Topic # 2

STOCK AND BOND

VALUATION
Strategic Financial Management

Stock Valuation
The process of calculating the fair market value of a stock by using a
predetermined formulas that factors in various economic indicators. Stock
valuation can be calculated using a number of different methods. The most
common methods used are the discounted cash flow method, the P/E method,
and the Gordon model. Whichever method is chosen must be done accurately
so that the price of stock can be valued properly.
Bond Valuation
The fundamental principle of bond valuation is that the bond's value is equal
to the present value of its expected (future) cash flows. The valuation process
involves the following three steps:
1. Estimate the expected cash flows.
2. Determine the appropriate interest rate or interest rates that should be used
to discount the cash flows.
3. Calculate the present value of the expected cash flows found in step one by
using the interest rate or interest rates determined in step two.

Common Stock
Common stock is a form of corporate equity ownership, a type of security. The
terms "voting share" or "ordinary share" are also used frequently in other parts
of the world; "common stock" being primarily used in the United States.
It is called "common" to distinguish it from preferred stock. If both types of
stock exist, common stock holders cannot be paid dividends until all preferred
stock dividends are paid in full.
In the event of bankruptcy, common stock investors receive any remaining
funds after bondholders, creditors (including employees), and preferred stock
holders are paid. As such, common stock investors often receive nothing after a
bankruptcy.
Shareholders' rights

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Common stock usually carries with it the right to vote on certain matters, such
as electing the board of directors. However, a company can have both a "voting"
and "non-voting" class of common stock.
Holders of voting common stock are able to influence the corporation through
votes on establishing corporate objectives and policy, stock splits, and electing
the company's board of directors. Some holders of common stock also receive
preemptive rights, which enable them to retain their proportional ownership in
a company should it issue another stock offering. There is no fixed dividend
paid out to common stock holders and so their returns are uncertain,
contingent on earnings, company reinvestment, and efficiency of the market to
value and sell stock.
Classification
Common stock is classified to differentiate the founders' share from publicly
held stock. 'Class A' is frequently used to designate the publicly held portion of
the firm's common stock, while 'Class B' is used for the founders' share. Class
B share usually holds more voting rights, sometimes 10 votes per share
compared to 1 vote per share; the standard for Class A share.
Ordinary shares
Ordinary shares are also known as equity shares and they are the most
common form of share in the UK. An ordinary share gives the right to its owner
to share in the profits of the company (dividends) and to vote at general
meetings of the company. The residual value of the company is called common
stock. A voting share (also called common stock or an ordinary share) is a share
of stock giving the stockholder the right to vote on matters of corporate policy
and the composition of the members of the board of directors.
Preferred Stock
A class of ownership in a corporation that has a higher claim on its assets and
earnings than common stock. Preferred shares generally have a dividend that
must be paid out before dividends to common shareholders, and the shares
usually do not carry voting rights.

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Preferred stock combines features of debt, in that it pays fixed dividends, and
equity, in that it has the potential to appreciate in price. The details of each
preferred stock depend on the issue.
Features
Preferred stock is a special class of shares which may have any combination of
features not possessed by common stock. The following features are usually
associated with preferred stock:

Preference in dividends

Preference in assets, in the event of liquidation

Convertibility to common stock.

Callability, at the option of the corporation

Nonvoting

Preference in Dividends
In general, preferred stock has preference in dividend payments. The preference
does not assure the payment of dividends, but the company must pay the
stated dividends on preferred stock before paying any dividends on common
stock.
Preferred stock can be cumulative or noncumulative. A cumulative preferred
requires that if a company fails to pay a dividend (or pays less than the stated
rate,) it must make up for it at a later time. Dividends accumulate with each
passed dividend period (which may be quarterly, semi-annually or annually).
When a dividend is not paid in time, it has "passed"; all passed dividends on a
cumulative stock make up a dividend in arrears. A stock without this feature is
known as a noncumulative, or straight, preferred stock; any dividends passed
are lost if not declared.
Other Features or Rights

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Preferred stock may or may not have a fixed liquidation value (or par
value) associated with it. This represents the amount of capital which
was contributed to the corporation when the shares were first issued.

Preferred stock has a claim on liquidation proceeds of a stock corporation

equal to its par (or liquidation) value, unless otherwise negotiated. This
claim is senior to that of common stock, which has only a residual claim.

Almost all preferred shares have a negotiated, fixed-dividend amount.

The dividend is usually specified as a percentage of the par value, or as a
fixed amount

Some preferred shares have special voting rights to approve

extraordinary events (such as the issuance of new shares or approval of
the acquisition of a company) or to elect directors, but most preferred
shares have no voting rights associated with them; some preferred shares
gain voting rights when the preferred dividends are in arrears for a
substantial time. This is all variable on the rights assigned to the
preferred shares at the time of incorporation.

The above list (which includes several customary rights) is not comprehensive;
preferred shares (like other legal arrangements) may specify nearly any right
conceivable. Preferred shares in the U.S. normally carry a call provision,
enabling the issuing corporation to repurchase the share at its (usually limited)
discretion.
Advantages of Preference Shares
1. No obligation for dividends: A company is not bound to pay dividend on
preference shares if its profits in a particular year are insufficient. It can
postpone the dividend in case of cumulative preference shares also. No
fixed burden is created on its finances.
2. No interference: Generally, preference shares do not carry voting rights.
Therefore, a company can raise capital without dilution of control. Equity
shareholders retain exclusive control over the company.
3. Trading on equity: The rate of dividend on preference shares is fixed.
Therefore, with the rise in its earnings, the company can provide the
benefits of trading on equity to the equity shareholders.
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4. No charge on assets: Preference shares do not create any mortgage or

charge on the assets of the company. The company can keep its fixed
assets free for raising loans in future
5. Variety: Different types of preference shares can be issued depending on
the needs of investors. Participating preference shares or convertible
preference shares may be issued to attract bold and enterprising
investors.
Bond Terminology
Bonds have their own unique terminology, and it is important to understand
these words if you are to be a successful bond investor.
1. Accrued Interest
Accrued interest is the interest that has been earned, but not yet been
paid by the bond issuer, since the last coupon payment.
2. Banker's Year
A banker's year is 12 months, each of which contains 30 days.
Therefore, there are 360 (not 365) days in a banker's year. This is a
convention that goes back to the days when "calculator" and
"computer" were job descriptions instead of electronic devices. Using
360 days for a year made calculations easier to do. This convention is
still used today in some calculations such as the Bank Discount Rate
that is used for discount (money market) securities.
3. Basis Point
A basis point is equal to 1/100th of 1%. You may hear that a bond
yield changed by 10 basis points (bps), which means that it changed
by 0.10%.
4. Bond
A bond is a debt instrument, usually tradable, that represents a debt
owed by the issuer to the owner of the bond. Most commonly, bonds
are promises to pay a fixed rate of interest for a number of years, and
then to repay the principal on the maturity date.
5. Call Date
Some bonds have a provision in the indenture that allows for early,
forced, redemption of the bond, often at a premium to its face value.
Bonds that have such a feature usually have a series of such dates
(typically once per year) at which they can be called. This series of
dates is referred to as the call schedule.
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6. Call Premium
The extra amount that is paid by a bond issuer if the bond is called
before the maturity date. This is a sweetener that is used to make
callable bonds attractive to investors, who would otherwise prefer to
own non-callable bonds.
7. Clean Price
The "clean price" is the price of the bond excluding the accrued
interest. This is also known as the quoted price.
8. Coupon Payment
This is the actual dollar amount that is paid by the issuer to the
bondholders at each coupon date. It is calculated by multiplying the
coupon rate by the face value of the bond and then dividing by the
number of payments per year. For example, a 10% coupon bond with
semiannual payments and a $1,000 face value would pay $50 every
six months.
9. Coupon Payment Date
The specified dates (typically two per year) on which interest payments
are made.
10. Coupon Rate
The stated rate of interest on the bond. This is the annual interest
rate that will be paid by the issuer to the owners of the bonds. This
rate is typically fixed for the life of the bond, though variable rate
bonds do exist. The term is derived from the fact that, in times past,
bond certificates had coupons attached. The coupons were redeemed
for cash payments.
11. Current Yield
A measure of the income provided by the bond. The current yield is
simply the annual interest payment divided by the current market
price of the bond. The current yield ignores the potential for capital
gains or losses and is therefore not a complete measure of the bond's
rate of return.
12. Dated Date
The dated date of a bond is the date on which it first begins to accrue
interest. This is often the same as the issue date, but not always. If
the settlement date is before the dated date, then the purchaser will
pay the issuer the accrued interest for that amount of time. Of course,
the purchaser will get a full coupon payment on the first coupon date,
so the purchaser will get the accrued interest back at that time.
13. Day Count Fraction
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The fraction of a year between two dates, calculated using the

appropriate day count convention (e.g., 30/360 or actual/actual). The
day count fraction will vary slightly depending on the day count
method used. This is used when valuing bonds, swaps, derivatives,
and when calculating accrued interest on a bond.
14. Day-count Basis
A method of counting the number of days between two dates. There
are several methods, each of which makes different assumptions
about how to count. 30/360 (a banker's year) assumes that each
month has 30 days and that there are 360 days in a year. Actual/360
counts the actual number of days, but assumes that there are 360
days in a year. Actual/Actual counts the actual number of days in
each month, and the actual number of days in a year. In Excel bond
functions, 0 signifies 30/360, 1 specifies actual/actual, 2 is
actual/360, 3 is actual/365 (which ignores leap days), and 4
represents the European 30/360 methodology.
15. Dirty Price
The "dirty price" is the total price of the bond, including accrued
interest. This is the amount that you would actually pay (or receive) if
you purchase (or sell) the bond.
16. Face Value
The principal of a bond is the notional amount of the loan. It is also
called the principal or par value of the bond, and represents the
amount that will be repaid when the bond matures.
17. Indenture
The legal contract between a bond issuer and the bondholders. The
indenture covers such things as the original term to maturity, the
interest rate, interest payment dates, protective covenants, collateral
pledged (if any), and so on.
18. Make-whole Call Provision
A provision in the bond indenture that allows the issuer to call the
bond on short notice by paying the bondholders the present value of
the remaining cash flows. The present value is determined by adding
a pre-specified premium (usually 15 to 50 basis points) to the yield on
a comparable Treasury security.
19. Maturity Date
The date on which the bond ceases to earn interest. On this date, the
last interest payment will be made, and the face value of the bond will
be repaid. This is also sometimes known as the redemption date.
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20. Redemption Value

This is typically the same as the face value of a bond. However, for a
callable bond, it is the face value plus the call premium. In other
words, this is the entire amount that will be received when the bond
is redeemed by the issuer.
21. Required Return
The required return is simply the return that an investor believes
he/she needs to earn in order to make an investment in a particular
security. It is based on the perceived riskiness of the security, the rate
of return available on alternative investments, and the investor's
degree of risk aversion. It is likely that two investors looking at the
same investment will have different required returns because of their
differing risk tolerance. The required return, along with the size and
timing of the expected cash flows, determines the value of the
investment to the investor. Note that the required return is different
from the yield (or promised rate of return), which is a function of the
cost of the investment and the cash flows, and not of investor
preferences.
22. Settlement Date
The date on which ownership of a security actually changes hands.
Typically, this is several days after the trade date. In the US markets,
the settlement date is usually 3 trading days after the trade date (this
is known as T+3). For bonds, a purchaser begins to accrue interest on
the settlement date.
23. Term to Maturity
The amount of time until the bond stops paying interest and the
principal is repaid.
24. Yield to Call
Same as yield to maturity, except that we assume that the bond will
be called at the next call date. Also known as yield to first call.
Frequently, the yield to all call dates is calculated, and then we can
find the worst-case, which is known as the yield to worst.
25. Yield to Maturity
The yield to maturity (YTM) of a bond is the compound average annual
expected rate of return if the bond is purchased at its current market
price and held to maturity. Implicit in the calculation of the YTM is
the assumption that the interest payments are reinvested for the life of
the bond at the same yield. The YTM is the internal rate of return
(IRR) of the bond.
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26. Yield to Worst

The lowest of all possible yields for the bond. It is calculated by
determining the minimum of the yield to maturity or any of the
various yields to call dates.
Stock Valuation
In financial markets, stock valuation is the method of calculating theoretical
values of companies and their stocks. The main use of these methods is to
predict future market prices, or more generally, potential market prices, and
thus to profit from price movement stocks that are judged undervalued (with
respect to their theoretical value) are bought, while stocks that are judged
overvalued are sold, in the expectation that undervalued stocks will, on the
whole, rise in value, while overvalued stocks will, on the whole, fall.

Stock Valuation Method:

Earnings Per Share (EPS)
Is the net income available to common shareholders of the company
divided by the number of shares outstanding. Usually there will be two
types of EPS listed: a GAAP (Generally Accepted Accounting Principles)
EPS and a Pro Forma EPS, which means that the income has been
adjusted to exclude any one time items as well as some non-cash items
like amortization of goodwill or stock option expenses.
Price to Earnings
Now that the analyst has several EPS figures (historical and forecasts),
the analyst will be able to look at the most common valuation technique
used, the price to earnings ratio, or P/E. To compute this figure, one
divides the stock price by the annual EPS figure. For example, if the
stock is trading at $10 and the EPS is $0.50, the P/E is 20 times. A
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complete analysis of the P/E multiple includes a look at the historical

and forward ratios.
Growth Rate
Valuations rely very heavily on the expected growth rate of a company.
One must look at the historical growth rate of both sales and income to
get a feeling for the type of future growth expected. However, companies
are constantly changing, as well as the economy, so solely using
historical growth rates to predict the future is not an acceptable form of
valuation. Instead, they are used as guidelines for what future growth
could look like if similar circumstances are encountered by the company.
Calculating the future growth rate requires personal investment
research. This may take form in listening to the company's quarterly
conference call or reading a press release or other company article that
discusses the company's growth guidance. However, although companies
are in the best position to forecast their own growth, they are often far
from accurate, and unforeseen events could cause rapid changes in the
economy and in the company's industry.
Price Earnings to Growth
This valuation technique has really become popular over the past decade
or so. It is better than just looking at a P/E because it takes three factors
into account; the price, earnings, and earnings growth rates. To compute
the PEG ratio, the Forward P/E is divided by the expected earnings
growth rate (one can also use historical P/E and historical growth rate to
see where it has traded in the past). This will yield a ratio that is usually
expressed as a percentage. The theory goes that as the percentage rises
over 100% the stock becomes more and more overvalued, and as the PEG
ratio falls below 100% the stock becomes more and more undervalued.
The theory is based on a belief that P/E ratios should approximate the
long-term growth rate of a company's earnings. Whether or not this is
true will never be proven and the theory is therefore just a rule of thumb
to use in the overall valuation process.
Sum of Perpetuities Method

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The PEG ratio is a special case in the sum of perpetuities method (SPM)
equation. A generalized version of the Walter model (1956), SPM
considers the effects of dividends, earnings growth, as well as the risk
profile of a firm on a stock's value. Derived from the compound interest
formula using the present value of a perpetuity equation, SPM is an
alternative to the Gordon Growth Model. The variables are:

is the value of the stock or business

is a company's earnings

is the company's constant growth rate

is the company's risk adjusted discount rate

is the company's dividend payment

In a special case where is equal to 10%, and the company does not pay
dividends, SPM reduces to the PEG ratio.

Additional models represent the sum of perpetuities in terms of earnings,

growth rate, the risk-adjusted discount rate, and accounting book value.
Return on Invested Capital (ROIC)
This valuation technique measures how much money the company
makes each year per dollar of invested capital. Invested Capital is the
amount of money invested in the company by both stockholders and
debtors. The ratio is expressed as a percent and one looks for a percent
that approximates the level of growth that expected. In its simplest
definition, this ratio measures the investment return that management is
able to get for its capital. The higher the number, the better the return.
To compute the ratio, take the pro forma net income (same one used in
the EPS figure mentioned above) and divide it by the invested capital.
Invested capital can be estimated by adding together the stockholders
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equity, the total long and short term debt and accounts payable, and
then subtracting accounts receivable and cash (all of these numbers can
be found on the company's latest quarterly balance sheet). This ratio is
much more useful when comparing it to other companies being valued.
Return on Asset (ROA)
Similar to ROIC, ROA, expressed as a percent, measures the company's
ability to make money from its assets. To measure the ROA, take the pro
forma net income divided by the total assets. However, because of very
common irregularities in balance sheets (due to things like Goodwill,
write-offs, discontinuations, etc.) this ratio is not always a good indicator
of the company's potential. If the ratio is higher or lower than expected,
one should look closely at the assets to see what could be over or
understating the figure.
Price to Sales (P/S)
This figure is useful because it compares the current stock price to the
annual sales. In other words, it describes how much the stock costs per
dollar of sales earned. To compute it, take the current stock price divided
by the annual sales per share. The annual sales per share should be
calculated by taking the net sales for the last four quarters divided by the
fully diluted shares outstanding (both of these figures can be found by
looking at the press releases or quarterly reports). The price to sales ratio
is useful, but it does not take into account any debt the company has.
For example, if a company is heavily financed by debt instead of equity,
then the sales per share will seem high (the P/S will be lower). All things
equal, a lower P/S ratio is better. However, this ratio is best looked at
when comparing more than one company.
Market Cap
Market cap, which is short for market capitalization, is the value of all of
the company's stock. To measure it, multiply the current stock price by
the fully diluted shares outstanding. Remember, the market cap is only
the value of the stock

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Enterprise Value
Enterprise Value is equal to the total value of the company, as it is
trading for on the stock market. To compute it, add the market cap (see
above) and the total net debt of the company. The total net debt is equal
to total long and short term debt plus accounts payable, minus accounts
receivable, minus cash. The enterprise value is the best approximation of
what a company is worth at any point in time because it takes into
account the actual stock price instead of balance sheet prices. When
analysts say that a company is a "billion dollar" company, they are often
referring to its total enterprise value. Enterprise value fluctuates rapidly
based on stock price changes.
EV to Sales
This ratio measures the total company value as compared to its annual
sales. A high ratio means that the company's value is much more than
its sales. To compute it, divide the EV by the net sales for the last four
quarters. This ratio is especially useful when valuing companies that do
not have earnings, or that are going through unusually rough times. For
example, if a company is facing restructuring and it is currently losing
money, then the P/E ratio would be irrelevant. However, by applying an
EV to Sales ratio, one could compute what that company could trade for
when its restructuring is over and its earnings are back to normal.
EBITDA
EBITDA stands for earnings before interest, taxes, depreciation and
amortization. It is one of the best measures of a company's cash flow and
is used for valuing both public and private companies. To compute
EBITDA, use a company's income statement, take the net income and
then add back interest, taxes, depreciation, amortization and any other
non-cash or one-time charges. This leaves you with a number that
approximates how much cash the company is producing. EBITDA is a
very popular figure because it can easily be compared across companies,
even if not all of the companies are profitable.
EV to EBITDA
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This is perhaps one of the best measurements of whether or not a

company is cheap or expensive. To compute, divide the EV by EBITDA
(see above for calculations). The higher the number, the more expensive
the company is. However, remember that more expensive companies are
often valued higher because they are growing faster or because they are a
higher quality company. With that said, the best way to use EV/EBITDA
is to compare it to that of other similar companies.
Bond Valuation
Bond valuation is the determination of the fair price of a bond. As with any
security or capital investment, the theoretical fair value of a bond is the present
value of the stream of cash flows it is expected to generate. Hence, the value of
a bond is obtained by discounting the bond's expected cash flows to the
present using an appropriate discount rate. In practice, this discount rate is
often determined by reference to similar instruments, provided that such
instruments exist. Various related yield-measures are then calculated for the
given price.
Present Value Approach
Below is the formula for calculating a bond's price, which uses the basic
present value (PV) formula for a given discount rate

where:
F = face values
iF = contractual interest rate
C = F * iF = coupon payment (periodic interest payment)
N = number of payments

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i = market interest rate, or required yield, or observed / appropriate yield

to maturity
M = value at maturity, usually equals face value
P = market price of bond.
Relative Price Approach
Under this approach an extension of the above the bond will be priced
relative to a benchmark, usually a government security; see relative valuation.
Here, the yield to maturity on the bond is determined based on the bond's
credit rating relative to a government security with similar maturity or
duration; see credit spread bond. The better the quality of the bond, the
smaller the spread between its required return and the YTM of the benchmark.
This required return is then used to discount the bond cash flows, replacing in
the formula above, to obtain the price.
Arbitrage-Free Pricing Approach
As distinct from the two related approaches above, a bond may be thought of as
a "package of cash flows" coupon or face with each cash flow viewed as a
zero-coupon instrument maturing on the date it will be received. Thus, rather
than using a single discount rate, one should use multiple discount rates,
discounting each cash flow at its own rate.
Here, we apply the rational pricing logic relating to Assets with identical cash
flows. In detail:
(1) the bond's coupon dates and coupon amounts are known with certainty.
Therefore
(2) some multiple (or fraction) of zero-coupon bonds, each corresponding to the
bond's coupon dates, can be specified so as to produce identical cash flows to
the bond. Thus
(3) the bond price today must be equal to the sum of each of its cash flows
discounted at the discount rate implied by the value of the corresponding ZCB.
Were this not the case,

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(4) the arbitrageur could finance his purchase of whichever of the bond or the
sum of the various ZCBs was cheaper, by short selling the other, and meeting
his cash flow commitments using the coupons or maturing zeroes as
appropriate. Then
(5) his "risk free", arbitrage profit would be the difference between the two
values.
Stochastic Calculus Approach
When modelling a bond option, or other interest rate derivative (IRD), it is
important to recognize that future interest rates are uncertain, and therefore,
the discount rate(s) referred to above, under all three cases - i.e. whether for all
coupons or for each individual coupon - is not adequately represented by a
fixed (deterministic) number. In such cases, stochastic calculus is employed.
The following is a partial differential equation (PDE) in stochastic calculus
which is satisfied by any zero-coupon bond.

The solution to the PDE - given in - is:

where

is the expectation with respect to risk-nuetral probabilities, and

is a random variable representing the discount rate;

To actually determine the bond price, the analyst must choose the specific
short rate model to be employed. The approaches commonly used are:

the CIR Model

the Black-Derman-Toy Model

the Hull-White Model

the HJM Framework

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the Chen Model.

Note that depending on the model selected, a closed-form solution may not be
available, and a lattice or simulation based implementation of the model in
question is then employed.

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