Topic 3- Valuing Bonds and Stocks Flashcards
What is an asset from a finance perspective and how is it thus valued?
A sequence of cash flows so the value of an asset is the value of all its future cash flow
What are the 5 basic features of a bond?
- Bond is a security that obligates the issuer to make specified payments to the holder of it
- Bond holders do not own the entity that issues the bond
- Bonds are IOUs
- Bond issuers pay a fixed amount of interest periodically to the bond holder and repays a fixed amount of principal at the date of maturity
- Debt instruments are characterised by maturity
What are the 2 types of participating bond investors?
- Individual investors
- Institutional investors
What are the 3 types of participating bond issuers?
- Government and its agencies
- State and local political subdivisions
- Corporations
Give 4 types of government bonds
- Treasury securities: treasury bills, notes, gilts
- TIPS (Treasury inflation-protected securities)
- Treasury STRIPS
- Securities issued by government agencies
What are debentures?
Unsecured bonds
What are subordinated/junior debentures?
Bonds with a lower priority in the event of bankruptcy
What are senior bonds?
Secured bonds
How are bond prices quoted?
They are quoted as a percentage of par value
What is the clean/flat price of a bond?
The quoted bond price
What is the dirty price of a bond?
The actual bond price
What is the formula for the dirty price of a bond?
Dirty price = clean price + accrued interest
What is the face/par value of a bond or principal?
Payment at the maturity of the bond
What is the coupon of a bond?
The interest payments paid to the bond holder
What is the coupon/annual rate of a bond?
Annual interest payment as a percentage of face value
What is the maturity rate of a bond?
Date when all coupon payments are made and principal repaid; bond’s official termination date
What is the current yield in a bond quote?
Coupon ÷ Market price
What does the net change in a bond quote show?
How much percent of par value the bond has increased since yesterday
What is Yield To Maturity (YTM)?
The opportunity cost of capital, or discount rate, of a bond
What are the 2 main features of a Zero-coupon bond/pure discount bond?
- Make no coupon payments
- Only payment is principal at maturity
What is a Treasury (T-)bill?
Government zero-coupon bond with a maturity of up to one year
What is the price of a zero-coupon bond?
The price you are willing to pay for a single cash flow (the par) received in the future i.e the PV of the principal discounted at the appropriate YTM
What is the formula for the price of a coupon bond?
P = (Par x annual coupon)/(1+YTM)^1 +...+ (Par x annual coupon)/(1+YTM)^t + Par/(1+YTM)^t P = PVannuity + PVprincipal
What is a common stock?
Ownership (equity) shares in publicly-held corporation
What are 3 main differences between bonds and stocks?
- Stockholders are the owners of the company
- Stock dividends have lower priority than bond payments
- Stocks last forever whereas bonds have a given period
What are the 3 main ways common stocks are traded?
- Primary market: new securities
- Secondary market: previously-issued securities
- Alternative forms of equity: preferred stocks, private equity
What is market capitalisation (market cap)?
The total value of a company’s outstanding shares
What is P/E ratio?
Ratio of stock price to earnings per share
What is Dividend yield?
The ratio of dividends paid and share price. Tells the investor how much dividend income they can expect for every $1 invested in the stock
What is the formula for market cap?
Market cap = price per share x outstanding shares
What is the formula for P/E ratio?
Price per share ÷ earnings per share
What is the formula for dividend yield?
Dividends per share ÷ price per share
Give 3 main measures of stock value
- Book value
- Liquidation value
- Market/intrinsic value
What is book value?
Net worth of the firm according to the balance sheet
What is liquidation value?
Net proceeds that could be realised by selling the firm’s assets and paying off its creditors
What is market/intrinsic value?
The value of the firm as determined by investors who would be willing to purchase the company
What are the 3 main approaches to equity valuation?
- Intrinsic valuation
- Relative valuation
- Contingent claim valuation
Describe intrinsic valuation
The value of an asset is a function of its fundamentals- cash flows, growth and risk. In general discounted cash flows are used to estimate intrinsic value
Describe relative valuation
The value of an asset is estimated based upon what investors are paying for similar assets. In general, this takes the form of value or principle multiples and comparing firms within the same business
Describe contingent claim valuation
When the cash flows on an asset are contingent on an external event, the value can be estimated using option pricing models
What is the formula for intrinsic stock value?
Intrinsic value = expected dividends per share over year + predicted stock price in one year/1 + investments’ rate of return
P_0 = DIV_1+P1/1+r
What is the Dividend Discount Model (DDC)?
Computation of today’s stock price: share value equals present value of all expected future dividends
What is the DDC formula?
P_0 = HΣt=1 DIV_t/(1+r)^t + P_H/(1+r)^H
wher H is investment time horizon
What is the Constant Dividend Growth (CDG) model?
Model assuming dividends growth at a constant rate forever, share price equivalent to PV of a growing perpetuity
What is the CDG formula?
P_0 = DIV_1/r-g
Give 4 main problems with the DDC model
- Some firms simply don’t have the data on dividends
- Firms may pay no dividends at all
- The growth rate may not be sustainable
- Values to equity holders come from the cash that’s left to the investors (free cash flow)
What is the formula for cost of equity capital?
r = DIV_1/P_0 + g = dividend yield + g
What are 4 common price multiples used to value stocks?
- P/E: share price/earnings per share
- P/S: share price/sales per share
- P/B: share price/book value of equity
- P/CF: share price/cash flow
