Valuation of bonds and shares

Bonds 

Generally a fixed income security which promise to give a certain fixed cash flow to the holder at certain pre-determined time points – coupon and the face value

Coupon

 Is the periodical payment. Periodicity pre-determined. Quantum is also pre-determined by the coupon rate

 Face value 

Is the lump sum payment at the end of the fixed period

Date of maturity 

Is the last coupon payment date and it also coincides with the lump sum payment of the face value

Price of bond

 Is the price at which bond can be sold or bought and it depends on market factors 

 

Yield  Is the actual return (as different from the coupon rate) worked out on the actual out flow, which is the price of the bond

 

Yield to maturity Is the rate at which we can discount the coupon payments until maturity and the face value at maturity to get the present value to be equal to the price of bond

Equity

Face value is the simplest approach to equity valuation. But this does not reflect the real value 

Book value is the distribution of net worth (assets less outside liabilities) among outstanding shares

This book value approach depends on accounting standards, procedures and conventions and therefore does not reflect the true value of the shares

Another approach to determine real value is to value shares using dividend discount models

 

 Under the DDM, it is assumed constant dividends are paid perpetually on a share and its value derived as the present value of perpetuity. It is possible dividends may grow at constant rate or at different rates. 

Caution - DDM While finding the value of share using dividend models, one has to use a discounting rate to obtain present value of a stream of cash flow. The problem is to find the appropriate discounting rate. We do not have yield curves for shares.

 Caution - DDM Another difficulty is the assumption about dividend payments

Caution – DDM This valuation approach looks at the return from shares and the main components of returns may not be dividend alone. It may be difference between prices at two different points of time

Hence the main problem is to find the future return. Using probability concepts, one can find expected return, which can be a good estimate of future return

The expected return can be calculated from either past prices or from forecasted values of prices. In either case, there is an uncertainty in the realization of predicted return. This is the inherent risk

Hence risk-return analysis becomes an important aspect in share valuation

The question to be addressed in RRA is the capacity to estimate future returns, which requires good amount of information.

Efficient market hypothesis proposes future prices do not depend on past prices. Current prices reflect all relevant information from the past and therefore it is not possible to forecast future prices and hence the returns. This means if a market is efficient it is not possible to predict the returns 

Valuation ratios

Yield  Is sum total of dividend yield and capital gains yield and is mathematically represented by Yield = Dividend + Price change / Initial price 

Dividend Yield Is the ratio of dividend received to the initial price paid and is represented by Dividend Yield = Dividend / Initial price 

Capital Gains Yield Is the ratio of Price change to the initial price paid and is represented by Capital Gains Yield = Price change / Initial price  

Market value to book value ratio

 Market value per share / Book value per share  

Price earning ratio Market price per share / Earning per share

 

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