The document explains the fundamental differences between bonds and stocks, highlighting that stocks represent ownership in a company while bonds are loans made to the issuer. It discusses the valuation methods for both financial instruments, emphasizing the importance of understanding their roles in financial management and the factors influencing their valuations. Additionally, it outlines common problems related to the valuation of bonds and stocks, along with examples of calculation methods.
The document explains the fundamental differences between bonds and stocks, highlighting that stocks represent ownership in a company while bonds are loans made to the issuer. It discusses the valuation methods for both financial instruments, emphasizing the importance of understanding their roles in financial management and the factors influencing their valuations. Additionally, it outlines common problems related to the valuation of bonds and stocks, along with examples of calculation methods.
The document explains the fundamental differences between bonds and stocks, highlighting that stocks represent ownership in a company while bonds are loans made to the issuer. It discusses the valuation methods for both financial instruments, emphasizing the importance of understanding their roles in financial management and the factors influencing their valuations. Additionally, it outlines common problems related to the valuation of bonds and stocks, along with examples of calculation methods.
The document explains the fundamental differences between bonds and stocks, highlighting that stocks represent ownership in a company while bonds are loans made to the issuer. It discusses the valuation methods for both financial instruments, emphasizing the importance of understanding their roles in financial management and the factors influencing their valuations. Additionally, it outlines common problems related to the valuation of bonds and stocks, along with examples of calculation methods.
is issued by a company to raise capital from investors for new projects or to expandits business operations. It represents a fractional ownership of equity in an organization. It is different from a bond, which operates like a loan made by creditors to the companyinreturn for periodic payments.
On the other hand, STOCKS is a share in the ownership of a
company. Stocks represents aclaim on the company's assets and earnings. As you acquire more stock, your ownershipstake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing.
Simply defined, a STOCK is a financial instrument which
represents partial ownershipinacompany. If a company has 1000 stocks and someone holds 400 stocks, this represents 40%ownership in the company. are issued by governments and corporations when they want to raise money. Bybuying a bond, you're giving the issuer a loan, and they agree to pay you back the facevalueof the loan on a specific date, and to pay you periodic interest payments along theway, usually twice a year.
The borrower issues a bond that includes the terms
of the loan, interest payments that will be made, and the maturity date the bond principal must be paid back. The interest payment is part of the return that bondholders earn for loaning their funds to the issuer. Hence, choosing the right mix of stocks and bonds can be one of the most basic yet confusing decisions facing any investor. In general, the role of stocks is to provide long-termgrowth potential and the role of bonds is to provide an income stream.
An important distinction when weighing the rewards of stocks vs. bonds
is that stocks have(theoretically) an unlimited ability for appreciation. That is, there is no upper limit tohowvaluable they can become.
On the other hand, a bond buyer generally knows the upper limit to expect on suchaninvestment, especially if it is held to maturity. It is true that a bond can sell at a premiumprior to maturity, but the potential for appreciation here is nowhere near as great as it is for stocks.. Both stocks and bonds are generally valued using discounted cash flow analysis—which takes the net present value of future cash flows that are owed by a security. Unlike stocks, bonds are composed of an interest (coupon) component and a principal component that is returned when the bond matures.
The valuation of corporate bonds is dependent on the
present value of future expected cash flows, discounted at a risk-adjusted rate (similar to a DCF). For example, a Php1,000 bond with a 10-year term and a 3% annual coupon would paytheinvestor Php30 per year for 10 years (Php1,000 x 0.03 = Php30 per year). Maturity: This iswhen the bond's principal is scheduled to be repaid to the bondholder (i.e. in one year, fiveyears, 10 years, and so on).
While the most common way of valuing a stock is by
calculating the price-to-earnings ratio. The P/E ratio is a valuation of a company's stock price against the most recently reportedearnings per share (EPS). DIFFERENCE BETWEEN BONDS AND STOCKS PROPER VALUATION OF BOND AND STOCK FACTORS INFLUENCING BOND VALUATION 1.COUPON RATE- the fixed interest rate paid to bondholders. 2.MATURITY DATE- the date when the bond issuer repays the face value to bondholder. 3.YIELD TO MATURITY(YTM)- the annual rate of return an investor’s aspects to earn if they hold the bond until maturity. 4.MARKET INTEREST RATE-changes in prevailing interest rates directly impact bond prices. 5.CREDIT RISK- the likelihood that the bond issuer will default on their debt obligation.. STOCK VALUATION
is the process of determining the
intrinsic value of a company’s stock based on its future earnings potential and risk. METHODS OF STOCK VALUATION 1. Discounted Cash Flow (DCF)- This model values a company stock by discounting it’s future free cash flow. 2. Dividend Discounted Model (DDM)- this model values a company stock based on the present value of its future dividend payments. 3. Comparable Company Analysis- this method compares the valuation multiples(such as P/E ratio or price to book ratio) of a company to its peers in the same industry. Bonds and stocks are essential components of financial management for several reasons PROBLEMS RELATED TO BONDS AND STOCKS VALUATION Solution Steps:
1. Coupon Payment: Coupon Payment = Face Value
Coupon Rate = 1,000 × 0.06 = 60
2. Present Value of Coupon Payments: The present
value of coupon payments is calculated using the formula for the present value of an annuity: Solution Steps: 1. Coupon Payment: Coupon Payment = Face Value Coupon Rate = 1,000 × 0.06 = 60
2. Present Value of Coupon Payments: The present value of coupon
payments is calculated using the formula for the present value of an annuity:
where C is the coupon payment, r is the discount rate, and n is the
number of periods. 3. Present Value of Face Value: The present value of the bond's face value is calculated using:
4. Bond Value: The bond value is the sum of the present values of the coupon payments and the face value: 2. Stock Valuation Using the Dividend Discount Model (DDM) This model values a stock based on the present value of future dividends.
Problem Example:
A company pays an annual dividend of $2.50 per share, and
dividends are expected to grow at a constant rate of 4% per year. If the required rate of return is 8%, what is the intrinsic value of the stock? Solution Steps: 1. Formula for DDM: The dividend discount model for a stock with constant growth is:
where: • P0 is the current stock price, • D0 is the current dividend, •g is the growth rate, and •r is the required rate of return. 2. Substitute values:
3. Zero-Coupon Bond Valuation A zero-coupon bond pays no
periodic interest but is issued at a discount and matures at its face value.
Problem Example: A zero-coupon bond has a face value of
$1,000 and matures in 5 years. If the market interest rate is 7%, what is the price of the bond? Solution Steps: 1. Formula: The price of a zero-coupon bond is the present value of the face value:
where FV is the face value, r is the discount rate, and n is the
number of periods.
2. Substitute values
The bond's price is approximately $712.99.
4. Preferred Stock Valuation
Preferred stock typically pays a fixed dividend and is valued
similarly to a perpetuity.
Problem Example: A preferred stock pays an annual dividend of $5, and the required rate of return is 10%. What is the value of the preferred stock? Solution Steps: 1. Formula: The value of preferred stock is:
where D is the dividend and is the required rate of return.
