Bonds and Stocks.ppt

					VALUATION – BONDS AND STOCKS




                               1
                       BONDS
 We  hear a lot about the stock market in
  the popular press, but not much about the
  bond market
 It may surprise you to learn that the U.S.
  bond market is over twice the size of the
  U.S. stock market
     Total outstanding debt in 2007: $29.2 trillion
     Total market value of common stock: $14.2
      trillion
 In general, bonds are less risky than stocks
    But, like all assets, high-yield bonds have
      higher risk



                                                       2
 Corporate    Bonds
 Bond ratings go from AAA(Best credit) to
  CCC. If the rating is D, then it is
  considered in default. BBB or better is
  considered investment grade, 0.5% or less
  chance of default. BB and below,
  historically default rate is around 4% but
  has reached above 10% in 90-91, 2001 for
  example.



                                               3
 WHICH TO BUY?

 High  Yield vs Investment grades
 Example
 AAA 5% with .2% historical default
 B, 9% with 4% historical default rate
 40% recovery rate on defaults
 Return = (1 – default rate) * interest rate
  – default rate * (1-recovery rate)
 Return for A, .998 * .05 - .002*.6 = 4.87%.
 Return for B, .96 * .09 - .04 * .6 = 6.24%
 Link   to corporate and Treasury quotes




                                            5
BOND VALUATION
 The value of a bond represents the present value
  of future cash flows.
 Bonds are easier to value than stocks because in
  the case of bonds, the cash flows are known
     Coupon amount
     Par value
   Investors also know the time remaining to
    maturity, and the prevailing market interest rate
    for bonds of similar risk



                                                        6
 Examples
 Calculate Price, Annual coupon, semi-
  annual coupon.
 What happens when interest rates
  change?
 How does maturity affect risk?
 How does coupon affect risk?
 Discount, Premium, at Par


                                          7
Holding period return
 Assume you buy a 10 year 8% annual
  coupon bond yielding 8%. 2 years later
  it is yielding 6%. What is your return?




                                            8
   Other Issues: Yield to Call
     The YTM calculation assumes that the bond is held to
      maturity
     What if the bond is called by the issuer prior to
      maturity? The investor would receive only the coupon
      payments up to the point of call, plus the call price
     This is called the Yield to Call




                                                              9
   Callable bonds are an advantage for the issuer, but a
    disadvantage for the investor
      If interest rates fall, the issuer can recall the more
       expensive debt and issue new debt at the new lower
       interest rate
      The investor is left with cash, just when interest rates
       are lower
   The call provision effectively puts a ceiling on the price of
    a bond
      If interest rates fall enough, the bond will be called
   Investors are not stupid – they require higher yields from
    callable bonds versus otherwise equivalent non-callable
    bonds
                                                                    10
   Example:
     20-year bond with 7 percent coupons, semiannual
     The bond can be called in 5 years at a call price of
      1,070
     The bond’s market price is $1,106.38.
     Calculate the Yield to Call:



    INPUT      40           -1106.38 35        1070
                N      I/YR   PV    PMT         FV
    OUTPUT            2.875
      YTC = 2 x 2.875 = 5.75%

                                                             11
MUNICIPAL BONDS AND YIELD
   Municipal bonds appear to offer low yields
    compared with corporate bonds and Treasury
    securities.
       This is because the interest from municipal bonds is
        tax exempt at the federal level, and generally at the
        state level as well
   In order to compare yields, we must compute the
    after-tax yield on municipal bonds




                                                                12
 Taxable    equivalent yield

                                   Muni yield
        Equivalent Taxable Yield 
                                   1 - tax rate
 Example: Pre-tax yield on municipal bond
 is 5%, and investor’s marginal tax rate is
 35%
     Equivalent taxable yield = 5 / (1-.35) = 7.69%
 Municipal bonds are more attractive to
 high-income investors (with high marginal
 tax rates)
                                                       13
DURATION
    A measure of the effective maturity of a bond
    The weighted average of the times until each
     payment is received, with the weights proportional
     to the present value of the payment
    Duration is shorter than maturity for all bonds
     except zero coupon bonds
    Duration is equal to maturity for zero coupon bonds
DURATION: CALCULATION


   wt  CF t (1  y )
                        t
                            Price
        T
   D   t wt
       t 1



   CFt  Cash Flow for period t
DURATION CALCULATION

 8%   Time    Payment PV of CF Weight C1 X
 Bond years           (10%)           C4

       1      80      72.727    .0765    .0765


       2      80      66.116    .0690    .1392


       3      1080    811.420   .8539    2.5617
 Sum
                      950.263   1.0000   2.7774
USES OF DURATION
 Summary measure of length or effective maturity
  for a portfolio
 Immunization of interest rate risk (passive
  management)
     Net worth immunization
     Target date immunization

   Measure of price sensitivity for changes in
    interest rate
DURATION/PRICE RELATIONSHIP

 Price change is proportional to duration and not to
   maturity
 DP/P = -D x [D(1+y) / (1+y)
 D* = modified duration
 D* = D / (1+y)
 DP/P = - D* x Dy
PRICING ERROR FROM CONVEXITY

 Price


              Pricing Error from
                    Convexity




         Duration


                                   Yield
CORRECTION FOR CONVEXITY

   Modify the pricing equation:


        DP
             D  Dy  1  Convexity (Dy )2
         P               2
   Convexity is Equal to:


                          CF t             
                                       t 
                            N
               1
                   2 
                                       2
                                   t t
        P  (1  y) t 1  (1  y )         
            Where: CFt is the cashflow (interest and/or
            principal) at time t.
                 Stock Investing:
October, this is one of the peculiarly
dangerous months to speculate in stocks.
The others are July, January September,
April, November, May, March, June,
December, August and February.

Mark Twain, 1899.
COMMON STOCK
 Equitysecurities (stocks) represent
  ownership in a corporation
 Common stockholders are residual claimants
     The have a claim on cash flows only after all
      other claimants (employees, suppliers,
      debtholders, the government) have been paid
 Atany point in time the market value of a
 firm’s common stock depends on many
 factors including:
     The company’s profitability (cash flows)
     The company’s growth potential
     Current market interest rates
     Conditions in the overall stock market
                                                      22
VALUATION APPROACH
 Examine Economic Environment(Federal
  Reserve Forecasts is a good place to start)
 Examine Industry/Sector Environment
 Examine Company
 Examine Price

   Best of all worlds: Finding a good company in a
    growing industry within an expanding economy
    that is undervalued. A tall order.
   We will not focus on the economic and industry
    environment in this class, but will start with
    some simple financial statement analysis to
    determine if we are dealing with a good
    company, and then look at valuation models to
    see if it is selling at an attractive price.
                                                      23
ANALYSIS OF FINANCIAL STATEMENTS


                                   24
INTRODUCTION
   The real value of financial statements lies in the
    fact that managers, investors, and analysts can
    use the information in the statements to:
     Analyze firm performance
     Plan changes to improve performance

   Ratio Analysis
       Calculating and analyzing financial ratios to assess a
        firm’s performance




                                                                 25
   Ratios fall into five groups:
       Liquidity ratios
       Asset management ratios
       Debt management ratios
       Profitability ratios
       Market value ratios
   After managers, analysts, or investors calculate
    a firm’s ratios they make two comparisons:
       Trend – comparison to the same firm over time
       Competitors – comparison to other firms in the
        same industry


                                                         26
LIQUIDITY RATIOS
 Liquidity ratios provide an indication of the ability
  of the firm to meet its obligations as they come
  due
 The two most common liquidity ratios are the
  current ratio and the quick (or acid-test) ratio.




                                                          27
 The broadest liquidity measure is the current
 ratio, which measures the dollars of current
 assets available to pay each dollar of current
 liabilities
  Current Ratio = CA / CL
 Inventory is the least liquid of the current
 assets, and is the current asset for which book
 values are the least reliable measure of market
 value. The quick, or acid-test ratio excludes
 inventory in the numerator, and measures the
 firm’s ability to pay off short-term obligations   28
 without relying on inventory sales:
  Quick Ratio = (CA – Inventory) / CL
ASSET MANAGEMENT RATIOS
 Asset management ratios measure how efficiently
  a firm uses its assets
 Many of these ratios are focused on a specific
  asset, such as inventory or accounts receivable.
 We will examine inventory and total asset
  turnover.




                                                     29
   Inventory Management
     The inventory turnover ratio
      measures the dollars of sales produced per dollar
      of inventory. Often this ratio uses cost of goods
      sold in the numerator rather than sales since
      inventory is listed on the balance sheet at cost
    Inventory Turnover = Sales / Inventory
                        or
    Inventory Turnover = Cost of Goods Sold / Inventory

   Total Asset Management
      The Total Asset Turnover ratio measures the dollars
       of sales produced per dollar of total assets

    Total assets turnover ratio = Sales / Total assets       30
DEBT MANAGEMENT RATIOS
 Debt management ratios
measure the extent to which
the firm uses debt (financial
leverage) versus equity to finance its assets. We will
  examine the following four:
       The debt ratio measures the percentage of total
        assets financed with debt.
        Debt ratio = Total debt / Total assets
       The debt-to-equity ratio measures the dollars of
        debt financing used for every dollar of equity
        financing.                                         31

        Debt-to-equity ratio = Total debt / Total equity
   The Equity Multiplier ratio measures the dollars of
    assets on the balance sheet for every dollar of equity
    financing

    Equity multiplier ratio = Total assets / Total equity


   The Times Interest Earned ratio measures
    the number of dollars of operating earnings
    available to meet each dollar of interest
    obligations

    Times interest earned = EBIT / Interest expense


                                                             32
PROFITABILITY RATIOS
 These ratios show the combined effect of liquidity,
  asset management, and debt management on the
  overall operating results of the firm
 These ratios are closely monitored by investors
       Stock prices react very quickly to unexpected changes
        in these ratios. We will look at the profit margin,
        ROA, and ROE.

   The Profit Margin is the percent of sales left after all
    firm expenses are paid

    Profit margin = Net income available to common
      stockholders / Sales                                      33
   The Return on Assets (ROA) measures the
    overall return on the firm’s assets, inclusive of
    leverage and taxes

     Return on Assets (ROA) = Net income available to
             common stockholders / Total Assets

   The Return on Equity (ROE) measures the
    return on common stockholders’ investment

     Return on Equity (ROE) = Net income available to
     common stockholders / Common stockholders’ equity

   ROE is affected by net income as well as the amount of
    financial leverage
   A high ROE is generally considered to be a positive sign of   34
    firm performance
      Unless it is driven by excessively high leverage
MARKET VALUE RATIOS
 While ROE is a very important financial
  statement ratio, it doesn’t specifically
  incorporate risk.
 Market prices of publicly traded firms do
  incorporate risk, and so ratios that
  incorporate stock market values are
  important.
 We will look at two, Market to book and PE



                                               35
 TheMarket-to-Book ratio measures the
 amount that investors will pay for the firm’s
 stock per dollar of equity used to finance the
 firm’s assets
  Market-to-book ratio = Market price per share / Book value per
   share

     Book value per share is an accounting-based
      number reflecting historical costs
     This ratio compares the market (current) value
      of the firm's equity to their historical costs.
     If liquidity, asset management, and accounting
      profitability are good for a firm, then the                  36

      market-to-book ratio will be high
 ThePrice-Earnings ratio is the best
  known and most often quoted figure
Price-earnings ratio = Market price per share / Earnings per share


      Measures how much investors are willing to
       pay for each dollar of earnings
      A high PE ratio is often an indication of
       anticipated growth
          Stocks are classified as growth stocks or value
           stocks based on the PE ratio
                                                                     37
DUPONT ANALYSIS
 DuPont analysis is a decomposition model
 ROA and ROE can be broken down into
  components in an effort to explain why they may
  be low (or high).
 ROE = profit margin x total asset turnover x
  equity multiplier
 ROE = NI/Sales x Sales/Total Assets x Total
  Assets/Total Equity
 The DuPont model focuses on
     Expense control (Profit Margin)
     Asset utilization (TA turnover)
     Debt utilization (Equity Mult)                38
TIME SERIES AND CROSS-SECTIONAL
ANALYSIS
 To analyze ratios in a meaningful way they must
  be compared to some benchmark
 There are two types of benchmarks:
     Performance of the firm over time (time series
      analysis)
     Performance of the firm against other companies in
      the same industry (cross-sectional analysis)
           Comparative ratios for industries are available from Value
            Line, Robert Morris Associates, Dun & Bradstreet, Hoover’s
            Online, and MSN Money




                                                                         39
FUNDAMENTAL STOCK ANALYSIS: MODELS OF
EQUITY VALUATION: IS IT UNDERVALUED?

    Basic Types of Models
      Balance Sheet Models
      Dividend Discount Models
      Price/Earning Ratios

    Estimating Growth Rates and Opportunities
DIVIDEND DISCOUNT MODELS:
GENERAL MODEL

                    
                             Dt
                Vo  
                    t  1 (1  k )
                                   t




  V0= Value of Stock
 Dt = Dividend
 k = required return
NO GROWTH MODEL


           D
      Vo 
           k
 Stocks that have earnings and dividends
  that are expected to remain constant
 Preferred Stock
NO GROWTH MODEL: EXAMPLE


          D
     Vo 
          k
 E1 = D1 = $5.00
 k = .15
 V0 = $5.00 / .15 = $33.33
CONSTANT GROWTH MODEL


          Do (1  g )
     Vo 
           kg

g   = constant perpetual growth rate
CONSTANT GROWTH MODEL: EXAMPLE


         Do (1  g )
    Vo 
          kg

 E1 = $5.00 b = 40%          k = 15%
 (1-b) = 60% D1 = $3.00 g = 8%
 V0 = 3.00 / (.15 - .08) = $42.86
ADDITIONAL VALUATION METHODS
   Variable Growth Techniques
     For high-growth firms, we can’t use the constant
      growth formula because we know that the firm can’t
      sustain the high growth forever
     These firms may have two different growth rates
         Growth during the supernormal growth period
         Steady growth after the firm matures

       We can use a multistage growth formula for these
        firms, but we can also use discounted cash flows in
        combination with the constant growth model




                                                              46
   Example: Suppose a firm currently has a dividend
    of D0 = $5. We expect the firm to grow at a rate of
    10% for three years, after which it will grow at 4%
    forever. The required return is 9%.
       First we can calculate the dividends:
         D1 = 5(1+.10) = 5.50
         D = 5.50(1.10) = 6.05
           2
         D = 6.05(1.10) = 6.655
           3
         D = 6.655(1.04) = 6.92
           4




                                                          47
 Now we can calculate the present value of all
  of the dividends in periods 4 to ∞, where the growth is
  constant forever
   P3 = D4/(kg)
       = 6.92/(.09-.04)
       = 138.42
Now we have all the cash flows, and we can find P0
P0 = 5.50/1.091 + 6.05/1.092 + (6.655 + 138.42)/1.093
   = $122.17



                                                            48
 Estimating some key inputs for Multi-Stage Growth Models
 Cash flow estimate
     Dividends
     Operating Cash Flow

     Free Cash Flow to Equity (what could be paid out and remain a going

      concern): NI - (1 – debt ratio) *( Change in Working Capital + Cap.
      Expend. – Depreciation)
   Cost of Capital/Required Return
     Bond Yield + premium, premium 5% or so
     Capm: Return = risk free + B(Expected Market Return – risk free)

     Your own personal required return

   Growth
     A) Geometric or Average growth rates of Earnings, Sales, Cash Flows
     B) Intrinsic Growth, ROE (1 – payout ratio)

     C) Analyst Estimates




                                                                         49
ESTIMATING DIVIDEND GROWTH RATES

  g  ROE  b
  g = growth rate in dividends
  ROE = Return on Equity for the firm

  b = plowback or retention percentage rate
        (1- dividend payout percentage rate)
ESTIMATING GROWTH VIA
HISTORICAL INFO.
 Dividend in 2000 was $1.
 Dividend in 2006 was $1.80

 Growth is (1.80/1)^(1/6)-1 = 10.29%
FREE CASH FLOW TO EQUITY


A much better model is to apply discount models to
  FCFE which may more accurately reflect a firms
  value.
FCFE = Net Income + depreciation – Cap. Expend.
  – change in working capital – principal debt
  repayments + new debt issues.
Apply model as per usual.
FREE CASH FLOW TO EQUITY
  Ifthe firm finances a fixed percentage of its
   capital spending and investments in
   working capital with debt, the calculation of
   FCFE is simplified. Let DR be the debt ratio,
   debt as a percentage of assets. In this case,
   FCFE can be written as
  FCFE = NI – (1 – DR)(Capital Spending +
   change in Working Capital – Depreciation)

  When    building FCFE valuation models, the
   logic, that debt financing is used to finance a
   constant fraction of investments, is very
   useful. This equation is pretty common.
FREE CASH FLOW TO THE FIRM


 FCFF   = EBIT(1-tax rate) + Dep. – Cap.
  Expenditures – Change in WC – Change
  in other assets.
 Again, proceed as normal(replace
  dividends with FCFF) but discount at
  firms cost of capital.
 You find value of firm. To find value of
  equity, simply subtract off debt.
LET’S LOOK AT AN EXAMPLE




 http://faculty.etsu.edu/trainor/FNCE%203300/Lowes.d
   oc

 Another interesting site you may want to use:
 http://caps.fool.com/Ticker.aspx?source=icaedilnk9950
   012&ticker=LOW
THE P/E MODEL
 The models we have used so far involve computing
  a stock’s intrinsic value using discounted cash
  flows to the investor
 Another approach is to assess a stock’s relative
  value
 The price-earnings (P/E) ratio represents the most
  common valuation yardstick in the investment
  industry



                                                       56
 The P/E ratio is simply the current price of
 the stock divided by the last four quarters of
 earnings per share:

                      Current stock price
        P/E 
              Per share earnings for last 12 months
 TheP/E ratio is used as an indication of
 expected growth of a company
  Larger growth rates lead to larger P/E ratios
  High P/E stocks are called growth stocks, whereas
   low P/E stocks are called value stocks              57
   Estimating Future Stock Prices
       Multiplying the P/E ratio by expected earnings results
        in an expected stock price




               Pn  ( P ) x E0 x (1  g ) n
                       E


                                                                 58
 Example:  The P/E ratio for Caterpillar
 is 12.98. The company earned $5.05 per
 share and paid a $1.10 dividend last
 year. Analysts estimate that the
 company will grow at an average annual
 rate of 12.8% over the next 5 years.
 Calculate the expected price of
 Caterpillar’s stock price in 5 years.

P5 = (P/E) x E0 x (1 + g)5
   = 12.98 x $5.05 x (1.128)5
   = $119.70
                                            59
OTHER TYPES OF VALUATION


 Use Price/sales
 Price/Cash flow

 All relative valuation models rely on the market
  to be fairly valued. What is a good Price/Sales
  ratio? Relies on comparisons which may or may
  not be valued accurately.
I leave you with the following:
“When it comes to investing, the rear-
 view mirror is always a lot clearer
 than the windshield.”

Warren Buffett




                                         61

				
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