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14 vues72 pagesBond & equity valuation-slides

Oct 18, 2015

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Bond & equity valuation-slides

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14 vues

Bond & equity valuation-slides

© All Rights Reserved

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Instruments (Bonds/Equities)

Instruments (Bonds/Equities)

Bond valuation

rate/bond price changes.

Valuation of coupon paying bonds, annual and semiannual

Yield-to-Maturity (YTM) calculation

Basics concerning stock valuation

Valuation of constant growth (mature) stocks.

Valuation of nonconstant growth stocks.

Corporate value or Free Cash Flow model

Functioning of the stock market (Secondary Market)

Sources of Finance

Bonds and Debentures(Unsecured Bonds)

Ordinary Shares (Equities):

matters (Directors)

Preference Shares:

Cumulative preference shareholders have right to dividend carried

over to next year in event of non-payment

Bond basics

is borrowed and is to be paid back along with interest/coupon.

Bonds are known as fixed income securities as all of the future

payments to be made on the bond are fixed or predetermined, as stated in

the bond contract.

all the future cash flows to be received by the bondholder.

Components

Principal amount (Face Value)

Specified interest rate (also known as the

coupon rate)

Date of maturity (Time)

Types of Bond

before maturity, at a predetermined price that is

always specified in the bond contract.

in the future, firms can retire these existing bonds and

replace them with new lower rate bonds.

Callable bonds will command a higher interest rate or yield

(lower price) than a comparable non-callable bond.

collateralized by some physical asset in case the issuer

defaults.

predetermined number of shares of common stock.

Investors are willing to accept a lower yield on such

bonds. The right to convert may become very

valuable.

exciting investment if the firm does unexpectedly well.

issuers ability to generate future cash flow to make

the promised payments. There is no collateral.

continued

junior to one or more senior bond issues. The more

senior bonds have the higher priority in bankruptcy

and/or liquidation.

Sinking fund provision: issuer may be required to

retire a certain amount of an issue each year. For

example, having to retire 10% of a 20 year bond issue

each year from year 11 to year 20.

Bond contract (indenture/deed)): a legal contract

between the issuer and bondholders that specifies all

of the terms and conditions of the bond issue.

CREDIT RATINGS

Each of the agencies assigns its ratings based on an in-depth analysis of the issuer's financial

condition and management, economic and debt characteristics, and the specific revenue sources

securing the bond.

Redemption Features (Callable, Convertible)

Credit Quality (AAA, BB)

Interest Rate

Price

Yield

Tax Status (Tax free/exemption)

coupon bond

mature in 3 years. The par value is Rs.100. Currently,

this bond sells for Rs.84.17 in the market. What

annual rate of return do investors currently require on

this three year bond?

similar bonds. This bonds time line appears below:

t=0

PV0 = 84.17

t=1

t=2

t=3

FV3 = 100 par

coupon bond, continued

the PV0 and FVn for multi period applications:

P/Y=1, and compute the I/Y=6%.

pays annual coupons

Assume that 10 years ago, a 20-year bond was issued and will

mature in 10 years. The par value is Rs.1000. It promises to

pay the owner 9% (fixed rate) coupon interest each year.

What is todays bond price?

This bond will pay (0.09)(Rs.1000) = Rs.90 coupon interest each year,

and will also pay off the Rs.1000 par value at t=10 years from today.

Currently, lets assume that the 10 year market required rate of interest

or return on this and comparable bonds is r=8.5% per year. Anyone

that buys this bond today will expect to earn this rate over the next 10

year. The bonds time line appears below:

kD=8.5%

t=0

t=1

PV0 = ?

90 coupon

t=9

t=10

90 coupon

1000 par

+ 90 coupon

=1090

pays annual coupons, continued

promised future cash flows, discounted at r=8.5% per year.

To calculate this bonds current price, add together the PVs of

the annuity of coupons and the PV of the par value lump sum.

The coupon stream annuity PV0=590.52 and the lump sum

PV0=442.29, and both sum up to 1032.81, which is therefore

the bonds current value or price. The TVM formulas are

shown below:

1

1

1

PAR

1

1000

PV0 C

90

n

n

10

10

r

0.085

r

1

r

1

r

0

.

085

1

0.085

1

0

.

085

changes, using the ten year bond

time passes and economic conditions change.

What will happen to this ten year bonds price if the

one year market required yield suddenly either (1)

decreases to r=8.0% or (2) increases to r=9.0%?

all existing fixed rate coupon bonds will rise.

all existing fixed rate coupon bonds will fall.

equal its par value.

The value of a premium bond would

decrease to Rs.1,000.

The value of a discount bond would

increase to Rs.1,000.

A par bond stays at Rs.1,000 if kd

remains constant.

1,200.00

Rs.1,167.68

Bond Value

1,100.00

k = 10%

k = 8%

k = 6%

1,000.00

900.00

Rs.863.73

$870.10

800.00

12 11 10 9

Time to Maturity

Current Yeild

this year?

Yield (C.G.Y)

Beg. V = 863.73, End V = 870.10

Annual coupon pmt

Current price

Current yield =

Current Yld = Rs.80/863.73 = 9.26%

Change in price

Beginning price

C.G.Y.=(870.10-863.73)/863.73= 0.74%

Total Return = 9.26% + 0.74% = 10%

return?

price(PV), but not its return.

Yield to Maturity (YTM) = the rate of return the

bond would earn if purchased at todays price and

held until maturity. Also called promised yield.

Yield to Call (YTC) = the rate of return the bond

would earn if purchased at todays price and held

until could be called.

Bond

Details

Orde

Boo

price the risk.

Stockholders have a residual claim, what remains after other obligations

met, including any new asset investment in the firm.

performance of firms and the risk of these cash flows.

Hardly there is any concrete theory to prove the expectations concerning

future performance.

as: (1) cash dividends and (2) share repurchases.

Intrinsic Value is the Present Value of all future

forecasted cash flows.

excess cash flow that can be paid out through both

dividends and stock repurchases.

We calculate the PV of all future forecasted FCFE at a

discount rate or cost of equity capital r.

valuation or unfortunately insert misconceptions and/or

pseudoscience into the analysis.

For simplicity here, we will assume that all the FCFE is paid as

a cash dividend, and thus the stocks intrinsic value today (V0)

is the PV of all future forecasted dividends. The timeline and

TVM valuation equation always resembles the following.

D3

Dt

D1

D2

V0

... ..

......

1

2

3

t

1 r 1 r 1 r

1 r

t=0

t=1

t=2

t=9

t=10

t=11

V0 = ?

D1

D2

D9

D10

D11

market prices (P)

estimates of value, here using discounted cash flow

(DCF) analysis.

here since stock valuation is a private effort. V 0 is thus

something we can estimate but not prove.

value or price P0 should equal the intrinsic value V0.

Note: the total value of any firms equity is always the

value per share times the total number of shares.

common stock

mature and is expected to grow at an assumed

constant rate g throughout the future.

firms cash dividends; however, everything associated with

the firm is also assumed to grow at the same rate g.

in the coming years, then constant growth valuation is

not appropriate. However, we will always assume

that constant growth does begin somewhere out in the

future.

Example: valuation of a

Constant Growth common stock

per share today and is expected to have a

constant growth rate of g=5% per year forever.

Based on the stocks perceived risk, the stock

has a required return of r=14% per year.

Growth common stock, continued

forecast the dividends for the following years:

D1 = D0(1+g) = (5.00)(1+0.05) = Rs.5.25

D2 = D0(1+g)2 = (5.00)(1+0.05)2 =Rs.5.5125

Dn = D0(1+g)n

The D0=Rs.5.00 per share has already been paid out and

is no longer part of the firm.

The intrinsic value V0 of the stock will be the Present

Value of all the future forecasted dividends, beginning

with D1.

Growth common stock, continued

Chapter 4) to calculate the Present Value. The

intrinsic value of any currently assumed constant

growth stock or investment is:

V =D /(k-g), plugging in the numbers we have:

0

1

V0=D1/(r-g) = 5.25/(0.14 0.05) = 5.25/0.09 = Rs. 58.33

If D =Rs. 5 has not yet been paid out, then the stock value

0

would be 58.33 + 5.00 =Rs.63.33 per share (cum dividend).

Thus this stock should be worth Rs.58.33 today if the firm is

expected to have a permanent growth rate of 5% per year and

next years dividend at t=1 years is Rs.5.25 per share.

given below:

V =D

t

t+1/(r-g); assuming that capital markets are efficient

For the equation to work: (1) r must exceed g and (2) all

dividends following the dividend in the equations numerator

must grow at a constant rate g.

This equation above will always give you the stock value,

exactly one year before the dividend that you plug into the

model. If you plug in the dividend expected at t=30 years,

then the equation gives you the value at t=29 years.

exactly one year from today?

D1=Rs.5.25, and D2=Rs.5.5125.

The constant growth equation, Vt=Dt+1/(r-g), calculates the

stocks value, exactly one year before the dividend that is

plugged into the equation. The dividend exactly two years from

today is estimated to be D2=Rs.5.5125 at t=2 years.

V = D /(r-g) = 5.5125/(0.14-0.05) =Rs.61.25

1

2

This stock is predicted to rise in value (or perhaps price) from

Rs.58.33 today to Rs.61.25 in exactly one year (t=1 years).

We thus forecast that in one year (t=1), the stock will be

worth Rs.61.25 per share just after it pays out D 1=Rs.5.25.

in exactly one year? A second approach.

price of a constant growth stock: Everything

associated with the firm is expected to grow at

the rate g=5% per year forever, including the

stocks value!

Rs.61.25

total return on investment

Cash dividends

The change in stock price (capital gain or loss)

on average, P0=V0,): for any constant growth stock

we have the following relation: P0 = D1/(r-g).

Rearrange the equation to yield the following relation

in terms of total return, we have: r = (D1/P0) + g

The second part is g, the capital gains yield

total return: r = (D1/P0) + g

D1=Rs.5.25, P0=Rs.58.33, and g=5%. Solving

the above equation, we have a known result:

expected 14% return comes to us as:

which is a 5% increase in stock price from Rs.58.33 to

Rs.61.25.

stock prices) can change

because investors demand a higher risk premium from

the stock.

because investors demand a lower risk premium from

the stock.

flow amounts, but rather the required return, due to risk

premium changes.

growth stocks (most stocks!)

forecast the following for most stocks that they cover:

Ten (10) future years of individual cash flows that can be paid out to

stockholde Refer to the valuation model at bottom of slide.

A terminal value, i.e., what the stock will be worth in exactly 10 years

(V10), assuming constant growth (maturity) at rate g following year 10.

through D10 and the PV of the terminal value V10=D11/(r-g).

A good approximation for the constant growth g (at maturity)

for a firm is expected future inflation plus the real expected

rate of economic growth in GDP.

V0

D11

D1

D2

D3

D10

1

...

..

1 r 1 1 r 2 1 r 3

1 r 10 r - g 1 r 10

An example of nonconstant

growth valuation

dividends, per share:

D7=Rs.0.90, ad D8=Rs.1.00. Timeline appears on next slide.

All dividends following year 8 or D8 will grow at g=6%

per year forever. This means that D9 = D8(1+g) =

1.00(1+0.06) = Rs.1.06, although this amount wont be

needed. We are also simplifying the example by assuming

that maturity begins at t=8 years.

Lets just assume here that the firms stock has r=10%

per year.

An example of nonconstant

growth valuation, continued

t=0

The salient item here is D8, since all dividend growth

after t=8 years will be at g=6% per year forever. We

can use this information to forecast the stocks value

exactly three years from now (at t=7 years).

V = D /(r-g) = 1.00/(0.10 0.06) = Rs.25.00

7

8

t=1

t=2

t=3

D1=0

D2=0

D3=0

t=4

t=5

t=6

t=7

t=8

g=6%

An example of nonconstant

growth valuation, continued

Value of D1, D2, D3, D4, D5, D6, D7 and V7 (Terminal

Value). As given previously, V7 = D8/(r-g) = 1.00/

(0.10-0.06) = Rs.25.00

D8

D5

D6

D7

D4

1

V0

4

5

6

7

1 r 1 r 1 r 1 r r - g 1 r 7

0.50

0.65

0.80

0.90

1

1.00

V0

4

5

6

7

1 0.1 1 0.1 1 0.1 1 0.1 0.1 - 0.06 1 0.1 7

V0 0.3415 0.4036 0.4516 0.0.4618 (25)(0.5132)

V0 $14.49 per share

example

XYZs first forecasted dividend is 18 years from today

at t=18 years, and is expected to be D18=Rs.6.00 per

share. Note that D0 through D17 are all forecasted to

be zero. All dividends past t=18 years are forecasted

to grow at g=7% per year.

The stock has a required return r=14%.

t=0

t=1

t=2

t=17

t=18

t=19

D1=0

D2=0

D17=0

D18=6.00

D19

g=7%

example, continued

constant growth formula, we can estimate the value

of XYZ shares at t=17 years, since constant growth

occurs following year 18.

exactly 17 years from today (t=17). Todays PV0 of

this year 17 value of Rs.85.71 is Rs.9.24

or Free Cash Flow (FCF) Model

Most financial analysts use the FCF model. FCF is the cash

that can be paid out to the firms investors, both the debt and

equity holde

The FCF model will give a value that is the total value of the

firms capital, i.e., the sum of both debt and equity. Note the

following items:

Net operating profit after tax: NOPAT = EBIT(1 - Tax Rate)

FCF = NOPAT - net new investment in operating capital.

capital both debt and equity. In Chapter 12, we will cover

the Weighted Average Cost of Capital or WACC.

or Free Cash Flow (FCF) Model

FCF1

FCF2

FCF3

FCFt

V0

... ..

......

1

2

3

t

1 wacc 1 wacc 1 wacc

1 wacc

model we covered. However, the V0 estimated here

is the total firm value or enterprise value of the firm.

stock value) must then be subtracted from the total value.

To obtain value per share, divide by the number of shares.

estimates using the FCF method may differ from

those using the FCFE/Dividend model we covered.

in the Indian capital markets

Primary Market:

Initial Public Offering (IPO): a privately held firm issues publicly

traded stock for the first time.

Private Placement

Rights Offer

The firm usually goes to an Investment Banker such as ICICI Bank,

HDFC Bank.

The investment banker usually underwrites the issue purchasing the

entire stock issuance from the firm and reselling it to the initial

investors.

Secondary Market

Central Depository Services

(India) Limited (CDSL)&

National Securities Depository

Ltd. (NSDL)

Depositories(DP)

Depositories (DP)

Individual

Firms

FI & FFI

securities

Broker

securities

Broker

Individual

Firms

FI & FFI

Clearing Banks

Axis Bank Ltd., Bank of India, Canara Bank, Citibank N.A, HDFC Bank, Hongkong &

Shanghai Banking Corporation Ltd., ICICI Bank, IDBI Bank, IndusInd Bank, Kotak

Wholesale Debt Market (WDM)

Derivative Segment (FO)

Retail Debt market (RDM)

The best price orders are matched first.

If more than one order arrives at the same price they are arranged in

ascending time order.

Best buy price is the highest buy price amongst all orders and similarly

best sell price is the lowest price of all sell orders.

Types of Settlement

Rolling Period Settlement

period stretching over more than one day are settled e.g. trades for the period

Monday to Friday.

The obligations for the account period are settled on a net basis. Account

period settlement has been discontinued since January 1, 2002, pursuant to

SEBI directives.

Rolling Settlement:

In a Rolling Settlement trades executed during the day are settled based on the

net obligations for the day.

In NSE, the trades pertaining to the rolling settlement are settled on a T+2 day

basis.

Types of Market

Normal Market

All orders which are of regular lot size or multiples thereof are traded in the Normal

Market. For shares that are traded in the compulsory dematerialised mode the

market lot of these shares is one. Normal market consists of various book types

wherein orders are segregated as Regular lot orders, Special Term orders,

Negotiated Trade Orders and Stop Loss orders depending on their order attributes.

Odd Lot Market

All orders whose order size is less than the regular lot size are traded in the odd-lot

market. An order is called an odd lot order if the order size is less than regular lot

size. These orders do not have any special terms/attributes attached to them. In an

odd-lot market, both the price and quantity of both the orders (buy and sell) should

exactly match for the trade to take place. Currently the odd lot market facility is

used for the Limited Physical Market as per the SEBI directives.

Auction Market

In the Auction Market, auctions are initiated by the Exchange on behalf of trading

members for settlement related reasons. There are 3 participants in this market

Initiator - the party who initiates the auction process is called an initiator

Competitor - the party who enters orders on the same side as of the initiator

the party who enters orders on the opposite side as of the initiator

Order Books

The Regular Lot Book contains all regular lot orders that have none of the

following attributes attached to them.

- All or None (AON), Minimum Fill (MF), Stop Loss (SL)

Special Terms Book

The Special Terms book contains all orders that have either of the following terms

attached:

- All or None (AON), Minimum Fill (MF)

The Negotiated Trade book contains all negotiated order entries captured by the

system before they have been matched against their counterparty trade entries.

Stop-Loss Book

Stop Loss orders are stored in this book till the trigger price specified in the order is

reached or surpassed. When the trigger price is reached or surpassed, the order is

released in the Regular lot book.

Auction Book

This book contains orders that are entered for all auctions. The matching process

Price Bands

Daily price bands are applicable on securities as below:

scrips on which derivative products are available or scrips included in indices on w

hich derivative products are available.

*

Price bands of 20% (either way) on all remaining scrips (including debentures,

warrants, preference shares etc).

Circuit Breakers

compulsory rolling settlement with effect from July 02, 2001.

breaker system applies at 3 stages of the index movement, either way viz. at 10%,

15% and 20%. These circuit breakers when triggered, bring about a coordinated

trading halt in all equity and equity derivative markets nationwide.

there would be a one-hour market halt if the movement takes place before 1:00

p.m.

In case after 1:00 p.m. but before 2:30 p.m. there would be trading halt for

hour.

after 2:30 p.m. there will be no trading halt at the 10% level and market shall

continue trading.

there shall be a two-hour halt if the movement takes place before 1 p.m.

after 1:00p.m. but before 2:00 p.m., there shall be a one-hour halt.

If the 15% trigger is reached on or after 2:00 p.m. the trading shall halt for

remainder of the day.

In case of a 20% movement of the index, trading shall be halted for the remainder

of the day.

The pay-in and pay-out days for funds and securities are prescribed as per the

Settlement Cycle. A typical Settlement Cycle of Normal Settlement is given

below:

Activity

Day

Trading

RollingSettlementTrading

Clearing

CustodialConfirmation

T+1workingdays

DeliveryGeneration

T+1workingdays

Settlement

SecuritiesandFundspayin

T+2workingdays

SecuritiesandFundspay

out

T+2workingdays

PostSettlement

ValuationDebit

T+2workingdays

Auction

T+3workingdays

BadDeliveryReporting

T+4workingdays

Auctionsettlement

T+5workingdays

Closeout

T+5workingdays

Rectifiedbaddeliverypayinandpay-out

T+6workingdays

Re-baddeliveryreporting

andpickup

T+8workingdays

Closeoutofre-baddelivery

T+9workingdays

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