Bond and Stock Valuation

Finance 476 University of Phoenix Online Week 3 Lecture Notes

Welcome to the third installment of lecture notes for Finance 476. This week, we will discuss how to use financial data to compute fair market prices for bonds and stocks and why financial analysts spend so much time valuing securities using these techniques.

Overview
n Bonds and their Valuation n Characteristics n Valuation Models n Risk and Bankruptcy n Stocks and their Value n Types of Stock n Valuation Models n Hybrids

There are two basic types of securities: What we call bonds are debt securities and what we call stocks are equity securities. Someone without a background in financial analysis may be tempted to think that a bond with a $1000.00 face value was worth, well, $1000.00. We will explore why this is not necessarily the case in the next several minutes. In addition to valuation models, we will look at the major characteristics of bonds in general and where bondholders stand in relation to other claimants in the event of a liquidation due to bankruptcy of the firm. Stocks are tougher to value, as their price is determined by negotiations between buyers and sellers on public markets. Still, it is useful to determine what the intrinsic value of a firm is with respect to fundamentals to aid in this negotiation process. In an efficient market, the intrinsic value and the market value will be necessarily the same. Finally, we will briefly discuss the different kinds of securities that combine some aspects of equity and debt in one package. These hybrid securities can be difficult to value, but nonetheless represent another class of security available to firms on the capital markets.

Bond Characteristics
n Par Value n Coupon n Maturity Date n Sinking Fund n Restrictive

Covenant n Call Provision

The $1000.00 bond we were talking about earlier has a face or par value of $1000.00. It would also have a coupon rate, which is the rate of interest it pays on a periodic basis, usually every six months. The maturity date is the date on which the principle or par value is returned by the firm to the investor holding the bond. A sinking fund provision ensures the orderly retirement of the bond issue by forcing the firm to buy back a percentage of the bond issue every year from investors who are selected by lottery. Restrictive covenants may be included in the bond issue to protect bondholders from undesirable changes in the risk portfolio of the firm, keeping in mind that investors in bonds have no say in the operations of the firm absent these covenants. Finally, a bond may have a call provision, which gives the firm the right to call the bond early at a set price. If a bond is called, the investor looses the interest he would have earned if he held the bond to maturity and also exposes him to reinvestment risk (the risk that an equivalent security paying the same return at the same risk level does not exist in the market).

Bond Valuation
Vb = INT ( PVIFAK D , N ) + PAR ( PVIFK D , N )
n n n n

KD is the coupon rate of the bond N is the number of periods being evaluated PAR is the face value of the bond INT is the dollars paid in interest per period

Bonds are valued as the net present value of the cash flows that they generate. Obviously, bonds generate interest payments which are cash flows. They also generate a repayment of the par value at some date in the future. These cash flows are discounted using the coupon rate to determine the present value of the bond. This discounted cash flow model is widely accepted in valuing bonds of all kinds.

Yield to Maturity

Vb =
n n n

INT PAR + N (1 + kd ) (1 + k d ) N

Vb is the bonds current value INT, PAR, kd, and N have same meaning as before Solve for kd

If the bond is held to the maturity date (e.g. it is not called by the firm earlier), then use this formula to compute the effective yield to maturity of the bond. Typically a bond is priced at a value that differs from par, so there is a stated interest rate and an implicit interest rate. Use trial and error or a financial calculator to compute kd from this equation, keeping in mind that N may not be given in years and kd may be given as an annual rate. In this equation, N is the periods to maturity, INT is the interest paid per period, kd is the yield to maturity, PAR is the par value of the bond, and Vb is the bonds present value and market price at the current time.

Yield to Call

VB =
n n n n

INT CALLPRICE + N (1 + k d ) (1 + k d ) N

Vb, INT, and kd have same meaning as before CALLPRICE is the price mentioned in the call feature N is the periods to the call date Again, solve for kd

If the bond is callable, another relevant value is the yield to call. This will typically be less than the yield to maturity, because if the yield to call were higher than the yield to maturity, the firm would not call the bond. The CALLPRICE is the price the firm pays at the call date to retire the bond; it is typically 3 to 5% higher than the par value of the bond. The remainder of the variables have the same definition as in the yield to maturity example.

Bonds and Risk

n n n

Interest Rate Risk

n

Price moves in opposite direction of rates Less with long maturities Not as bad as stock, but still there

Reinvestment Rate Risk

n

Default Risk
n

Bonds may seem safe, but in fact are very risky investments. Risk comes from three major places: interest rate risk, reinvestment risk, and risk of default. Interest rate risk is the reduction in the market value of the bond if the interest rate in the general economy for similar securities goes up. If kd available in the market changes from the current rate, then the bonds market price will adjust to bring the coupon in line with prevailing interest rates. For example, if a $1000.00 bond with a coupon of 5% every six months (10% annually) is held when interest rates increase from 10% to 15%, the face value of the bond will decrease until the kd computed by using the present value of the net cash flows is 15%. This will necessarily cause a reduction in the market price of the bond. This does not mean that the bonds par value changes; par value never changes. What is does mean is that an investor who wants to sell their bond early in the secondary market will get less than par to compensate for the reduced coupon of the bond in relation to equivalent investments. Another form of risk is reinvestment risk. This is the risk that the bond will be called or otherwise retired leaving the investor with cash that he can not invest as advantageously. Finally there is the obvious default risk. While better off than stockholders in the event of a bankruptcy, bondholders can also take a hit when a firm goes under.

Bankruptcy
n n

Chapter 11 Chapter 7
n n n n n n n n n n n

Secured Creditors Trustees Costs Expenses after filing Wages due to 2K Benefits due Customer Deposits Taxes Pension Plans General Creditors Preferred Stockholders Common Stockholders

Bankruptcy comes in two forms: Chapter 11 and Chapter 7. Chapter 11 bankruptcy is encountered when a firm reorganizes and renegotiates the terms of its debt. This is not good for bondholders, but they at least have a chance of getting some of their money back. Reorganizations under the Bankruptcy laws are administered by a trustee who acts as the bondholders interest and who is supervised by a judge. A firm may decide that its assets are worth more then the firm is as a going concern. At that point, Chapter 7 bankruptcy is declared and assets are sold to pay creditors. Here we see the order in which creditors line up to get their share of what is left of the firm after a liquidation sale. You can see that secured creditors come firs and that unsecured general creditors come near the bottom of the list. For this reason, secured credit is usually less expensive than general unsecured credit and carries a lower risk associated with this lower price.

Valuing Stock
Why Value Stock n Transactions involving Stock
n

Secondary Market Trading n New issues on Primary Market n IPOs n Share Buybacks
n

How to Determine Fair Value

The first question we need to answer is a simple one: Why bother valuing stocks at all? With the value of stocks being determined by the market it may be hard to see why anyone would want to prepare valuations based on anything other than looking up the stock price on the internet. The easiest way to see why someone would try to value a stock based on non-market data is that if the market is pricing the stock too high or low based on its fair value, then an investor who knew this could profit from the markets mistake. Other reasons include the need to price stock that is new to the market (IPOs) or to validate the markets pricing of a stock in the long term. Stock that is traded on the open market does not generate new funding for the company whose shares are being traded. When an individual buys a stock through Charles Schwab, for example, he is likely buying the stock from another individual investor. This transaction has nothing to do with the company that issued the stock, as it is a private transaction between two separate legal entities. New stock issued in the primary market, however, does result in both income to the firm and possible dilution of existing shareholders ownership interest in the firm. Initial Public Offerings obviously are between investors and the firm and generate capital that the firm can use in its operations. Finally, firms may buy stock on the open market. This buyback of stock is often done to support sagging share prices in the place of raising dividends. This all leads us to the need for a way to determine fair value of a stock independent of the value determined by the market.

Stock Valuation Models: Dividend Based

n

Expected Dividend
n

Price is discounted value of expected dividends Used to evaluate growing firms

= P o

t =1

Dn (1 + k s )t

Constant Growth
n

= P o

D1 ks g

Valuation of a stock is accomplished in a similar manner to bond valuations. The cash flows generated by the stock are determined and are discounted at the cost of stock (see FIN475 notes for determination of ks) to determine its present value. In one respect, the cash flow given off by a share of stock is represented by its dividend. Eventually, all monies generated by a firm will be returned to the owners in the form of dividends. The only cash compensation received by shareholders over the long term are dividends. The first equation shown discounts the expected dividend in each period and sums the results over all periods to generate a share price. The problem then becomes determining the expected dividends and how they will vary over time. The second equation solves this problem by treating the dividend stream as a perpetuity with an interest rate of ks less the dividend growth rate g. This model would work only if the firm is growing its dividend at a steady rate of g% per year. Since some firms do not pay dividends but still have value and since most firms do not grow at a uniform rate, this model has very severe limitations in the real world of security valuation. Lets look at an alternative that can handle the more general case of stock valuation.

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Valuing Stock: Corporate Value Model

FCFn Vc = n ( 1 ) + k n= 1 wacc
n n n

Firms value is net present value of free cash flows, discounted at the weighted average cost of capital. Best overall model. Can apply to all types of firms.

The corporate value model takes the approach that the value of the company is the net present value of the free cash flows of the company over the life of the firm. The idea is based on the fact that the free cash flow from a company belongs to its investors who will demand payment over the life of the firm in the form of dividends. This allows for firms that are growth oriented and who do not pay dividends in that these firms will eventually reach a state of lower growth and have to pay dividends to keep investors happy. The total value of the firm is then divided by the number of shares outstanding to get the share price. Notice that the free cash flow is discounted by the weighted average cost of capital, which reflects the firms capital structure and degree of leverage. Though not perfect, the corporate value model is the best thing going when trying to value a firm.

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Market Efficiency
n

Weak Form
n

All past price moves included in current price All public information included in price All information included in price

Semi-strong Form
n

Strong Form
n

If the market is efficient, then the price shown in the Wall Street Journal will equal the price computed by the corporate value method. The degree of market efficiency is a topic of hot debate. In its weak form, efficiency basically maintains that you cant profit by seeking to determine patterns in the price of stock over time. This means that things like Santa Claus rallies and the January effect cant be used to make profits. Most academics agree with at least this level of market efficiency. The semi-strong form of efficient market theory states that all public information is factored into stock prices. This would mean that all financial reports and data are considered by the market as a whole when determining the price and that analysis of such data can not be used to beat the market. Many but not all academics adhere to this level of efficiency, but there is debate as to the extent that it is true. The strong-form theory states that all information, public or not, is included in the market price. Since insider trading is a crime, it is unlikely that the strong form holds in any meaningful way in determining stock prices.

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Hybrid Securities
Preferred Stock n Capital Lease
n
n

FASB No. 13

Warrants n Convertible Bonds

n

Hybrid securities include features of both debt and equity. Preferred stock, for example, is paid a guaranteed dividend like a bond, but has a subordinate claim to a firms assets in the event of liquidation. Preferred stock does not have voting rights like common stock, but its dividend can be waived for a few years in a cash crunch situation. Capital leases are a form of debt that is secured by an asset. Leases are capitalized in accordance with FASB 13 to avoid misleading balance sheet implications. Since the lease payments must be made to avoid default and subsequent bankruptcy, leases are very similar to secured debentures (mortgages). Warrants are the rights to buy a stock at a set price by a set date. Warrants are issued to make a security more attractive to investors at lower price to the firm. Warrants have a value, which is determined by the stock price level at any given time. Convertible bonds are like bonds issued with warrants, except with warrants you can detach the warrant and sell it separately from the bond. This is not possible with a convertible, which must either be held as a bond or converted to a set number of shares (according to the conversion ratio, which is included with the terms and conditions of the bond issue).

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Conclusion
n

Valuation
Debt n Equity
n

Hybrid Securities n Efficient Markets n Discussion Questions

n

We have reviewed very briefly the highlights of debt and equity valuations and how they utilize net present value techniques to arrive at fair value for various securities, including hybrids of debt and equity. Further, we discussed the level of efficiency in the market and what it means to investors. Discussion Questions Week 3 1. If a bond has a par value of $1000 and a 10% coupon with a maturity date of 20 years from today, how much would it be worth to an investor if interest rates suddenly changed to 8% overnight? 2. A share of Neptune Trading Company is worth $75.00 on the open market. The company has a weighted average cost of capital of 12% and expects free cash flow of $13,000 a year for three years followed by five years of $15,000 per year flows and $25,000 per year for each year thereafter. If the company pays no dividends and maintains its current cost of capital, what is the value of the company per share with 10,000 shares outstanding? Would you buy this stock at $75.00 per share? 3. If markets are efficient in the semi-strong form, why do technical analysts review historical price fluctuations to determine investment advise?

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