r.
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5.6 Growth Opportunities
Growth opportunities are opportunities to invest
in positive NPV projects.
The value of a firm can be conceptualized as the
sum of the value of a firm that pays out 100percent of its earnings as dividends and the net
present value of the growth opportunities.
EPS
 NPVGO
P
r
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5.7 The Dividend Growth Model and
the NPVGO Model (Advanced)
We have two ways to value a stock:
The dividend discount model.
The price of a share of stock can be calculated as the
sum of its price as a cash cow plus the per-share value
of its growth opportunities.
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The Dividend Growth Model and the
NPVGO Model
Consider a firm that has EPS of $5 at the end of the first
year, a dividend-payout ratio of 30%, a discount rate of
16-percent, and a return on retained earnings of 20percent.
The dividend at year one will be $5 × .30 = $1.50 per share.
The retention ratio is .70 ( = 1 -.30) implying a growth rate in
dividends of 14% = .70 × 20%
From the dividend growth model, the price of a share is:
Div1
$1.50

 $75
P0 
r  g .16 .14
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The NPVGO Model
First, we must calculate the value of the
firm as a cash cow.
Div1 $5

 $31.25
P0 
r
.16
Second, we must calculate the value of the
growth opportunities.
.20 

3
.
50
3.50  .16 
$.875

 $43.75
P0 
r g
.16 .14
Finally,
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5.8 Price Earnings Ratio
Many analysts frequently relate earnings per share to
price.
The price earnings ratio is a.k.a. the multiple
Calculated as current stock price divided by annual EPS
The Wall Street Journal uses last 4 quarter’s earnings
Price per share
P/E ratio 
EPS
Firms whose shares are “in fashion” sell at high multiples. Growth
stocks for example.
Firms whose shares are out of favor sell at low multiples. Value
stocks for example.
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Other Price Ratio Analysis
Many analysts frequently relate earnings per
share to variables other than price, e.g.:
Price/Cash Flow Ratio
cash flow = net income + depreciation = cash flow
from operations or operating cash flow
Price/Sales
current stock price divided by annual sales per share
Price/Book (a.k.a. Market to Book Ratio)
price divided by book value of equity, which is
measured as assets – liabilities
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5.9 Stock Market Reporting
52 WEEKS
YLD
VOL
NET
HI
LO STOCK SYM DIV % PE 100s HI LO CLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75
Gap has
been as
high as
$52.75 in
the last
year.
Gap pays a
dividend of 9
cents/share
Given the
current price,
the dividend
yield is ½ %
Gap has
been as low
as $19.06 in
the last year.
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Gap ended trading
at $19.25, down
$1.75 from
yesterday’s close
Given the
current price, the
PE ratio is 15
times earnings
6,517,200 shares
traded hands in the
last day’s trading
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5.9 Stock Market Reporting
52 WEEKS
YLD
VOL
NET
HI
LO STOCK SYM DIV % PE 100s HI LO CLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75
Gap Incorporated is having a tough year, trading near their
52-week low. Imagine how you would feel if within the
past year you had paid $52.75 for a share of Gap and now
had a share worth $19.25! That 9-cent dividend wouldn’t
go very far in making amends.
Yesterday, Gap had another rough day in a rough year. Gap
“opened the day down” beginning trading at $20.50,
which was down from the previous close of $21.00 =
$19.25 + $1.75
Looks like cargo pants aren’t the only things on sale at Gap.
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5.10
Summary and Conclusions
In this chapter, we used the time value of money
formulae from previous chapters to value bonds
and stocks.
1. The value of a zero-coupon bond is
F
PV 
T

(1 r )
C
2. The value of a perpetuity is
PV 
r
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5.10 Summary and Conclusions (continued)
3. The value of a coupon bond is the sum of the
PV of the annuity of coupon payments plus the
PV of the par value at maturity.
C
PV 
r

1 
F
1   T    T
 (1 r )  (1 r )
The yield to maturity (YTM) of a bond is that single rate that
discounts the payments on the bond to the purchase price.
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5.10 Summary and Conclusions (continued)
5. A stock can be valued by discounting its
dividends. There are three cases:
Div
Zero growth in dividends P0 
r
Div1
Constant growth in
P0 
r g
dividends
 DivN 1
Differential growth in dividends

 r g
T



C
(
1
g

2
1)



P
1

T 
N



r g1  (1 r )  (1 r )
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5.10 Summary and Conclusions (continued)
6. The growth rate can be estimated as:
g = Retention ratio × Return on retained earnings
7. An alternative method of valuing a stock was
presented, the NPVGO values a stock as the
sum of its “cash cow” value plus the present
value of growth opportunities.
EPS
 NPVGO
P
r
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