VALUATION OF BONDS

AND SHARES
BUSINESS FINANCE
TOPIC 5
 Business Finance Topic 5 – Valuation of Bonds & Shares

VALUATION OF BONDS AND SHARES

• Value of an Asset
• Intrinsic Value
• Bond Valuation
• Relationship between yield and price
• Share Valuation
• Required Rates of Return
 Business Finance Topic 5 – Valuation of Bonds & Shares

VALUE OF AN ASSET

Different ways of measuring the value of an asset

• Book value
• Liquidation: No going concern value
• Market: Price in the market
• Intrinsic: Present Value of future cash flows
• May be different to the market value of the asset
• Can make investing decisions based on the intrinsic value
• It is unlikely that the four different techniques above will result in the
same value
 Business Finance Topic 5 – Valuation of Bonds & Shares

INTRINSIC VALUE DETERMINED BY

• Amount and timing of future net cash flows (NCF)

• Riskiness of future cash flows

• Investors’ required rate of return (RRR) (discount rate, hurdle rate)

• The market value (price) = intrinsic value

• in an efficient market
 Business Finance Topic 5 – Valuation of Bonds & Shares

THE BASIC PROCESS OF VALUATION

Asset Characteristics Investor Attributes

Amount of expected cash flows

Investor’s assessment of the riskiness of the asset’s
Timing of expected cash flows cash flows
Riskiness of cash flows Investor’s willingness to bear risk

Investor’s required rate of return Determine

Asset Value =
Present value of expected cash flows discounted
using the investor’s required rate of return
 Business Finance Topic 5 – Valuation of Bonds & Shares

EXAMPLE 1
INTRINSIC VALUE OF A PROJECT

Estimates of future cash flows:

• Income: $10 million p.a.
• Expenses: $3.90 million p.a.
• Difference: $6.10 million p.a. (operating cash flow)
• Intend to sell the project for $250 million at end year 2
• Required Rate of Return on this investment: 15% p.a.
 Business Finance Topic 5 – Valuation of Bonds & Shares

PROJECT: FUTURE CASH FLOWS

Period (year) 0 1 2
Income + $10.00m + $10.00m
Less expenses - $3.90m - $3.90m
Operating cash flow + $6.10m + $6.10m
Sale of project + $250.00m
Net cash flow + $6.10m + $256.10m

PV at 15% + $5.30m + $193.65m

Total PV = 5.30 + 193.65 = $198.95m
Calculator technique:
EL 738: 0 ENT, 6.1 ENT, 256.1 ENT, 2ndF CASH 15 I/Y ENT, ▼, COMP

Intrinsic (Present) Value = $198.95m

 Business Finance Topic 5 – Valuation of Bonds & Shares

INTRINSIC VALUE OF FINANCIAL

INSTRUMENTS

1. Debt
Transfers funds from lender to borrower usually for a defined time period
Cash Flows constitute: regular Interest payments and Principal on maturity

2. Equity
Transfers funds from owner to the business usually for an indefinite time period
Cash Flows constitute: Share of Profit (Dividend)
 Business Finance Topic 5 – Valuation of Bonds & Shares

BOND (DEBENTURES, NOTES)

• Long term debt finance for large amounts
• Can be used for financing of a company’s projects

• Issued (sold) by companies or governments to investors who pay the

current bond price (primary market)

• Bond investor is legally entitled to receive specified amounts in the

future from the bond issuer

• The current bond owner can sell it to another investor for the current
bond price (secondary market)
 Business Finance Topic 5 – Valuation of Bonds & Shares

BOND TERMINOLOGY
Maturity: the date the principal is paid back in full
Term: Total length of time of the bond from issue date to maturity- 5 years,
10 years
Term to Maturity: Time remaining
Par (face, maturity, principal) value: Amount to be paid at end of term
(Maturity date)
Coupon (interest): Amount to be paid each period = coupon rate % x par
value
Yield to maturity: Used as the discount rate, reflects current interest rates
 Business Finance Topic 5 – Valuation of Bonds & Shares

BOND: PRICE (INTRINSIC VALUE )

Current Bond Price (Intrinsic Value) =

PV of coupon and par (maturity) value amounts discounted at current yield to
maturity
Example 2: 10-year Corporate Bond
• Par Value $1000,
• Coupon rate 8% p.a. paid annually,
• term to maturity 4 years (term was 10 years so 6 years have now elapsed)
• yield to maturity (YTM) 10% p.a.
 Business Finance Topic 5 – Valuation of Bonds & Shares

BOND VALUATION
0 1 2 3 4
$1000
$80 $80 $80 $80

Value???

CALC: 80 PMT, 1000 FV, 4 n, 10 I/Y, COMP PV = -936.60

Therefore: The current bond price is $936.60

 Business Finance Topic 5 – Valuation of Bonds & Shares

YIELD OF BOND DECREASES

0 1 2 3 4
$1000
$80 $80 $80 $80

Value???

If the yield (YTM) decreases to 9% p.a. (that is goes down from 10%) the current
value of the bond price must change.

CALC: 80 PMT, 1000 FV, 4 n, 9 I/Y, COMP PV = -967.60

Therefore: The current bond price is $967.60

A 1% fall in yield causes bond value (price) to increase by $31.00

 Business Finance Topic 5 – Valuation of Bonds & Shares

YIELD OF BOND INCREASES

0 1 2 3 4
$1000
$80 $80 $80 $80

Value???

If the yield (YTM) increases to 11% p.a. (increases from 10%) the current value of
the bond price must change.

CALC: 80 PMT, 1000 FV, 4 n, 11 I/Y, COMP PV = -906.93

Therefore: The current bond price is $906.93

A 1% increase in yield causes bond value (price) to decrease by $29.67

 Business Finance Topic 5 – Valuation of Bonds & Shares

WHAT HAPPENS IF YIELD CHANGES?

Inverse relationship between yield and price

 yield (interest rate, yield to maturity) causes
 in bond price (value)

Alternatively:
 yield (interest rate, yield to maturity) causes
 in bond price (value)

Interest rate risk!

 Business Finance Topic 5 – Valuation of Bonds & Shares

PAR, PREMIUM, DISCOUNT

• If yield = bond coupon rate, the bond will sell at its par value (e.g. $1000)
• If yield  bond coupon rate, the bond will sell at a "premium“ above its par value
(try yield of 7%, PV = $1033.87)
• If you had an investment paying you 8% (the bond) but market rates were only 7%,
you would pay more than the par value for the bond. Hence you pay a premium for
the extra return
• If yield  bond coupon rate, the bond will sell at a "discount” below its par value
(ie when yield of 10%, PV = $936.60)
• If you had an investment paying 8% but the market is returning 10% - you would
not be happy. So you would not pay the full par value of the bond - you would pay
less - a discount.
 Business Finance Topic 5 – Valuation of Bonds & Shares

BOND LIABILITY VALUE

The issuer of the bonds has a liability to pay future coupons and par value

• Current bond price x quantity is the total market value and is the market’s
valuation of this liability (e.g. 10,000 bonds x $936.60 = $9.366m)

• Yield changes → bond price changes → total market value changes →

liability value changes

• Yield rises from 10% to 11%: Total market value (liability) falls (10,000 x
$906.93 = $9.069m)
 Business Finance Topic 5 – Valuation of Bonds & Shares

SHARE VALUATION
• Cash flows from investments in shares (or equities) come from future dividends
and an eventual sale to another investor at a future date at some future share price
• Future share price = dividends and sale at a price some time into the future
• The sale some time in the future will also be a stream of dividends and yet another
future share price. Taking this to its logical conclusion, the value of a share is the
payment of dividends forever- a perpetuity.
• Thus current share value (price) = PV of perpetual dividend stream discounted at an
investor’s required rate of return
• But what is the dividend?
• Two main types of shares
• Preference shares - a fixed dividend
• Ordinary shares - an unknown dividend
 Business Finance Topic 5 – Valuation of Bonds & Shares

PREFERENCE SHARES
• Entitles holder to a perpetual (ongoing) fixed dividend amount paid
before ordinary shareholders

• Value of Preference Share: VP = D/RP

where VP = Value Preference Share; D = annual dividend; RP = required rate of return

Example 3:
Preference Dividend = $1.50 p.a., RP = 12% p.a.

Preference share value = $1.50/0.12 = $12.50

So if there were 10,000 preferences shares in issue, the market value would be $125,000
 Business Finance Topic 5 – Valuation of Bonds & Shares

ORDINARY SHARES (EQUITY)

• Entitles holder to an uncertain (variable) dividend amount paid from profit after
tax

• As company is a separate legal entity it can theoretically pay dividends in

perpetuity if it continues to exist in perpetuity

• Value of Ordinary Share = present value of perpetual dividend amounts

• If there is a constant dividend amount each period, similar to a preference share:
VE = PO = D1/RE
where VE = value of a share, or the price today at time zero PO; D1 = dividend at period 1; RE = required rate of
return
 Business Finance Topic 5 – Valuation of Bonds & Shares

SINGLE HOLDING PERIOD

Assume a shareholder only holds one share for one period. The
investor will expect the next dividend D, at the next period time 1,
and the investor could also sell the share for the current price P at
time 1:
VE = PV of dividend (D1) + PV of expected market price (P1)
D1 P1
VE  
1  RE  1  RE 
 Business Finance Topic 5 – Valuation of Bonds & 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?
$120
$5.50

$VE = ??? RE = 15%

𝐷1 𝑃1 $5.50+$120
𝑉𝐸 = + = = $109.13
(1+𝑅𝐸 ) (1+𝑅𝐸 ) (1.15)

You would be willing to pay $109.13 per share for this expected future payoff
 Business Finance Topic 5 – Valuation of Bonds & Shares

MULTIPLE PERIODS

• Need to estimate the dividend amount for each period and value of the share at
the end!
• Easier if can assume dividends are expected to grow in perpetuity by a
constant rate (growth rate, X% p.a.)
• So the dividend today at time 0 is (1+g) times larger at time 1
• Dividend growth valuation model (Gordon growth model)
𝐷1 𝐷0 (1+𝑔)
𝑉𝐸 = 𝑃0 = =
(𝑅𝐸 −𝑔) (𝑅𝐸 −𝑔)
where g = growth rate
and RE is the investors required rate of return
 Business Finance Topic 5 – Valuation of Bonds & Shares

EXAMPLE 5

• ABC Company’s shares are expected to pay a dividend of $0.25 per share at
the end of the next period (note this is D1) and future dividends are expected to
grow at 5% p.a.

• If you have a required return (RE) of 15% p.a. how much would you pay for
ABC shares?
 Business Finance Topic 5 – Valuation of Bonds & Shares

Timeline

D1=$0.25 D2 = $0.2625
Price … --> ∞
1 2 years

RE = 15% p.a.
If dividend growth (g) = 5% p.a.

𝐷1 $0.25
𝑃0 = = = $2.50
(𝑅𝐸 −𝑔) 0.15 − 0.05

Caution: The formula requires D1

 Business Finance Topic 5 – Valuation of Bonds & Shares

ESTIMATING DIVIDEND GROWTH (g)

1. Historical data of dividend/share

2. Dividend growth comes from the reinvestment of retained earnings
g = ROE x r
where ROE = the return on equity
r = the percentage of company profits retained

Note: A company’s profit after tax can be paid out in dividends or retained.
The amount paid out (as a % of the net income) is called the payout ratio.
The retained amount, again as a % is called the retention ratio
 Business Finance Topic 5 – Valuation of Bonds & Shares

REQUIRED RATES OF RETURN (RRR)

• Each investor can have a different required rate of return for each
individual investment (e.g. debt or equity securities)
• Individual investor’s RRR represent the rate of return that they need to
earn on any money invested in the company to be compensated for the
perceived risk
• The consensus of all investors’ RRR is reflected in the market price of
securities
• Market prices can be used to infer investors’ RRR
• Market prices are known for all securities
• The intrinsic value of a security is the present value of its future
(estimated) cash flows (examples in next slides).
 Business Finance Topic 5 – Valuation of Bonds & Shares

RRR FOR BONDS

• RRR for bondholders (RB) = the rate of return investors require if the bond is to
be held to maturity
• RB may be obtained either:
• Directly via current interest rates that are used as the yield to determine the
bond price
• Inferred from bond price by solving for I/Y
Example 6:
A 4 year, 6% p.a. coupon bond has a face value of $100 is currently priced in the
bond market at $102. We can infer the RRR for bondholders:
102 +/- PV, 6 PMT, 100 FV, 4 n, COMP I/Y giving 5.43%
Bondholders expect 5.43% p.a. return on their money from investing in a bond with
this maturity and coupon payments
 Business Finance Topic 5 – Valuation of Bonds & Shares

RRR PREFERENCE SHARES

• Can infer RRR of preference shareholders (RP) by re-arranging the

valuation equation:
𝐷
𝑅𝑝 =
𝑃𝑃
Example 7: A Preference share with a dividend D of $0.95 per share. The
current market price of this share is $10
$0.95
𝑅𝑝 = = 9.5%
$10
 Business Finance Topic 5 – Valuation of Bonds & Shares

ORDINARY SHARES

• Can infer RRR of ordinary shareholders (RE) by

re-arranging the dividend growth valuation equation
𝐷1
𝑃0 =
(𝑅𝐸 − 𝑔)
Rearranging…

𝐷1
𝑅𝐸 = +𝑔
𝑃𝑜
 Business Finance Topic 5 – Valuation of Bonds & Shares

EXAMPLE 8
• The current market price for XYZ shares is $12. XYZ has recently paid a
dividend of $0.80 (note this is D0 NOT D1) which are expected to grow at an
annual rate of 5% p.a.

• Infer the required rate of return expected by investors from D1, the current
market price and the growth in dividends

𝐷1 𝐷0 (1 + 𝑔)
𝑅𝐸 = +𝑔 = +𝑔
𝑃𝑜 𝑃𝑜
$0.80(1 + 0.05) $0.84
𝑅𝐸 = + 0.05 = + 0.05 = 12.00%
$12 $12
An investors required rate of return for this share is 12.00%
 Business Finance Topic 5 – Valuation of Bonds & Shares

COMPARING REQUIRED RATES OF

RETURN

• Bonds (RB) : 5.43%

• Preference shares (RP) : 9.5%

• Ordinary shares (RE) : 12.00%
• Relationship between risk and return?