Lecture Presentation Software

to accompany

Investment Analysis and Portfolio Management

Eighth Edition by

Frank K. Reilly & Keith C. Brown

Discounted Dividend Valuation

Characteristics of a Bond
There are three important things to know about any bond before you buy it: the par value, the coupon rate, and the maturity date. Knowing these three items (and a few other odds and ends depending on what kind of bond you are buying) allows you to analyze the bond and compare it to other potential investments.

Par value
Par value is the amount of money the investor will receive once the bond matures, meaning that the entity that sold the bond will return to the investor the original amount that it was loaned, called the principal. Par value for corporate bonds is normally $1,000, although for government bonds it can be much higher.

Coupon Rate
The coupon rate is the amount of interest that the bondholder will receive expressed as a percentage of the par value. Thus, if a bond has a par value of $1,000 and a coupon rate of 10%, the person holding the bond will receive $100 a year. The bond will also specify when the interest

Maturity Date
The maturity date is the date when the bond issuer has to return the principal to the lender. After the debtor pays back the principal, it is no longer obligated to make interest payments. Sometimes a company will decide to "call" its bond, meaning that it is giving the lenders their money back before the maturity date of the bond. All corporate bonds specify whether they can be called and how soon they can be called.

Valuation of Bonds
Calculating the value of bonds is relatively easy because the size and time pattern of cash flows from the bond over its life are known. A bond typically promises 1. Interest payments every six months equal to one-half the coupon rate times the face value of the bond 2. The payment of the principal on the bonds maturity date .

Valuation of Bonds : Terms

Bond security that obligates the issued to make specified payments to the bondholder. Corporate bond long-term debt issued by a private corporation typically paying semiannual coupons and returning the face value at maturity. Bond indenture a legal contract Coupon fixed amount of interest payments.

Valuation of Bonds : Equations

If not specified in the problem the par value of a bond is always $1,000. Coupon rate
= annual coupon payment/ par value

Bonds coupon yield

= coupon / bonds current market price Basic equation = +C/(1+r)2+C/(1+r)3++C/(1+r)n + M/(1+r)n C/1+r

Valuation of Bonds
Example: in 2006, a $10,000 bond due in 2021 with 10% coupon will pay $500 every six months for its 15-year life. In addition the bond issuer promises to pay the $10,000 principal at maturity in 2021. The required rate of return is 10%.

Valuation of Bonds
Present value of the interest payments is an annuity for thirty periods at one-half the required rate of return: $500 x 15.3725 = $7,686 The present value of the principal is similarly discounted: $10,000 x .2314 = $2,314 Total value of bond at 10 percent = $10,000

Valuation of Bonds
The $10,000 valuation is the amount that an investor should be willing to pay for this bond, assuming that the required rate of return on a bond of this risk class is 10 percent

Valuation of Bonds
If the market price of the bond is above this value, the investor should not buy it because the promised yield to maturity will be less than the investors required rate of return

Valuation of Bonds
Alternatively, assuming an investor requires a 12 percent return on this bond, its value would be: $500 x 13.7648 = $6,882 $10,000 x .1741 = 1,741 Total value of bond at 12 percent = $8,623 Higher rates of return lower the value! Compare the computed value to the market price of the bond to determine whether you should buy it.

Valuation of Bonds : Examples

1. Assume Worlwide bonds has a par value of $1000 in 2008 maturing at 2019 with a required rate of return assumed to be 8%. Coupon rate is $91.25. What is the total value of the bond? 1. Suppose the markets required rate of return on worldwide bonds is 10%. What is the value of the bond?

Quiz # 2

Valuation of Preferred Stock

Owner of preferred stock receives a promise to pay a stated dividend, usually quarterly, for perpetuity. P/S is a perpetuity because it has no maturity. Issuer of this stock does not have the same legal obligation to pay investors as do issuers of bonds. Since payments are only made after the firm meets its bond interest payments, there is more uncertainty of returns. Therefore, investors should require a higher rate of return on a firms preferred stock than on its bonds.

Valuation of Preferred Stock

The value is simply the stated annual dividend divided by the required rate of return on preferred stock (kp)
Dividend V kp

Valuation of Preferred Stock

The value is simply the stated annual dividend divided by the required rate of return on preferred stock (kp)
Dividend V kp

Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required rate of return of 9 percent

Valuation of Preferred Stock

The value is simply the stated annual dividend divided by the required rate of return on preferred stock (kp)
Dividend V kp

Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required rate of return of 9 percent $8 V .09

Valuation of Preferred Stock

The value is simply the stated annual dividend divided by the required rate of return on preferred stock (kp)
Dividend V kp

Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required rate of return of 9 percent $8 V $88.89 .09

Valuation of Preferred Stock

Given a market price, you can derive its promised yield

Valuation of Preferred Stock

Given a market price, you can derive its promised yield
Dividend kp Price

Valuation of Preferred Stock

Given a market price, you can derive its promised yield
Dividend kp Price

At a market price of $85, this preferred stock yield would be

$8 kp .0941 $85.00

Approaches to the Valuation of Common Stock

Two approaches have developed
1. Discounted cash-flow valuation
Value of the stock is estimated based upon the present value of some measure of cash flow, including dividends, operating cash flow, and free cash flow

2. Relative valuation technique

Value estimated based upon its current price relative to significant variables, such as earnings, cash flow, book value, or sales

Valuation Approaches and Specific Techniques

Approaches to Equity Valuation
Figure 11.2

Discounted Cash Flow Techniques

Present Value of Dividends (DDM)
Present Value of Operating Cash Flow Present Value of Free Cash Flow

Relative Valuation Techniques

Price/Earnings Ratio (PE)

Price/Cash flow ratio (P/CF)

Price/Book Value Ratio (P/BV) Price/Sales Ratio (P/S)

Approaches to the Valuation of Common Stock

Both of these approaches and all of these valuation techniques have several common factors:
All of them are significantly affected by investors required rate of return on the stock because this rate becomes the discount rate or is a major component of the discount rate; All valuation approaches are affected by the estimated growth rate of the variable used in the valuation technique

Why and When to Use the Discounted Cash Flow Valuation Approach
The measure of cash flow used
Dividends
Cost of equity as the discount rate

Operating cash flow

Weighted Average Cost of Capital (WACC)

Free cash flow to equity

Cost of equity

Dependent on growth rates and discount rate

Why and When to Use the Relative Valuation Techniques

Provides information about how the market is currently valuing stocks
aggregate market alternative industries individual stocks within industries

No guidance as to whether valuations are appropriate

best used when have comparable entities aggregate market and companys industry are not at a valuation extreme

Discounted Cash-Flow Valuation Techniques

CFt Vj t t 1 (1 k )
Where: Vj = value of stock j n = life of the asset CFt = cash flow in period t k = the discount rate that is equal to the investors required rate of return for asset j, which is determined by the uncertainty (risk) of the stocks cash flows
t n

The Dividend Discount Model (DDM)

The value of a share of common stock is the present value of all future dividends
D3 D1 D2 D Vj ... 2 3 (1 k ) (1 k ) (1 k ) (1 k ) Dt (1 k ) t t 1
n

Where:
Vj = value of common stock j

Dt = dividend during time period t

k = required rate of return on stock j

3 Methods Used in the Dividend Discount Model (DDM)

1. Zero-growth which assumes that all dividend paid by stocks remain the same. D1

r 2. Constant growth model - assumes that dividends grow by a specific percent annually. D1

Vj =

Vj

kg

3. Variable growth model divides growth into 3 phases:

1. 2. 3. Fast initial Slow transition that ultimately ends with a lower rate that Is sustainable over long period of time.

SPj 2 D1 D2 Vj = + + 2 (1+ k) (1+ k) (1+ k)2

The Dividend Discount Model (DDM)

If the stock is not held for an infinite period, a sale at the end of year 2 would imply:
SPj 2 D1 D2 Vj 2 (1 k ) (1 k ) (1 k ) 2

The Dividend Discount Model (DDM)

Selling price at the end of year two is the value of all remaining dividend payments, which is simply an extension of the original equation
D3 D4 D SPj 2 2 (1 k ) (1 k ) (1 k )

D3 D4 D (1 k ) (1 k ) 2 (1 k ) PV ( SPj 2 ) 2 (1 k ) D3 D4 D 3 4 (1 k ) (1 k ) (1 k )

The Dividend Discount Model (DDM)

Stocks with no dividends are expected to start paying dividends at some point

The Dividend Discount Model (DDM)

Concept is still the same except that some of the early dividend payment is zero. Stocks with no dividends are expected to start paying dividends at some point, say year three...
D3 D1 D2 D Vj ... 2 3 (1 k ) (1 k ) (1 k ) (1 k )

The Dividend Discount Model (DDM)

Stocks with no dividends are expected to start paying dividends at some point, say year three...
D3 D1 D2 D Vj ... 2 3 (1 k ) (1 k ) (1 k ) (1 k ) Where:

D1 = 0 D2 = 0

The Dividend Discount Model (DDM)

Infinite period model assumes a constant growth rate for estimating future 2 n D0 D0 (1 g ) dividends(1 g ) D0 (1 g )
Vj (1 k ) (1 k )
2

...

(1 k ) n

Where: Vj = value of stock j

D0 = dividend payment in the current period

g = the constant growth rate of dividends k = required rate of return on stock j

n = the number of periods, which we assume to be infinite

The Dividend Discount Model (DDM)

Infinite period model assumes a constant growth rate for estimating future dividends
D0 (1 g ) D0 (1 g ) D0 (1 g ) Vj ... 2 (1 k ) (1 k ) (1 k ) n D1 This can be reduced to: Vj kg
2 n

The Dividend Discount Model (DDM)

Infinite period model assumes a constant growth rate for estimating future dividends
D0 (1 g ) D0 (1 g ) D0 (1 g ) Vj ... 2 (1 k ) (1 k ) (1 k ) n D1 Vj This can be reduced to: kg
2 n

1. Estimate the required rate of return (k)

The Dividend Discount Model (DDM)

Future dividend steam will grow at a constant rate for an infinite period
D0 (1 g ) D0 (1 g ) D0 (1 g ) Vj ... 2 (1 k ) (1 k ) (1 k ) n D1 Vj This can be reduced to: kg
2 n

1. Estimate the required rate of return (k) 2. Estimate the dividend growth rate (g)

Infinite Period DDM and Growth Companies

Assumptions of DDM: 1. Dividends grow at a constant rate 2. The constant growth rate will continue for an infinite period 3. The required rate of return (k) is greater than the infinite growth rate (g)

END

Infinite Period DDM and Growth Companies

Growth companies have opportunities to earn return on investments greater than their required rates of return To exploit these opportunities, these firms generally retain a high percentage of earnings for reinvestment, and their earnings grow faster than those of a typical firm This is inconsistent with the infinite period DDM assumptions

Infinite Period DDM and Growth Companies

The infinite period DDM assumes constant growth for an infinite period, but abnormally high growth usually cannot be maintained indefinitely Risk and growth are not necessarily related Temporary conditions of high growth cannot be valued using DDM

Valuation with Temporary Supernormal Growth

Combine the models to evaluate the years of supernormal growth and then use DDM to compute the remaining years at a sustainable rate

Valuation with Temporary Supernormal Growth

Combine the models to evaluate the years of supernormal growth and then use DDM to compute the remaining years at a sustainable rate For example: With a 14 percent required rate of return and dividend growth of:

Valuation with Temporary Supernormal Growth

Year 1-3: 4-6: 7-9: 10 on:
Dividend Growth Rate 25% 20% 15% 9%

Valuation with Temporary Supernormal Growth

The value equation becomes
2.00(1.25) 2.00(1.25) 2 2.00(1.25) 3 Vi 2 1.14 1.14 1.14 3 2.00(1.25) 3 (1.20) 2.00(1.25) 3 (1.20) 2 4 1.14 1.14 5 2.00(1.25) 3 (1.20) 3 2.00(1.25) 3 (1.20) 3 (1.15) 6 1.14 1.14 7 2.00(1.25) 3 (1.20) 3 (1.15) 2 2.00(1.25) 3 (1.20) 3 (1.15) 3 8 1.14 1.14 9 2.00(1.25) 3 (1.20) 3 (1.15) 3 (1.09) (.14 .09) (1.14) 9

Computation of Value for Stock of Company with Temporary Supernormal Growth

Discount Year 1 2 3 4 5 6 7 8 9 10 Dividend $ 2.50 3.13 3.91 4.69 5.63 6.76 7.77 8.94 10.28 11.21
a

Present Value $ $ $ $ $ $ $ $ $
b

Growth Rate 25% 25% 25% 20% 20% 20% 15% 15% 15% 9%

Factor 0.8772 0.7695 0.6750 0.5921 0.5194 0.4556 0.3996 0.3506 0.3075 0.3075

Exhibit 11.3

2.193 2.408 2.639 2.777 2.924 3.080 3.105 3.134 3.161

$ 224.20
a

$ 68.943 $ 94.365

Value of dividend stream for year 10 and all future dividends, that is $11.21/(0.14 - 0.09) = $224.20 The discount factor is the ninth-year factor because the valuation of the remaining stream is made at the end of Year 9 to reflect the dividend in Year 10 and all future dividends.