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Week 2: Bonds, Equity and Basic Valuation. Sept. 15, 2011. 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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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.)
next week
Next Week
  • Macroeconomics and Research Reports
    • Basics of macroeconomics
    • Industry overviews in reports