Week 2: Bonds, Equity and Basic Valuation

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

Primary Asset Types: Bond • A bond typically has a payment schedule that looks like this:

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 • 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 • 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 • 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 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 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? • 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.

Example • 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 • Use the present value of money • Sum of future cash flows, discounted to today • 5 year bond, $50 coupon, interest rate is 5%

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 • 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 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 • 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 • 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 • 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 • 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 • 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 • 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)

Example • 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 • 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 • 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 • Macroeconomics and Research Reports • Basics of macroeconomics • Industry overviews in reports

See you next week

Week 2: Bonds, Equity and Basic Valuation