Valuation of shares & bonds

There are two distinct aspects of this topic: (1) pricing securities, & (2) calculating a
securitys expected rate of return. (1) involves calculating a securitys intrinsic value
(IV) based on the valuers required rate of return. (2) involves calculating a securitys
expected return based on its current market price (P
0
). Note that: (1) a securitys
current market price may not be the same as its intrinsic value, and (2) a securitys
expected return may not be the same as its required rate of return. These differences
lead to the flowing decision rules:
If P
0
< IV security is underpriced, therefore buy
If P
0
> IV security is overpriced, therefore sell.
If expected return > required return, security is underpriced, therefore buy
If expected return < required return, security is overpriced, therefore sell.
The golden rule is buy low, sell high.
Pricing bonds
A bond has a: par value = face value = redemption value = nominal value;
coupon rate of interest applied to its par value; maturity date.
Bond interest is typically paid twice-yearly.
PV of a bond = (1) PV of the interest payments (an annuity) +
(2) PV of the par value (future value).
See text pages 277-281.
Note that the price of a bond is inversely related to its yield or discount rate; ie the
higher the yield on a bond, the lower will be its price, and vice-versa.
When the yield on a bond is lower than its coupon rate, its price will be higher than its
par value.
When the yield on a bond is higher than its coupon rate, its price will be lower than its
par value.
return of rate required r
Example
A bond has a par value of $100, a coupon rate of 10.75% and matures in 5 years. If
interest is paid annually and the required rate of return is 10%, what is the bonds IV?
Answer
PV of the annuity: $10.75 [1 (1.1)
-5
] / 0.1 = $40.75
PV of par value: $100 / (1.1)
5
= 62 .09
Total PV = IV = $102 .84
Pricing preference shares
IV = annual dividend required rate of return = D
p
/ RROR = D
p
/R
p
Example
A preference share has a par value of $100 and a dividend rate of 10.75%. If the
required rate of return is 10%, what is the shares IV?
Answer
PV = IV = $10.75 / 0.1 = $107.50
Pricing ordinary shares
D
1
= D
0
(1 + g)
g = expected growth rate. Can be defined in terms of growth in the book value (BV)
of shareholders funds
= BV
1
/ BV
0
1
= return on equity (ROE) profit retention ratio.
Example
A share has just paid an annual dividend of $0.54. The book value of shareholders
funds is currently $11,020,801. One year ago the book value of shareholders funds
was $10,699,807. During the past year there were no changes to paid-up capital. The
risk-free rate of return is currently 5%. A risk premium of 8% is required for investing
in the share. What is its PV?
Answer
Required rate of return = 5% + 8% = 13%
Growth rate = 11,020,801/10,699,807 1 = 0.03
D
0
= $0.54 D
1
= $0.54 1.03 = $0.5562, or
2
g r
D
PV
1

D
1
= $0.54 11,020,801/10,699,807 = $0.5562
PV = $0.5562 / (0.13 0.03) = $5.56
Expected rates of return
Shares
= D
1
/ P
0
+ g
Example
If the share in the previous example has a current market price of $5.02, what is its
expected rate of return?
Answer
D
1
/ P
0
+ g
= 0.5562/5.02 + 0.03
= 14.08%
Is this share worth buying?
Yes: its market price is below its intrinsic value and its expected rate of return is
higher than its required rate of return.
Bonds
Expected return = yield to maturity = internal rate of return (IRR - interest symbol i
on the calculator).
The IRR is the discount rate that equates the PV of a bonds future cash flows with its
current market price. This rate can be identified either through a process of iteration or
by using an electronic device such as a financial calculator or an Excel spreadsheet.
Note that if the price of a bond is below its par value, its yield will be higher than its
coupon rate, and vice-versa.
Example
A bond has a par value of $100, a coupon rate of 10.5% payable semi-annually and has
4.5 years to maturity. If its current price is $117.52, what is its expected rate of return?
3
return of rate ected exp r
g yield dividend r +
Answer
Because the current market price is above par value, we know that the expected return
must be less than the coupon rate.
This calculation is best done using a financial calculator (or spreadsheet).
The key strokes are:
9 n 117.52 +/- PV 5.25 PMT 100 FV COMP i x 2 = 6.00%
Calculating bonds yields without a financial calculator
If we know the price of a bond, we can calculate its yield to maturity (YTM); i.e. the
discount rate that equates the present value of the bonds future cash flows with its
current price. The textbook sometimes refers to a bonds YTM as the bondholders
expected rate of return. However, whether or not a bonds YTM will be the rate of
return actually realised by the bondholder will depend on the rate at which the bonds
coupons can be reinvested. Remember that a bond YTM is an annual percentage rate
(APR), as opposed to an effective annual rate (EAR).
Example
What is the YTM of a three-year bond with a face value of $100 and a 14% coupon
paid twice per year, if the price of the bond is $110.15?
Solution
The time line is shown below.
-110.15 7 7 7 7 7 107
0 1 2 3 4 5 6
We need to find the value of i such that:
110.15 =
6
6
) m i 100(1
2 i
) 2 i (1 1
7

+ +

,
_

+
For equations of this type there is no algebraic solution for i when the exponent is
greater than 4. In all such cases an approximation method needs to be used for
determining the value of i. The routine is a two-part process involving first using an
equation for determining an approximate value of i and then using a solution
algorithm to bring the approximate value of i closer and closer to its true value
through successive iterations. This is the solution method used by electronic devices
and may also be used manually.
Using a financial calculator, the YTM in this example is easily found to be 10.00%.
Using the Sharp EL-735, the key-strokes are: 6 n 110.15 +/- PV 7 PMT 100 FV
COMP i 2 =
4
Without a financial calculator, the following equation defines an approximate bond
YTM:
Bond YTM
a 6 . 0 1
n a c
+

(8)
Where a = V
b
/M 1
Applied to the current example, a = 110.15/100 1 = 0.1015. Equation (8) then defines
an approximate yield of 10.007%, as follows:
Bond YTM
( ) 1015 . 0 6 . 0 1
3 1015 . 0 14 . 0
+

0609 . 1
106167 . 0
0.100072
10.0072%
In this case the approximation equation has yielded a reasonable result. But if we do
not know that 10.00% is the actual YTM, we cannot assess the accuracy of 10.0072%.
However, in all cases such as this we can obtain a better approximation of the actual
YTM by using an appropriate solution algorithm, such as Newton's Method.
Alternatively, if we designate the first approximation as i
a
, a second approximation,
designated i
b
, can be defined in either of the following two ways:
(1) i
b
= i
a

a
PV
a
+ 1
(2) i
b
=
m
a
FV nm
a
1
1
1
]
1

,
_

+
1
1
1
where PV
a
= the present value of the bonds cash flows per dollar
of bond when discounted at i
a
FV
a
= the future value of the bonds cash flows per dollar of
bond when compounded at i
a
Using the first method, we find:
PV
a
= $
( )
1
1
]
1

+

a
nm
a
i
m i
c
1 1
+ $1(1 + i
a
/m)
-nm
= $
( )
1
1
]
1

+

100072 . 0
2 100072 . 0 1 1
14 . 0
6
+ $1(1 + 0.100072/2)
-6
= $0.355257543 + $0.746061907
= $1.1013
5
i
b
= 10.0072%
1015 . 1
1013 . 1
= 10.0054%
Using the second method (which was developed by Chris Deeley in
2005), we find:
FV
a
= FV of coupons per dollar of bond + $1
= $
( )
1
1
]
1

+
a
nm
a
i
m i
c
1 1
+ $1
= $0.14
1
1
]
1

100072 . 0
1 050036 . 1
6
+ $1
= $0.14 3.4012645 + $1
= $1.476177
i
b
=
2 1
1015 . 1
476177 . 1
6 1

1
1
]
1

,
_

= 0.10001466 = 10.001466%
Either of the foregoing methods can be repeated until the actual YTM
is identified when i
n
= i
n1
to the required degree of accuracy. The
second method (Deeleys Method) is recommended, despite its
greater complexity, on the grounds that it approaches the actual
YTM far more quickly than the first method.
Using Deeleys Method, the second iteration gives us a YTM of 10.0006%, calculated
as follows:
FV
b
= FV of coupons per dollar of bond + $1
= $
( )
1
1
]
1

+
b
nm
b
i
m i
c
1 1
+ $1
= $0.14
1
1
]
1

10001466 . 0
1 05000733 . 1
6
+ $1
= $0.14 3.401019135 + $1
= $1.47614268
i
c
=
2 1
1015 . 1
47614268 . 1
6 1

1
1
]
1

,
_

= 0.100006 = 10.0006%
6
Repeating this routine with 10.0006% as the reinvestment rate will confirm that the
actual YTM is 10.00% (to two decimals). The following equation also confirms
10.00% as the actual YTM:
V
b
=
( )
( )
nm
nm
m i M
m i
m i
C

+ +
1
1
]
1

+
1
1 1
= $7
( )
( )
6
6
05 . 1 100
5 . 0 . 0
05 . 1 1

+
1
1
]
1

= $7 5.075692 + $100 0.7462
= $35.53 + $74.62
= $110.15 = the given price of the bond.
Note that although the method just demonstrated is of a type often described as one of
trial and error, it is nevertheless a systematic routine of repetition or iteration. Each
repetition of the routine will always generate a more accurate approximation of the
YTM until the actual YTM is identified to the required degree of accuracy. It is, of
course, your understanding of the concepts that is important, not that you can
necessarily calculate the precise answer. Depending upon the nature of the question, it
is often sufficient to calculate a range within which the YTM falls. Nevertheless, now
that youve seen the hassles involved in calculating a YTM without a financial
calculator, you may appreciate the value of having one, and knowing how to use it.
Preference shares
Expected return = D / P
0
Example
A preference share has a par value of $100 and a dividend rate of 10.5% payable
annually. If its current price is $117.52, what is its expected rate of return?
Answer
10.5 / 117.52 = 8.9%
Financial calculations without using a financial calculator
Rate of interest
If $1 grows to $10 over 10 years, what is the rate of interest?
Ans. i = 10
1/10
1 = 0.2589 = 25.89%
Check: $1 (1.2589)
10
= $1 9.998 = $10.00
7
Number of periods
If $1 grows to $10 at 10% pa, how long does it take?
Ans. n = log 10/ log 1.1 = 24.16 years
Check: $1 (1.1)
24.16
= $1 10.0011 = $10.00
Calculating periodic payments when paying off a debt or saving for a
future amount, without using a financial calculator or tables
Paying off a debt
A debt which is paid off in equal periodic instalments may be referred to as a credit
foncier loan. It is a present value (PV) that needs to be paid off and the amount of each
instalment (or payment) can be calculated by dividing the PV by equation 4-12a,
which is on page 79 of the text. Note that this is a double-decker equation in which i
is the denominator. Because the PV (the numerator) is to be divided by this equation,
the equation should be inverted and then multiplied by the PV.
Example
See problem 4-15 at page 98.
Payment (PMT) = 60,000 0.09/(1 1.09
-25
)
= 60,000 0.10180625
= $6,108.38
Saving for a future amount
It is a future value (FV) that needs to be saved for and the amount of each instalment
(or payment) can be calculated by dividing the FV by equation 4-11a, which is on page
81 of the text. Note that this is a double-decker equation in which i is the
denominator. Because the FV (the numerator) is to be divided by this equation, the
equation should be inverted and then multiplied by the FV.
Example
See problem 4-18 at page 98.
Payment (PMT) = 100,000 1.05
10
0.1/(1.1
10
1)
= 162,889.46 0.62745394
= $10,220.56
Note that the first part of this answer calculates the expected future value of the
property, which is expected to increase in value at the rate of 5% per year for 10 years.
Note also that with this sort of calculation, you should not round-off until completion
of the calculation.
8