1. ©2009 McGraw-Hill Ryerson Limited 1 of 34 10 Valuation and Rates of Return Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

2. 2 of 34 Chapter 10 - Outline Valuation: Concepts and Relation with Financing and Investment Decisions Valuation of Bonds Valuation of Preferred Stock Valuation of Common Stock Valuation Using the Price-Earnings Ratio Summary and Conclusions

3. ©2009 McGraw-Hill Ryerson Limited 3 of 34 Learning Objectives 1.Describe the valuation of a financial asset as based on the present value of future cash flows. (LO1) 2.Explain that the required rate of return in valuing an asset is based on the risk involved. (LO2) 3.Calculate the current value (price) of bonds, preferred shares and common shares based on the future benefits (cash flows). (LO3)

4. ©2009 McGraw-Hill Ryerson Limited 4 of 34 Learning Objectives 4.Calculate the yields on financial claims based on the relationship between current price and future expected cash flows. (LO4) 5.Describe the use of a price-earnings ratio to determine value. (LO5)

5. ©2009 McGraw-Hill Ryerson Limited 5 of 34 Valuation: Concepts and Relation with Financing and Investment Decisions A financial asset (security) is a claim against a firm, government or individual for future expected cash flows. Examples of financial assets are bonds, preferred stocks and common stocks. Valuation of a financial asset is to determine the present value of those future anticipated cash flows using an appropriate discount rate. LO1

6. ©2009 McGraw-Hill Ryerson Limited 6 of 34 Valuation: Concepts and Relation with Financing and Investment Decisions An investment decision should be made by comparing the price (or market value) of a financial asset to its present value. Alternatively, the same decision can be made by determining the discount rate that equates the market value of a financial asset with the present value of its future expected cash flows. This discount rate is the market-determined required rate of return and also referred to as yield. LO1

7. ©2009 McGraw-Hill Ryerson Limited 7 of 34 Valuation: Concepts and Relation with Financing and Investment Decisions Financial assets are issued by firms to attract funds from investors. Therefore, the required or expected rate of return or yield on these financial assets is the cost of financing for issuing firms. In turn, the issuing firm must earn at least this rate of return on its projects (the capital budgeting decision) in order to add value to shareholders’ wealth. LO1

8. ©2009 McGraw-Hill Ryerson Limited 8 of 34 FIGURE 10-1 The relationship between time value of money, required return, cost of financing, and investment decisions LO1

9. ©2009 McGraw-Hill Ryerson Limited 9 of 34 Factors Influencing the Required Rate of Return (Yield) Real Rate of Return: –represents the opportunity cost of the investment –in the early 1990’s, 5-7%, but now about 3-4% Inflation Premium: –a premium to compensate for the effects of inflation –lately, 2% Risk Premium: –a premium associated with business and financial risk –typically, 2-6% Thus, the Required Rate of Return equals: Real Rate of Return + Inflation Premium + Risk Premium LO2

10. ©2009 McGraw-Hill Ryerson Limited 10 of 34 Example of a Required Rate of Return Required return on a bond issued by a firm + Real Rate of Return3% + Inflation premium4 = Risk-free rate7% + Risk premium3 = Required rate of return 10% LO2

11. ©2009 McGraw-Hill Ryerson Limited 11 of 34 Valuation of Bonds A bond contractually promises 2 things: -- a stream of annuity payments, “I” (called interest or coupon) -- a final payment, P n (called maturity, face or par value, usually is $1,000) I I III PnPn Present Value = Price (P b ) Discounted at Y N = 5 LO3

12. ©2009 McGraw-Hill Ryerson Limited 12 of 34 Valuation of Bonds Bond Price (P b ) = PV of Coupons + PV of Par The discount factor, called the yield to maturity or simply the yield (Y), is the link between the price investors are willing to pay and those future expected cash flows. Y is market-determined and represents the required rate of return demanded by investors. Using a financial calculator: 20 N; 10 I/Y; 100 PMT; 1,000 FV; CPT PV = -1,000 Using the formula: LO3

13. ©2009 McGraw-Hill Ryerson Limited 13 of 34 Relationship Between Bond Prices and Yields Bond prices are inversely related to bond yields (move in opposite directions) Please distinguish between the bond yield and the coupon rate, which equals coupon/par value. As interest rates in the economy change, the price or value of a bond changes: – if the required rate of return (i.e., the yield, Y) increases, the price of the bond will decrease – if the yield (Y) decreases, the price of the bond will increase LO4

14. ©2009 McGraw-Hill Ryerson Limited 14 of 34 Table 10-1 Bond price sensitivity to yield to maturity LO4

15. ©2009 McGraw-Hill Ryerson Limited 15 of 34 LO4

16. ©2009 McGraw-Hill Ryerson Limited 16 of 34 0........$1,000.00$1,000.00 1........ 1,018.52982.14 5........1,079.85927.90 10........1,134.20887.00 15........1,171.19863.78 20........1,196.36850.61 25........1,213.50843.14 30........1,225.16838.90 Time Period Bond Price withBond Price with in Years 8 Percent Yield 12 Percent Yield (of 10 percent bond) to Maturity to Maturity Table 10-2 Bond price sensitivity to time to maturity changes LO4

17. ©2009 McGraw-Hill Ryerson Limited 17 of 34 FIGURE 10-2 Relationship between time to maturity and bond price* LO4

18. ©2009 McGraw-Hill Ryerson Limited 18 of 34 Company Name Coupon (interest rate %) Maturity Date (April 8, 2022) Price (Last transaction price = $138.50/ $100 of face value) Yield (Rate relating current price, coupons and maturity value) Change(Closing price up $1.12/ $100 from previous day) Reading Bond Quotations LO3/LO4

19. ©2009 McGraw-Hill Ryerson Limited 19 of 34 Valuation of Bonds: 2 Issues 1. Determine yield to maturity from the bond price a) Trial and Error: solving for the discount rate, Y, from the formula b) Using a financial calculator: 15 N; -932.89 PV; 110 PMT; 1000 FV; CPT I/Y = 11.98(%) 2. Semiannual interest (coupon) and bond prices a) Divide the annual interest (coupon) rate by 2 b) Multiply the number of years by 2 c) Divide the yield to maturity by 2 An example: a 10%, $1,000 par value 20-year bond, Y = 12% 20x2 = 40 N; 12/2 = 6 I/Y; 100/2 = 50 PMT; 1000 FV; CPT PV = -849.54 LO3

20. ©2009 McGraw-Hill Ryerson Limited 20 of 34 Valuation of Preferred Stock Preferred stock: –usually represents a perpetuity (something with no maturity date) –has a fixed dividend payment –is valued without any principal payment since it has no ending life –is considered a hybrid security –owners have a higher priority of claim than common shareholders –price is based upon PV of future dividends LO3

21. ©2009 McGraw-Hill Ryerson Limited 21 of 34 Valuation of Preferred Stock Cash flows from a preferred stock ∞ DpDp DpDp DpDp DpDp DpDp Discounted at K p n = ∞ Present Value = Price (P p ) LO3

22. ©2009 McGraw-Hill Ryerson Limited 22 of 34 Valuation of Preferred Stock Formula for the present value of an infinite stream of constant dividends at a given discount rate equal to K LO3 p p p p D K P 

23. ©2009 McGraw-Hill Ryerson Limited 23 of 34 Valuation of Preferred Stock Determining the Required Rate of Return (Yield) from the Market Price LO4

24. ©2009 McGraw-Hill Ryerson Limited 24 of 34 Valuation of Common Stock The value of common stock is the present value of a stream of future dividends Common stock dividends can vary, unlike preferred stock dividends There are 3 possible cases: 1.No growth in dividends (valued like preferred stock) 2.Constant growth in dividends 3.Variable growth in dividends Required rate of return reflects both the dividend yield on the stock and the expected growth rate in the dividend LO3

25. ©2009 McGraw-Hill Ryerson Limited 25 of 34 Valuation of Common Stock 1. No Growth in Dividends -- similar to preferred stock 2. Constant Growth in Dividends a) the dividend growth rate, “g”, must be constant forever b) the discount rate, K e, must exceed the growth rate, “g” LO3

26. ©2009 McGraw-Hill Ryerson Limited 26 of 34 Valuation of Common Stock 3. Variable Growth in Dividends LO3

27. ©2009 McGraw-Hill Ryerson Limited 27 of 34 FIGURE 10B-1 Stock valuation under supernormal growth analysis APP-10B

28. ©2009 McGraw-Hill Ryerson Limited 28 of 34 Valuation of Common Stock Determining the Inputs for the Dividend Valuation Model a)dividends: annual reports or investment web sites b)the required rate of return, K e : * CAPM * K e = yield on long-term Government of Canada bond + risk premium c)growth rate, “g”- historical growth rate in dividends, EPS, revenues per share, or cash flow per share LO4

29. ©2009 McGraw-Hill Ryerson Limited 29 of 34 Valuation of Common Stock Determining the Required Rate of Return from the Market Price The required rate of return consists of 2 things: 1)dividend yield = D 1 /P 0 2)anticipated growth in the future = g LO4

30. ©2009 McGraw-Hill Ryerson Limited 30 of 34 Valuation Using the Price-Earnings Ratio The Price-Earnings (P/E) ratio can also be used to value stocks The P/E ratio is influenced by: – the earnings and sales growth of the firm – the risk (or volatility in performance) – the debt-equity structure of the firm – the dividend policy – the quality of management – a number of other factors In August 2008, the average P/E for the top 300 companies of the Toronto Stock Exchange was 17 to 1. LO5

31. ©2009 McGraw-Hill Ryerson Limited 31 of 34 High vs. Low P/Es A stock with a high P/E ratio: – indicates positive expectations for the future of the company – means the stock is more expensive relative to earnings – typically represents a successful and fast-growing company – is called a growth stock A stock with a low P/E ratio: – indicates negative expectations for the future of the company – may suggest that the stock is a better value or buy – is called a value stock LO5

32. ©2009 McGraw-Hill Ryerson Limited 32 of 34 Your Daily Paper CompanyVolumeHighLowCloseChange Inco 3760 29.15028.50028.600-.400 Stock Name Volume (Total number of shares traded (100s) Close (Last price paid at close of trading) High (Highest price paid per share for the day was $29.15) Low (Lowest price paid per share for the day was $28.50) Change (Difference between today’s price and previous day’s. A $0.40 decrease) Reading Stock Quotations LO3/LO4

33. ©2009 McGraw-Hill Ryerson Limited 33 of 34 Summary and Conclusions Valuation of financial assets – bonds, preferred stock, and common stock – is determined by the present value of future cash flows. The discount rate used in the valuation process is called the rate of return or yield to maturity. The required rate of return is composed of a real rate of return, an inflation premium, and a risk premium.

34. ©2009 McGraw-Hill Ryerson Limited 34 of 34 Summary and Conclusions The price, or current value, of a bond is equal to the present value of interest (or coupon) payments (I t ) over the life of the bond plus the present value of the principal payment (P n ) at maturity. The discount rate used is the yield to maturity (Y). The value of preferred stock is the present value of an infinite stream of level dividend payments. In general, the value of common stock is also the present value of an expected stream of future dividends. However, there are 3 possible scenarios. The price-earnings (P/E) ratio is an easy rule of thumb used to determine the value of a common stock.