1 / 50

Security Valuation FIN 461: Financial Cases & Modeling

Security Valuation FIN 461: Financial Cases & Modeling. George W. Gallinger Associate Professor of Finance W. P. Carey School of Business Arizona State University. Valuation Fundamentals. Value of any financial asset is the PV of future cash flows

dewey
Download Presentation

Security Valuation FIN 461: Financial Cases & Modeling

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Security ValuationFIN 461: Financial Cases & Modeling George W. Gallinger Associate Professor of Finance W. P. Carey School of Business Arizona State University

  2. Valuation Fundamentals • Value of any financial asset is the PV of future cash flows • Bonds: PV of promised interest & principal payments • Stocks: PV of all future dividends • Valuation is the process linking risk & return • Output of process is asset’s expected market price • Key input is the expected return on an asset • Defined as the return an arms-length investor would require for an asset of equivalent risk • Debt securities: risk-free rate plus risk premium(s) • Required return for stocks  using CAPM or other asset pricing model. W. P. Carey School of Business

  3. Basic Valuation Model • P0 = Price of asset at time 0 (today) • CFt = cash flow expected at time t • r = discount rate (reflecting asset’s risk) • n = number of discounting periods (usually years) Model expresses the price of any asset at t = 0 mathematically. W. P. Carey School of Business

  4. Start with Bonds • Calculate price • Calculate yields • Current • Holding period • Yield to maturity. W. P. Carey School of Business

  5. How to Value Bonds • Identify the size and timing of cash flows. • Discount at the correct discount rate. • If you know the price of a bond and the size and timing of cash flows, the yield to maturity is the discount rate. W. P. Carey School of Business

  6. Definition & Example of a Bond • Consider a U.S. government bond listed as 63/8% of December 2009 • The par value of the bond = $1,000 • Coupon payments are made semi-annually (June 30 and December 31 for this particular bond) • Since the coupon rate is 63/8% the payment = $31.875 • On January 1, 2002 the size and timing of cash flows are: W. P. Carey School of Business

  7. Pure Discount Bonds Information needed for valuing pure discount bonds: • Time to maturity (T) = Maturity date - today’s date • Face value (F) • Discount rate (r) Present value of a pure discount bond at time 0: W. P. Carey School of Business

  8. Pure Discount Bonds: Example Find the value of a 30-year zero-coupon bond with a $1,000 par value and a YTM of 6%. W. P. Carey School of Business

  9. Level-Coupon Bonds Information needed to value level-coupon bonds: • Coupon payment dates and time to maturity (T) • Coupon payment (C) per period and Face value (F) • Discount rate Value of a level-coupon bond = PV of coupon payment annuity + PV of face value W. P. Carey School of Business

  10. Level-Coupon Bonds: Example Find the present value (as of January 1, 2002), of a 6-3/8 coupon T-bond with semi-annual payments, and a maturity date of December 2009 if the YTM is 5%. • On January 1, 2002 the size and timing of cash flows are: W. P. Carey School of Business

  11. Current Yield W. P. Carey School of Business

  12. Holding Period Rate of Return W. P. Carey School of Business

  13. Importance & Calculation of Yield to Maturity • Yield to maturity (YTM) • Rate of return investors earn if they buy the bond at P0 and hold it until maturity • YTM on a bond selling at par (P0 = Par) = coupon rate • When P0Par, the YTM will differ from the coupon rate • YTM is the discount rate that equates the PV of a bond’s cash flows with its price • Use T-Bond with n=2 years, 2n=4, C/2=$20, P0=$992.43 W. P. Carey School of Business

  14. Price & Yield Relationships W. P. Carey School of Business

  15. Semi-Annual Bond Interest Payments • Most bonds pay interest semi-annually rather than annually • Can easily modify basic valuation formula; divide both coupon payment (C) and discount rate (r) by 2: • C annual coupon payment; C/2  semi-annual payment • r annual required return; r/2  semi-annual discount rate • n number of years; 2n semi-annual payments. W. P. Carey School of Business

  16. Semi-Annual Bond Interest Payments … An example.... Value a T-Bond Par value = $1,000 Maturity = 2 years Coupon pay = 4% r = 4.4% per year = $992.43 W. P. Carey School of Business

  17. Characteristics of Bonds • Important factors can be stated using 5 bond theorems. W. P. Carey School of Business

  18. Bond Theorem 1 • Market rate > coupon rate • Bond's price is less than its face value of $1000 • Market rate < coupon rate • Bond's price exceeds its face value • Market rate = coupon rate • Bond's price = face value. W. P. Carey School of Business

  19. Bond Theorem 2 • The longer the maturity, the greater the price change. W. P. Carey School of Business

  20. Bond Theorem 3 W. P. Carey School of Business

  21. Bond Theorem 4 • Maturity has no effect on bond value, and thus gains or losses, when the coupon rate = market rate • If the market rate < coupon rate, the bond's capital gains--the price minus the face value of $1000--become smaller as maturity shortens • If the market rate > coupon rate, the bond's capital losses become smaller as maturity shortens. W. P. Carey School of Business

  22. Bond Theorem 5 • Maturity has no affect if coupon rate equals market rate. W. P. Carey School of Business

  23. Bond Risk PremiumsFebruary 97-November 98 97 98 W. P. Carey School of Business

  24. Term Structure of Rates • Term structure of interest rates compares YTMs of comparable risky securities and maturities at a point in time • Provides info about market's forecast of rates and inflation W. P. Carey School of Business

  25. Some Historical Perspective 16 May 1981 14 12 10 January 1995 Interest Rate % 8 August 1996 6 October 1993 4 2 1 3 5 10 15 20 30 Years to Maturity W. P. Carey School of Business

  26. Shapes & Levels of Treasury Yield CurveOctober 1998 5.1 October 9 4.9 October 8 4.7 October 2 4.5 Yield % 4.3 4.1 3.9 3.7 1 5 10 30 Maturity in Years W. P. Carey School of Business

  27. YTM & Forward Rates W. P. Carey School of Business

  28. Bond Duration Coupon rate = 8%; market rate = 8% W. P. Carey School of Business

  29. Factors Influencing Duration • Duration increases with maturity • Decreases with higher yield, higher coupon rates, and higher payment frequency. W. P. Carey School of Business

  30. Discuss Common Stocks W. P. Carey School of Business

  31. Valuation of Stocks • Value a function of expected future cash flows • Capital gains • Dividends • Growth prospects • Zero • Constant • Differential. W. P. Carey School of Business

  32. Dividend Fundamentals • Relevant dates for dividend payments • Announcement, ex dividend, record and payment dates • Stock price should drop by about dividend amount on ex date • Legal factors affecting dividend policy • Capital impairment constraint: Cannot pay out “legal capital” • Cannot accumulate earnings to escape taxes • Contractual constraints on dividend payments • Loan covenants restrict, but don’t prevent, dividend payments • Establish a “pool” of earnings that can be paid out • Liquidity and ownership constraints • Must have cash on hand (cannot used borrowed funds) • High payout leads to potential dilution • Investment opportunity sets of investors. W. P. Carey School of Business

  33. Types of Dividends • Types of cash dividends • Regular Cash Dividend • Special Cash Dividend • Types of dividend policies • Constant payout policy (almost never observed) • Constant nominal payments (standard worldwide) • Low regular and extra dividend • Stock dividends and stock splits • Stock repurchase (3 methods) • Buying shares on the market • Tender Offer to Shareholders • Private Negotiation (Green Mail). W. P. Carey School of Business

  34. U.S. Firms Paying Dividends, by Exchange 100 NYSE 80 60 AMEX Percent 40 NASDAQ 20 0 1926 1936 1946 1956 1966 1976 1986 1996 Year W. P. Carey School of Business

  35. Aggregate Dividend Payout %, U.S. Corporate Sector (1970-2000) % W. P. Carey School of Business

  36. Mkt. Value Share Repurchase Announcements, (1980-1999) $US Bns W. P. Carey School of Business

  37. Market Reaction to Share Repurchase Announcements 25% 20% 15% 10% 5% CUMULATIVE MEAN RATE OF RETURN 0% -5% -10% -60 -50 -40 -30 -20 -10 0 +10 +20 +30 +40 +50 +60 TRADING DAY W. P. Carey School of Business

  38. Patterns Observed in Dividend Policies • Dividend policies show distinct national patterns • Companies in common law countries tend to have higher payouts than those from civil law countries • Dividend policies have pronounced industry patterns, and these are the same worldwide • Profitable firms in mature industries tend to pay out much larger fractions of their earnings • Within industries, dividend payout tends to be directly related to asset intensity and the presence of regulation • But payout is inversely related to growth rate • Almost all firms maintain constant nominal dividend payments per share for long periods of time • Companies tend to "smooth" dividends, and these are far less variable than are corporate profits. W. P. Carey School of Business

  39. Real-World Influences on Dividends • Personal taxes on dividends should discourage payments • Empirical evidence is ambiguous • Dividends paid before 1936 (no taxes) and after • Some evidence of positive relation between payout and PS • Security issuance costs should discourage dividends • If costly to issue new stocks & bonds, firm should retain cash • Investor trading costs argue in favor of dividends • But cost of selling shares for income has fallen steadily • Dividends might be a “residual” after funding investments • But dividends are most stable of all cash flow series • May convey information in markets with info asymmetries • But what specific info & isn’t there a cheaper way to signal? • Latest empirical evidence: div signal the past, not the future. W. P. Carey School of Business

  40. How Do Corporations Really Set Dividend Payments? • Dividends determined today as they were for Lintner (1956) • Managers believe investors value steady dividend payments • Managers have a target payout ratio, but only over time • Will allow payout to vary in the short term to keep $div same • Will only raise $div if permanent earnings increase • Will only cut $div if firm facing financial disaster • Managerial reluctance to change nominal dividend payment gives rise to partial adjustment model • Assume target payout ratio = 0.50, profits initially $2.00/sh • Implies annual dividend of $1.00/sh; quarterly div of $0.25/sh • Suppose permanent earnings suddenly rise to $3.00/sh • Will not increase dividend to $1.50/year immediately. Instead, • May do so in $0.05 quarterly increments, over 2.5 yrs. W. P. Carey School of Business

  41. Key Dividend Dates W. P. Carey School of Business

  42. Calculating Intrinsic Price of a Non-constant Dividend Stream W. P. Carey School of Business

  43. Valuation of Perpetual Dividend Streams W. P. Carey School of Business

  44. Valuation of Two-Stage Dividend Streams W. P. Carey School of Business

  45. Estimates of Parameters in the Dividend-Discount Model • The value of stock depends upon its discount rate, r, and growth rate, g. • Where does r come from? • Where does g come from? W. P. Carey School of Business

  46. Where Does r Come From? • Best to use the CAPM • Discussed last lesson. W. P. Carey School of Business

  47. Formula for Stock’s Growth Rate g = (1 – EPS / DPS) × ROE / [1 – RR × ROE] This is sustainable growth! W. P. Carey School of Business

  48. Other Approaches to Common Stock Valuation • Book value: • Assumes assets can be sold at book value • Liquidation value: • More realistic than book value, but doesn’t consider firm’s value as a going concern • Price/Earnings (P/E) multiples: • Reflects the amount investors will pay for each dollar of earnings per share • P/E multiples differ between and within industries • May be helpful for privately-held firms • A “lazy person’s” approach to valuation • Discounting • Free cash flows • Economic value added (aka EVA). W. P. Carey School of Business

  49. Other Price Ratio Analysis • Many analysts frequently relate earnings per share to variables other than price, e.g.: • Price/Cash Flow Ratio • Cash flow = Net income + depreciation = cash flow from operations or operating cash flow • Price/Sales • Current stock price divided by annual sales per share • Price/Book (aka market-to-book ratio) • Price divided by book value of equity, which is measured as assets – liabilities. W. P. Carey School of Business

  50. The End W. P. Carey School of Business

More Related