Corporate Finance
(FIN770) - Chapter 5: Bond
and Stock Valuation
November 16, 2021
Prepared by:
- Nur Ernisha Anis Suraya
- Khairunnisa
Equity Valuations
- A commitment of funds for a period of time to derive a rate of return
- Funds are invested to compensate the investors with the expected rate to
inflation from the risks
Type of Investments:
- Overvalued
- Undervalued
- Fairly Valued
Investment Decision Process
Step 1
Step 2
Step 3
Estimate intrinsic value
at the required rate of
return
Compare intrinsic value
with prevailing market
price
If Estimated Value >
Market Price :
• Buy or Hold
If Estimated Value <
Market Price :
• Sell or Don’t Buy
Theory of Valuation
1
●
Value of Asset = Present Value of Expected
Returns
2
●
To convert, expected return stream needs to be
discounted at the required rate of return
3
●
Expected returns stream : Dividend,
interest, earnings
4
●
The required rate of return reflecting the
risk factors
Overview of Valuation Process
Top-down, Three-Step Approach
Bottom Up, Stock Valuation, Stock
Picking Approach
Overview of Investment Process
Analysis of Alternative Economies and
Security Markets
Analysis of Alternative
Industries
Top-down,
Three-Step Approach
Analysis of Individual
Companies and Stocks
Summary of Investment Process
Examine the value of an overall market
and determine which markets to invest
in or to overweight
Search for the best
industries
May discover that the “best companies”
are not the best investments because
they may be overvalued
Search for the best
companies
A company in a good
industry offers the greatest
potential for excess returns
Two General Approaches of Equity Valuations
Discounted Cash-Flow
Techniques
●
●
Present value of some measure of
cash flow, including dividends,
operating cash flow, and free cash
flow
Examples – Present Value of
Dividends (DDM), Present Value of
Operating Free Cash Flow, Present
Value of Free Cash Flow to Equity
Relative Valuation Techniques
●
●
Value estimated based on its price
relative to significant variables, such
as earnings, cash flow, book value, or
sales
Examples – Price/Equity, Price/Cash
Flow, Price/Book Value, Price/Sales
Discounted Cash Flow Valuation Technique
●
DCF—Discounted cash flow, which is
the sum of all future discounted cash
flows that an investment is expected to
produce
●
CF—Cash flow for a given year. CF1 is
for the first year, CF2 is for the second year,
and so on.
●
r—Discount rate, or the target rate of
return on the investment expressed in
decimal form
Example:
Apple stock trades for about $120 per share. Wall Street analysts are forecasting $4.45 in earnings per share in 2021,
and the company's earnings are expected to grow by 14.7% annually over the next five years. We assume that Apple's
annual earnings growth slows to 5% in perpetuity after five years, and that the expected annualized growth rate of the
S&P 500 is 10% for the foreseeable future.
The formula considers all of Apple's future cash flows, which isn't practical to calculate by hand. But just to give
you a glimpse of the mathematics behind the method, here are the first few parts of the infinite sum of future
discounted cash flows:
Sum of the present values of Apple's future cash flows: $140.46. Since the stock is currently trading at $120,
this implies that Apple stock is undervalued by about 15%.
Discounted Cash Flow Valuation Technique
Present Value of Free Cash Flows To Equity (FCFE)
Free cash flows to equity are derived after operating cash flows
(OCF)
Have been adjusted for debt payments (interest and principle)
These cash flows precede dividend payments to the
common stockholder
The discount rate used is the firm’s cost of equity (k)
rather than WACC
Discounted Cash Flow Valuation Technique
Present Value of Operating Free Cash Flows To Firm (FCFF)
Derive the value of the total firm by discounting the total operating
cash flows (OCF) prior to the payment of interest to the
debt-holders
Subtract the value of debt to arrive at an estimate of the value
of the equity
Similar to the DDM but the discount rate used is the
WACC
Relative Valuation Techniques
Attempts to value a
company by
comparing it to
similar companies or
the overall market or
the stock’s own
trading history
Value can be
determined by
comparing to similar
stocks based on
relative ratios
Ratios include
price/earning;
price/cash flow;
price/book value
and price/sales
P/E Ratio:
• Value a company by measuring current market price per share
relative to earning per share
• Value stock based on expected annual earnings (profits)
• High P/E ratio means investors anticipating higher growth of
the company in the future
• Also known as Earnings Multiplier
The most popular
relative valuation
technique is based
on price to earnings
(P/E Ratio)
ECONOMIC OR
MACROMARKET ANALYSIS
Understanding Market Analysis
●
●
Stock prices normally is the reflection of investors’ expectations of what is
going on in the economy
Economic growth leads to higher stock prices since economic growth leads
to greater profits of the companies
Measures
1. The leading, coincident, and lagging economic
indicators
2. Sentiment indicators
3. Monetary policy indicators – money supply,
interest rate, inflation rate
Indicators
Leading
Coincident
Lagging
Economic series that
usually reach peaks or
troughs before
corresponding peaks or
troughs in aggregate
economic activity
Four economic time
series that have peaks or
troughs that roughly
coincide with the peaks
and troughs in the
business cycle
Seven series that
experience their peaks
and troughs after those
of the aggregate
economy
Sentiment and Expectations Surveys
1
2
3
Consumer expectations
are considered relevant
as the economy
approaches cyclical
turning points
The intuition is that
consumers must have
confidence in order to
spend
Consumer spending
accounts for
approximately 70% of
gross domestic product
Monetary Policy: Money Supply
1
●
Changes in the growth rate of the money
supply affect the aggregate economy
2
●
Open market operation by buying and selling
government securities to adjust reserves and money
supply in the country - Central Bank
3
●
Declines in the rate of growth of the money
supply have preceded business contraction
4
●
Increase in the rate of growth of the money
supply have preceded economic expansions
Monetary Policy: Money Supply
5
●
Changes in money supply will affect stock
prices
6
●
Studies examine whether changes in money supply
precede changes in stock prices. The results varied
Monetary Policy: Interest, Inflation
1
●
Focus on interest rate and inflation rate rather that only
on money supply that would affect stock returns
2
●
The relationship between some economic variables
(interest, inflation, GDP) and stock returns is
significantly related
3
●
Monetary policy variables (interest, inflation, money
supply) were significant predictors of future stock
returns along with company variables
To determine the relationship
between inflation and interest rates
Impact of Inflation, Interest Rates
and Stock Prices
• Not direct and not consistent
• Effect varies over time
Industry Analysis
Understanding Industry Analysis
●
●
●
Profit-seeking firms have determined that industry analysis matters, as
evidenced by the fact that investment firms often assign analysts to cover a
particular industry
Industry’s overall risk can be relatively stable over time
Part of the planning strategy for valuing individual companies and selecting
stocks for a portfolio
Industry Analysis Process
1
2
3
4
Business cycle and
industry sectors
Structural
economic changes
and alternative
industries
Evaluating an
industry’s life cycle
Analysis of the
competitive
environment in an
industry
●
The Business Cycle
and Industry Sectors
Business cycle is the period of time from
which an economy’s output of goods and
services peaks, contracts (in a recession),
recovers from the prior expansion to reach
the prior peak (recovery), and then grows
further (expansion)
●
Different industries perform
well or poorly in different parts
of the business cycle
Investors monitor economic
trends and attempt to move
their investments from one
sector (or industry within a
sector) to another sector (or
industry) as economic trends
change
Structural Economic Changes Impact Industry (Non-Cyclical
Factors)
Factors other than economic that affect industries
Demographics - Crucial to both the demand side (consumption)
and the supply side (particularly labor)
Lifestyles - Deals with how people live, work, form households,
consume, enjoy leisure and educations
Technology
●
A product or service and how it is produced and delivered
●
New technology can completely change an industry
Politics and Regulation
●
Tremendous impact on industries
●
Reflects social values, and the result is that today’s social trend may
be tomorrow’s law, regulation, or tax
Analysis of Industry Life Cycle
Deceleration of growth
and decline
Mature industry growth
Pioneering development
Stage 1
Stage 3
Stage 5
Stage 2
Stage 4
Rapidly accelerating
industry growth
Stabilization market
maturity
Analysis of Industry Life Cycle
Analysis of Industry Competition
Refers to the intensity of
competition in the
industry
Competitive strategy is
described as the search
by a firm for a favorable
competitive position in
an industry
Examine the basic
competitive structure of
its industry because the
potential profitability of
a firm is heavily
influenced by the
profitability of its
industry
Analysis of Industry Competition (Porter’s Competitive Forces)
Global Industry
1
●
The macroeconomic environment in the major
producing and consuming countries for this industry
2
●
An overall analysis of the significant companies in
the industry and the products produced
3
●
What are the accounting differences by country and how
do these differences impact the relative valuation ratios?
4
●
What is the effect of currency exchange rate
trends for the major countries?
Company Analysis
Understanding Company Analysis
Which are the best companies within the desirable industries?
Are they overpriced?
Good companies are not necessarily good investments
What is the intrinsic value of the firm’s stock?
How does the intrinsic value compare with the market value?
Can the stock be bought?
Certain terms to differentiate between definition of company and definition of stock
●
●
●
●
●
●
●
Final Considerations Offering Above-Average Risk Adjusted Performance
●
●
●
●
Which are the best companies within these desirable industries?
What is the intrinsic value of the firm’s stock?
How does the intrinsic value compare with the market value?
Certain terms to differentiate between definition of company and definition of stock
Companies vs Stocks
01
02
03
●
Growth companies
●
Growth Stock
Defensive Companies
●
●
●
Stocks of growth companies
Higher rate of return than other stocks with similar risk
Achieved this superior risk-adjusted rate of return because the
market has undervalued it compared to other stocks (meaning
its intrinsic value is greater than its current market price
●
Future earnings are more likely to withstand an economic
downturn
Have relatively low business risk and no excessive financial risk
Typical examples are public utilities or grocery chains—firms that
supply basic consumer necessities
●
●
●
04
Defense Stocks
Consistently experience above-average increases in sales and
earnings
Yield rates of return greater than the firm’s required rate of return
●
The rate of return is not expected to decline or decline less than
the overall market decline
Have low or negative systematic risk because their returns are
unlikely to be harmed significantly in a bar market
Companies vs Stocks
●
01
Cyclical Companies
●
●
02
Cyclical Stock
●
●
●
03
Speculative Companies
●
●
04
Speculative Stocks
●
●
Sales and earnings are heavily influenced by aggregate business
activity
The companies would outperform during economic expansion
and underperform during economic contractions
Have greater changes (volatility) in rates of return than the
overall market rates of return
Have high betas
Stock of a cyclical company, however, is not necessarily a
cyclical stock
Whose assets involve great risk but those that also have a
possibility of great gain
A good example of a speculative firm is one involved in oil
exploration
Possess a high probability of low or negative rates of return and
a low probability of normal or high rates of return
Are overpriced, and would experience either low or negative rates
of return when market adjusts the stocks price to their true value
For example, an excellent growth company whose stock is
selling at an extremely high P/E ratio
Value Stocks vs Growth Stocks
●
●
●
Value stocks are those that appear to be undervalued for reasons besides
earnings growth potential
Value stocks usually have low P/E ratio or low ratios of price to book value than
Growth stocks
Growth stocks are companies that have positive earnings surprises and above
average risk adjusted rates of return because the stocks are undervalued
Company Analysis
Examining a company in
detail to determine its
fundamental characteristics
and subsequently
Two analyses:
• Firm competitive
strategies
• SWOT analysis
04
.
01
Using information to derive
the intrinsic value of its
stock in order to decide
should we invest in that
company or not
.
03
02
Understand the firm’s overall
strategic approach
Firm Competitive Strategies
●
●
●
Defensive competitive strategy involves positioning the firm to deflect the
effect of the competitive forces in the industry
Offensive competitive strategy is one in which the firm attempts to use its
strengths to affect the competitive forces in the industry
Porter (1980 & 1985) major competitive strategies:
• Low-cost leadership
• Differentiation
Porter Major Competitive Strategies
Low-Cost Strategy
• Low-cost producer and,
hence, the cost leader in its
industry Porter Major
Competitive Strategies
Differentiation Strategy
• Unique in its industry in an
area that is important to buyers
SWOT Analysis
Estimating Intrinsic Value
●
●
●
Intrinsic value is the real value or worth of the stock
If Estimated Intrinsic Value > Market Price, Buy or Keep the stock
If Estimated Intrinsic Value < Market Price, Sell or Don’t Buy the stock
Management of Bonds Investment
FUNDAMENTALS OF BOND
TERM STRUCTURE OF INTEREST RATES
BOND VALUATION
BOND PORTFOLIO MANAGEMENT
STRATEGIES
BASIC FEATURES OF
A BOND
Public bonds are long-term, fixed-obligation debt
securities packaged in convenient, affordable
denominations for sale to individuals and
financial institutions
The issuer of a bond agrees to:
●
●
Pay a fixed amount of interest
periodically to the holder
Repay a fixed amount of principal at the
date of maturity
The principal is due at maturity and is often
called the par (or face) value
Interest is paid every six months although
some issues pay in intervals as short as a
month or as as a year
DEBT MARKET Issue's Original Maturity
Short-term Issues
●
Maturities of 1 year or less The market for these
instruments is commonly known as the money market
Intermediate- term
Issues
●
●
Maturities in excess of 1 year but less than 10 years
These instruments are known as notes
Long-term
Obligations
●
●
Maturities in excess of
Know as bonds
4
BOND CHARACTERISTICS Intrinsic Features
Term to maturity: Specify the number of years
before a bond matures. Two types of maturity:
●
●
Term bond: single maturity date
Serial bond: series of maturity dates
Coupon Rate: Determine the periodic interest
income that bondholder will receive
BOND CHARACTERISTICSFeatures Affecting A Bond's Maturity
Callable
1
●●
The
macroeconomic
in the
major
Issuer
can retire bondenvironment
prior to maturity
and
has to pay
producing
andan
consuming
countries
for this value
industry
call
premium,
amount above
the maturity
Non-Callable
2
●
●
An overall analysis of the significant companies in
Issuer cannot retire bond prior to maturity
the industry and the products produced
Deferred
3 Call
●●
What are
the accounting
by country
and how
Issuer
cannot
retire up to differences
certain period
after issuing
but
do these
differences
could
retire
after that impact the relative valuation ratios?
Sinking Fund
●
Funds to be allocated to help smooth out the principal
payment
THE GLOBAL BOND MARKET STRUCTUREParticipating Investors in Global Bond Markets
Individual Investors
Institutional Investors
Who are the Institutional?
●
●
●
●
●
Life Insurance Companies
Commercial Banks
Property and Liability Insurance Companies
Pension Funds
Mutual Funds
What would influence the Institutional?
●
●
Tax code applicable to the institution
Nature of the institution's liability structure
THE RATING COMPANY IN MALAYSIA The Global Bond Market Structure
1- MALAYSIAN
CORPORATION BERHAD
(MARC)
2- RAM RATING SERVICES
BERHAD
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Obtaining Information
on Bonds
Price information to bond investors
is substantially different from price
information to stock investors
Most bonds trading are done on the
over-the-counter (OTC) market
Bond investors rely on rating
agencies for credit analysis and
popular publications before
investing in bonds
Bond Yield Curves
Bond's yield to maturity is perhaps the most important statistic for an investor to consider
Yield to maturity is the expected return to the bond, meaning that it is an expression of how the investor
anticipates being compensated for owning the security
Factors causing interest rates (i) to rise or fall
i = RFR + I + RP
The source of interest rate changes
can be in terms of the economic
conditions and issue characteristics
Where:
RFR=real risk-free rate of interest
RP=Risk premium
I = expected rate of inflation
i=f( Economic Factors + Issues
Characteristics)
= (RFR + I) + RP
Effect of Economic Factors
-Real risk-free rate
of interest (RFR) is
the economic cost
of money
-Opportunity cost
necessary to
compensate
individuals for
forgoing
consumption
Determined by the
real growth rate of
the economy with
short-run effects
due to easing or
tightening in the
capital market
Expected rate of
inflation is the
other economic
influence on
interest rates
Add the expected
level of inflation (I) to
the real risk-free rate
(RFR) to specify the
nominal RFR, which
is an observable rate
like the current yield
on government
T-bills
Impact of Bond Characteristics
Issue characteristics are unique to individual securities, market sectors, or countries will influence the
bond's risk premium (RP)
Bond investors separate the risk premium into four components:
●
●
●
●
The quality of the issue as determined by its risk of default relative to other bonds
The term to maturity of the issue, which can affect price volatility
Indenture provisions, including collateral, call features, and sinking-fund provisions
Foreign bond risk, including exchange rate risk and country risk
TYPES OF YIELD CURVES
TERM STRUCTURE
OF INTEREST RATES
The term structure of interest rates is the relationship
between the maturity and rate of return for bonds with
similar levels of risk
Interest rate and time to maturity would affect the yield
(return) of a bond
A graphic depiction of the term structure of interest
rates is I called the yield curve
TERM STRUCTURE
THEORY
Expectations Theory
Liquidity Preference Theory
Segmented-Market Theory
Expectations Theory
The shape of the yield curve reflects investor
expectations about future interest rates
Any long-term interest rate simply represents
the geometric mean of current and future
one-year interest rates expected to prevail
over the life of the issue
Can explain any shape of yield curve:
Rising and Falling of:
Segmented-Market Theory
Liquidity Preference Theory
Long-term securities should provide higher
returns than short-term obligations
Investors are willing to sacrifice some yields to
invest in short-maturity obligations to avoid the
higher price volatility of long-maturity bonds
The yield curve should generally slope upward
and that any other shape should be viewed as
a temporary aberration
Different institutional investors have different
maturity needs that lead them to confine their
security selections to specific maturity
segments
The yields for a segment depend on the
supply and demand within that maturity
segment
Slope of the yield curve is determined by the
general relationship between the prevailing
rates in each market segment
Fundamentals of Bond
Valuation
The value of a bond equals the present value of its expected cash flows
The value (current market price) indicates what an investor willing to pay for the bond in order to
obtain the returns that would take into consideration the risk factors associated with the bond
The Yield Model
Investors often price bonds in terms of their yields
Par yield (in) is the single discount rate that would be applied to every cash flow (that is, coupon payments and principal)
associated with the bond
Par yield is often referred to as the bond's yield to maturity or also its Internal Rate of Return (IRR)
Use the observed current market price (MPS) and the promised cash flows to compute the expected yield on the bond
Current Yield is a measure of the current income from the bond as a percentage of its price
CY= C/MP0
Where C is the fixed annual coupon
MPO is the bond's current market price
Yield-to-Maturity Valuation (Alternative Measurement)
Value of a bond is the summation of the present values of its coupon payments and par of face
value payments
Equation (annually):
Equation (semi-annually):
Where:
C = stated annual coupon rate
F = face or par value of bond
M = market value of bond
I = yield to maturity, stated on an annualized basis
n = maturity date of bond, stated in years
BOND PORTFOLIO MANAGEMENT
STRATEGIES
Volatility of interest rate has provided increasingly attractive returns to bond investors of all types
Active bond portfolio managers find frequent opportunities to realize capital gains that resulted from those
rate shifts to be attractive
Fixed-income portfolios generally produce both less return and less volatility than other asset classes
Investment bond style:
● Credit Quality: Quality of the bond issuer
● Interest Rate Sensitivity: Maturity of the bond which will be affected by change in the interest rate
1. Buy and hold
2. Indexing
Bond
Portfolio
Strategy
M
Te atVceh
ch setd
nciq ibfuu
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gsu ming
e
A form of asset-liability management
ulumt
iveestibme
e
un
ActV
agoeng
Man cegies
t
Stra
Allows the bond
manager flexibility to
actively manage the
portfolio subject to
an overriding
constraint that the
portfolio remains
immunized at some
predetermined yield
level
Con
ti
Proc ngent
V sedu
tibure
(Stre
lum
u
c
Mancontugrueed A
age
men ctive
t)
Passive Portfolio
Vestibulum congue
Strategies
um
l
u
utisb eunet
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p
s
ng
reV-e gceom
o
C ana gy
M rate
St
1. Attempt to beat the market
over time
2. Mostly the success or failure
of this strategy is going to
come from the ability to
accurately forecast future
interest rates
3. Closely tied to the
manager's view of what factors
or market conditions that
produce risk-adjusted returns
1. Combines Passive and Active
Styles
2. Management places a significant
part (70 to 80 percent) of the
available funds
3.The rest of the portfolio is actively
managed in the "plus" portion of the
portfolio
Thank you!