Valuation Concepts © 2005 Thomson/South-Western

Basic Valuation From “The Time Value of Money” we realize that the value of anything is based on the present value of the cash flows the asset is expected to produce in the future.

Basic Valuation The Value of the Asset = the sum of the discounted cash flows the asset is expected to generate over time Required return = the rate you use to discount the cash flows back. = the rate of return investors consider appropriate for holding such an asset = based on riskiness and economic conditions

Key Terms for Bonds Principal Amount = Face Value = Maturity Value,= Par Value: The amount of money borrowed Coupon Payment: The specified number of dollars of interest paid each period, generally each six months, on a bond. Coupon Interest Rate: The stated annual rate of interest paid on a bond. Maturity Date: A specified date on which the par value of a bond must be repaid. Original Maturity: The number of years to maturity at the time the bond is issued. Call Provision: Gives the issuer the right to pay off bonds prior to maturity. 4

Changes in Bond Values Over Time Par Value Bond Discount Bond Premium Bond

Par Value Bonds Par Value Bond: When the going interest rate = the bond’s coupon interest rate The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt.

Discount Bonds An increase in interest rates in the economy causes the price to fall Discount Bond = when a bond sells below its par value occurs whenever the going rate of interest rises above the coupon rate The bond value decreases so that the rate of return investors earn equates to the higher kd.

Premium Bonds A decrease in interest rates in the economy causes the bond price to rise Premium = when a bond sells above its par value occurs whenever the going rate of interest falls below the coupon rate The bond value increases so that the rate of return investors earn equates to the lower kd.

Calculating a Bond’s Current Yield Current yield = the annual interest payment on a bond divided by its current market value Current yield

Interest Rate Risk on a Bond Interest Rate Price Risk: the risk of changes in bond prices to which investors are exposed due to changing interest rates. Interest Rate Reinvestment Rate Risk: the risk that income from a bond portfolio will vary because cash flows have to be reinvested at current (presumably lower) market rates.

Valuation of Financial Assets - Equity (Stock) Common Stock Preferred Stock: hybrid similar to bonds with fixed dividend amounts similar to common stock as dividends are not required and have no fixed maturity date

Stock Valuation Models Term: Expected Dividends

Stock Valuation Models Term: Market Price

Stock Valuation Models Term: Intrinsic Value

Stock Valuation Models Term: Expected Price

Stock Valuation Models Term: Growth Rate

Stock Valuation Models Term: Required Rate of Return

Stock Valuation Models Term: Dividend Yield

Stock Valuation Models Term: Capital Gain Yield

Stock Valuation Models Term: Expected Rate of Return = Expected dividend yield + capital gains yield

Stock Valuation Models Term: Actual Rate of Return

Expected Dividends as the Basis for Stock Values If you hold a stock forever, all you receive is the dividend payments. The value of the stock today is the present value of the future dividend payments.

Stock Values with Zero Growth A Zero Growth Stock is a common stock whose future dividends are not expected to grow at all = A PERPETUITY

Normal, or Constant, Growth Normal Growth is growth that is expected to continue into the foreseeable future at about the same rate as that of the economy as a whole. g = a constant

Normal, or Constant, Growth (Gordon Growth Model) A Constant Growth Stock is a common stock whose future dividends are expected to grow at a constant rate = A GROWING PERPETUITY

Valuing Stocks with Nonconstant Growth Nonconstant Growth: The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole.

Valuing Stocks with Nonconstant Growth Compute the value of the dividends that experience nonconstant growth, and then find the PV of these dividends. Find the price of the stock at the end of the nonconstant growth period, at which time it has become a constant growth stock, and discount this price back to the present. Add these two components to find the intrinsic value of the stock P0.

Stock Market Equilibrium The expected rate of return as seen by the marginal investor must equal the required rate of return, The actual market price of the stock must equal its intrinsic value as estimated by the marginal investor, ^ kx = kx. P0 = P0. ^

Changes in Stock Prices Investors change the rates of return required to invest in stocks. Expectations change about the cash flows associated with particular stocks.