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Topic 6

Valuation of Bonds and shares

Learning Objectives

Explain why we need to understand valuation

Give various definitions for the term value

Explain the process of valuing an asset

Understand how to value bonds, preference shares

and ordinary shares

Appreciate the concept of an investors expected rate

of return and be able to compute the expected rate of
return on bonds, preference shares and ordinary
shares

Understand the relationship between a companys

earnings and the value of its ordinary shares

Definitions of value

Book value

Liquidation value

Going-concern value

Market value

Intrinsic value

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Market efficiency and behavioural

finance

An efficient market is a market in which the

value of all assets and securities at any instant
in time fully reflect all available information
market value = intrinsic value

Recall Topic 5

Valuation: The process

Value is determined by three elements:

The investors required rate of

return
Riskiness of these cash flows
Amount and timing of the assets
expected cash flows

Basic factors determining an

assets value

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The basic valuation model

(10- 1)

where Ct = The cash flow to be received in year t

R = The investors required rate of return
V = The intrinsic or present value of an asset

Bond valuation

Bonds pay fixed coupon payments at fixed

intervals and pay the par value at maturity

$I

$I

$I+$M

Simply discount the cash flows at the investors

required rate of return.

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Bond valuation

(10-2)

(10-2a)

where $I
$M
Rb
Vb

= The coupon interest payment in year t

= The maturity value
= The investors required rate of return
= The intrinsic or present value of the bond

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Bond valuation
Example (annual coupon):
Suppose our firm decides to issue 20-year bonds with a
par value of $1,000 and annual coupon payments. The
return on other bonds of similar risk is 12%, so we decide
to offer a 12% coupon interest rate.
What would be a fair price for these bonds?

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Bond valuation
120

120

120

PV ?
0

PV

120

1000
120

19

20

= PMT { [ 1 ( 1 + i ] / i } + FV / ( 1 + i
= 120 x [{ 1 (1.12)-20 } / 0.12] + 1000 / 1.1220
= $1000.00
)-n

)n

or using tables:
PV
= PMT x PVIFAi,n + FV x PVIFi,n
= 120 x PVIFA12%,20 + 1000 x PVIF12%,20
= 120 x 7.469 + 1000 x 0.104
= $1000.28
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Share dividend
The periodic cash flows from an investment in
shares are dividends.
Three possible scenarios for the dividend:
1. Constant Dividend (no growth / zero
growth)
2. Growth in Dividend (constant growth)
3. Variable Dividend Growth
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Preference shares

Are a form of equity

Have no fixed maturity

Investors are paid a fixed dividend

Constant dividend = perpetuity

Can be:

cumulative/non-cumulative

redeemable/irredeemable

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Preference share valuation

Vp = Annual dividend (D)
Required rate of return (Rp)

(10-5)

Example:
XYZ preference shares pay a $4.12 dividend per year. If
our required rate of return on XYZ preference shares is
9.5%, what would we consider a fair price for these shares?
Answer:

Vp = D / Rp
= 4.12 / 0.095
= $43.37

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Valuation of ordinary shares

Variable-income securities

Dividends depend on earnings

Dividend amounts are not fixed

Represent equity or ownership

When valuing ordinary shares, the growth factor, g, is

used
g = ROE x r
where ROE = the return on equity

(10-6)

r = the percentage of company profits retained

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Valuation of ordinary shares

Single holding PV
period
of dividend

VE =

(D1)

VE =

D1
( 1 + RE )

market
+ PV of expected
price (P )
1

P1
( 1 + RE )

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Valuation of ordinary shares

Example:
You expect XYZ shares to pay a $5.50 dividend at the end
of the year. The share price is expected to be $120 at that
time. If you require a 15% rate of return, what would you
pay for the share now?
5.50
120
?

Answer:

VE =

$5.50 + $120
(1 + 0.15) (1+ 0.15)
= $109.13

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Valuation of ordinary shares

Multiple holding periods

(10-7)

Is this model practical?

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Valuation of ordinary shares

Constant growth model
Assumes ordinary dividends will grow at a constant rate
into the future

VE = D1 / (RE - g)
D1
RE
g

(10-9)

= the dividend at the end of year 1

= the required rate of return on ordinary shares
= the constant, annual dividend growth rate

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Valuation of ordinary shares

Example:
XYZ shares recently paid a $5.00 dividend. The dividend is
expected to grow at 10% per year indefinitely. What would
we be willing to pay if our required rate of return on XYZ
shares is 15%?
Answer:

D1 = D0( 1 + g ) = $5.00 x 1.10 = $5.50

VE = D1 / ( RE g ) = $5.50 / ( 0.15 0.10 ) = $110

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Expected rates of return

The discount rate that equates the present value

of the future cash flows with the current market
price

For bondholders:

For preference shareholders:

For ordinary shareholders:

ERR = yield to maturity (YTM)

ERR = dividend yield

ERR = dividend yield + dividend growth rate

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Calculating expected rates of

return
Example (for a preference shareholder):
If we know the preferred share price is $40, and the
preferred dividend is $4, what is the expected return?
Answer:

Substituting in Equation 10-11

Rp = D/ P = $4 / $40 = 0.10 = 10%

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Calculating expected rates of

return
Example (for an ordinary shareholder):
We know a share will pay $3 dividend in one years time,
has a current price of $27, and an expected growth rate for
the future of 5%. What is the markets implied rate of
return?
Answer: Substituting

in Equation 10-9
RE = D1 / P + g
= $3 / $27 + 0.05
= 0.1611
= 16.11%

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Calculating expected rates of return

Example (for a bondholder):
Suppose we paid $898.90 for a $1,000 par 10% coupon
bond with 8 years to maturity and semi-annual coupon
payments.
What is our yield to maturity?
Answer: By trial and Error

i = 6% per 6 months
YTM = 2 x 6 = 12% p.a.

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