Valuation of Bonds and Shares

Lecture 7
VALUATION OF
BONDS AND SHARES
Concept Map
Features
SHARES BONDS
Valuation
Learning Outcomes
• Calculate the price of a bond
• Determine the yield to maturity of bonds
• Determine Accurate price of shares
• Compare different investments and types of
investments.
Introduction
This lecture builds heavily on lecture 5
and 6. Lecture 5 covered the time value
of money. Lecture 6 covered the
relationship of risk and return . Please
review and understand these two lectures
before you actually start on this lecture.
Introduction
This lecture, we consider the application of the
valuation concept to determine the value of
bonds and shares. The valuation process needs
two inputs: cash flows (returns) and discount rate
(which as we saw relates closely to risk.)
This lecture is divided into six sections:

 Price and value,
 How are security prices set?
 Principles of security valuation,
 Valuing of bonds,
 Valuing preference shares, and
 Valuing ordinary shares.
Price and value
Price is a fact. It is the sum at which a willing buyer and
a willing seller do business. It is normally created by the
forces of supply and demand.
Value is subjective. It is what the individual believes it is

worth to him. Each individual may have different
perception of the value to him of an item. Your lecture
guide (booklet) may have a price of $50. I believe it
would be good value to each of you, at $100. Some
students have not bought the lecture guide: to them the
value is less than $100.
How are security prices set?
Security prices are set by the buyer and seller.
The buyer bids what he is willing to pay, the
seller offers for sale at a price he wants. If the
prices match, then this is the market price of
the security. Price is a fact.
It is a consensus of what buyers are willing to

pay, and what sellers are willing to accept. It is
a consensus of what the market believes the
security is worth (the “value” placed by the
majority of market participants on the
security).
Principles of security valuation
A wide-quoted number is the book value of a share, or the net
asset value of a share, defined thus
Book value = total asset minus total liabilities

Net asset value total number of ordinary shares
This is normally based on the accounting (“book”) value of the

assets: which normally use arbitrary rules of depreciation, and
commonly ignore “goodwill” – the value added to the company
by management competence, reputation, patents etc. For
example the market value of Coca Cola shares is about twenty
times the tangible net asset value per share. Most of the value
is the brand name, market image and patents (recipes)
The market (“intrinsic”) value of a share – the value
placed on it by a consensus of market participants – is
usually stated as the net present value of all future cash
flows, or “the discounted value of all future cash flows
accruing to the investor”. This is so important that
stating it a second time. The value of a share is the net
present value of all future cash flows.
PV = ∑ {CFt / (1 + r)t }
This is simple. Important know this equation.
a) How do you determine future cash flows?
b) What rate do you use for discounting them?
Future cash flows may be subjective. For a bond, you may
believe that the future cash flows (your contractual
entitlement) are known.
For a share, with future cash flows coming from dividends, and
possibly some future sale of the share or even a possible take
over of the company, it is very much a matter of opinion. For
example, there is no way of knowing what the dividend and
share price will be, five years from now.
A discount rate, this is again a matter for individual. It is

largely a matter of the return each individual requires for a
certain level of risk (the personal risk aversion factor and the
utility of the expected future earnings).
The important thing to remember is that the return on capital

(return on investment) for an investor, is the cost of capital for
the company.
Valuing bonds
Bonds are long-term debt securities. Typically a
bond is a “package” of two assets:
 A right to interest payment, and

 A right to repayment of principal on maturity.
Valuing bonds
Zero – coupon bond
Let us start with repayment on maturity. This is easy if
we imagine a “zero coupon bond”, a bond which pays
no interest. This bond would initially be sold at a
“discount” (often a “deep discount”) to its nominal or
maturity value.
The price at which a bond is sold is dictated by the

consensus view of the correct discount rate – there
must be enough people agreeing on this discount rate
to buy all the bonds offered. Some will see the risk as
too great relative to the return: they will not buy. But
there must be enough to see the return as adequate for
the risk, to buy all the supply of bonds available.
Valuing bonds
For example:
What would be the “value” today (Sept 2012) of a zero-
coupon bond maturing on 8 September 2019, if our required
discount rate is 6%?
Answer
Bonds normally have a nominal value, payable at maturity, of
$1000. Most bonds pay interest (coupon payments) twice
yearly, so we consider the interest to be compounded twice
yearly. On this basis,
Interest rate per period = 6%/2 = 3%
Number of half-year periods until Sept. 2016, n = 12
Valuing bonds
Consider the time line
T0 T1 T2 …………. T12
Sep 12 Mar 13 Sept 13 Sept 18
1000
PV = FV/ (1 + r )n r = 3% n = 12 half-year periods
We can either use table 2 or our calculators.

Either way:
 Present value = $701.40
 The value of this zero-coupon bond if
bought today. Would be $701.40
Valuing bonds
Interest – coupon bond
Now think of a similar bond, but imagine it had a “coupon”
of 8%, paid in two half-yearly instalments of 4%. The cash
flow of these interest payments ONLY.
T0 T1 T2 T12
Sep 12 Mar 13 Sept 13 Sept 18
40 40 …….. .. 40
For these semi-annual interest payments ($1,000*8%/2),

present value is given by the annuity table, table 4
PV = 40*PVIFA (3%, 12 periods) = $398.16

Valuing bonds
Note the discount rate is still 3% semi-annually (6%
annually). If we were buying the interest payments only we
would expect to pay $398.16 to buy this future income
stream. For the complete “package”, the final price we
would be willing to pay, would be:
Bond price = $701.40 + 398.16 = $1099.56
Note that 8% is the coupon: the interest rate paid on the

$1000 bond by the bond issuer. 6% is the discount rate, the
return required by the investor as the absolute minimum he
requires in payment for this level of risk. Do not confuse
these two numbers!
Valuing bonds
If our investor actually buys his bond for $1099.56, i.e. if the
market price is $1099.56, then the redemption yield, or
yield to maturity (YTM) is the important number both to
investor and to bond issuer. There is one other, less helpful,
number: the current (or running) yield. This is the current
return the bond holder is getting for his investment. In this
case, he is receiving $80 per year, on an investment of
$1099.56.
His current yield is:
Current yield = Yearly interest = 80 = 7.273%

Market price 1099.56
Valuing preference shares
A preference share is a “fixed dividend share”. It carries more risk
than the bond, so it would normally require a higher return – that
is, a higher discount rate. It is normally considered to be ageless,
i.e. a perpetuity.
If our investor required a return on debt of 6%, he might well

require 8% on preference share. For a $1 nominal value, 4%
undated preference share, the price would be given by the
perpetuity formula:
Price= Annual dividend = $.04/.08 = .50

Interest rate
He should be willing to buy the “pref” at any price up to 50 cents

Valuing ordinary shares
The basic formula in valuing ordinary shares is the same
“discounted value of all future cash flows” model. The
model is:
PV = ∑ (cash flow)t
(1 + r)t
This is most often encountered in the form of the dividend growth

model, written thus
Share price = dividend next year

(R – g)
Where R is the expected return on the share, and g is the annual

growth rate. This assumes a constant growth rate of earnings and
dividends.
This formula is also used in the form:
R(e) = dividend next year + g

Share price
This is the SECOND important formula in corporate finance. I

will expect you to remember it and to be able to use it.
Steady growth rate

If a company has had a steady growth rate, and expects this to
continue, then this formula is ideal for pricing the share. The
assumption is that:
Dividend next year = Dividend this year * (1 + g)
For example:
Pacific Nators Ltd have grown at 4% per year for the last four
years, and the chairman has stated that he expects the
growth to continue. They have just paid out a dividend of 25
cents, and share price is $5. What is the expected return on
Pacific Nators Ltd’s shares?
Answer:
This dividend = 25 cents
Next dividend = 25*(1.04) = 26 cents
R(e) = 26 + 4% = 9.2%
500
Another example:
You consider that the return on Sand-dunes Ltd should be
11%. Sand-dunes have just paid a 40 cent dividend, and
growth is a steady 5%. What is the share price?
Answer
This dividend 40 cents
Next dividend 40*(1.05) = 42 cents
Share price = Dividend next = 42c = 700 cents =$7

(R – g) (.11 - .05)
Zero growth shares
Steady sales, profits and dividends. No growth. In this case,
use the same model but with g = 0.
Share price = Dividend

R
Effectively this is the perpetuity formula!
The dividend growth model can be adjusted for various

other situations, but the basic formula is good.
Finite holding time
If you intended to hold the shares for a finite

period, say five years, then you need to estimate
future dividends and the final share price, and then
to use the normal cash flow discount model.
Finite holding time
For example
You need to hold shares in Auntie Rinum Ltd for 5 years, Dividends
yesterday (2011) was 40 cents, and you expect this to rise by one
cent each year. You expect to sell the shares in five years (2016)
450 cents.
T0 T1 T2 T3 T4 T5
Today 2012 2013 2014 2015 2016
dividend dividend dividend dividend DIV 45

41 42 43 44 PRICE 450
Applying the discount factor to each of these cash flows

individually, you reach a share price using the “discounted value of
all future cash flows” model.
A changing future
If you anticipate a change at some time in future, then this
must be designed into the model. Often this is solved by
valuing the share after the change, and then working back to
the present time.
For example
Assume today is 2010, Moon Waves Ltd grown rapidly, at 10%
per year: paying 40 cents dividend this year. This 10% growth
is expected to continue for two more years, then to slow
down to 5% growth after that. Your required return from the
company is 9.5%.
Answer:
T0 T1 T2
Today 2011 2012
Dividend 44 cents Dividend 48.4 cents
Growth slows to 5% after
this dividend
Do this in two stages:
a) Share value in 2012, once dividend growth has slowed
to 5%, is given by :
Share value = Dividend next = 48.4 * 1.05 =1129.33 cents
(r – g) (.095 - .05)
Price earnings ratio
The price-earnings ratio is based on current years

earnings. You try to identify “similar” companies, to
determine their price-earnings ratio.
For example, the BDQ bank had earnings this year of

$1.71 per share, and the QED bank (which seems to be
very similar) has a price-earnings (P/E ratio) of 16. On
this basis, a fair price for BDQ shares might be 16 *
$1.71. This is only useful as a rough guide. Two
companies are never identical. BDQ has a growth rate
5%, QED only 4%. BDQ has a whiz-kid chief executive,
QED a relatively orthodox one. So the comparison is
never perfect.
Price earnings ratio
In general, the dividend growth model (or a variant of

it) may be the most useful. Remember it!
R(e) = dividend next + growth

Share price
END OF LECTURE
HAVE A NICE DAY

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Lecture 7

This lecture is divided into six sections:

Value is subjective. It is what the individual believes it is

It is a consensus of what buyers are willing to

Book value = total asset minus total liabilities

This is normally based on the accounting (“book”) value of the

A discount rate, this is again a matter for individual. It is

The important thing to remember is that the return on capital

 A right to interest payment, and

The price at which a bond is sold is dictated by the

We can either use table 2 or our calculators.

For these semi-annual interest payments ($1,000*8%/2),

PV = 40*PVIFA (3%, 12 periods) = $398.16

Bond price = $701.40 + 398.16 = $1099.56

Note that 8% is the coupon: the interest rate paid on the

Current yield = Yearly interest = 80 = 7.273%

If our investor required a return on debt of 6%, he might well

Price= Annual dividend = $.04/.08 = .50

He should be willing to buy the “pref” at any price up to 50 cents

This is most often encountered in the form of the dividend growth

Share price = dividend next year

Where R is the expected return on the share, and g is the annual

R(e) = dividend next year + g

This is the SECOND important formula in corporate finance. I

Steady growth rate

Next dividend = 25*(1.04) = 26 cents

Share price = Dividend next = 42c = 700 cents =$7

Share price = Dividend

Effectively this is the perpetuity formula!

The dividend growth model can be adjusted for various

If you intended to hold the shares for a finite

dividend dividend dividend dividend DIV 45

Applying the discount factor to each of these cash flows

The price-earnings ratio is based on current years

For example, the BDQ bank had earnings this year of

In general, the dividend growth model (or a variant of

R(e) = dividend next + growth

HAVE A NICE DAY

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