1. Mutual Investment Club of Cornell Week 2: Bonds, Equity and Basic Valuation Sept. 15, 2011

2. Mutual Investment Club of Cornell For today…  Basic Investment Types  Bonds  Equity  Basic Research and Valuation Techniques

3. Mutual Investment Club of Cornell Asset Class: Bonds  Bonds are a type of debt security.  Bondholders receive (usually semi-annual) payments called coupons.  At the bond’s maturity, bondholders receive the Par or Face Value of the debt.

4. Mutual Investment Club of Cornell Primary Asset Types: Bond  A bond typically has a payment schedule that looks like this: PeriodPayment 1$50 2 …… N-1$50 N$1050

5. Mutual Investment Club of Cornell Things to Note about Bonds  Relatively predictable cash inflows (easier to value).  Cash flows are legally guaranteed  Bond-holders fare better in the event of bankruptcy (more on that later)

6. Mutual Investment Club of Cornell Bond Characteristics  Secured/Unsecured: whether payment is backed by assets  Tax status: some government bonds are tax exempt  Callability: Whether or not a bond can be called early by the issuing company

7. Mutual Investment Club of Cornell Bond Ratings  Bongs are rated by three credit rating agencies  Moody’s, S&P and Fitch  The lower a bond rating is, the higher the yield will be  Investors want to be compensated for higher risk, as defined by a lower rating  Countries can also be rated (see US downgrade)

8. Mutual Investment Club of Cornell Time Value of Money  If I have $100 today and can invest it at 5% interest (compounded annually), how much will I have after 1 year? 2 years? 10 years?  $100 * (1 +.05) = $105 (1 year)  $105 * (1 +.05) = $110.25 (2 years)  $100 * (1 +.05) 10 = $162.89 (10 years)  n years?  $100 * (1 +.05) n

9. Mutual Investment Club of Cornell Time Value of Money  Problems like this are known as future value problems. They answer the question “If I have PV dollars today, how much will I have if I invest at interest rate r for n periods.  FV = PV * (1 + r) n

10. Mutual Investment Club of Cornell Time Value of Money  Present Value problems do the opposite: They answer the question “How much money do I need to put away today to have FV dollars in n periods if I can invest at rate r?  PV = FV/(1+ r) n  For a series of cash flows, the formula is:  Σ(CF/(1+ r) t ) = CF 1 /(1 + r) + … + CF T /(1 + r) T

11. Mutual Investment Club of Cornell What does this mean for us?  Using our P = $100, r = 0.05, n = 1 example from earlier, the present value formula tells us that we should be indifferent between receiving $100 today and receiving $105 in one year.  Consequently, the value of a financial asset is the present value of its expected cash flows.

12. Mutual Investment Club of Cornell Example  Suppose I offered you a slip of paper that entitles you to $100 in 1 year, $150 in 2 years, and $50 in 3 years. How much would you be willing to pay for this paper (the interest rate is 5%)?  PV = CF 1 /(1 + r) + CF 2 /(1 + r) 2 + CF 3 /(1 +r) 3  = 100/(1.05) + 150/(1.05) 2 + 50/(1.05) 3  $274.48

13. Mutual Investment Club of Cornell Valuation Example  Use the present value of money  Sum of future cash flows, discounted to today  5 year bond, $50 coupon, interest rate is 5% YearCash FlowPresent Value 150 47.62 250 45.35 350 43.19 450 41.13 51050 822.70 Total 1000

14. Mutual Investment Club of Cornell Valuation Example  What happens if the market interest rate rises to 6%?  5 year bond, $50 coupon, interest rate is 5% YearCash FlowPresent Value 150 47.16 250 44.50 350 41.98 450 39.60 51050 784.62 Total 957.86

15. Mutual Investment Club of Cornell Asset Class: Equity Common Stock  Common stock represents a claim on the profits of the company.  Think of stock as partial ownership in a business  When investing, ask whether you would want to be an owner of the company?  Stock owners assume the risk of the company  If it goes under, they probably won’t get paid

16. Mutual Investment Club of Cornell Asset Class: Equity Common Stock  Common stockholders get paid only if all other claimants are paid first.  Common stockholders are paid in the form of dividends, payments made at the discretion of management.  So the value of a share of common stock is the present value of its expected future dividends.  Some companies prefer return money through stock repurchases.

17. Mutual Investment Club of Cornell Aside on Valuation  The present value of a perpetual (never ending) cash flow is (CF)/r.  The present value of a perpetual cash flow that grows at a rate g every year is (CF)/(r – g).  To value a stock using DCF, we estimate its dividends for five years, then assume a constant growth rate thereafter.

18. Mutual Investment Club of Cornell Profitability Ratios  Helps ensure that a company can clear its expenses  One ratio is profit margin: Net Income/Revenue  Always compare to other similar companies  Watch out for continuous year over year margin declines  May indicate disappearing competitive advantage

19. Mutual Investment Club of Cornell Liquidity Ratios  How quickly a company can turn its assets into cash  Current Ratio: Current Assets/Current Liabilities  Measure of companies ability to pay off liabilities coming due soon  Under 1 may signal trouble in the near future

20. Mutual Investment Club of Cornell Solvency Ratios  How well the company can deal with long term obligations  Total Debt to Total Assets  Short + Long Term Debt/Total Assets  Shows how assets were financed  Through debt or equity  Usually lower is better, but could mean company is passing up growth opportunities

21. Mutual Investment Club of Cornell Valuation Ratios  Attempts to measure how good an investment would be  Price to Earnings (P/E) Ratio  Market Value/Earnings Per Share  How much investors are willing to pay for $1 of current earnings  Higher P/E means higher expected future growth  Best used to compare against other companies

22. Mutual Investment Club of Cornell Valuing Common Stock  PV = D 1 /(1 + r) + D 2 /(1 + r) 2 + D 3 /(1 + r) 3 + D 4 /(1 + r) 4 + (D 5 + P 5 )/(1 + r) 5, where P 5 = D 5 /(r – g) YearCash FlowPresent Value 1D1 D 1 /(1 + r) 2D2 D 2 /(1 + r) 2 3D3 D 3 /(1 + r) 3 4D4 D 4 /(1 + r) 4 5D5 + P5 (D 5 + P 5 )/(1 + r) 5 Present Value Total of above

23. Mutual Investment Club of Cornell Example  We expect dividends to be $3, $5, $10, $12, and $13 in years 1 through 5, with 3% growth thereafter. The interest rate is 8%. After 5 years, we sell. Note: P 5 = 13/(.05) = 260 YearCash FlowPresent Value 13 2.78 25 4.29 310 7.94 412 8.82 513 + 260 185.80 Total 209.62

24. Mutual Investment Club of Cornell Preferred Stock  A special type of equity  Preferred stock carries a fixed interest rate, but the company can choose to not pay it.  However, before common stockholders can receive dividends, preferred stockholders must receive all of their back-dividends.  Preferred stockholders rank above common stockholders in the capital structure.

25. Mutual Investment Club of Cornell The Capital Structure  A company is in default if it has failed to pay its debt obligations on time.  In the event of default and bankruptcy, a company’s assets are liquidated, and entities that have a claim on its assets are paid in this order:  Government  Debt-holders  Equity-holders  Note: within each class there are more layers (Senior debt, junior debt, etc.)

26. Mutual Investment Club of Cornell Next Week  Macroeconomics and Research Reports  Basics of macroeconomics  Industry overviews in reports

27. Mutual Investment Club of Cornell See you next week