Lecture 4

Bond valuation
Stock valuation
 To raise
Review
To use
Capital Capital

Maximize firm’s value

Capital Budgeting
Capital Structure
Share- (investment)
(Financing) Debt-
holder Chapter 4, 5, 6
holder
Concepts:
Corporate Time value of money
Risk premium

Manager Theory:
Discounted cash flow model

Financial Statements:
Balance sheet/ Income Statement/
Cash flow Statement/Financial Cash
Flow & Financial ratios

Financial markets
Bond (chapter 8); Stock (chapter 9)
CAPM (chapter 11, 12); Wacc (Chapter 13)
 Chapter 8
Interest Rates and Bond Valuation
Outline

8.1 Bonds and Bond Valuation

• Bond valuation and Yield to Maturity
• Interest rate risk and yield
8.2 Government and Corporate Bonds
• Type of bonds
• Default risk & Bond ratings and what they mean
8.5 Determinants of Bond Yields
• Term structure & Yield curve
• What determine the YTM
 8.1 Bonds and Bond Valuation

• A bond is a legally binding agreement between a borrower and a

lender that specifies the:
– Par (face) value
• The principal amount of a bond that is repaid at the end of
the term
– Coupon rate
• The annual coupon divided by the face value of a bond
– Coupon payment
• Stated interest payment made on a bond
– Maturity Date
• Date on which the principal amount of a bond is paid
– The yield to maturity is the required return on the
bond(YTM):
• The rate required in the market on a bond
Example of Valuing Bonds

Level-Coupon Bonds:
− Promise of a regular coupon payment each period plus
face value (i.e., principal) repayment at maturity
− Key parameters: Coupon payment dates and amounts (C)
Time to maturity (T), Face value (F)
Discount rate (r)
$C $C $C $C  $ F

0 1 2 T 1 T
C 1  F
BondValue  1  
r  (1  r )  (1  r )T
T
− Bond value = PV(coupons) + PV(face value)
Example of valuing Bond

Consider a bond with a coupon rate of 10% and coupons

paid annually. The par value is $1,000 and the bond has 5
years to maturity. The yield to maturity is 11%. What is
the value of the bond?
$100 $100 $100 $100  $1,000

0 1 2 4 5

− B = PV of coupons + PV of par value

− B = $100[1 – 1/(1.11)5] / .11 + $1,000 / (1.11)5
− B = $369.59 + 593.45 = $963.04
Zero Coupon Bonds (Pure Discount Bonds)

Promise to pay a single cash payoff at some maturity date

Key parameters:
Time to maturity (T) = maturity date - today’s date
Face value (F), Discount rate (r)

$0 $0 $0 $F

0 1 2 T 1 T
Present value of a pure discount bond at time 0
F
PV 
T
(1 r)
Example of a zero coupon bond
Find the value of a 30-year zero-coupon bond with a $1,000
par (face) value. The
appropriate discount rate is 6%.

$0 $0 $0 $1,000 0,1$

0
3
9
$
0

0122


0 1 2 29 30

F $1,000
PV    $174.11
T 30
(1 r) (1.06)
Bond Valuation (Semi-annual coupon payment)
• Consider a U.S. government bond with as 6.375% coupon
that expires in December 2013.
– The Par Value of the bond is $1,000.
– Coupon payments are made semiannually (June 30 and
December 31 for this particular bond).
– Since the coupon rate is 6.375%, the payment is $31.875.
– On January 1, 2009 the size and timing of cash flows are:

$31.875 $31.875 $31.875 $1, 031.875


1/1/ 09 6 / 30 / 09 12 / 31/ 09 6 / 30 /13 12 / 31/13
 Bond Example
• On January 1, 2009, the required yield is 5%.
• The current value is:
$31.875  1  $1, 000
PV  1 10 
 10
 $1, 060.17
.05 2  (1.025)  (1.025)

• Now assume that the required yield is 11%.

• How does this change the bond’s price?

$31.875  1  $1, 000

PV  1 10 
 10
 $825.69
.11 2  (1.055)  (1.055)
Bond Concepts: Yield to Maturity (YTM)

The market required rate of return for bonds of similar risk

and maturity.

Computing YTM: The discount rate that makes the present

value equal to the current bond price.

Example: Consider a bond that pays $300 at date 1 and date

2 and also repays $1,000 principal (face value) at date 2.
The bond currently sells for $1,200. What is it’s YTM?

1,200 = 300/(1+r) + 1,300/(1+r)2

.1733 = r
So YTM is 17.33%
Current Yield vs. Yield to Maturity
• Current Yield = annual coupon / price

• Example: 10% coupon bond, with semi-annual coupons,

face value of 1,000, 20 years to maturity, $1,197.93 price

Current yield = 100 / 1197.93 = .0835 = 8.35%

YTM with Semiannual Coupons
• Suppose a bond with a 10% coupon rate and semiannual
coupons has a face value of $1,000, 20 years to maturity,
and is selling for $1,197.93.

– Is the YTM more or less than 10%?

– What is the semi-annual coupon payment?

– How many periods are there?

– N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT

I/Y = 4% (Is this the YTM?)
 YTM and Bond Value

When the YTM < coupon, the bond

1300 trades at a premium.

1200
Bond Value

1100 When the YTM = coupon, the

bond trades at par.
1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6.375% Discount Rate
When the YTM > coupon, the bond trades at a discount.
 Bond Concepts: Premium bonds vs. discount bonds
• Bond prices and market interest rates move in opposite directions.
• When coupon rate = YTM, price = par value
• When coupon rate > YTM, price > par value (premium bond)
• When coupon rate < YTM, price < par value (discount bond)
 Bond Concepts: Interest Rate Risk

The risk that arises for bondholders from fluctuating interest rates.
• Price Risk
– How much interest rate risk a bond has depends on how
sensitive its price to interest changes.
– Long-term bonds have more price risk than short-term bonds
• More-distant cash flows are more adversely affected by
an increase in interest rates.
– Low coupon rate bonds have more price risk than high
coupon rate bonds.
• More of the bond’s value is deferred to maturity (thus,
for a longer time) if the coupons are small.
Interest Rate Risk and Time to Maturity

18
 Coupon Rates and Bond Prices
Bond Value

Consider two otherwise identical bonds.

The low-coupon bond will have much
more volatility with respect to changes in
the discount rate.

High Coupon Bond

Low Coupon Bond
Par

CL CH Discount Rate
Bond Concepts: Interest Rate Risk (cont.)

• Reinvestment Rate Risk

Uncertainty concerning rates at which cash flows can be
reinvested

Short-term bonds have more reinvestment rate risk than

long-term bonds.

High coupon rate bonds have more reinvestment rate risk

than low coupon rate bonds.
Bond Pricing with a Spreadsheet
• There are specific formulas for finding bond prices and
yields on a spreadsheet.
– PRICE(Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)

– YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
– Settlement and maturity need to be actual dates
– The redemption and Pr need to given as % of par value
8.2 Government and Corporate Bonds
• Treasury Securities
– Federal government debt
– T-bills – pure discount bonds with original maturity less than
one year
– T-notes – coupon debt with original maturity between one and
ten years
– T-bonds – coupon debt with original maturity greater than ten
years
– Assuming no default risk

• Municipal Securities
– Debt of state and local governments
– Varying degrees of default risk, rated similar to corporate debt
– Interest received is tax-exempt at the federal level
– More attractive to high-income, high-tax bracket investors
 Example Municipal Bonds
23
• A taxable bond has a yield of 8% and a municipal bond has
a yield of 6%
– If you are in a 40% tax bracket, which bond do you
prefer?
• After tax return is 8% * (1 - .4) = 4.8%
• Prefer municipal of 6%
– At what tax rate would you be indifferent between the
two bonds?
• 8%(1 – T) = 6%
• T = 25%

23
Default Risk of Corporate Bonds

• Greater default risk relative to government bonds

• The promised yield (YTM) may be higher than the expected
return due to this added default risk
• Default risk is likelihood that a borrower will not make the
promised payments
• Because of default risk, corporate bonds offer higher yields
than government bonds; the difference is known as the default
risk premium
• Private firms evaluate default risk and assign a credit rating,
charging borrowers a one-time fee prior to the release of the
rating.
(1) Moody’s
(2) Standard and Poor’s
Bond Ratings

An assessment of the creditworthiness: how likely the firm is to

default and the protection creditors have in a default.
Standard & Moody’s Description
Poor’s
Investment Grade
AAA Aaa Highest quality
AA Aa High quality, slightly more risk than top rating
A A-1, A Upper-medium grade, possible future impairment
BBB Baa Medium grade, lacks outstanding investment
characteristics
Noninvestment Grade
BB Ba Some speculative characteristics
B B Highly speculative, small assurance of interest and
principal payments
CCC Caa Low quality, probable default
CC Ca Low quality, poor prospect of attaining investment
standing
C, D C Lowest quality, in default
The Bond Indenture

• Contract between the company and the

bondholders that includes:
– The basic terms of the bonds
– The total amount of bonds issued
– A description of property used as security, if
applicable
– Sinking fund provisions
– Call provisions
– Details of protective covenants
 Bond Type (coupon type)
27
27 • Fixed coupon bond
• Zero coupon bond
• Floating rate bond
– Coupon rate floats depending on some index value
– Examples – adjustable rate mortgages and inflation-
linked Treasuries
– There is less price risk with floating rate bonds
• The coupon floats, so it is less likely to differ
substantially from the yield-to-maturity
– Coupons may have a “collar” – the rate cannot go
above a specified “ceiling” or below a specified “floor”

27
Bond type (seniority )
• Security
– Collateral – secured by financial securities, or in
general, any asset pledged on the debt
– Mortgage – secured by real property, normally land or
buildings
– Debentures – unsecured
– Notes – unsecured debt with original maturity less than
10 years
• Seniority
– Senior debt
– Subordinator or junior debt
 Bond Types (embedded options)
• Callable bonds: a type of bond (debt security) that allows the
29 issuer of the bond to retain the privilege of redeeming the bond at
some point before the bond reaches its date of maturity

• Puttable bonds: The holder of the puttable bond has the right, but
not the obligation, to demand early repayment of the principal.
The put option is exercisable on one or more specified dates

• Convertible bonds: a type of bond that the holder can convert

into a specified number of shares of common stock in the issuing
company or cash of equal value

• There are many other types of provisions that can be added to a

bond and many bonds have several provisions – it is important to
recognize how these provisions affect required returns 29
Securitized Bonds
• Also called asset-backed bonds
• Bondholders receive interest and principal
payments from a specific asset rather than a
specific company or government
• Mortgage backed securities are the best-known
type of securitized bond, but others include
– Car loans
– Credit cards
8.5 Determined of bond yield

Term Structure of Interest Rates

Term structure: The relationship between time to maturity and

yields, all else equal
– The effect of default risk, different coupons, etc. has been
removed.

Yield curve: Graphical representation of the term structure

– Normal = upward-sloping  Long-term yields > Short-
term yields
– Inverted = downward-sloping  Long-term yields < Short-
term yields
6-31
 Term structure theories
• Expectations hypothesis
– long-term interest rate represents the geometric mean
of current and future one-year interest rates
• Liquidity preference hypothesis
– Long-term securities should provide higher returns
than short-term obligations
• Segmented market hypothesis
– Different institutional investors have different
maturity needs that lead them to confine their
security selections to specific maturity segments
Upward-Sloping Yield Curve

REPLACE with FIGURE 6.5 A

6-33
Downward-Sloping Yield Curve

6-34
 Yield to Maturity
36 • Yield to Maturity:
– “Required” Rate of Return on the bond
– “Fair” Discount Rate of the bond
• It prices the riskiness of the bond.

36
Additional Factors Affecting Required Return

Default risk premium: bond ratings

Liquidity premium: bonds that have more frequent trading

will generally have lower required returns

Taxability premium: some bonds are tax-exempt and

investors demand the extra yield for taxable bonds as
compensation.

Anything else that affects the risk of the cash flows to the
bondholders will affect the required returns.
6-37
Summary
• How do you find the value of a bond, and why do bond
prices change?
• What are bond ratings, and why are they important?
• What is the term structure of interest rates?
• What factors determine the required return on bonds?
 Chapter 9
Valuing Stocks
Outlines of stock valuation

I. The present value of common stock

Understand how stock prices depend on future dividends and dividend growth

II. Dividend discount model (DDM)

Be able to compute stock prices using the dividend growth model

III. Value of growth

Understand how growth opportunities affect stock values

IV. Why P/E ratio, how to use it?

Meaning of P/E ratio, other price multiples
Drawback of price multiple
I. The PV of Common Stocks

Cash flows to stockholders

If you buy a share of stock, you can receive cash in two ways.
– The company pays dividends: cash income
– You sell your shares: capital gains

As with bonds, the price of the stock is the present value of these
expected cash flows.

41
Examples

• Suppose you are thinking of purchasing the stock of Moore Oil, Inc.
You expect it to pay a $2 dividend in one year, and you believe that
you can sell the stock for $14 at that time. If you require a return of
20% on investments of this risk, what is the maximum you would be
willing to pay?
– Compute the PV of the expected cash flows
– Price = (14 + 2) / (1.2) = $13.33

• Now, what if you decide to hold the stock for two years? In addition
to the $2 dividend in one year, you expect a dividend of $2.10 and a
stock price of $14.70 both at the end of year 2. Now how much would
you be willing to pay?
− PV = 2 / (1.2) + (2.10 + 14.70) / (1.2) = 13.33
2

42
Example extension

• What if you decide to hold the stock for three periods? In addition to
the dividends at the end of years 1 and 2, you expect to receive a
dividend of $2.205 and a stock price of $15.435 both at the end of
year 3. Now how much would you be willing to pay?
− PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 = 13.33

• What if you hold for four years? For five years? For more years?

• You could continue to push back when you would sell the stock

43
Developing the model
D1  P1
Holding for one period: P 
0 1 r
D D P
Holding for two periods: P  1  2 22
0 1 r (1 r )
D1 D2 DH  PH
Holding for H periods: P    .......... .. 
0 1 r (1 r) 2 (1 r) H
Holding forever: D1 D2
P    .......... .........
0 1 r (1 r) 2
You would find that the price of the stock is really just the present value
of all expected future dividends.


Dt
P̂0  
t 1 (1  R )
t

So, how can we estimate all future dividend payments?

44
Estimating Dividends: Special Cases

Zero growth (or constant dividend)

– Firm will pay a constant dividend forever.
– Applies well to preferred stock.
– Price is computed using the perpetuity formula.

Constant growth
– Firm will increase the dividend by a constant percent every
period.

Nonconstant growth (or differential growth)

– Dividend growth is not consistent initially, but settles down to
constant growth eventually.

45
Case1: Zero Growth

If constant dividends are expected at regular intervals forever, then this is

like preferred stock and is valued as a perpetuity
Div1  Div 2  Div 3  

Div1 Div 2 Div 3

P0    
1 2 3
(1  r ) (1  r ) (1  r )
Div
P0 
r
Suppose stock is expected to pay a $0.50 dividend every quarter and the
required return is 10% with quarterly compounding. What would be the
price?
− P0 = .50 / (.1 / 4) = .50 / .025 = $20

46
Case 2: Constant Growth

Dividends are expected to grow at a constant percent per period.

Div1  Div 0 (1  g )
2
Div 2  Div1 (1  g )  Div 0 (1  g )

3
Div 3  Div 2 (1  g )  Div 0 (1  g )
..
.

Since future cash flows

D 0 (1  g) growDat a constant rate forever, the value of a
0  stock is 
1
constantPgrowth the present value of a growing perpetuity.
R-g R-g

47
Example

Stock paid a $2 dividend last year

Expected to grow at 10% forever
Appropriate discount rate is 15%
 
What should the price be?
 
Using the Constant Growth DDM
 
Po= 2(1.10)/(.15-.10) = $44
 
  Key implications of Constant Growth model
  
A. Higher expected dividend ==> higher value
  B. Higher discount rate ==> lower value
  C. Higher growth rate g ==> higher value
 
Case 3: Differential Growth

• Assume that dividends will grow at different rates in the foreseeable

future and then will grow at a constant rate thereafter.
• To value a Differential Growth Stock, we need to:
– Estimate future dividends in the foreseeable future.
– Estimate the future stock price when the stock becomes a Constant
Growth Stock (case 2).
– Compute the total present value of the estimated future dividends
and future stock price at the appropriate discount rate.
Case 3: Differential Growth

Dividends will grow at rate g1 for T years and grow at rate g2 thereafter

Div 0 (1  g1 ) Div 0 (1  g1 ) 2
…
0 1 2
DivT (1  g 2 )
Div 0 (1  g1 )T  Div 0 (1  g1 )T (1  g 2 )
… …
T T+1
 Case 3: Differential Growth

We can value this as the sum of:

 a T-year annuity growing at rate g1

C  (1  g1 )T 
PA  1  
R  g1  (1  R )T 
 plus the discounted value of a perpetuity growing at rate g2 that starts in
year T+1  Div T 1
 
R  g
PB   2 

(1  R)T
Consolidating gives:
 Div T 1 
 
C  (1  g1 )T   R  g 2 
P 1 T 

R  g1  (1  R )  (1  R )T
A Differential Growth Example

A common stock just paid a dividend of $2. The dividend is expected to

grow at 8% for 3 years, then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.

 $2(1.08)3 (1.04) 
 
$2  (1.08)  (1.08)  
3
.12  .04 
P 1   
.12  .08  (1.12)3  (1.12)3

P  $54   1  .8966 
 $32.75 
3
(1.12)

P  $5.58  $23.31 P  $28.89

Another Example: Differential Growth

Expected dividend next year is $2.00

Dividends expected to grow 20% annually at years 1-4
Dividends expected to grow 5% annually from year 5 onwards
Appropriate discount rate is 10%
What is the value of the stock?

Year Dividend Present Value

1 2.00 2/(1.1) = 1.82
2 2(1.2) = 2.40 2.40/(1.1)2 = 1.98 3
2(1.2)2 = 2.88 2.88/(1.1)3 = 2.16
4 2(1.2)3=3.46 3.46/(1.1)4 = 2.36
5 3.46 (1.05)=3.63
Dividend in years 5 and onwards can be viewed as a growing perpetuity
Year 4 value of 3.63/(.10-.05) = 72.58
Year 0 value of 72.58/(1.1)4 = 49.57

Total present value of stock = 1.82 + 1.98 + 2.16 + 2.36 + 49.57 = 57.89
II. Dividend Discount Model (DDM)

1. The growth rate

Method 1 – Use analysts’ or insiders’ estimates/guestimates

Method 2 – Use historical industry averages or extrapolate based on
past trends
Method 3 – Use formula:
g = retention ratio x return on retained earnings=b x ROE

(i) retention ratio = % of earnings reinvested (i.e., not paid as dividends)

(ii) return on retained earnings = expected return on reinvested earnings
(typically estimated as a firm’s overall ROE)
Where Does Growth Come From?

• Three parts of growth:

– Technology improve over time, i.e., the return on existing assets
improves.
– Additional external financing
– Reinvest earnings—retained earnings

• The first two vary for different firms. We focus on the last one.

55
Example: Sources of Growth
Assume you issued $100 of stocks to start a company producing tennis
balls. The technology is the following: for each $1 invested, you earn
20% return each year forever (ROE).

(i) What is your earning in year 1?

(ii) If you pay all the earning as dividends, how much will be your
earning in year 2? What is the growth rate?

(iii) What if you invest all the earning in purchasing new machines?

(iv) What if you invest b of the earning? (b is called the retention ratio)

56
 Example: Sources of Growth
57
(i) E1 = (100)(20%) = 20

(ii) E2 = 20, g=0

(iii) E2 = E1+(E1)(20%) = 24
g = E2/ E1 –1 = 20%

(iv) E2 = E1+(E1*b)(20%)
g = E2/ E1 –1 = (20%)(b)

57
 Calculating the Growth Rate

58 • Et: Earning at time t ,

• ROE: Return on equity
• b: retention ratio (% of earning retained)

E t 1  E t  (E t  b)  ROE
E t 1
 1  b  ROE ,
Et
E t 1
g 1
Et

g  b  ROE
58
2. The discount rate

Method 1 – estimate a model of the risk/return tradeoff and a measure of

the risk of a cash flow stream, develop this method later in the course

Method 2 – use the observed price to back out the discount rate that the
market is using in pricing the security

Div 1
Recall that P0 
rg

Rearrange and solve for r Div 1

r g
P0
Example: Given the following data, what is r?

Data:
Firm has 500,000 shares outstanding at a current price of $20 per
share
Next year’s earnings expected to be 1,000,000
Next year’s expected dividend is $1 per share
Historical ROE of 20%

Solution
$1 x 500,000 = $500,000
Next year total dividends =
$1,000,000 - $500,000 = $500,000
Earnings reinvested =
500,000 / 1,000,000 = .5
Retention ratio = .5 x .20 = .10
Expected growth rate (g) =
r = (1/20) + .10 = .15 or 15%
r= (D1/P0) + g 
Additional notes

Estimating g is notoriously difficult, but very important!

Estimating r for an individual security is similarly difficult

Growth rates g exceeding r are possible in the short run, but never in
perpetuity

Constant growth model makes strong assumptions, sometimes they

are a reasonable approximation, sometimes not
When is the Dividend Discount Model particularly problematic?
62

• Firm may not pay dividend currently and future

dividends are difficult to estimate
• These tend to be:
– Young firms
• Currently aren’t making profits or dividends.
– “Growth” firms: New technologies, growth hard to forecast
– AMZN, NetFlix, Google

62
III. Value of Growth
• Recall the constant DDM:

DPS EPS  (1  b)
P 
R  g R  b  ROE
• If b=0, What is the value of the firm? EPS
P
R
• The value of a firm can be conceptualized as the sum of the value of a
firm that pays out 100% of its earnings as dividends plus the net
present value of the growth opportunities.

EPS
P  NPVGO
R
 NPVGO Model: Example

Consider a firm that has forecasted EPS of $5, a discount rate of 16%, and is
currently priced at $75 per share.
• We can calculate the value of the firm as a cash cow.

EPS $5
P0    $31.25
R .16
• So, NPVGO must be: $75 - $31.25 = $43.75
Retention Rate and Firm Value
• An increase in the retention rate will:
– Reduce the dividend paid to shareholders
– Increase the firm’s growth rate

• These have offsetting influences on stock price

• Which one dominates?
DPS EPS  (1  b)
• Recall : P 
R  g R  b  ROE
• If ROE=R, what is the value of firm: EPS  (1  b) EPS
P 
R  (1  b) R
If ROE>R, then increased retention increases firm value
IF ROE<R, then increase retention decrease firm value

What is the economic rationale here?

IV. Price-Earnings Ratio

• Many analysts frequently relate earnings per share to price.

• The price-earnings ratio is calculated as the current stock price divided by
annual EPS.
– The Wall Street Journal uses last 4 quarter’s earnings

Price per share

P/E ratio 
EPS
PE and NPVGO

• Recall, P  EPS  NPVGO

R
• Dividing every term by EPS provides the following description
of the PE ratio:
1 NPVGO
P/E  
R EPS
• So, a firm’s PE ratio is positively related to growth
opportunities and negatively related to risk (R)
Alternative way to understand PE ratio and growth opportunity

• Recall P  DPS  EPS  (1  b )

R  g R  b  ROE

• PE = 1  b
Rg

• Again So, a firm’s PE ratio is positively related to growth

opportunities and negatively related to risk (R)
How to use P/E ratio to value a stock?

Example:
• Whiteboard.com is going public. What is a reasonable stock valuation?

Company MktValue Sales EBITDA NI

(Millions) (Millions) (Millions) (Millions) P/ E P/ S
Whiteboard ? 80 20 100 ? ?
eCollege $2,100 70 17 30 70 30
Blackboard $3,000 75 18 150 20 40

Use the P/E Multiple to value the firm.

Industry average P/E: (70+20)/2=45
Mkt Value of Whiteboard: 45 x $100= $4,500 millions
If issue 100 million shares, price will be $45
• Use the P/S Multiple to value the firm.
– Industry average P/S: (30+40)/2=35
– Mkt Value of Whiteboard: 35 x $80= $2,800 millions
– If issue 100 million shares, price will be $28

Company MktValue Sales EBITDA NI

(Millions) (Millions) (Millions) (Millions) P/ E P/ S
Whiteboard ? 80 20 100 ? ?
eCollege $2,100 70 17 30 70 30
Blackboard $3,000 75 18 150 20 40

70
Potential Problems with Price multiples

• Assumptions:
– Competitors are properly valued / priced
• The whole industry can be mispriced.
– Example: internet stocks in 2002 before the bubble burst.
– Hard to find a perfect benchmark of price multiple
• Which multiples to use?
– P/B, P/E, P/S?
– Should we use last year’s P/E ratio or average of past five years?
• What if the firm has different growth aspect than the competitors?

71
RISK AND RETURN
I. Return Statistics

The history of capital market returns can be summarized by describing the:

( R1    RT )
– Average return R
T

Investment Average Return

Large Stocks 12.3%

Small Stocks 17.1%
Long-term Corporate Bonds 6.2%
Long-term Government Bonds 5.8%
U.S. Treasury Bills 3.8%
Inflation 3.1%
Risk Premiums

Risk-free rate:
– Rate of return on a riskless investment.
– Treasury Bills are considered risk-free.

Risk premium:
– Excess return on a risky asset over the risk-free rate.
– Reward for bearing risk.

Historical risk premiums: Large Stocks: 12.3 – 3.8 = 8.5%

Small Stocks: 17.1 – 3.8 = 13.3%
L/T Corporate Bonds: 6.2 – 3.8 = 2.4%
L/T Government Bonds: 5.8 – 3.8 = 2.0%
II. Risk statistics

Risk is measured by the dispersion, spread, or volatility of returns.

 R 
T
2
R
Historical return variance: VAR(R)  σ 2  i 1
i

T 1

– Common measure of return dispersion.

– Also call variability.

SD(R)  σ  VAR(R)
Standard deviation:
– Square root of the variance.
– Sometimes called volatility.
Example: calculating historical variance and standard
deviation

Using data for large-company stocks:

(1) (2) (3) (4) (5)

Average Difference: Squared:
Year Return Return: (2) - (3) (4) x (4)
1926 11.14 11.48 -0.34 0.12
1927 37.13 11.48 25.65 657.82
1928 43.31 11.48 31.83 1013.02
1929 -8.91 11.48 -20.39 415.83
1930 -25.26 11.48 -36.74 1349.97
Sum: 57.41 Sum: 3436.77

Average: 11.48 Variance: 859.19

Standard Deviation: 29.31

10-76
Historical Standard Deviations: Second Lesson
III. Portfolio

The expected return of a portfolio is the weighted average of the expected

returns of the respective assets in the portfolio.
m
E ( RP )   w j E ( R j )
j 1

You can also find the expected return by finding the portfolio return in
each possible state and computing the expected value as we did with
individual securities.

Example: Consider the portfolio weights computed previously. If the

individual stocks have the following expected returns, what is the expected
return for the portfolio?
– DCLK: 19.65%, KO: 8.96%, INTC: 9.67%, KEI: 8.13%
 E(RP) = .133(19.65) + .2(8.96) + .267(9.67) + .4(8.13) = 10.24%
 Portfolio Risk
• Portfolio standard deviation is NOT a weighted average of the standard
deviation of the component securities’ risk
• First, compute the portfolio return for each state:
RP = w1R1 + w2R2 + … + wmRm
• Second, compute the expected portfolio return, variance, and standard
deviation using the same formula as for an individual asset.

• Example: consider the following information

− Equally-weighted portfolio of Stock A and Stock B
State Probability A B
Boom .4 30% -5%
Bust .6 -10% 25%
 What is the expected return and standard deviation for each asset?
 What is the expected return and standard deviation for the portfolio?
Portfolio Risk

– The expected return and standard deviation for each asset:

– E(RA)= .4(.3) + .6(-0.1) = .06 = 6%
– A2 = .4(.3-.06)2 + .6(-0.1-.06)2 = .0384 ; A = .1959

– E(RB)= .4(-0.05) + .6(.25) = .13= 13%

– B2 = .4(-0.05 -.13)2 + .6(.25-.13)2 = 0.0216 ; A = .1470

• The expected return and standard deviation for the portfolio:

• E(RP)=.5(6%) + .5(13%) = 9.5%

• RP in Boom: .5(30%) + .5(-5%) = 12.5%

• RP in Bust: .5 (-10%) + .5(25%) = 7.5%
– P2 = .4(0.125 -.095) 2 + .6(.075 -.095) 2 = .0006; P = .0245
Example: Portfolio returns and Variance:

Assets Return E(P) risk ( )

A 6% 19.59%

B 13% 14.70%

50% A + 50% B 9.5% 2.45%

The risk in portfolio is reduced greatly, but the return is not

reduced in the same proportion.
Another way to calculate Portfolio Variance: two assets

 p 2  Var[ R p ]  Var  w1 R1  w2 R2 

 p  w1  1  w2  2  2 w1w2 12
2 2 2 2 2
82

where 12 is the covariance between stocks 1 and 2:

 12  12 1 2 , - 1  12  1
 Statistics Reminder: Covariance

• Covariance:

   
n m
~ ~ ~ ~
Cov( X , Y )   xy   pij xi  E ( X ) y j  E (Y )
i 1 j 1

• Correlation: A standardized measure of covariation.

~ ~  xy
~ ~ Cov ( X ,Y )
Corr ( X , Y )   xy  ~ ~ 
StD ( X ) StD (Y )  x y
IV. Diversification

Systematic Risk vs. Unsystematic Risk

Systematic risk:
 Risk factors that affect a large number of assets
 Also known as non-diversifiable risk or market risk
 Includes such things as changes in GDP, inflation, interest rates,
etc.

Unsystematic risk:
 Risk factors that affect a limited number of assets
 Also known as unique risk and asset-specific risk
 Includes such things as labor strikes, part shortages, etc.
Implication for Asset Returns

• Total risk = Systematic risk + Unsystematic risk

• Unsystematic risk can be diversified away, while
systematic risk has to be held by investors.
• The market rewards investors for bearing risk, but only
for bearing the necessary risk, i.e., the systematic risk.
• Bearing unsystematic risk is unnecessary since it can be
eliminated via diversification, thus, is not rewarded.

As a consequence of diversification,
an asset’s expected return depends only on its
systematic risk.
Diversification

Diversification:
 Portfolio diversification is the investment in several different asset classes or
sectors
 Diversification is not just holding a lot of assets
 For example, if you own 50 Internet stocks, then you are not diversified
 However, if you own 50 stocks that span 20 different industries, then you are
diversified

Principle of diversification:
 Diversification can substantially reduce the variability of returns without an
equivalent reduction in expected returns
 This reduction in risk arises because worse-than-expected returns from one
asset are offset by better-than-expected returns from another asset
 However, there is a minimum level of risk that cannot be diversified away -
that is the systematic portion
Portfolio Diversification
V. CAPM, Systematic Risk and Beta

Systematic risk principle:

 There is a reward for bearing risk
 There is not a reward for bearing risk unnecessarily
 The expected return on a risky asset depends only on that asset’s
systematic risk since unsystematic risk can be diversified away

Measuring systematic risk

 We use the beta coefficient to measure systematic risk
 What does beta tell us?
 A beta of 1 implies the asset has the same systematic risk as the
overall market
 A beta < 1 implies the asset has less systematic risk than the overall
market
 A beta > 1 implies the asset has more systematic risk than the overall
market
Properties of Beta

• Beta measures the sensitivity of a stock price to market

movements:
– Stocks with betas higher than 1 tend to amplify the overall
movements of the market.
– Stocks with betas between 0 and 1 tend to move in the same
direction as the market, but not as far.
• An investor of a high beta stock will expect to earn a higher
return than an investor in a low beta stock, because
exposure to systematic risk is rewarded
– Exposure to idiosyncratic risk is not rewarded.
Estimating b with Regression

Security Returns

i ne
c L
i s ti
te r
a c
ar
Ch Slope = bi
Return on
market %

Ri = a i + biRm + ei
The Formula for Beta

Cov( Ri , RM )  ( Ri )
i  
 ( RM )
2
 ( RM )

Clearly, your estimate of beta will

depend upon your choice of a proxy
for the market portfolio.
Examples of Beta Coefficients
 Relationship between risk and expected return (CAPM)

Beta and the Risk Premium

Risk premium = expected return – risk-free rate
The higher the beta, the greater the risk premium should be
30%

25%
E(RA)
Expected Return

20%

15%

10%Rf

5%

0%
A
0 0.5 1 1.5 2 2.5 3
Beta 93
Rf = 8%; A = 1.6
 Reward-to-Risk Ratio

• The reward-to-risk ratio is the slope of the line illustrated in the previous example
 Slope = (E(RA) – Rf) / (A – 0)
 Reward-to-risk ratio for previous example = (20 - 8) / (1.6 - 0) = 7.5

• What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the
line)?
• What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below the
line)?

 Market equilibrium:
In equilibrium, all assets and portfolios must have the same reward-to-risk ratio.

E ( RA )  R f E ( RM )  R f

A M
Security Market Line and CAPM

Security market line (SML): the representation of market equilibrium

 The slope of the SML is the reward-to-risk ratio: (E(RM) – Rf) / M
 But since the beta for the market is ALWAYS equal to one, the slope can be
rewritten as:
 Slope = E(RM) – Rf = market risk premium

Capital asset pricing model (CAPM):

 Defines the relationship between risk and return
 E(Ri) = Rf + i(E(RM) – Rf)
 If we know an asset’s systematic risk, we can use the CAPM to determine its
expected return
 This is true whether we are talking about financial assets or physical assets
SML and Equilibrium

96
Using CAPM

Factors Affecting Expected Return

 Pure time value of money – measured by the risk-free rate
 Reward for bearing systematic risk – measured by the market risk
premium
 Amount of systematic risk – measured by beta

Example: consider the betas for each of the assets given earlier. If the
risk-free rate is 3.15% and the market risk premium is 9.5%, what is the
expected return for each?
Security Beta Expected Return
DCLK 4.033.15 + 4.03(9.5) = 41.435%
KO 0.843.15 + .84(9.5) = 11.13%
INTC 1.053.15 + 1.05(9.5) = 13.125%
KEI 0.593.15 + .59(9.5) = 8.755%
97
Practice
• The risk-free rate is 4%, and the required return on the market is 12%.
What is the required return on an asset with a beta of 1.5?

– R = .04 + 1.5 (.12 - .04) = .16 = 16%

• What is the required return on a portfolio consisting of 40% of the

asset above and the rest in an asset with an average amount of
systematic risk?

– R = .4 (.16) + .6 (.12) = .136 = 13.6%

Summary
• What determines the price of a share of stock?

• What determines g and R in the DDM?

• Decompose a stock’s price into constant growth and NPVGO values.

• Discuss the importance of the PE ratio

• How do you compute the expected return and standard deviation for an
individual asset? For a portfolio?

• What is the difference between systematic and unsystematic risk?

• What type of risk is relevant for determining the expected return?