Week 3 bonds equity and basic valuation
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Week 3: Bonds, Equity and Basic Valuation. February 22, 2012. For today…. Basic Investment Types Bonds Equity Basic Research and Valuation Techniques. Asset Class: Bonds. Bonds are a type of debt security. Bondholders receive (usually semi-annual) payments called coupons .

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Week 3: Bonds, Equity and Basic Valuation

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Week 3 bonds equity and basic valuation

Week 3: Bonds, Equity and Basic Valuation

February 22, 2012

For today

For today…

  • Basic Investment Types

    • Bonds

    • Equity

  • Basic Research and Valuation Techniques

Asset class bonds

Asset Class: Bonds

  • Bonds are a type of debt security.

  • Bondholders receive (usually semi-annual) payments called coupons.

  • At the bond’s maturity, bondholders receive the Par or Face Value of the debt.

Primary asset types bond

Primary Asset Types: Bond

  • A bond typically has a payment schedule that looks like this:

Things to note about bonds

Things to Note about Bonds

  • Relatively predictable cash inflows (easier to value).

  • Cash flows are legally guaranteed

  • Bond-holders fare better in the event of bankruptcy (more on that later)

Bond characteristics

Bond Characteristics

  • Secured/Unsecured: whether payment is backed by assets

  • Tax status: some government bonds are tax exempt

  • Callability: Whether or not a bond can be called early by the issuing company

Bond ratings

Bond Ratings

  • Bongs are rated by three credit rating agencies

    • Moody’s, S&P and Fitch

  • The lower a bond rating is, the higher the yield will be

  • Investors want to be compensated for higher risk, as defined by a lower rating

  • Countries can also be rated (see US downgrade)

Time value of money

Time Value of Money

  • If I have $100 today and can invest it at 5% interest (compounded annually), how much will I have after 1 year? 2 years? 10 years?

    • $100 * (1 + .05) = $105 (1 year)

    • $105 * (1 + .05) = $110.25 (2 years)

    • $100 * (1 + .05)10 = $162.89 (10 years)

  • n years?

  • $100 * (1 + .05) n

Time value of money1

Time Value of Money

  • Problems like this are known as future value problems. They answer the question “If I have PV dollars today, how much will I have if I invest at interest rate r for n periods.

  • FV = PV * (1 + r)n

Time value of money2

Time Value of Money

  • Present Value problems do the opposite: They answer the question “How much money do I need to put away today to have FV dollars in n periods if I can invest at rate r?

  • PV = FV/(1+ r)n

  • For a series of cash flows, the formula is:

    • Σ(CF/(1+ r)t) = CF1/(1 + r) + … + CFT/(1 + r)T

What does this mean for us

What does this mean for us?

  • Using our P = $100, r = 0.05, n = 1 example from earlier, the present value formula tells us that we should be indifferent between receiving $100 today and receiving $105 in one year.

  • Consequently, the value of a financial asset is the present value of its expected cash flows.



  • Suppose I offered you a slip of paper that entitles you to $100 in 1 year, $150 in 2 years, and $50 in 3 years. How much would you be willing to pay for this paper (the interest rate is 5%)?

  • PV = CF1/(1 + r) + CF2/(1 + r)2 + CF3/(1 +r)3

  • = 100/(1.05) + 150/(1.05)2 + 50/(1.05)3

  • $274.48

Valuation example

Valuation Example

  • Use the present value of money

  • Sum of future cash flows, discounted to today

  • 5 year bond, $50 coupon, interest rate is 5%

Valuation example1

Valuation Example

  • What happens if the market interest rate rises to 6%?

  • 5 year bond, $50 coupon, interest rate is 5%

Asset class equity common stock

Asset Class: Equity Common Stock

  • Common stock represents a claim on the profits of the company.

  • Think of stock as partial ownership in a business

  • When investing, ask whether you would want to be an owner of the company?

  • Stock owners assume the risk of the company

    • If it goes under, they probably won’t get paid

Asset class equity common stock1

Asset Class: Equity Common Stock

  • Common stockholders get paid only if all other claimants are paid first.

  • Common stockholders are paid in the form of dividends, payments made at the discretion of management.

  • So the value of a share of common stock is the present value of its expected future dividends.

  • Some companies prefer return money through stock repurchases.

Aside on valuation

Aside on Valuation

  • The present value of a perpetual (never ending) cash flow is (CF)/r.

  • The present value of a perpetual cash flow that grows at a rate g every year is (CF)/(r – g).

  • To value a stock using DCF, we estimate its dividends for five years, then assume a constant growth rate thereafter.

Profitability ratios

Profitability Ratios

  • Helps ensure that a company can clear its expenses

  • One ratio is profit margin: Net Income/Revenue

  • Always compare to other similar companies

  • Watch out for continuous year over year margin declines

    • May indicate disappearing competitive advantage

Liquidity ratios

Liquidity Ratios

  • How quickly a company can turn its assets into cash

  • Current Ratio: Current Assets/Current Liabilities

  • Measure of companies ability to pay off liabilities coming due soon

  • Under 1 may signal trouble in the near future

Solvency ratios

Solvency Ratios

  • How well the company can deal with long term obligations

  • Total Debt to Total Assets

    • Short + Long Term Debt/Total Assets

  • Shows how assets were financed

    • Through debt or equity

  • Usually lower is better, but could mean company is passing up growth opportunities

Valuation ratios

Valuation Ratios

  • Attempts to measure how good an investment would be

  • Price to Earnings (P/E) Ratio

    • Market Value/Earnings Per Share

  • How much investors are willing to pay for $1 of current earnings

  • Higher P/E means higher expected future growth

  • Best used to compare against other companies

Valuing common stock

Valuing Common Stock

  • PV = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3 + D4/(1 + r)4 + (D5 + P5)/(1 + r)5, where P5 = D5/(r – g)



  • We expect dividends to be $3, $5, $10, $12, and $13 in years 1 through 5, with 3% growth thereafter. The interest rate is 8%. After 5 years, we sell. Note: P5 = 13/(.05) = 260

Preferred stock

Preferred Stock

  • A special type of equity

  • Preferred stock carries a fixed interest rate, but the company can choose to not pay it.

    • However, before common stockholders can receive dividends, preferred stockholders must receive all of their back-dividends.

  • Preferred stockholders rank above common stockholders in the capital structure.

The capital structure

The Capital Structure

  • A company is in default if it has failed to pay its debt obligations on time.

  • In the event of default and bankruptcy, a company’s assets are liquidated, and entities that have a claim on its assets are paid in this order:

    • Government

    • Debt-holders

    • Equity-holders

  • Note: within each class there are more layers (Senior debt, junior debt, etc.)

Questions for discussion

Questions for Discussion

  • Question 1:

    • Which is more expensive debt or equity?

  • Question 2:

    • As an investor, in the case of bankruptcy would you rather own debt or equity?

Research for next week

Research for Next Week

  • Utilize Johnson School databases to conduct basic research of your company

  • Search for an read relevant news articles in regards to your company and industry



  • Answer 1: Equity

    • Giving up ownership of the company

    • Debt acts as a tax shield

  • Answer 2: Debt

    • Debt holders have a stake in the remaining assets of a company and are therefore one of the first parties to receive compensation

Macroeconomic presentation

Macroeconomic Presentation

  • Government Bonds that have been downgraded:

    • United States: AA+/Aaa

    • Italy: BBB+/Aa2

    • France: AA+/Aaa

    • Greece: CCC/Caa1

    • Spain: A-/A-1

    • Netherlands: AA/Aa1

    • Germany: AA+/Aa1

  • European Debt Crisis

Macroeconomic team

Macroeconomic Team

Types of Investing

Investing Perspective

What makes us different?

Questions or concerns

Questions or Concerns?

Next week

Next Week

  • Macroeconomics and Research Reports

    • Basics of macroeconomics

    • Industry overviews in reports

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