Bond and Stock Valuation Concepts Flashcards
Bond duration - Definition
- 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
Bond duration - Formula
- provided on formula sheet
- y = current yield on comparative bonds
-c = annual coupon - t = years to maturity
What duration tells us
- 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
Immunization
- 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
zero coupon bonds
- have durations equal to their maturities
- their price fluctuates more than bonds with same maturities - because no coupons
Change in bond prices
- 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%
Duration formula
- good for calculating small changes
- less accurate for large changes
Using duration to manage bond portfolios
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
Bond price volatility guidelines
- 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
Convexity
- 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
Capitalized earnings
- 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
Dividend growth models
- foundation for valuation of common stock
- zero growth model
- constant growth model
Zero growth model
price = dividend / required rate of return
- same valuation as preferred stock
Constant growth model
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
Dividend discount model
- 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
dividend discount model shortcuts
- 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
Price/earnings ratio
- 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
Price/free cash flow
- analysis of issuer’s free cash flow
V = FCF1 / r-g
Book value
- 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
Return of Equity (ROE)
- 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)
Dividend payout ratio
- percentage of earnings paid to common shareholders as cash dividends
= common dividends paid / EPS
EPS = ROE * book value or nw
