Valuation of Long

Term Securities

By lkjs
Saeed Akbar
 Topics to be Covered

Distinctions Among Valuation Concepts

Bond Valuation
Preferred Stock Valuation
Common Stock Valuation
Rates of Return (or Yields)
 What is Value?
Liquidation value represents the amount of money that could be realized if
an asset or group of assets is sold separately from its operating
organization.
Going-concern value represents the amount a firm could be sold for as a
continuing operating business.

Book value represents either

(1) an asset: the accounting value of an asset i.e. the asset’s cost minus
its accumulated depreciation;
(2) a firm: total assets minus liabilities and preferred stock as listed on the
balance sheet.
Market value represents the market price at which an asset trades.

Intrinsicvalue or fundamental value is the "true, inherent, and essential value"

of an asset independent of its market value
 Bond Valuation
A bond is a long-term debt instrument issued by a corporation or
government.
The maturity value (MV) [or face value] of a bond is the stated
value. It is the value which is printed on the bond certificate. In the
case of Pakistan Investment Bond, the face value is Rs.100,000.
The bond’s coupon rate is the stated rate of interest paid on the bond.
A bond's term to maturity is the period during which its owner will
receive interest payments on the investment. When
the bond reaches maturity, the owner is repaid its par value, or face value.
 Bond Valuation
 A simple bond is valuated through the following formula.
 Valuation of Different Types of


Bonds
A perpetual bond is a bond thatnever matures. It has an infinitelife.
Lets derive the formula for valuation of perpetual bond.

 or (Recall the perpetuity formula)

 Example of Perpetual Bond
 Bond P has a $1,000 face value and provides an8%coupon. The
appropriate discount rate or required rate of return is10%. What is the
valueof the perpetual bond?
 Solution: INT = 8% of $1,000 = 1000 x 0.08 = $80
Kd= 10% or 0.10
 Now let’s put the values in the formula
 Valuation of Different Types of

Bonds
A non-zero coupon-paying bond
finitematurity.
is a coupon-paying bond with a

 Example
Bond C has a $1,000 face value and provides an 8% annual coupon
for30years. The appropriate discount rateis10%. What isthe value of the
couponbond?
Solution:

= 80 x 9.426 + 57.31 = $811.39

 Valuation of Different Types of
 A zero-coupon bond is a bondBonds
that pays no interest but sells at a deep
discount from its face value.

Example
Bond Z has a $1,000 face valueand a 30-yearlife. The appropriate
discount rateis 10%. What is the value of the zero-couponbond?
Solution:

57.31
 Semiannual Compounding
 Some bonds pay interest twice a year like Pakistan Investment Bonds.
To calculate the value of such bonds, the following adjustments are
needed in the formula.
Dividekdby2, Multiplyn by2 and divide INT by 2

Example
Bond C has a $1,000 face value and provides an 8% semiannual coupon
for15years. The appropriate discount rate is 10% (annualrate). What is the
value of the couponbond?
Solution:

=
 Preferred Stock Valuation
Preferred Stock is a type ofstock that promises a (usually) fixed dividend.
Preferred stock has preference over common stock in the payment of dividends
and claims on assets.
Given the fact that preferred stock divided has a fixed dividend paid after a
specific time period and it has no maturity, so this is the case of perpetuity.

Where: Vp represents Value of preferred stock

DP represents preferred stock dividend
kprepresents the discount rate or required rate of return on the preferred stock

 Example: Stock PS has an 8%, $100 par value issueoutstanding. The appropriate discount
rateis10%. What is thevalue of the preferred stock?
Solution: DP = $100 ( 8% ) =$8

kp=10%
So = $80
 Common Stock Valuation
Common stock is a type of security which represents equity
ownership in a corporation. Common stockholders are paid their
dividends from the leftover earnings after paying the dividend of
preferred stockholders. Unlike the preferred stockholders, the
dividends of common stockholders are not fixed.
Common stockholders’ dividends may have Constant Growth
or Non-Constant or Supernormal Growth. So the valuation
will be different for both cases.
 The Constant Growth Dividend
 Model
The constant growth dividend model assumes common stock
dividends will be paid regularly and grow at a constant rate. The
constant growth dividend model (also known as the Gordon growth
model because financial economist Myron Gordon helped develop and
popularize it) is shown below
 The Constant Growth Dividend
 Model
Example: Assume your required rate of return (k ) for Wendy’s
s
common stock is 10 percent. Suppose your research leads you to
believe that Wendy’s Corporation will pay a $0.25 dividend in one year
(D1), and for every year after the dividend will grow at a constant rate
(g) of 8 percent a year. What is the value of Wendy’s Common Stock?
 Solution:

 In a no-growth situation, g, in the denominator becomes zero. To value

stocks that have no growth is particularly easy because the value is
simply the expected dividend (D1) divided by ks.
The Nonconstant, or Supernormal, Growth Model
 Some companies have very high growth rates, known as supernormal
growth of the cash flows. Valuing the common stock of such
companies presents a special problem because high growth rates
cannot be sustained indefinitely
 The constant growth dividend model for common stock, then, must
be adjusted for those cases in which a company’s dividend grows at a
supernormal rate that will not be sustained over time. We do this by
dividing the projected dividend cash flow stream of the common
stock into two parts: the initial supernormal growth period and the
next period, in which normal and sustainable growth is expected. We
then calculate the present value of the dividends during the fast-
growth time period first. Then we solve for the present value of the
dividends during the constant growth period that are a perpetuity.
The sum of these two present values determines the current value of
the stock.
The Nonconstant, or Supernormal, Growth Model
 suppose Supergrowth Corporation is expected to pay an annual
dividend of $2 per share one year from now and that this dividend
will grow at a 30 percent annual rate during each of the following four
years (taking us to the end of year 5). After this supernormal growth
period, the dividend will grow at a sustainable 5 percent rate each
year beyond year 5. The cash flows are shown in the following figure.
 The Nonconstant, or Supernormal, Growth Model
 The valuation of a share of Supergrowth Corporation’s common stock
is described in the following three steps.
 Step 1: Add the present values of the dividends during the
supernormal growth period. Assume that the required rate of return,
ks, is 14 percent.
$2.00 × 1/(1.14)1 = $ 1.75
Discount Factor:
$2.60 × 1/(1.14)2 = $ 2.00
$3.38 × 1/(1.14)3 = $ 2.28
$4.39 × 1/(1.14)4 = $ 2.60
$5.71 × 1/(1.14)5 = $ 2.97
Σ = $11.60
 Step 2: Calculate the sum of the present values of the dividends
during the normal growth period, from t6 through infinity in this case.
To do this, pretend for a moment that t6 is t1. The present value of
the dividend growing at the constant rate of 5 percent to perpetuity
could be computed using the following Equation.
 The Nonconstant, or Supernormal, Growth Model

Note: In order to calculate the present value of an amount (discounting),

we use the formula
 The Nonconstant, or Supernormal, Growth Model
 Step 3: Finally we add the present values of the dividends from the
supernormal growth period and the normal growth period. In our
example we add $11.60 + $34.63 = $46.23. The sum of $46.23 is the
appropriate market price of Supergrowth Corporation’s common
stock, given the projected dividends and the 14 percent required rate
of return on those dividends.
 Rate of Return or Yield to Maturity
Most investors want to know how much return they will earn on a bond to gauge whether
the bond meets their expectations. That way, investors can tell whether they should add the
bond to their investment portfolio. As a result, investors often calculate a bond’s yield to
maturity before they buy a bond. Yield to maturity (YTM) represents the average rate of
return on a bond if all promised interest and principal payments are made on time and if the
interest payments are reinvested at the YTM rate given the price paid for the bond.
 Steps to calculate the rate of return (or yield).

1. Determine the expected cash flows.

2. Replace the intrinsic value (VB) with the market price (P0).

3. Solve for the market required rate of return (kd) that equates the
discounted cash flows (right hand side) to the market price (left hand side).
 Bond’s Yield to Maturity
Replace VB with P0 and then use a discount rate or required rate of return
(kd) which make the right hand side of the equation equal to the left
hand side.
We cannot solve the above equation for kddirectly because kdappears
three times in the equation. So we will use trial-and-error method, i.e. we
will keep guessing a value for kduntil the right hand side of the equation
becomes equal to the left hand side.
 Bond’s Yield to Maturity
Example:
Julie Miller want to determine theYTM for an issue of outstanding bonds at
BasketWonders(BW). BW has an issue of 10% annual coupon bonds with
Face Value of $1,000 and15 years lefttomaturity. The bonds have a current
market valueof $1,250.What is theYTM?

 Solution: Let’s use 9% for kd and see what happens.

$1,250 = $100 (8.06) + $274.57

$1250 ≠ $1080.60
The left hand side is greater than right hand side which means that the rate which
we applied (9%) is too high. We will now try a lower rate.
 Bond’s Yield to Maturity
 Let’s try 7%

$1,250 = $100(9.12) + $362.20

$1,250 ≠ $1274.20
Now the rate is too low. So the true rate of return or YTM (k d) is slightly higher than 7%.
The trial and error method is quite time consuming. There is another method which is
called interpolation (the one we used in Capital Budgeting chapter). The formula for
interpolation is as follows:

Where:
LDR = Lower Discount Rate, IV = Intrinsic Value, MP = Market Price, UDR = Upper Discount Rate
 Bond’s Yield to Maturity
Now we have the following values
 LDR= 7% IV at LDR= $1,274.20
 UDR = 9% IV at UDR = $1,080.60
 MP = $1,250
Let’s put the value in the interpolation formula

.0725 or 7.25% (Approx)

So the true YTM is 7.25% approximately.
 Semi-Annual Coupon Bond’s YTM
 In order to find the YTM of a bond which pays semi-annual coupon,
we will make the following changes
 Divide kd by 2, Divide INT by 2 and Multiply n by 2

Rest of the procedure is same.

 Determining Yield on Preferred
 Stock
Determining the yield on preferred stock is quite simple. Recall the
valuation formula for preferred stock and replace Vp by P0 .

Now solve the equation for kp

Example: Assume that the annual dividend on each share of preferred

stock is$10. Each share of preferred stock is currently trading at$100. Whatis
the yield on preferredstock?

Solution:

= 0.10 or 10%
Determining Yield on Common Stock
 To find the yield on common stock, recall the constant growth
dividend model that we used for common stock valuation

Now solve for ks

Example: Assume that the expected dividend (D1) on each share of

common stock is$3. Each share of common stock is currently trading at $30
and has an expected growth rateof5%. What is the yield on commonstock?

Solution:

= .15 or 15%