Bond and Stock Valuation Concepts

Question 1

Bond duration - Definition

Answer 1

• measures the weighted average maturity of the bonds cash flow on a present value basis
• the present values of the cash flows are used as weighs in calculating the weighted average maturity
• inversely related to YTM (market interest rates)
• inversely related to coupon rate
• duration and maturity are positively related

Question 2

Bond duration - Formula

Answer 2

• provided on formula sheet
• y = current yield on comparative bonds
  -c = annual coupon
• t = years to maturity

Question 3

What duration tells us

Answer 3

• allows investors to compare the price volatility of bonds with equal coupons but different terms
• risk averse prefer short duration bonds
• aggressive investors prefer long duration only when they think interest rates will decline, and low duration when they will rise

Question 4

Immunization

Answer 4

• passive investment strategy
• seeks to safeguard a bond portfolio against interest rate volatility
• when duration of overall portfolio is equal to a preselected time horizon
• time horizon matches financial planning goal
• goal in 10 years, dont choose bonds with 10 year maturity, chose bond with 10 year duration
• can be used to offset interest rate risk and reinvestment rate risk, closer duration is to selected time horizon the better

Question 5

zero coupon bonds

Answer 5

• have durations equal to their maturities
• their price fluctuates more than bonds with same maturities - because no coupons

Question 6

Change in bond prices

Answer 6

• duration is most important measure of how risky bonds are because it measures their sensitivity to interest rate changes
• duration tells you how a bond fund will react to change in rates
  eg. if bond has duration of 8 years, it should lose 8% of its value if interest rates on similar bonds rise by 1%

Question 7

Duration formula

Answer 7

• good for calculating small changes
• less accurate for large changes

Question 8

Using duration to manage bond portfolios

Answer 8

UPS
- if interest rates are expected to rise, buy high coupon bonds with short maturities to shorten duration
- interest UP Shorten duration

FALLEN
- if interest rates are expected to fall, buy low coupon bond with long maturities to lengthen duration
- interest rates FAL LENghten duration

Question 9

Bond price volatility guidelines

Answer 9

• when coupon is smaller, relative price fluctuation is greater
• when term to maturity is longer, relative price fluctuation is greater
• when market interest rates are lower, relative price fluctuation is greater

Question 10

Convexity

Answer 10

• expresses the degree to which duration changes as a bond’s yield to maturity changes
• largest for low coupon bonds, long maturity bonds, and low yield to maturity bonds
• allows us to improve the duration approximation for bond price changes

Question 11

Capitalized earnings

Answer 11

• based on estimates of an issuers underlying earning power multiplied by a capitalization rate
• factor only a single future period’s estimated earning or cash flow, growth and risk must remain fairly constant
• sable company better than new company

Question 12

Dividend growth models

Answer 12

• foundation for valuation of common stock
• zero growth model
• constant growth model

Question 13

Zero growth model

Answer 13

price = dividend / required rate of return
- same valuation as preferred stock

Question 14

Constant growth model

Answer 14

price = D1 / r-g
Price = Do (1+g) / r-g
Price = dividend (1 + growth rate of dividend) / required rate of return - growth rate of dividends

• pick stock that is undervalued. Calculation is greate than current trading price

Question 15

Dividend discount model

Answer 15

• if market lowers required rate of return for a stock, the value of stock will rise
• the opposite lowers the value
  if investors expect the growth in dividends will be higher as a result of favorable development of the form, value of stock will rise

Question 16

dividend discount model shortcuts

Answer 16

• for accelerating or decelerating dividend growth rates. when rate is split, begin with LAST growth rate to calculate DDM

Shortcut #1
- if the 1st growth rate is lower than the 2nd growth rate, choose the next lowest number in the answer

if the first growth rate is higher than the second, choose the next highest number in the answer

Question 17

Price/earnings ratio

Answer 17

• DDM will not work if company pays no dividends
• P/E ratio assumes stocks price has relationship to earnings per share
  current market price = P/E * earnings

Question 18

Price/free cash flow

Answer 18

• analysis of issuer’s free cash flow
  V = FCF1 / r-g

Question 19

Book value

Answer 19

• accounting value of equity shown on balance sheet
  Sum of common stock outstanding, capital in excess of par, and retained earnings

= assets - liabilities - preferred equity common

Question 20

Return of Equity (ROE)

Answer 20

• used to determine earnings growth and dividend growth
• determined before common stock dividends is paid but after preferred dividends
  ROE = earnings per common (EPS) / common equity (nw or book value)

Question 21

Dividend payout ratio

Answer 21

• percentage of earnings paid to common shareholders as cash dividends

= common dividends paid / EPS
EPS = ROE * book value or nw