Chapter 9: Bond and Stock Valuation

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Business Valuation
Chapter 12
April 6, 2009
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Learning Objectives

• Understand the importance of business valuation.
• Understand the importance of stock and bond
  valuation.
• Learn to compute the value and yield to maturity
  of bonds.
• Learn to compute the value and expected yield on
  preferred stock and common stock.
• Learn to compute the value of a complete business.

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Importance of Business Valuation

• If the basic goal of the firm is to maximize the
  value of the firm, then it is important to be
  able to measure that value
• When a firm contemplates raising money, it needs
  to know the value of its securities so it knows
  how much to issue.
• If you want to invest in a company, its
  important to know if the company is over valued
  or under valued

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General Valuation Model

• To develop a general model for valuing a
  business, we consider three factors that affect
  future earnings
• Size of cash flows
• Timing of cash flows
• Risk associated with receiving the cash

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Total Market Value of a Business

• Present value of current liabilities
• present value of long term debt
• present value of preferred stock
• present value of stockholders equity
• Total value of Business Assets
• (Note the present value of the current
  liabilities is basically the same as their book
  value)

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Bond Valuation Model

• Bond Valuation is an application of time value
  model introduced in chapter 8.
• The value of the bond is the present value of
  the cash flows the investor expects to receive.
• What are the cash flows from a bond investment?

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Bond Valuation Model

• 3 Types of Cash Flows
• Amount paid to buy the bond (PV)
• Coupon interest payments made to the bondholders
  (PMT)
• Repayment of Par value at end of Bonds life (FV).

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Bond Valuation Model

• Discount rate (K)
• Calculator
• n time until maturity
• I/Y k discount rate/cost of capital
• PV value of the bond (Vb)
• PMT coupon interest paid (Int)
• FV par value at maturity

• Bonds time to maturity (N)

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IBM Bond Wall Street Journal Information
Cur Net Bonds Yld Vol Close Chg AMR 6¼24 c
v 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ ¼ IBM 63/8
05 6.6 228 965/8 -1/8
(Close price expressed as a of 1,000. So, 96
5/8 966.25)
Link to Bondtrac Financial Information
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IBM Bond Timeline
63.75
63.75
63.75
63.75
63.75 1000.00
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IBM Bond Timeline
Compute the Value for the IBM Bond given that you
require an 8 return on your investment. In
other words, how much would you be willing to pay
for this bond since the coupon rate is only
6.375)?
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IBM Bond Timeline Calculator Solution
935.12
Bond is selling for 966.25. Would you buy it?
5 8 ? 63.75 1,000
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Most Bonds Pay Interest Semi-Annually
e.g. semiannual coupon bond with 5 years to
maturity, 9 annual coupon rate. Instead of 5
annual payments of 90, the bondholderreceives
10 semiannual payments of 45.
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Most Bonds Pay Interest Semi-Annually
Compute the value of the bond given that you
require a 10 return on your investment. Do not
use the coupon rate!
Since interest is received every 6 months, we
need to use semiannual compounding
Semi-Annual Compounding
10 5 2
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Calculator Solution
961.38
10 5 ? 45 1,000
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Yield to Maturity (IRR)
VB 63.75(PVIFA5, x) 1000(PVIF5,x) Solve for
X by trial and error, and interpolation ugh!
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Yield to Maturity
Calculator Solution

• 7.203

5 ? -966.25 63.75 1,000
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Yield to Maturity (YTM)

• If YTM gt Coupon Rate bond Sells at a DISCOUNT
• If YTM lt Coupon Rate bond Sells at a PREMIUM
• See Saw

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Interest Rate Risk

• Bond Prices fluctuate over Time
• As interest rates in the economy change, required
  rates on bonds will also change resulting in
  changing market prices.

Interest Rates
VB
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Interest Rate Risk
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Valuing Preferred Stock
P0 Value of Preferred Stock
PV of ALL dividends discounted at investors
Required Rate of Return Assume 10.
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Valuing Preferred Stock
Buy?
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Yield (K) on Preferred Stock

• The rate of return (K) an investor would earn if
  they pay the current market price (MP) and
  receive the promised dividends (Div)
• If MP Div / K, then solving for K, we get
• K Div / MP
• If Div is 2.31 and MP is 23.75, then
• K YTM 2.31/23.75 9.73

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Valuing Individual Shares of Common Stock
P0 PV of ALL expected dividends discounted at
investors Required Rate of Return
Not like Preferred Stock since D0 D1 D2
D3 DN , therefore the cash flows are no longer
an annuity.
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Constant Growth Dividend Model
Reduces to
Requires ks gt g
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Constant Growth Dividend Model
What is the value (Price) of a share of common
stock if the most recently paid dividend was
1.14 per share and dividends are expected to
grow at a rate of 7? Assume that you require a
rate of return of 11 on this investment.
1.22 30.50 (what you are willing .04
to pay)
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Yield (Kcs) on Common Stock

• If the Value (price) of a share of common stock
  can be expressed by the equation
• Price D1/(K g), then solving for K we get
• Kcs (D1/Price) g
• So if D1 is 4.80, the stock price is 52.00 net
  and the rate of growth (g) is 4, then
• Kcs 4.80/52.00 .04 .0923 .04 .1323 or
  13.23

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Total Market Value of a Business

• Present value of current liabilities
• present value of long term debt
• present value of preferred stock
• present value of stockholders equity
• Total value of Business Assets
• (Note the present value of the current
  liabilities is basically the same as their book
  value)

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The P/E Valuation Model

• You can use the Price/Earnings ratio to value a
  share of stock if you can determine the P/E ratio
  of the Industry
• Stock Price Industry P/E ratio x EPS
• EPS is earnings per share of the firm
• If projected EPS is 2 and industry P/E is 15,
• The Stock price 2 x 15 30
• Stock price x shares outstanding firm value
• If 10M shares, then x 30 300,000,000

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Other Valuation Methods

• Angel investor investments
• Present value of discounted future cash flows
• Rule of thumb 10 times future earnings