Chapter 8

Valuation Concepts
➢ Explain how (a) bond prices are determined
and (b) stock prices (values) are determined
under different growth assumptions.
➢ Explain how yields (market rates) for both
stocks and bonds are determined.
➢ Describe the relationship between stock and
bond prices and market rates of return.
➢ Identify factors that affect the prices of
stocks and bonds.

2
➢ Using time value of money concepts, we
realize that the value of any asset is based
on the present value of the cash flows the
asset is expected to produce in the future

3
   
Asset CF1 CF 2 CF n
= + ++
value (1+ r) 1 (1+ r) 2 (1+ r) n

C^Ft = the cash flow expected to be generated by

the asset in Period t

r = the return investors consider appropriate for

holding such an asset - usually referred to
as the required return

4
➢ Bond is a long term debt instrument
➢ Value is based on present value of:
◦ Stream of interest payments
◦ Principal repayment at maturity

5
rd = required rate of return on a debt
instrument
N = number of years before the bond
matures
INT = amount of interest paid each year
M = par, or face, value of the bond to
be paid off at maturity

6
Bond value = PV of an annuity of interest
+ PV of a lump-sum payment at maturity

7
Genesco
10% Annual coupon
10 years to maturity
$1,000 bonds
Valued at 10% required rated of return = rd

8
Numerical solution

9
Financial Calculator Solution

INPUTS 10 10 ? 100 1,000

N I/Y PV PMT FV
OUTPUT -1,000

10
Spreadsheet
Solution

11
➢ YTM is the average rate of return earned on
a bond if it is held to maturity

This rule of thumb formula gives an

approximate YTM for annual coupons.

For semi-annual, the usual formula is:

12
➢ A bond that pays $70 interest per year
currently sells for $821. The bond, which has a
$1,000 maturity value, matures in 19 years.
Coupon Bond Premium/Discount
Amortized over life

13
Financial Calculator Solution

INPUTS 19 ? -821 70 1,000

N I/Y PV PMT FV
OUTPUT 9.0

14
➢ YTC is the average rate of return earned on
a callable bond if it is held to the date of
its first call

15
➢ A bond that pays $70 interest per year
currently sells for $821. The bond, which has
a $1,000 maturity value, matures in 19 years.
The bond can be called in nine years at a call
price of $1,070.

16
Financial Calculator Solution

INPUTS 9 ? -821 70 1,070

N I/Y PV PMT FV
OUTPUT 10.7

17
➢ When the rd (market rate) equals the coupon rate of
interest, the bond will sell at its par value.
➢ Interest rates in the economy change continuously.
➢ As interest rates change, so do the market values
of bonds such that the rate of return earned by
investing in a bond—that is, its yield to maturity
(YTM)—is the same as the appropriate interest
rate in the financial markets.

18
➢ When market rates rise, bond prices decrease, and vice
versa
➢ When the market rate, rd, is equal to a bond’s coupon
rate of interest, the bond’s market price equals its
maturity (par) value, and the bond is said to be selling
at par.
➢ When rd is greater than a bond’s coupon rate of
interest, the bond’s market price is less than its
maturity value, and the bond is said to be selling at a
discount.
➢ When rd is less than a bond’s coupon rate of interest,
the bond’s market price is greater than its maturity
value, and the bond is said to be selling at a premium.

19
➢ The market value of a bond will always
approach its par value as its maturity
date approaches, provided the firm does
not go bankrupt

20
21
Other yields besides Yield to Maturity

Approximate Return measures of a bond:

➢ Current Yield = Coupon Rate / Price

➢ Simple Yield = Current Yield + Capital Gains Yield (ann)

Coupon Nominal−Price
= +
Price N x Price
N= Years to Maturity

22
23
➢ Interest Rate Price Risk - the risk of
changes in bond prices to which investors
are exposed due to changing interest rates

➢ Interest Rate Reinvestment Rate Risk - the

risk that income from a bond portfolio will
vary because cash flows have to be
reinvested at current market rates

24
25
➢Common stock
➢Preferred stock
◦ Hybrid
• Similar to subordinated perpetual bonds with fixed
dividend amounts
• if company is expected to distribute dividends to
common shares
• Then Price = Preferred Dividend / Long Term YTM
• if company is cash poor and may not pay dividends,
then instead of default coupon payments are
delayed. The difference is marginal.

26
➢ Terms:Current and Expected Dividends

Dˆt The dividend that the stockholder

expects to receive at the end of Year t
D0 The most recent dividend, which already
has been paid
Dˆ1 The next dividend expected to be paid
at the end of the year (Year 1)
Dˆ2 The dividend expected at the end of two
years

27
➢ Terms:Market, Intrinsic and Expected Price

P0 The price at which the stock sells in the

market today

The value of an asset that, in the mind of a

ˆ
P 0 particular investor, is justified by the facts.
Can be different for different investors.
The expected price of the stock at the end
Pˆt of Year t

28
➢ Terms:Growth Rate

g The expected rate of change in

dividends per share

29
➢ Terms:Rates of return
rs Required rate of return = minimum rate of
return that stockholders consider acceptable,
given the returns available on similar-risk
investments
rˆs The rate of return on a stock that an individual
investor expects to receive; can be different for
different stockholders

Rs The rate of return that an individual investor

actually receives; realized or after-the-fact
rate of return

30
➢ Terms:Expected rate of return, rˆs

31
➢ Expected Dividends as the Basis for Stock
Values
• Assuming you would buy and hold a stock forever,
all you would receive would be the dividend
payments
• The value of this stock should therefore be the
present value of all the dividend payments expected
in the future…up to infinity
• But if you would sell it, the price should again be the
same PV (Future Dividends). So selling and a fixed
horizon does not change the valuation principle.

32
 ➢ Expected Dividends as the Basis for Stock
Values


Stock Dˆ1 Dˆ2 Dˆ Dˆt
= Pˆ0 = + +…+ =
Value (1+ rs ) (1+ rs )
1 2
(1+ rs )
t =1 (1+ rs )t

33
➢ Stock Values with Zero Growth
◦ A zero growth stock is a common stock whose
future dividends are not expected to grow at all,
thus g = 0

D + D D
P̂0 = 2 +…+
(1+ rs ) (1+ r s)
1
(1+rs ) 
D
= = Value of a zero growth stock
rs
Similar to a Preferred Stock
34
➢ Normal, or Constant, Growth
◦ Growth that is expected to continue into the
foreseeable future at about the same rate as that of
the economy as a whole
◦ g = constant

Note: this is a simplifed model that will be amended

35
➢Constant Growth Model (Gordon Model)

D0 (1+g)1 D0 (1+g)2 D0 (1+g)

P̂0 = + +…+
(1+ rs ) 1
(1+ rs )
2
(1+ rs )


D0 (1+g) Dˆ1 Value of a constant

= = =
rs − g rs − g growth stock

36
 Dˆ1
rˆs = + g
P0
= Dividend yield + Growth yield

to simplify,we assume everything is

proportional
Growth of Earnings
= Growth of Dividends
= Rise in Stock Price
37
➢ The part of the life cycle of a firm in which
its growth is either much faster or much
slower than that of the economy as a whole

38
➢ To determine the value of a nonconstant
growth stock, we generally assume the
nonconstant growth ends at some point in
the future
➢ At the point where nonconstant growth
ends, we assume constant growth begins
➢ Follow three steps to compute the current
value of a nonconstant growth stock

39
➢ Step 1: Start computing dividends
◦ Compute only the dividends that are expected to
be paid during the nonconstant growth period
◦ Using the investors’ required rate of return, rs,
compute the present values (PVs) of these
nonconstant growth dividends
◦ Sum the PVs

40
➢ Step 2: Compute the value of the stock at
the end of the nonconstant growth period
◦ Compute the first dividend that is affected by the
constant growth rate using the following equation

ˆ
P =
(First constant growth dividend)
=
Dˆt (1+ gnorm )
=
Dˆt+1
t
rs − gnorm rs − gnorm rs − gnorm

◦ Compute the present value of Pˆt

Pˆt PV of constant growth

PV of Pˆt = =
(1+ rs )t dividends beginning in Year t+1

41
➢ Step 3: Sum the PV of the nonconstant growth
dividends computed in Step 1 and the PV of
Pˆt computed in Step 2 to determine the
current value of the stock

Pˆ0 = (PV of nonconstant growth dividends) + (PV of Pˆt)

42
43
➢ Investors change the rates of return required
to invest in stocks
➢ Expectations about the cash flows associated
with stocks change as well
➢ There can be (and generally are) large
differences between expected and realized
prices and returns

44
100 years history of the Dow Jones 30

45
S&P 500 History since 2006

46
S&P 500 distribution of Yearly returns

47
Growth stocks

48
US Companies EPS Growth (5Y)

https://finviz.com/map.ashx?t=sec&st=eps5y 49
US Companies EPS Growth (5Y)

https://finviz.com/map.ashx?t=sec&st=pb 50
➢ How are bond prices determined?
◦ Computed as the present value of the cash flows the
bond is expected to pay during its life
◦ The value of a bond is based on the interest payments
and the repayment of the bond’s principal value
➢ How are stock prices determined?
◦ The value of a stock is based on the dividend
payments that the stock is expected to generate
during its life.
◦ Dividend Discount Model (DDM) - all future dividends
are discounted to the present period to determine the
stock’s current value

51
➢ How are stock and bond yields determined?
◦ The current market values of both stocks and bonds
are based on (1) the cash flows the investments are
expected to generate during their lives and (2) the
rate of return (yield) that investors require to purchase
the investments.
◦ The yield on any investment is comprised of two
components: (1) the yield that is produced by the
income that investors receive from the investment,
and (2) the capital gains yield, which is defined as the
change in the investment’s market value from the
beginning of the year to the end of the year.

52
➢ What is the relationship between stock and
bond prices and market rates of return?
◦ When market rates increase, the prices of both stocks
and bonds decrease
◦ To earn higher rates of return, investors lower the
prices they are willing to pay for their investments
(stocks or bonds).

53
➢ What factors affect the prices of stocks and
bonds?
◦ The price (value) of a financial asset, such as a stock
or a bond, is determined by two primary factors:
1. The cash flows the asset is expected to generate in
the future
2. The rate of return that investors require to invest in
the asset.
◦ Everything else equal, if the expected cash flows
increase, the asset’s value increases
◦ The asset’s value also increases if investors lower the
rate of return they require to purchase it.

54