3. Investment Planning. 8. Valuation of Bonds and Stocks Flashcards
Some people believe that everything there is to know about a company is reflected in its securities trading prices in the secondary market. This is known as the Efficient Market Hypothesis (EMH), which states that all information about an investment is known to the market. These people would probably purchase index securities such as index funds or exchange traded funds because they do not believe that there is any way to beat the market.
However, there is also a significant amount of people who believe that they can discover and exploit mispriced securities. They believe that there is an intrinsic value in each security that when compared to the market price, may present an opportunity to make a profit, or earn returns greater than the market. These investors apply a variety of valuation methods to calculate the intrinsic value of securities. They would likely buy stocks based on their own research or purchase mutual funds when they believe the fund’s investment strategy will provide better returns than the market.
The Valuation of Bonds and Stocks module, which should take approximately four hours to complete, will explain various valuation methods that are used to identify the value of stocks and bonds.
Upon completion of this module, you should be able to:
* Define and calculate capitalized earnings,
* Define and calculate the intrinsic value of a security,
* List, compare, and contrast various dividend growth models, and
* List and define various ratio analyses.
According to the efficient market hypotheses (EMH), various forms of security analysies are futile at the different levels of market efficiency. List the 3 forms and dismisses.
- Weak Form - Technical Analysis
- Semi-Strong Form - Both Technical and Fundamental Analysis
- Strong Form - All analysis futile, including insider information
Module Overview
Beyond time value of money concepts, financial ratios can be used to support the valuation of stocks. These financial ratios reveal certain statistics about a company’s stock that can be used for trend analysis by comparing them to historic, industry benchmark or competitor data.
This module focuses on how to make an investment decision based on the valuation of bonds and stocks.
To ensure that you have a solid understanding of the valuation of bonds and stocks, the following lessons will be covered in this module:
* Capitalization of Income (Bond)
* Capitalization of Income (Stock)
* Dividend Growth Models
* Price/Earnings Models
* Three Stage Dividend Discount Model
* Ratio Analysis
What does a positive and negative NPV mean?
If the intrinsic value – purchase price = a positive number (or if NPV > 0), then the bond is underpriced or undervalued and the bond should be purchased.
If the intrinsic value – purchase price = a negative number (or if NPV < 0), then the bond is overpriced or overvalued and the bond should not be purchased.
Section One Summary
We have learned how the capitalization of income valuation method is used to identify underpriced and overpriced bonds. Using the time value of money equations, we can determine the promised yield to maturity. We can determine the net present value of the bond using the required rate of return of an ideal yield to maturity. If the net present value of the bond is positive, then it is worthwhile to invest in the bond. The valuation assessment can be completed when the investor is determining what he or she thinks should be the appropriate yield to maturity or required rate of return.
In this lesson, we have covered the following:
* Yield-to-maturity can be calculated for a bond if the current market price and promised cash flows of the bond are given. The investor can then compare it with an appropriate discount rate.
* Intrinsic Value is the present value of the bond discounted by the appropriate yield to maturity or required rate of return. The value is compared to the market price of the bond to determine the net present value of a bond.
* Required Rate of Return also called the appropriate yield to maturity, is determined through a thorough study of the characteristics of a bond issue.
Brian is considering purchasing a 10-year, 5.5% Treasury Note with a $10,000 par value. If the Treasury yield curve indicates that 6% is the appropriate yield for such bonds, what is the fair market value of this bond, assuming annual payments?
* $9,632.00
* $10,000.00
* $10,897.78
* $8,655.12
$9,632.00
* PV = $550(PVIFA 5.5%,10) + $10,000 (PVIF 5.5%,10) or 10000 FV, 550 PMT, 10N, 6 I, PV = $9,632.00.
Brian is considering a bond maturing in 10 years with a coupon rate of 7.5% and a $1,000 par value that is selling for $978.33. If his analysis determined that the appropriate annual YTM for the bond should be 7%, what is the net present value of this bond? (Coupon is paid twice per year.)
* $57.20
* -$57.20
* 7.82%
* $1,035.53
$57.20
* The promised YTM should be $978.33 = $37.50(PVIFA 2y, 20) +$1,000(PVIF 2y, 20) = 7.82% annually, which is greater than 7%; this is an indication that the bond is undervalued and the NPV will be positive. To solve this problem you need to resolve the following: n = 20 (10 years x 2 semi-annual compounding) i = 3.5 (7% / 2 semi-annual compounding) PMT = $37.50 ($1,000 par x 7.5% coupon = $75 yearly / 2 semi-annualpayments) FV = $1,000 PV = ($1,035.53) Therefore, NPV = $1,035.53 - $978.33 = $57.20. The NPV is positive; therefore, the bond is undervalued.
Consider a bond that is currently selling for $950 and has a remaining life of three years. The bond makes annual coupon payments amounting to $60 per year and has a par value of $1,000, or C1 = $60, C2 = $60, and C3 = $1,060 (= $1,000 + $60). Suppose the appropriate YTM for this bond is 9%. What would be its intrinsic value?
* $950.00
* $1,000.00
* $924.06
* -$25.94
$924.06
* PV $60 (PVIFA 9%,3) + $10,000 (PVIF 9%,3) or, using a financial calculator, 1000 FV, 60 PMT, 3 N, 9 I, PV = $924.06. Note that - $25.94 is the net present value of the bond, or the difference between the value of the bond and the purchase price. (NPV = V-P). Therefore, this bond is overpriced and should not be bought.
Section 2 - Capitalization of Income (Stock)
When you purchase a share of common stock, you receive dividend payments whenever they are declared, and then at some point in the future you generally sell the stock. Where does that price you are going to get when you sell your common stock come from? Well, it’s based on the future dividend payments the buyer expects while the stock is held plus some capital gains. Therefore, the value of a share of stock should be the present value of its future dividends. The difference between using the Capitalization of Income for stocks versus bonds is that the cash flows for a stock are unknown and there is no maturity date where the principal (par value) is returned to the investor. Companies can pay out dividends forever, because common stock has no termination date.
To ensure that you have a solid understanding of capitalization of income (stock), the following topics will be covered in this lesson:
* Net present value
* Internal rate of return
* Application to common stocks
Upon completion of this lesson, you should be able to:
* Calculate net present value,
* Compute internal rate of return, and
* Determine the value of common stocks.
PRACTITIONER ADVICE
Please note that different financial authors may use different terms for the same concept. While the author from the original textbook uses stock valuation terms of Net Present Value and Internal Rate of Return for the dividend discount models, the current textbook’s author uses contemporary terms of intrinsic value and expected return.
Section 2 – Capitalization of Income (Stock) Summary
When comparing the capitalization of income between bonds and stocks, you will notice that for stocks, not only is the discount rate an uncertainty, but the time to maturity and the cash flow amount are unknown as well. However, if research does come up with these variables, it is possible to calculate Net Present Value (NPV) and Internal Rate of Return (IRR). This enables comparisons between intrinsic value and prevailing price in order to see if the investment is favorable.
In this lesson we have covered the following:
* Capitalization of income for stocks applies present value concepts to determine the present value of the future cash flows, namely the dividends.
* Net present value difference between the present value of the future inflows, less the purchase price of the investment.
- Internal rate of return is a method of making capital budgeting decisions. The IRR is computed by calculating the discount rate by setting the NPV to zero. If the IRR is greater than the required rate of return or the market capitalization rate, the investment is favorable.
- Application to common stock when using the capitalization of income to determine the intrinsic value of common stocks, dividend amounts replace cash flows.
- Market capitalization rate can be used as the appropriate discount rate for stocks when determining intrinsic value. The capital asset pricing model is used to identify the market capitalization rate. It is the total of the risk-free rate, plus the market risk premium, as well as the security’s individual risk premium.
The internal rate of return is sometimes referred to as:
* Risk-adjusted return
* Implied return
* Alpha return
* Implicit return
Implied return
* The present value of expected dividends can be calculated for a given required rate of return. However, many investment firms use a computerized trial and error procedure to determine the discount rate that equates the present value of the stock’s expected dividends with its current price. Sometimes this long-run internal rate of return is referred to as the security’s implied return.
Alta Cohen is considering buying a machine to produce baseballs. The machine costs $10,000. With the machine, Alta expects to produce and sell 1,000 baseballs per year for $3 per baseball, net of all costs. The machine’s life is five years, with no salvage value. On the basis of these assumptions and an 8% discount rate, what is the net present value of Alta’s investment?
* $1878.13
* $1979.13
* $1978.13
* $1089.13
$1978.13
* The first step is to establish a cash flow line: Time / Cash Flows 0 / (10,000) 1 / 3,000 2 / 3,000 3 / 3,000 4 / 3,000 5 / 3,000
* Keystrokes: 10000 CHS g CFo 3000 g CFj 5 g Nj 8 i f NPV
* The Calculator Returns: 1,978.13
* The Project should be accepted since the NPV is positive.
A stock investment has a market capitalization rate of 11% and an internal rate of return of 10%. Which of the following statements is true?
* The stock has a positive NPV
* The stock has a negative NPV
* The stock is a favorable investment
* The stock is an unfavorable investment
The stock is an unfavorable investment
* Since k^ is less than k, or the IRR is less than the appropriate discount rate, the stock is an unfavorable investment. There is not enough information to determine whether or not the net present value is positive or negative.
Section 3 - Dividend Growth Models
Capitalization of income for stocks is dependent on the ability to estimate future cash flows, which, because dividends aren’t known until they’re declared, is an almost unmanageable task. If the company does poorly, it won’t pay dividends. If the company does well, it will usually pay dividends. In effect, we know how stocks should be valued, but we have a very difficult time implementing this valuation process.
Different types of dividend discount models (DDMs) reflect different sets of assumptions about dividend growth rates. Investors typically make certain simplifying assumptions about the growth of common stock dividends. For example, a common stock’s dividends may be assumed to exhibit zero growth or growth at a constant rate. Assumptions that are more complex allow for multiple growth rates over time.
These are the different types of usable DDMs:
* Zero-growth Model
* Constant-growth Model
* Multiple-growth Model
Upon completion of this lesson, you should be able to:
* Enumerate and explain the different dividend discount models,
* Compare NPV and IRR in each DDM, and
* Compare the relationship of the constant growth model with the zero growth model.
Mountainside Electric Company is expected to pay cash dividends amounting to $2 per share into the indefinite future and has a required rate of return of 10%. If the market price for the stock is currently $18.50 per share, identify the correct valuation.
* Overvalued
* Undervalued
* Fairly priced
Undervalued
* V = $2.00 ÷ 0.10 = $20.
* Since the price of the share is trading currently at $18.50, Mountainside Electric Company stock is undervalued by $1.50 per share, according to the zero growth dividend model.
Kelley Promotions, Inc paid a $1 per share dividend last year. Kelley Promotions is expected to grow the dividend at a rate of 4% per year indefinitely. Assuming a required rate of return of 8%, what is the value of the Kelley Promotions, Inc. stock? How would that compare to its current price of $29? Click all that apply.
* Fairly priced
* V=$26
* V=$27
* Undervalued
* Overvalued
* V=$28
V=$26
Overvalued
* V=$1(1+.04)/(.08-.04)=$26. $29-$26=$3.
* The stock is $3 overvalued.
Describe the Multiple Growth Model
A more general DDM for valuing common stocks is the multiple-growth model. With this model, the focus is on a time in the future (denoted by T), after which dividends are expected to grow at a constant rate (g).
Valuing a share of common stock with the multiple-growth model requires that the present value of the forecast stream of dividends be determined. This process can be facilitated by dividing the expected dividend stream into two parts:
* finding the present value of each part, and
* adding these two present values together.
The first part consists of finding the present value of all the forecast dividends that will be paid up to and including time T, and denoting this present value by VT. The second part consists of finding the present value of all the forecast dividends that will be paid after time T and involves the application of the constant-growth model.
The value of the stock = V = VT- + VT+
V=∑Tt=1Dt(1+k)t+Dt+1(k−g)(1+k)T
The two-stage model assumes that a constant growth rate (g1) exists only until some time (T), when a different growth rate (g2) is assumed to begin and continue thereafter.
Practitioner Advice: Economic conditions and company forecasts are constantly changing. As a result, valuation methods that offer flexibility in company growth projections are especially valuable. The most useful of the dividend discount models, therefore, is the two-stage model because it is the only one that allows for a fast growth phase where g > k, followed by a “normal” phase where k > g.
Exam Tip: Here’s the typical fact pattern for Multi-Stage Dividend Discount Model questions:
A client owns a stock paying a certain dividend rate, which changes to another (constant) dividend rate in the future. A time frame and the client’s required rate of return will be provided. From there, you will be asked to calculate the valuation of the stock based on the dividend payments and, possibly, use a valuation result to determine whether a stock is overvalued or undervalued in the market.
As the name of the calculation states, there are many steps to conduct as you work toward a solution. Know that breaking the problem into three, smaller problems, makes the calculation more manageable and easier to understand.
Section 3 - Dividend Growth Models Summary
An investor can determine if a stock is undervalued, overvalued, or trading at fair market value with fundamental analysis. The analysis is done by applying the concept of intrinsic value, which is possible if all the information regarding a corporation’s future anticipated growth, sales figures, cost of operations, industry structure and other things are available and examined. The resulting analysis then provides the resulting value of the stock. The dividend models such as zero growth, constant growth, multiple growths, two- and three-stage growth models enable the investor to make the decision of buying or selling the stock.
However, we must predict what will happen to dividends in the future to use dividend discount models. Unfortunately, this means that the answers we get from our valuation formula won’t be overly reliable. In other words, because the assumptions we make might not be accurate, our conclusions might not be accurate. However, this method is still valuable for the insights and implications it yields as to what determines and affects stock prices.
In this lesson, we have covered the following:
* Zero Growth Model is based on the assumption that future dividends will remain at a fixed dollar amount.
* Constant Growth Model assumes that dividends will grow from period to period at the same rate forever.
* Multiple Growth Model focuses on a time in the future when the business reaches maturity and after which dividends are expected to grow at a constant rate.
* Two- and Three-stage Models assume that a constant growth rate exists until time T when a different growth rate begins and continues thereafter.
Spring Valley Bedding stock currently sells for $53 per share. The stock’s dividend is expected to grow at 6% per year indefinitely. Spring Valley just paid a dividend of $3 per share. What would be the stock’s internal rate of return?
* 13%
* 12%
* 11%
* 10%
12%
* Assuming that a stock is fairly valued if its dividend is growing at a constant rate, the internal rate of return can be found by solving the intrinsic value equation for k * = (D2/V)+g = [($3X 1.06)/ $53] + 0.06 = .12 or 12%.
A&B Company paid dividends amounting to $.75 per share. Over the next year, it is expected to pay dividends of $2 per share. The year after that, dividends are expected to amount to $3 per share. At this time, the forecast is that dividends will grow by 10% per year indefinitely, indicating that T = 2 and g = 10%. With a current stock price of $55 per share and a required rate of return on the company’s shares of 15%, what is the NPV of the A&B Co.’s shares?
* $1.08
* -$1.08
* $4.01
* $3.30
-$1.08
* DT+1 = D3 = $3(1 + 0.10) = $3.30. VT- = $2/(1+.15)^1 + $3/(1+0.15)^2 = $4.01. VT+ = $3.30/(0.15-0.10)(1+0.15)^2= $49.91. V = $4.01 + $49.91 = $53.92. With a current stock price of $55 per share, NPV = -$1.08. The company appears to be fairly priced. That is, A&B Co. is not significantly mispriced because V and P are nearly of equal size.
Match the correct model and description.
Zero-growth Model
Constant-growth Model
Multiple-growth Model
* Dividend will have different amounts until time T, then it will have the same growth rate forever.
* Dividend will grow at the same rate forever.
* Dividend will remain the same amount forever.
- Zero-growth Model - Dividend will remain the same amount forever.
- Constant-growth Model - Dividend will grow at the same rate forever.
- Multiple-growth Model - Dividend will have different amounts until time T, then it will have the same growth rate forever.
