BOND VALUATIONS
BOND: A security sold by governments and corporations to raise money from investors today in exchange
for promised future payments
𝒓𝒏 = 𝒀𝑻𝑴𝒏
We often refer to the YTM of the appropriate maturity, zero-coupon risk-free bond
as the risk-free interest rate
2. COUPON BONDS
COUPON BONDS: Pay investors their face value at maturity, and in addition, these bonds make regular
coupon interest payments
• TREASURY NOTES: Original maturities from 1-10 years
• TREASURY BONDS: Original maturities of more than 10 years
Yield To Maturity
YTM: The yield to maturity of a bond is the discount rate that sets the present value of the promised bond
payments equal the current market price of the bond
• The YTM is the per-period rate of return for holding the bond from today until maturity on date n
ZERO-COUPON BONDS
If a bond’s YTM has not changed, then the IRR of an investment in the bond equals the YTM even if you sell
the bond early
COUPON BONDS
Between coupon payments, the prices of all bonds rise at a rate equal to the YTM as the remaining cash
flows of the bond become closer
• As each coupon is paid, the price of the bond drops by the amount of the coupon
THE SENSITIVITY OF A BOND’S PRICE TO CHANGES IN INTEREST RATES DEPENDS ON THE TIMING OF ITS CASH
FLOWS
• Shorter-maturity zero-coupon bonds are less sensitive to changes in interest rates than are longer-
term zero-coupon bonds
• The sensitivity of a bond’s price to changes in interest rates is measured by the bond’s duration –
Bonds with high durations are highly sensitive to interest rate changes
IF PRICE OF COUPON BOND WERE HIGHER… IF PRICE OF COUPON BOND WERE LOWER…
SELL COUPON BOND BUY COUPON BOND
BUY ZERO-COUPON BOND SHORT SELL ZERO-COUPON BOND
COUPONS WITH THE SAME MATURITY CAN HAVE DIFFERENT YIELDS DEPENDING ON THEIR COUPON RATES
• As the coupon increases, earlier cash flows become relatively more important than later cash flows
in the calculation of the present value
CORPORATE BONDS
CORPORATE BONDS: Bonds issued by corporations
• Issuer may default
• CREDIT RISK: The risk of default means that the bond’s cash flows are not known with certainty
THE BOND’S EXPECTED RETURN, WHICH IS EQUAL TO THE FIRM’S DEBT COST OF CAPITAL, IS LESS THAN THE YTM
IF THERE IS A RISK OF DEFAULT
• Moreover, a higher YTM does not necessarily imply that a bond’s expected return is higher
• Note that the bond’s price decreases, and its YTM increases, with the greater likelihood of default
Bond Ratings
The rating depends on the risk of bankruptcy as well as the bondholders’ ability to lay claim to the firm’s
assets in the event of such a bankruptcy
• Thus, debt issues with low-priority claim in bankruptcy will have a lower rating than issues from the
same company that have a high-priority claim in bankruptcy or that are backed by a specific asset
such as a building or a plant
• EG: Investment-grade bonds, speculative bonds, junk bonds, high-yield bonds
STOCK VALUATION
THE LAW OF ONE PRICE IMPLIES: The price of a security should equal the present value of the expected cash
flows an investor will receive and the appropriate cost of capital with which to discount those cash flows
STOCK PRICE
𝑫𝑰𝑽𝟏 + 𝑷𝟏
𝑷𝟎 =
𝟏 + 𝒓𝑬
A Multiyear Investor
As a two-year investor, we care about the dividend and the stock-price in year 2
• Does this imply that a two-year investor will value the stock differently than a one-year investor?
• No – They care about the stock price in year 2 indirectly
o These prices will affect the price for which she can sell the stock at the end of year 1
o Suppose the investor sells the stock to another one-year investor with the same beliefs
o The investor will expect to receive the dividend and the stock price at the end of year 2, so
he will be willing to pay the present value of those cash flows
STOCK PRICE
𝑫𝑰𝑽𝟏 𝑫𝑰𝑽𝟐 + 𝑷𝟐
𝑷𝟎 = +
𝟏 + 𝒓𝑬 (𝟏 + 𝒓𝑬 )𝟐
Dividend-Discount Model
𝑫𝑰𝑽𝟏 𝑫𝑰𝑽𝟐 𝑫𝑰𝑽𝟑 𝑫𝑰𝑽𝒏
𝑷𝟎 = + 𝟐
+ 𝟑
+ ⋯+
𝟏 + 𝒓𝑬 (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )𝒏
The price of the stock is equal to the present value of the expected future dividends it will pay
Dividend Yields, Capital Gains & Total Returns
Capital Gains
Yield
TOTAL Return
𝑫𝑰𝑽𝟏 + 𝑷𝟏 𝑫𝑰𝑽𝟏 𝑷𝟏 − 𝑷𝟎
𝒓𝑬 = − 𝟏 = +
𝑷𝟎 𝑷𝟎 𝑷𝟎
Dividend Yield
DIVIDEND YIELD: The percentage return the investors expects to earn from the dividend paid by the stock
CAPITAL GAINS YIELD: The capital gain the investor will earn on the stock
TOTAL RETURN
TOTAL RETURN: The total return is the expected return that the investor will earn for one-year investment in
the stock
THE EXPECTED TOTAL RETURN OF THE STOCK SHOULD EQUAL THE EXPECTED RETURN OF OTHER INVESTMENTS
AVAILABLE IN THE MARKET WITH EQUIVALENT RISK
• Firms must pay its shareholders a return commensurate with the return they can earn elsewhere
while taking the same risk
• If the stock offered a higher return than other securities with the same risk, investors would sell those
other investments and buy the stock instead
o This activity would drive up the stock’s current price, lowering its dividend yield and capital
gain rate
According to the constant dividend growth model, the value of the firm depends on the dividend
level for the coming year, divided by the equity cost of capital adjusted by the expected growth
rate of dividends
DIVIDEND PAYOUT RATE: The fraction of its earnings that the firm pays as dividends each year
By investing cash today, a firm can increase its future dividends. If all increases in future earnings result
exclusively from new investment made with retained earnings, then:
𝑪𝑯𝑨𝑵𝑮𝑬 𝑰𝑵 𝑬𝑨𝑹𝑵𝑰𝑵𝑮𝑺
𝑬𝑨𝑹𝑵𝑰𝑵𝑮𝑺 𝑮𝑹𝑶𝑾𝑻𝑯 𝑹𝑨𝑻𝑬 =
𝑬𝑨𝑹𝑵𝑰𝑵𝑮𝑺
If the firm chooses to keep its dividend payout rate constant, then the growth in dividends will equal growth
of earnings
PROFITABLE GROWTH
A firm can INCREASE ITS GROWTH RATE BY RETAINING MORE OF ITS EARNINGS
• However, if the firm retains more earnings, it will be able to pay out less of those earnings, and will
have to reduce dividends
• If a firm wants to increase its share price, should it cut its dividend and invest more, or should it cut
investment and increase its dividend?
o The answer will depend on the profitability of the firm’s investments
o The effect of cutting the firm’s dividend to grow crucially depends on the RETURN ON NEW
INVESTMENT
CUTTING THE FIRM’S DIVIDEND TO INCREASE INVESTMENT WILL RAISE THE STOCK PRICE IF, AND ONLY IF, THE
NEW INVESTMENTS HAVE A POSITIVE NPV
CHANGING GROWTH RATES
The price of the stock is equal to the present value of the expected future dividends it will pay
TOTAL PAYOUT MODEL: Values ALL of the firm’s equity, rather than a single share
• Discount the total payouts that the firm makes to shareholders, which is the total amount spent on
both DIVIDENDS and SHARE REPURCHASES
• Then, we divided by the current number of shares outstanding to determine the share price
We can apply the same simplifications that we obtained by assuming constant growth in the dividend
discount model
• The only change is that we discount total dividends and share repurchases and use the growth rate
of total earnings (Rather than earnings per share) when forecasting the growth of the firm’s total
payouts
3. DISCOUNTED FREE CASH FLOW MODEL
DISCOUNTED CASH FLOW MODEL: Begins by determining the total value of the firm to all investors – both
equity AND debt holders
• The advantage of the discounted free cash flow model is that it allows us to value a firm without
explicitly forecasting its dividends share repurchases, or its use of debt
NET INVESTMENT: Investment intended to support the firm’s growth, above and beyond the level needed to
maintain the firm’s existing capital
Net Investment
𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 = 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔 − 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏
ENTERPRISE VALUE: The value of the firm’s underlying business, unencumbered by debt and separate
from any cash or market
• The net cost of acquiring the firm’s equity, taking its cash, paying off all debt and thus owning the
unlevered business
Enterprise Value
𝑬𝑵𝑻𝑬𝑹𝑷𝑹𝑰𝑺𝑬 𝑽𝑨𝑳𝑼𝑬 = 𝑴𝑨𝑹𝑲𝑬𝑻 𝑽𝑨𝑳𝑼𝑬 𝑶𝑭 𝑬𝑸𝑼𝑰𝑻𝒀 + 𝑫𝑬𝑩𝑻 − 𝑪𝑨𝑺𝑯
WACC: The average cost of capital the firm must pay to all of its investors, both debt and equity holders
Often, the terminal value is estimated by assuming a constant long-run growth rate gFCF for Free
Cash flows beyond year N, so that:
𝑭𝑪𝑭𝑵 𝟏 + 𝒈𝑭𝑪𝑭
𝑽𝑵 = =' + 𝒙 𝑭𝑪𝑭𝑵
𝒓𝑾𝑨𝑪𝑪 − 𝒈𝑭𝑪𝑭 𝒓𝑾𝑨𝑪𝑪 − 𝒈𝑭𝑪𝑭
𝑽𝟎 + 𝑪𝒂𝒔𝒉𝟎 − 𝑫𝒆𝒃𝒕𝟎
𝑷𝟎 =
𝑺𝒉𝒂𝒓𝒆𝒔 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈𝟎
A Comparison Of Discounted Cash Flow Models Of Stock Valuation
Valuations
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑭𝒊𝒓𝒎 = 𝑽𝒂𝒍𝒖𝒆 𝑶𝒇 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔 + 𝑪𝒂𝒔𝒉
VALUATION MULTIPLES
VALUATION MULTIPLE: The ratio of the value to some measure of the firm’s scale
• We can adjust for differences in scale between firms by expressing their value in terms of a valuation
multiple
PRICE-TO-EARNINGS MULTIPLE
P/E RATIO: A firm’s P/E ratio is equal to the share price divided by its earnings per share
• When you are buying a stock, you are buying the rights to a firm’s future earnings
• Because differences in the scale of the firms’ earnings are likely to persist, you should be willing to
pay proportionally more for a stock with higher current earnings
𝑺𝒉𝒂𝒓𝒆 𝑷𝒓𝒊𝒄𝒆
𝑷⁄𝑬 𝑹𝑨𝑻𝑰𝑶 =
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆
FORWARD P/E: The P/E multiple computed based on its forward earnings (Expected earnings over the next
12 months)
• For valuation purposes, the forward P/E is generally preferred, as we are most concerned about
future earnings
TRAILING P/E: A firm’s trailing P/E is computed using its trailing earnings (earnings over the period 12 months)
To interpret the P/E multiple, consider the stock price formula for the case of constant dividend growth:
𝑷𝟎 = 𝑫𝒊𝒗𝟏/(𝒓𝑬 – 𝒈)
𝑫𝒊𝒗𝟏
𝑷𝟎 𝑬𝑷𝑺𝟏 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑷𝒂𝒚𝒐𝒖𝒕 𝑹𝒂𝒕𝒆
𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑷 𝑬 = = =
𝑬𝑷𝑺𝟏 𝒓𝑬 − 𝒈 𝒓𝑬 − 𝒈
• This implies that if two stocks have the same payout and EPS growth rates, as well as equivalent risk
(and therefore the same equity cost of capital), then they should have the same P/E
• It shows that firms and industries with high growth rates, and that generate cash well in excess of
their investment needs so that they can maintain high payout rates, should have high P/E multiples
𝑬𝒏𝒕𝒆𝒓𝒑𝒓𝒊𝒔𝒆 𝑽𝒂𝒍𝒖𝒆
𝑬𝑽⁄𝑬𝑩𝑰𝑻 =
𝑬𝑩𝑰𝑻
𝑬𝒏𝒕𝒆𝒓𝒑𝒓𝒊𝒔𝒆 𝑽𝒂𝒍𝒖𝒆
𝑬𝑽⁄𝑬𝑩𝑰𝑻𝑫𝑨 =
𝑬𝑩𝑰𝑻𝑫𝑨
𝑬𝒏𝒕𝒆𝒓𝒑𝒓𝒊𝒔𝒆 𝑽𝒂𝒍𝒖𝒆
𝑬𝑽⁄𝑭𝑪𝑭 =
𝑭𝑪𝑭
ENTERPRISE VALUE TO EBITDA MULTIPLES: Because capital expenditures can vary substantially from period to
period (EG: A firm may need to add capacity and build a new plant one year, but then not need to
expand further for many years), most practitioners rely on EV/EBITDA multiples
• As with P/E multiples, this multiple is higher for firms with high growth rates and low capital
requirements (so that FCF is high in proportion to EBITDA)
𝑽𝟎 𝑭𝑪𝑭𝟏 /𝑬𝑩𝑰𝑻𝑫𝑨𝟏
=
𝑬𝑩𝑰𝑻𝑫𝑨𝟏 𝒓𝑾𝑨𝑪𝑪 − 𝒈𝑭𝑪𝑭
LIMITATIONS OF MULTIPLES
1. FIRMS ARE NOT IDENTICAL
• The usefulness of a valuation multiple will depend on the nature of the differences between the
firms and the sensitivity of the multiples to these differences
• The differences in these multiples are most likely due to differences in their expected future
growth rates, profitability and risk (And therefore cost of capital)
2. COMPARABLES ONLY PROVIDE INFORMATION REGARDING THE VALUE OF THE FIRM RELATIVE TO THE
OTHER FIRMS IN THE COMPARISON SET
• Using multiples will not help us determine if an entire industry is overvalued
• The market to book value for most successful firms substantially exceeds 1 – This indicates the value
of the firm’s assets when put to use exceeds their historical cost
o This is one way a company’s share price provides feedback to its managers on the market’s
assessment of their decisions
• VALUE STOCKS: Low market-to book ratios
• GROWTH STOCKS: High market-to-book ratios
Enterprise Value
ENTERPRISE VALUE: The enterprise value of a firm assesses the value of the underlying business assets,
unencumbered by debt and separate from any cash and marketable securities
Retained Earnings
RETAINED EARNINGS: The difference between a firm’s net income and the amount it spends on dividends
• Also: The retention ratio x net income
Profitability Ratios
Gross Margin
GROSS MARGIN: The ratio of gross profits to revenues (Sales)
• A firm’s gross margin reflects its ability to sell a product for more than the cost of producing it (Only
taking into account the COGS of the product)