Outline of Session Outline of Session 4

Outline of Session 4
Three Basic Valuation Methods
Bond Valuation
Stock Valuation
Factors Affecting Stock Prices
Preferred Stock Valuation
In−class Exercises
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 1 of 19

A Few Words on Valuation
There are three basic valuation methods, namely,
Discounted Cash Flow (DCF) Method
Relative Valuation Method
Contingent−Claim Method
Values of securities rarely stay constant.
Valuation is not a one−time job. Re−valuation is always
needed.
We usually don’t observe the discount rates. We
observe prices instead and infer discount rates from
changes in prices. The return is the discount rate.
In a well−functioning financial market, we can
estimate a discount rate for each type of security of
varying degree of risk.
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 2 of 19

Bonds
Bonds are one type of fixed income security.
Various types of bonds
Government bonds
Corporate bonds
Pure discount (or Zero−coupon) bonds
Console
A typical bond has the following information
on it.
Maturity date
Coupon rate (can be fixed or floating rate)
Frequency of interest payments per year
Face value
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 3 of 19

Bond Valuation
We use the DCF method to value a bond and
get the bond price.
To value a bond, we just discount periodic
interest payments and face value of a bond at
the prevailing market interest rate
appropriate for its risk class.
Bond Price =
Int
1
+
2
( 1 + YTM) ( ) ( ) N
Yield−to−Maturity (YTM) is a discount rate
that solves the above equation.
Int
Bond price and its yield is jointly determined.
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 4 of 19
2
1 + YTM
Int
+ ... +
N
+ Face Value
1 + YTM

Calculation of Bond Price
Example:
A 5−year 5%−coupon government bond is
being issued.
This bond pays interest annually.
Its face value is 100,000 Baht.
The prevailing market interest rate for a
5−year risk−free bond is 5%.
5,000 5,000 5,000 5,000 5,000 + 100,000
Bond Price = + + + +
5
2
3
4
( 1 + 5% ) ( 1 + 5% ) ( 1 + 5% ) ( 1 + 5% ) ( 1 + 5% )
= 100,000 Baht
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 5 of 19

What−if the Interest Rate Changes
If the prevailing market interest rate for a
5−year risk−free bond is 6%, then
5,000 5,000 5,000 5,000 5,000 + 100,000
Bond Price = + + + +
5
2
3
4
( 1 + 6% ) ( 1 + 6% ) ( 1 + 6% ) ( 1 + 6% ) ( 1 + 6% )
= 95,787.64 Baht
If the prevailing market interest rate for a
5−year risk−free bond is 4%, then
5,000 5,000 5,000 5,000 5,000 + 100,000
Bond Price = + + + +
5
2
3
4
( 1 + 4% ) ( 1 + 4% ) ( 1 + 4% ) ( 1 + 4% ) ( 1 + 4% )
= 104,451.82 Baht
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 6 of 19

These curves
are convex.
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 7 of 19

Bond Price Relationship to YTM
When the coupon rate = the market
interest rate (YTM), a bond will sell at
par.
When the coupon rate > the YTM, a
bond will sell at a premium.
When the coupon rate < the YTM, a
bond will sell at a discount.
But why?
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 8 of 19

Interest Rate Risk (or Price Risk)
Interest Rate Risk sometimes is called “Price Risk”.
Investment in bonds (even in a risk−free bond like a
government bond) can be risky due to fluctuation in
the market interest rates.
As you can see, when the market interest rate goes up,
bond price declines, and vice versa, resulting in a gain
or loss.
Notes:
Bond price does not decline in linear fashion.
The longer the maturity of a bond, the greater the
price risk, other things being equal. Why?
The lower the coupon rate of a bond, the greater the
price risk, other things being equal. Why?
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 9 of 19

Common Stock
Common Stock (or just “Stock”) is a security,
which represents ownership in a company.
Owning a stock entitles you to some share of a
company’s profits (or dividends).
Shareholders are last in line to claim against a
company’s assets in the event of bankruptcy.
Investment in stocks therefore is considered
more risky than investment in bonds.
Investment returns in stocks include capital
gains/losses and dividends.
© 2009 Charn Soranakom, Ph.D.
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 10 of 19

Stocks and the Stock Market
Stocks are traded in the stock market.
You need a broker to trade stocks.
Know the differences between
Primary market and Secondary market
Auction market and Dealer market
Capital gains/losses and dividends
Understand
Bids, asks, and prices
P/E and P/B ratios
Dividend yield
Commissions and taxes
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 11 of 19

Stock Valuation
Same DCF concept applies.
To value a stock and get a stock price, you
simply discount expected dividend and stock
price next year at the rate of return
appropriate for its risk class.
For example:
ABC stock will pay 10−Baht dividend next year.
You expect the stock price to be 110 Baht next year.
What should be the current stock price?
P
0
=
Div
1
+
( 1 + r ) ( 1 + r )
S
P
1
10 + 110
=
S
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 12 of 19

P
P
0
1
=
=
Div
1
( 1 + r ) ( 1 + r )
Div
S
2
+
P
1
S
( 1 + r ) ( 1 + r )
S
+
P
2
S
P
P
0
0
1
⎡
⎢
Div
⎣
⎛ Div
2
+ P
+
⎜
⎝ +
S
2
=
=
1
( 1 + r
) ⎜
( 1 r
)
Div
S
1
2
( 1 + r ) ( ) ( ) 2
S
+
Div
1 + r
S
2
+
P
2
1 + r
S
⎞⎤
⎟
⎥
⎠⎦
P
0
=
Div
1
+
+
+ ...
2
3
( 1 + r ) ( ) ( ) ( ) ∞
S
Div
1 + r
S
2
Div
1 + r
S
3
Div
1 + r
S
∞
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 13 of 19

Stock Valuation (cont…)
Case 1: Assuming no growth in dividends
Div1
Div1
P
0
=
r
S
=
r or P
S
Case 2: Assuming a constant growth in dividends (g%)
Div1
Div1
P
0
=
r
S =
+
g
r
−
g or
P
S
Case 3: Assuming a non−constant growth in dividends
P
0
=
Div
1
2
( 1 + r ) ( 1 + r ) ( 1 + r )
S
+
Div
S
2
+ ... +
Div
S
t
t
+
0
0
⎡Div
⎢
⎣ r
t
S
( 1 + g)
−g
( 1 + r ) t
S
⎤
⎥
⎦
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 14 of 19

Where Does g Come From?
Year
1 2 3 4
BV of Equity per Share 100.00 105.00 110.25 115.76
Return on Equity (ROE) 10.00% 10.00% 10.00% 10.00%
Earnings per Share (EPS) 10.00 10.50 11.03 11.58
Payout Ratio 50.00% 50.00% 50.00% 50.00%
Retention Ratio (1−Payout
Ratio) 50.00% 50.00% 50.00% 50.00%
Dividend per Share (DPS) 5.00 5.25 5.51 5.79
Growth Rate in Dividends (g) 5.00% 5.00% 5.00%
Growth Rate in EPS (g) 5.00% 5.00% 5.00%
Growth Rate in Stock Price (g) 5.00% 5.00% 5.00%
Stock Price (assuming PE=20) 200.00 210.00 220.50 231.53
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 15 of 19

Factors Affecting Stocks’ Prices
Change in forecast of earnings and
dividends (EPS and DPS)
Change in forecast of growth (g)
Change in expectation of rate of return
(r S )
Supply and demand
Price manipulation
Psychology factor
Market sentiment
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 16 of 19

Preferred stock
is classified as equity.
Preferred Stock
owner usually cannot vote, but may be allowed to vote if
dividends have not been paid for some time.
(usually) pays fixed dividends as a percentage of par value.
has higher priority of claims against company’s assets and
profits (dividends) over common stock.
dividends can be cumulative or noncumulative.
has characteristics of a debt, but dividend is not
tax−deductible.
is not popular among investors. Therefore, corporations do not
want to issue this type of security.
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 17 of 19

Preferred Stock Valuation
Use DCF method.
Discount preferred dividends at the
appropriate discount rate to obtain the
price of preferred stock.
For example:
XYZ preferred stock pays 1−Baht dividend. If you
discount at 10%, you get a price of 10 Baht per share.
1 1
Preferred Stock Price
+
2
=
( 1 + 10% ) ( 1 + 10% ) ( 1 + 10% )
1
10%
= 10 Baht
+ ... +
=
∞
1
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 18 of 19

In−class Exercises
Let’s do some exercises in class together.
Last Updated: June 11, 2009 © 2009 Charn Soranakom, Ph.D. Session 4 | Slide 19 of 19