CHAPTER 7

Asset Valuation:
Basic Bond andStock
Valuation Models
Valuation is the process of determining the fair value of a
financial asset. The process is also referred to as “valuing” or
“pricing” a financial asset. The fundamental principle of valuation
is that the value of any financial asset is the present value of the
expected cash flows. This principle applies regard- less of the
financial asset.

Thus, the valuation of a financial asset involves the

following three steps:
(1) estimate the expected cash flows;

(2) determine the appropriate interest rate or interest rates that should be used to discount the cash flows;

(3) calculate the present value of the expected cash flows using the interest rate or interest rates.
It is important to remember that the
user of any valuation model is exposed
to modeling risk. This is the risk that
the output of the model is incorrect
because the assumptions on which it is
based are incorrect. Consequently, it is
imperative that the results of a valuation
model be stress-tested for modeling risk
by altering the assumptions.
VALUING BONDS
Valuation begins with the estimation of the
cash flows. Cash flow is simply the cash that
is expected to be received at some time from
an investment.

Such bonds that do not contain such option-

type features are referred to as option-free
bonds.
Bonds that have one or more such options are referred to
generically as bonds with embedded options.
These bonds include callable bond, putable bonds, and
convertible bonds.
A callable bond is a bond issue that grants the issuer the right to retire (that
is, call) the bond issue prior to the stated maturity date.

A putable bond is a bond issue that grants the bondholder the right to have the
issuer retire the bond issue prior to the stated maturity date.

In the case of aconvertible bond, the bondholder has the right to convert the bond issue into
the issuer’s common stock. Moreover, all convertible bonds are callable and some are putable.
For example, a major sector of the bond market is the market for
securities backed by residential mortgage loans, called mortgage-
backed securities.

The cash flows for these securities are monthly and include the
interest payment, the scheduled principal repayment, and any amount
in excess of the scheduled principal repayment. It is this last
component of a mortgage-backed securities’ cash flows—the payment
in excess of the regularly scheduled principal payment—that make it
difficult to project cash flows. This component of the cash flow is
referred to as a prepayment.
In addition, there are securities that are backed by loans that are not
residential mortgage loans. These securities are referred to as asset-
backed securities.
Determining the Appropriate Rate or Rates
Once the cash flows for a bond issue are estimated, the next step is to
determine the appropriate interest rate.

To do this, the investor must address the following three questions:

1.What is the minimum interest rate the investor should require?
2.How much more than the minimum interest rate should the investor
require?
3.Should the investor require the same interest rate for each estimated
cash flow or a unique interest rate for each estimated cash flow?

Minimum Interest Rate

The minimum interest rate that an investor should require is the
yield available in the marketplace on a default-free cash flow. I

The minimum interest rate that investors want is referred to

as the base interest rate.
Premium Over the Base Interest Rate
The premium over the base interest rate on a Treasury security
that investors will require reflects the additional risks the investor
faces by acquiring a security that is not issued by the U.S.
government
This premium is called a risk premium or a spread over Treasuries.
Thus we can express the interest rate offered on a non-Treasury security as

Base interest rate + Risk premium

or equivalently,
Base interest rate + Spread

The factors that affect the spread include

(1) the issuer’s perceived creditworthiness;
(2) any embedded options;
(3) the taxability of the interest received by investors; and
(4) the expected liquidity of the security.
Perceived Creditworthiness of Issuer
Default risk refers to the risk that the issuer of a bond may be
unable to make timely principal or interest payments.

The spread between Treasury securities and non-Treasury securities

that are identical in all respects except for quality is referred to as
a quality spread or credit spread.

Inclusion of Options As explained earlier, it is not uncommon

for an issue to include a provision that gives the bondholder or the
issuer an option to take some action against the other party.

Taxability of Interest Unless exempted under the federal income

tax code, interest income is taxable at the federal level. In addition
to federal income taxes, there may be state and local taxes on
interest income
Expected Liquidity of an Issue
Bonds trade with different degrees of liquidity. The greater the
expected liquidity, the lower the yield that investors would
require. Treasury securities are the most liquid securities in the
world
Single or Multiple Interest Rates
For each cash flow estimated, the same interest rate can be used to
calculate the present value. Alternatively, it can be argued that each
cash flow is unique and, therefore, it may be more appropriate to value
each cash flow using an interest rate specific to that cash flow.

Discounting the Estimated Cash Flows

Given the estimated cash flows and the appropriate interest rate or
interest rates that should be used to discount the estimated cash flows,
the final step in the valuation process is to value the cash flows.
 To illustrate, consider an option-free bond that matures in four years, has a
coupon rate of 10%, and has a maturity value of $100. For simplicity, let’s assume
for now that the bond pays interest annually, and the same discount rate of 8%
should be used to calculate the present value of each cash flow. Then the cash flow
for this bond is:
The present value of this bond assuming the various
discount rates is $106.9456.
Valuing Semiannual Cash Flows
The procedure is to simply adjust the coupon payments by dividing the annual
coupon payment by 2 and adjust the discount rate by dividing the annual
discount rate by 2. The time period t in the present value formula is treated in
terms of six-month periods rather than years.

For example,

consider once again the four-year 10% coupon bond with a maturity value of
$100. The cash flow for the first 3.5 years is equal to $5 ($10/2). The last cash
flow is $105. If an annual discount rate of 8% is used, the semiannual discount
rate is 4%.
The interest earned by the seller is the interest that has accrued since the
last coupon payment was made and the settlement date. This interest is
called accrued interest.

When the price of a bond is computed using the present value calculations
described earlier, it is computed with accrued interest embodied in the
price. This price is referred to as the full price.
(Some market participants refer to it as the dirty price.) It is the full
price that the buyer pays the seller. From the full price, the accrued
interest must be deducted to determine the price of the bond, sometimes
referred to as the clean price.
Traditional Approach to Valuation
The traditional approach to valuation has been to discount every cash
flow of a bond by the same interest rate (or discount rate).

The Arbitrage-Free Valuation Approach

The fundamental fl aw of the traditional approach is that it views
each security as the same package of cash flows
The reason this is the proper way to value a bond is that it does not
allow a market participant to realize an arbitrage profit by taking
apart or “stripping” a security and selling off the stripped
securities at a higher aggregate value than it would cost to
purchase the security in the market.
Another name used for the zero-coupon Treasury rate is the Treasury
spot rate.
Valuation Using Treasury Spot Rates
Treasury spot rates are used to value a Treasury security

· Credit spreads and the valuation of non Treasury securities

-the Treasury spots rates can be used to value any default free security
- the value of non- Treasury security is found by discounting the cash flow
by the treasury spot rates .

· The discount the cash flow non Treasury security is the treasury spot rate
plus.
- The six month treasury spore rate is 3%
- The ten year Treasury spot rate is 60 %

>the draw back of this approach is that there is no reason to expect the
credit spreads to be the same regardless of when the cash flow is expected
to be receive.
When the credit zero spreads for a given issuer are added to the
Treasury spot rates, the resulting term structure is used to value
bonds of issuers of the same credit quality. This term structure is
referred to as the benchmark spot rate curve or benchmark zero-
coupon rate curve.

Ø Valuing bonds with embedded options

- Two approaches to valuation we have presented have dealt with the
valuation of option free bonds
- Treasury security and an option free-non treasury security can be
valued using the procedures describe previously .
Ø Practitioners commonly use two models in such cases :
- The lattice model- is used to value collable bonds and putable bonds
- The monte Carlo simulation- is used to value mortgage backed
securities and certain types of asset backed securities .
Ø The are four features common to the binomial and non Monte Carlo
valuation models
- First , each model begins with yield on treasury securities and
generates the treasury spot rates
- Second, each model makes an assumption about the expected
vitality assumption
- Fourth, the model is calibrated to the treasury market .
Ø Valuation of common stock using dividend discount models
- Dividends are cash payments made by a corporation to it’s owner
- Most dividends discount models use current dividends .
Ø Dividends Measure
✓ Dividends are measured using three different measures
· Dividends per
share
· Dividend yield · Dividend payout
Ø Dividends and stock prices
- If an investor buys a common stock he or she has bought shares that
represents an ownership interest in the corporation
- Shares common stock are perpetual security that is , there Is no maturity
- The investor who owns share of common stock has the might to receive
certain portion of any dividends --- but dividends are not sure thing
- Dividends are either constant or grow at a constant rate . But there is no
guarantee that dividends will be paid in the future .
- Preferred shareholders are similar situation s as the common shared holders
.
Ø Three major difference between the dividends of preferred and
common sahres
– the dividends on preferred stock usually are specified at a fixed rate or
dollar account .
- Preferred shareholders are given preference
- If the preferred stock has commutative feature
Ø Basic dividend discount models
- Is simply the application of present value analysis which assert that the fair
price of an asset is the present value of the expected cash flow
Ø The finite life general dividend discount model
- Can be modified by assuming a finite life for the expected cash
flows
- The expected sale price is also called terminal price and is
intended to capture the future value of all subsequent dividend
payouts .
Ø Assuming a constant discount rate
- A special case of the finite life general DDM that is more commonly used in
practice is one In which is assumed that the discount rate is constant .
- The forecasting of dividends is somewhat of easier
- Management can be queried and cash flows can be projected for a given
scenario .
- The discount rate is the required rate of return .
Ø Assessing relative value
- Given the fair price derived from dividend discount model ,the assessment
of the stock proceeds along the following lines

✓ if the market price is

✓ the opposite holds for
below the fair price
a stock whose market
derived from the
price is greater than the
model ,the stock in
model derived price .
under valued cheap .

✓ The DDM tell us when ✓ while stock may be

mispriced ,an investor must
the price of the stock
also consider how mispriced
should be expected to it is in order to take the
move to it’s fair price . appropriate action .
Ø Constant growth dividend discount model
- If future dividend are assumed to grow at a constant rate .
Multiple dividend discount
- The assumption of constant growth Is unrealistic and can
be even misleading
- Most practitioner modify the constant growth DDM by
assuming that companies will go through different growth
phases .
- Dividends are assumed to growth at a constant rate .
- Molodovsky,May and chattiner (1965)
Were some of prisoners in modifying the DDM to accomadale
different growth rate .