FINANCIAL MARKETS NOTES ANNUALIZED DISCOUNT RATE & ANNUALIZED

(Roverson D. Mortega) INVESTMENT RATE

FINANCIAL MARKETS FORMULAS

NET ASSET VALUE

Net Asset Value = (Market Value of the Portfolio –
Liability) ÷ Number of Shares

Each share → stands for proportional interest in the

portfolio of financial instruments & valued at NAV

NAV → Interpreted to be a per share metric

NAV is used in Regulated Investment Companies (RIC)

→ Financial Intermediaries that sells shares to the
general public in exchange for cash

Cash or Proceeds Received → Invested in a diversified

portfolio of financial instruments

Asset Management Firms → Contracted by RIC to

manage the investment portfolio
Investors’ POV → Discount Rate indicates how much in
(Chapter 2 – Financial Intermediaries and Other return, in %, they can get from a particular security
Participants – Page 49)
ADR Formula Above → For a non-interest-bearing
security like Treasury Bills
CONSUMER PRICE INDEX ADR Weakness → A. Use of face amount as
Purchasing Power → Based on CPI denominator, computed return is understated // B. Use
of 360 days to annualize the return, understates the
CPI → Weighted average value of the basket of prices return
of all commodities representing the market
AIR → Uses 365 days to annualize the return (366 for
Inflation Rate → Degree of movement of the CPI from a leap years) & true initial investment in the computation
period to another → Portrays a more accurate representation of returns
Inflation → Indication of Market Risk // Affects the (Chapter 4 – Money Market and Related Financial
ability to purchase and settle obligations // In finance, Instruments – Page 107 to 108)
driver of the financing costs

CPI1 → Current Price Index

CPI2 → Base Price Index

(Chapter 3 – Financial Regulation and the Central Bank

– Page 85)
MARKET SECURITY VALUE Risk Free Rate → The rate that assumes zero default in
the market where this is more or less equivalent to the
rates offered by the sovereign

Calculating Interest Rate by the Function of the Market

Value

OR

Market Security Value = Face Value x PV Factor

Money Market Securities Valuation → Important to

determine at what amount an investor is willing to pay
in exchange of a security

Above Formulas are using Present Value Approach Bond Sold at a Premium → Par Value < Market Value →
Interest Rate used in Valuation → Shall reflect the Nominal Rate > Market Rate
required return based on the investor’s perceived risk
→ May also use prevailing interest rate in the market

Period is less than a year → Divide the Annual Interest

Rate

Higher Interest Rate → Lower Market Security Value

Return = Face Value – MSV

(Chapter 4 – Money Market and Related Financial

Instruments – Page 112)

DETERMINATION OF INTEREST RATE

Interest = Risk Free Rate + Debt Margin or Debt Spread

or Risk Premium

Real Risk Free Rate = (Risk Free Rate – Current Inflation)

+ Future Inflation

To determine the appropriate interest rates, the

following factors should be considered assuming cash
flows are already established:

➢ Interest Rates in the Industry

➢ Risk Exposure
➢ Compensation on the Market Expectation
Bond Sold at a Discount → Par Value > Market Value → Zero-Coupon Bond → No periodic coupon payments →
Nominal Rate < Market Rate Interest Earned = Par Value – Purchase Price or PV of
the Zero Coupon Bond
PV of Zero-Coupon Bond = Face or Par Value x PV Factor
Generally, Coupon-Paying Bond is more valuable than
Zero-Coupon Bond

Valuation for a Non-Treasury Bond (Adding Risk

Premium)
Previous Illustrations → Default-Free Rate

For a Non-Treasury Bond → Risk Premium has to be

added to the base interest rate (Treasury Rate)

Risk Premium → Also called constant credit spread →

(Chapter 5 – Managing the Credit Risk of the Financial For example, risk premium is 100bps equivalent to 1%
Instrument – Page 127 to 130) → Discount Rate to be used is Treasury Rate + 1%

(Chapter 6 – Debt Securities Market – Page 155)

BOND VALUATION SHARE VALUATION

Bond Valuation → Technique for determining the Purpose of Share Valuation
theoretical fair value of a particular bond
➢ To assess if the price offered is reasonable
Bond Valuation → Includes calculating the PV of the ➢ To choose the best stocks that fit their
bond’s future interest payments, also known as its cash investment appetite
flow & the bond’s value upon maturity, also known as
its face or par value Value of a Share → Equivalent to the PV of the future
cash flows that can be received from the investment →
Items that the investors can receive from an investment
must be projected to identify future cash flows

PV of the Bond = PV of Future Coupon Payments + PV of

Face or Par Value

PV of the Bond = (Periodic Coupon Payment x PV

Factor) + (Face or Par Value x PV Factor)
A. One-Period or Multiple Period Valuation Model Basic Dividend-Based Valuation Model Formula:
➢ Investor tends to sell the share after a fixed Stock Value Today = (Dividends Year 1 x PV Factor Year
number of years → Only needs to consider 1) + (Dividends Year 2 x PV Factor Year 2) + (Dividends
dividends to be received for the holding period Year 3 x PV Factor Year 3)…..
(and expected selling price)
Rate used on PV Factor → Required Return on Ordinary
➢ Fit for an investment wherein there is an
Shares
expected fixed holding time
Dividends → Assumed at Year-End
Stock Value Today = (Cash Flow Year 1 x PV Factor Year
1) + (Cash Flow Year 2 x PV Factor Year 2) + (Cash Flow (Chapter 7 – Equity Securities Market – Page 191)
Year 3 x PV Factor Year 3)…..
Rate used on PV Factor → Required Return on Ordinary
Shares B1. Zero-Growth Model

Cash Flow → Assumed at Year-End ➢ Assumes that the dividend will be fixed and not
change anymore in the future
➢ Simplest approach to share valuation
➢ Very useful in preferred share valuation since
dividend is fixed

Stock Value Today = Expected Div per Share at Year 1 ÷

Required Return on Ord Share

(Chapter 7 – Equity Securities Market – Page 190)

B. Dividend-Based Valuation Techniques

➢ Most common share valuation technique →

through dividends
➢ Future dividends → Most relevant input for
share valuation → It embodies future cash
flows which is the usual return received
(Chapter 7 – Equity Securities Market – Page 191 to
➢ Timing of dividends is a little tricky → Because
192)
there is no assurance when will a company
declare dividends
➢ This Valuation Model/Technique can be further
interpreted by anticipating how much dividend
will grow: B1. Zero-Growth Model // B2.
Constant Growth Model // B3. Variable Growth
Model
B2. Constant Growth Model or Gordon Growth Model B3. Variable Growth Model
➢ Most widely known model used in share ➢ Developed to incorporate changes in growth
valuation rate in the valuation since future growth rates
➢ Dividends are assumed to grow at a constant may go up or down
rate forever
Four Steps Involved in the Variable Growth Model:
➢ Growth rate is always assumed to be lower
than required return 1. Determine value of expected cash dividends at
➢ First dividend is assumed to be received right the end of each year using the initial growth
away and the next will be after a year rate assumptions. To compute, apply the growth
➢ Reasonableness of expectations of investors rate assumption on the current dividend and do
regarding future profitability of the firm and this year on year.
future dividends is important to determine the 2. Compute for the PV of the expected dividends
right share valuation during the initial growth period.
3. At the initial growth period, determine the
Stock Value Today = Expected Dividend per Share at End
value of the stock (from that point to infinity)
of Year 1 ÷ (Required Return on Ord Share – Growth
using the constant growth model. The
Rate)
assumption here is that from this point
onwards, dividend will grow at a constant pace,
hence, the use of the constant growth model.
4. Add the computed PV of the expected dividends
during the initial growth period and the
computed value of the stock at the end of the
initial growth period.

(Chapter 7 – Equity Securities Market – Page 192 to

193)
Other Approaches to Share Valuation E. Liquidation Value per Share
➢ Almost similar to BVPS but the value of assets
are market value instead of book value
C. Free Cash Flow
➢ More realistic compared to BVPS because it
➢ An alternative to dividend-based share approximates that assets will be sold at MV
valuation ➢ Still lacks consideration on the future earning
➢ Free Cash Flow → Refers to the cash flow that potential of the company
are available for debt creditors and
shareholders after satisfying all other operating
obligations F. Price Earnings (P/E) Multiples
➢ Useful when computing the value of startup
➢ Uses P/E Ratio to compute for the share price
companies, companies without any dividend
→ Shows the amount how much investors are
history, and operating division of a big
willing to pay for each peso of earnings
company
➢ Can use average P/E Ratio of a particular
➢ Estimates the value of a company as a whole
industry as a reference point to determine
Value of Ordinary Shares = MV of Entire Company – MV company’s value
of Debt – MV of Preferred Shares ➢ Average P/E Ratio for the industry can be
researched from publicly available information
➢ Very helpful in valuing non-publicly traded
D. Book Value per Share companies
➢ Better methodology than BVPS and LVPS since it
➢ Amount per share that will be received if all of considers expected earnings
the company assets are sold based on its exact ➢ Firms under the same industry are expected to
book values and whose proceeds will go to have similar P/E Ratios in the long run
ordinary shareholders after satisfying claims ➢ Higher than Average P/E Ratio → Market is
from creditors and preference shareholders expecting company earnings to increase that
➢ Lacks sophistication and relies on historical will pull down P/E Ratio to the normal level OR
balance sheet data Market feels that company earnings has low
➢ Does not consider expected earnings potential risk and investors are willing to pay a premium
of the firm and has no link to the true market
value of the firm P/E Multiples = Expected EPS of the Company x Average
PE Ratio for the Industry similar to the company

OR

BVPS = (BV of Assets – BV of Liabilities – BV of Pref

Shares) ÷ Total Number of Outstanding Ord Shares

(Chapter 7 – Equity Securities Market – Page 197 to

198)
COUNTRY RISK PREMIUM
➢ Additional return or premium demanded by
investors to compensate them for higher risk
associated with investing in a foreign country,
compared to a domestic market
➢ CRP is generally higher for developing markets
than developed nations
➢ Calculation involves estimating the risk
premium for a mature market such as US and Total Equity Risk Premium = CRP + Risk Premium for a
adding default spread to it Mature Equity Market
➢ Method 1: Sovereign Debt Method →
comparing the spread on sovereign debt yields ➢ CRP calculation entails estimating the risk
between the country and a mature market like premium for a mature market and adding a
the US default spread to it
➢ Method 2: Equity Risk Method → basis is the
relative volatility of equity market returns
between a specific country and a developed Incorporating CRP into CAPM
nation
➢ Capital Asset Pricing Model (CAPM) → Details
Method 3: the relationship between systematic risk and
expected return for assets, particularly stocks
→ Can be adjusted to reflect the risks of
international investing

CAPM Formula:

➢ Annualized Standard Deviation → Measure of

Volatility
➢ Country’s Stock Market is significantly more
volatile than the Sovereign Debt Market → CRP
is on the higher side
➢ Risk Premium calculated in this formula is
applicable to equity investing → CRP here is
synonymous with Country Equity Risk Premium
Three (3) Approaches for Incorporating CRP to CAPM C. Considering Country Risk as a Separate Risk Factor
→ To derive an Equity Risk Premium that can be used
➢ Multiplying CRP with a variable
to assess the risk of investing in a company located in a
➢ In general terms, a company that has significant
foreign country
exposure to a foreign country – by virtue of
A. As a Total Risk Premium getting a large percentage of its revenues from
that country (Sx) or having a substantial share
➢ Assumes that every company in the foreign
of its manufacturing located there – would have
country is equally exposed to country risk
a higher value than a company that is less
➢ Makes no distinction between companies like
exposed to that country (Sc)
an export-oriented company and a small local
business
➢ CRP is added to the mature market expected
return

(Chapter 8 – International Financial Markets – Page

233 to 237)

Reference/s: Fundamentals of Financial Markets 2019

B. As part of the Market Risk Premium Edition by Lascano, Baron, & Cachero

➢ Market Risk Premium = Market Return – Risk

Free Rate
➢ Assumes that the company’s exposure to
country risk is similar to its exposure to other
market risk