Valuing Bonds and Stocks Flashcards
What is an asset from a finance perspective?
An asset is a sequence of cash flows.
What is the formula for an asset?
Asset = {CF1, CF2, …, CFt}
The value of an asset is the value of all its future cash flows
What is a bond?
A bond is a security that obligates the issuer to make specified payments to the holder of it, a “debt instrument”
What are bonds a form of ?
IOUs
How are bonds paid back?
Borrower pays a fixed amount of interest periodically to the bond holder.
Borrower repays a fixed amount of principal at the date of maturity
What are coupons?
The fixed amount of interest the borrower pays to the bond holder periodically.
Alternative definition: The nominal rate of interest on a fixed-interest security.
How often do coupons tend to be paid?
Normally every six months (semi-annually)
What are zero-coupon bonds?
A debt security that does not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the bond is redeemed for its full face value.
What are debt instruments categorised by?
Their maturity
What are the three categories for the maturity of debt instruments, and explain each?
Money Market - short-term issues that mature within one year
Notes - intermediate-term issues that mature between one and ten years
Bonds - long-term obligations with maturity greater than ten years
What does face (par) value, or principal mean?
The stated value that will be required payment at the maturity of the bond
What is the coupon rate (usually quoted as annual rate)?
Annual interest payment as a percentage of face value.
What is a the name of a bond with a coupon rate of zero?
A zero-coupon bond
What is the maturity date of a bond?
Date when all coupon payments are made and principal repaid: bond’s official termination date
Who tend to be the investors of bonds? (2)
Individual investors
Institutional investors
- Life Insurance Companies
- Commercial Banks
- Property and Liability Insurance Companies
- Pension Funds
- Mutual Funds
Who are the participating issuers of bonds? (4)
Government and government agencies
State and local political subdivisions (municipalities)
Corporations
International issues
- Foreign bonds
- Eurobonds
What is a Eurobond?
A Eurobond is an international bond that is denominated in a currency not native to the country where it is issued
What are the types of commonly traded government bonds? (4)
Treasury securities
TIPS
Treasury STRIPS
Securities issued by government agencies
What are treasury securities?
Bonds issued by the US treasury.
Considered to be free from credit risk (though they’re still subject to interest rate/price risk)
What forms can treasury securities come in? (3)
Treasury bills (T-bills)
Notes
Bonds
What are T-bills?
T-bills have maturities of less than one year and do not make explicit interest payments, paying only the face (par) value at the maturity date.
How often do treasury notes and treasury bonds pay coupons?
Treasury notes and Treasury bonds pay semiannual coupon interest at a rate that is fixed at issuance
What are TIPS?
Treasury Inflation-protected Securities:
- Semiannual coupon interest payments
- Par value begins at $1000 and is adjusted semiannually for changes in the CPI
- Fixed coupon rate is paid semiannually as a % of the inflation adjusted par value
What types of corporate bonds are there? (4)
Carries default possibilities (credit risk)
Secured (senior) bonds
- Secured against assets
Unsecured bonds (debentures)
- Not backed by collaterals
Subordinated (junior) debentures
- Lower priority in the event of bankruptcy
What is a bond yield?
Yield is a figure that shows the return you get on a bond
How do you calculate a bonds current yield?
The current yield is the bond’s coupon rate divided by its market price
What is the relationship between price and bond yield?
Price and yield are inversely related and as the price of a bond goes up, its yield goes down
What are bonds quoted on the basis of? (2)
Yield or price
What are price quotes presented as a percentage of, and how are these percentages written?
Presented as a percentage of par.
98½ is not $98.50 but 98.5% of par
A municipal $5,000 bond quoted at 98½ would be $4,925
What is accrued interest on a bond?
The accrued interest of a bond is the amount of interest earned on the bond but awaiting payment.
What is the distinction between clean (flat) and dirty bond prices?
Quoted price is clean price
Actual price is dirty price = clean price + accrued interest
As a bond holder, what are you entitled to?
You are entitled to all the cash flows of the bond, i.e. coupon payments (interest) if any, plus the principal when the bond matures
How much money are you willing to give up in exchange for these future cash flows?
The present value of the future cash flows
What is the Yield to Maturity? (YTM)
The opportunity cost of capital, or discount rate, for a bond (the rate of return).
The total rate of return that will have been earned by a bond when it makes all interest payments and repays the original principal.
What is YTM usually quoted in the form of?
Annual percentage rate (APR)
What are zero-coupon bonds also called?
Pure discount bonds
What is the only payment in zero-coupon bonds?
The principal at maturity
Give two examples of a zero-coupon bond
T-bills
STRIPS
What determines the price you will pay for a zero-coupon bond?
What does this price equal?
The price you are willing to pay for a single cash flow (the par) received in the future.
Equal to the present value of the principal discounted at the appropriate yield to maturity
10 years ago (14 Feb 2013), the 1-year T-bill was quoted at 0.16%, the price of a $1,000 par T-bill then:
P = $1000/(1+0.0016) = $998.40
What can you determine if coupon rate is less than the YTM?
Bond price is smaller than the par value
How do you calculate the present value of a bond?
(PV of an annuity = coupon) + (PV of the final principal payment)
Calculate the total PV os this bond:
In 2020, a $10,000 par government bond that matures in 2035 (15 years) with 10% annual coupon
The yield to maturity of the bond is 12%
What is this bond selling at?
PV of interest payments =($1,000/0.12) x (1 – 1/1.1215) = $6,811
PV of principal =$10,000/ 1.1215 = $1,827
Total value of bond = $8,638
Selling at a discount, below par.
When is a bond said to be trading at a discount?
When does this happen?
When the bond price is lower than the par.
This happens when coupon rate < YTM
When is a bond said to be trading at a premium?
When does this happen?
When the bond price is larger than the par.
This happens when coupon rate > YTM
When is a bond said to be trading at par?
When does this happen?
When the bond price equals the par.
This happens when coupon rate = YTM
What happens to the bond price as the bond approaches its maturity?
Bond price will converge it face value
What is a common stock?
Ownership (equity) shares in publicly-held corporations
What is the income from a common stock?
A dividend
Are common stocks a higher priority than a bond?
No, they are a lower priority
What is the differnece in time periods between a bond and a stock?
Normally a stock can exist forever, unlike bonds with a fixed maturity date.
What is private equity?
Private equity is an asset class consisting of equity securities (and sometimes debt) in operating companies that are not publicly traded on a stock exchange.
What is a preferred stock?
A preferred stock offers a series of fixed payments to the investor. Preferred stock usually has no voting right, but has higher priority than common stocks on dividends
What are the 3 places that common stocks are traded?
Primary market
Secondary market
Market innovations
What is the difference between the primary and secondary market for common stocks?
primary market trades new securities, whereas the secondary market trades previously-issued securities
How are common stocks traded through market innovations?
Electronic Communication Networks (ECNs)
Exchanged Traded Funds (ETFs)
What is the bid price of a share?
The price at which investors are willing to buy shares
What is the ask price for a share?
The price at which current shareholders are willing to sell their shares
What market capitalisation (market cap)?
The total value of a company’s outstanding shares
What is the P/E ratio?
Ratio of stock price to earnings per share. High p/e, growth stock, and value stock vice versa
What is the 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 earnings per share?
The portion of a company’s profit allocated to each outstanding share of common stock (total profit divided by total number of shares outstanding).
You are considering investing in a firm whose shares are currently selling for £50 per share with 1,000,000 shares outstanding. Expected dividends are £2/share and earnings are £6/share.
Work out the market cap, P/E ratio, and the dividend yield.
Market capitalisation = £50 x 1,000,000 = £50,000,000
P/E = £50/£6 = 8.33
D/Y = £2/£50 = 0.04 = 4%
What is the book value?
Net worth of the firm according to the balance sheet
What is the liquidation value?
Net proceeds that could be realized by selling the firm’s assets and paying off its creditors.
What is the market (intrinsic) value?
The value of the firm as determined by investors who would be willing to purchase the company.
What does the market value treat the firm as, unlike the book and liquidation value?
Market value treats the firm as a going concern
To help identify sources of value, what do financial managers sometimes do?
Financial managers sometimes construct market-value balance sheets.
What are market value balance sheets?
Balance sheet showing market rather than book values of assets, liabilities, and shareholders’ equity.
What is the going-concern value?
The difference between a company’s actual value and its book or liquidation value
What does going concern mean?
A business that is operating and making a profit
What are the three approaches to equity valuation?
Intrinsic valuation
Relative valuation
Contingent claim valuation
What is intrinsic valuation?
The value of an asset is a function of its fundamentals – cash flows, growth and risk. In general, discounted cash flow models are used to estimate intrinsic value.
What is a 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 price multiples and comparing firms within the same business.
What is a 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.
When will the intrinsic valuation and relative valuation converge?
They will converge in efficient markets
What is the equation for the present value of a stock?
PV(stock) = PV (expected future dividends)
For a stock, what are the future cash flows? (2)
Dividends
Ultimate sale price
How do you calculate the intrinsic value (Po) of a share?
P0 = (DIV1 + P1) / (1 + r)
DIV1= The expected dividends per share over a year
P1= The predicted stock price in one year
r= Investments’ ROR for the stock, or simply the cost of equity
What does the dividend discount model show?
Computation of today’s stock price: share value equals present value of all expected future dividends
How do you calculate the value of today’s stock price? (Dividend discount model)
Po = [Div 1 / (1 + r)] + [DIV2 / (1 + r)^2] + … + [(DIVh + Ph) / (1 + r)^h)
= Sigma[DIVt / (1+r)^t] + Ph/ (1 + r)^h
H= investment time horizon
Divt = Dividends per share in the t^th period
r = investments’ rate of return for the stock
What does the constant dividend growth (CDG) model assume?
Assumes dividends growth at a constant rate forever
In the CDG model, how do you calculate the share price and what is it equivalent to?
Po = DIV1 / (r - g)
g= growth of dividends
Equivalent to PV of a growing perpetuity
How do you calculate the cost of equity capital?
r = (Div1 / Po) + g = dividend yield + g
What are the problems with the DDC model? (4)
Some firms simply do not have the data on dividends
Firms may pay no dividends at all (as for most Chinese or Swedish listed companies)
The growth rate may not be sustainable
Values to equity holders come from the cash that’s left to the investors (FREE CASHFLOW)
What are the problems with the DDC model? (4)
Some firms simply do not have the data on dividends
Firms may pay no dividends at all (as for most Chinese or Swedish listed companies)
The growth rate may not be sustainable
Values to equity holders come from the cash that’s left to the investors (FREE CASHFLOW)
What is the price sales (P/S) ratio?
The P/S ratio is a firm’s stock price divided by sales per share
What is the price-book (P/B) ratio?
The P/B ratio is a firm’s stock price divided by book value of equity per share.
What is the price-cash floe (P/CF) ratio?
The P/CF ratio is a firm’s stock price divided by cash flow per share, where cash flow may be defined as operating cash flow or free cash flow.
Do bonds issues from bond providers with a low credit score tend to have a high or low yield?
A high yield as there is a high chance of the issuer defaulting on the bond
Why do some firms not pay dividends?
Dividends in some countries are charged at a high tax rate
What do intrinsic valuations not take into account?
Market mood- doesn’t compare relative prices
The present quoted price for a bond is £965 and the accrued interest is £15. How much should an investor pay for the bond if she wants to purchase it now?
£980
