Valuation of Long Term Securities bonds and stocks

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Valuation of Long Term Securities (bonds and
stocks)

• FIN 5000-week 4
• Fall 2009 Joint MBA

???
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What has Mickey Mouse got to do with this?

• In february 2004 Comcast put a hostile take over
  bid on Disney
• Comcast offered about 54 billion for Disney
• Many professionals said the bid was far too low
  and therefore could not be successful
• Comcast claimed it offered a 10 premium for the
  shareholders
• But since it was a share for share deal Comcast
  paid for it with its own shares
• After the bid Disney shares raised 10 and
  Comcast shares fell about 10 at that time the
  premium evaporated and Comcast actually offered a
  price for Disney at a discount
• The deal did not effectuate as you imagine
• The board of Disney refused to accept it and the
  shareholders of course also refused
• In the meantime a fight at the top was taking
  place between the cousin of Walt Disney and the
  CEO Michael Eisner(see the picture)
• Eisner won then but has now agreed to leave
  Disney per 2006 for early retirementgoodbye Mr.
  Eisnerwho saved Disney when it was about to go
  bankrupt

Bye bye Mr. Eisner
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Look at the valueline doc.
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And the remainder(you can enlarge to read or
download the doc.)
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And has Disney bonds outstanding?
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Valuation

• Liquidation value Sell as separated asset from
  ongoing operations (low) for instance when a
  company is bankrupt
• Book Value Shareholders equity in the balance
  sheet of a company
• Market Value Share Price number of (common)
  shares outstanding
• Intrinsic Value Long Term Free Cash Flow/Cost of
  Capital

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Valuation of Bonds

• A Bond is a confession of debt paper from the
  government or a company
• Each Bond has
• A face value (say 1,000)
• A Coupon rate (say 10 per year)
• A maturity ( for example 9 years)
• A cost of capital (return that the investor wants
  for this specific paper (say 12) This is called
  the cost of debt (Kd)
• Calculating the value of a bond means calculating
  the cash flows that the bond will generate over
  its life and discounting at 12

Put a value on mickey?
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So the value is

• V100/(112)100/(112)2
  100/(112)91000/(112)9
  893,80
• So an investor should pay not more then 893,80
  to buy this bond
• The bond is sold at a discount (lower then its
  face value of 1000)
• Note that all the coupons are discounted at 12
  and at the end of the life time the amount of the
  debt ( 1000) will be paid back

Thanks!
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But if Kd 8 instead of 12

• V100/(18)100/(18)2 100/(18)9100
  0/(18)9 1124,79
• The bond is sold at a premium So now the bond
  has a value higher then its face value

Donalds Uncle
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When will this bond sell at face value (at par)?

• If the coupon rate offered by the issuer of the
  bond (10) is equal to the return (Kd) the
  investor demands so if Kd10
• The return offered (coupon rate) is equal to the
  required Kd so the investor is willing to pay the
  full amount of 1000
• Check it out!

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Perpetual bonds

• Perpetual means that they will give coupon income
  forever
• If the coupon is 10 and Kd12
• The value of such a bond isV I/Kd with Ithe
  amount of the coupon
• Value 100/12 833,33

Investor Have lunch or be lunch!
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Zero coupon bond

• Some bonds do not pay a coupon
• They simply mature after several years
• What is the value of such a bond?
• Say Kd12 and maturity is 10 yrs.
• Value 1000/(112)10 322
• You should pay only pay 322 for such a bond

Zero Coupon Bond ?
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Most bonds issued in the US

• Pay coupon interest twice a year (semi annually)
• A 10 bond with half year coupons and 12 years
  maturity with Kd14 and a face value of 1000
  can be valued at
• V50/(1 14/2)1 50/(114/2)2...
  50/(114/2)241000/(114/2)24 770,45

Demo 2 coupons per year!
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Preferred stock valuation

• Preferred stock offers preferred dividend
• A perpetual stream of fixed dividends will make
  the valuation look like a perpetual bond
• Value Dp (yearly amount of dividends)/Kp ( the
  return the investor wants on this preferred
  stock)
• So if the dividend is 9 per share of 1000 and
  Kp 14 then Value per preferred share
  Dp/Kp9/14 64,29

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The most important valuation is the one for
common stock

• If a share will be hold forever the value is the
  DCF of all future dividends
• Assumed that the yearly dividends are the same
  and that Ke the return that an investor wants on
  these common shares
• Value per share D1/(1Ke)D2/(1Ke)2Dn/(1Ke)
  n
• So if D1D2D3Dn 10
• And Ke is 10 Value/share 10/10 100

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But in reality

• Companies pay different dividends every year
• Shareholders hold shares for a short time (not
  forever)
• In this case value/share is (assume the
  shareholder hold the shares 2 years
• Value/shareD1/(1Ke)D2/(1Ke)2 P2/(1Ke)2
  where P2 the value of the share at the end of
  the second year

Be bullish!
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Dividend constant growth

• If dividend grows every year by a certain then
  D2D1(1g) where g is the growth percentage and
  D1D0(1g)
• Now value/shareD0(1g)/(1ke)D0(1g)2/(1Ke
  )2Dn(1g)n/(1Ke)n
• This can be simplified to
• Value/shareD1/(Ke-g) proof!
• Note assume Kegtg and D0(1g)n/(1Ke)n
  converges to 0 (nil) for this reason

Bear market?
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Homework assignment

• Go to Yahoo Finance
• Find out if your teams company pays dividend and
  how much per share
• What are the earnings per share (latest figures)
• What is the pay out ratio (dividends per
  share/earnings per share)
• Find out how much dividend the company has paid
  in the past per share
• Find g (the dividend growth)
• Assume that Ke10
• Use the dividend growth model to calculate the
  value per share and compare it with todays share
  price of your company
• Does the share market values your company shares
  higher or lower then the dividend growth model?
• Why do you think this is the case?

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Earnings Multiplier approach

• If b the retention rate ( of earnings that the
  company wants to retain i.e. does not want to pay
  out as dividends)
• Then (1-b) the pay out ratio ( the company will
  pay out in dividends)
• Assume (1-b)D1/E1 D1 expected dividend per
  share of period 1 and E1expected earnings per
  share of period 1
• Rewrite D1(1-b)E1
• Then if Value/shareD1/(Ke-g) substitute
  D1(1-b)E1
• And Value/Share V (1-b)E1/(Ke-g)
• And V/E1 (earnings multiplier) or P/E
  (1-b)/(Ke-g)
• Say the retention rate is 40 g6 and Ke14
  and E1 6.67 then the value/share is
  V0.606.67/(14-6) 50
• Earnings Multiplier(1-40)/(14-6) 7.5 times
• Value/shareExpected earnings/shareEarnings
  Multiplier (PE ratio) 6.677.5 50

Stock market talk
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Rate of Return (yield)

• The Yield to Maturity (YTM) for bonds is
• Say you know todays price of a bond
• You know also the coupon rate and how many times
  the coupon will pay per year
• But you would like to calculate at which Kd
  (yield) the present value of all coupons and the
  1000 at maturity will result in todays price
  this Kd is the Yield

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Illustration

• A Bond can be bought today for 761
• The coupon is 80 (8) per year
• Maturity is 12 years
• So we want to find Kd in
• 76180/(1Kd)180/(1Kd)280/(1Kd)12
• We can find it with trial and error or with the
  IRR function in Excel(treat 761 as initial
  cash out)
• Kd11.828

Jump!
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Note that

• If interest rates rise bond prices fall
• If interest rates fall bond prices increase
• So interest rates and bond prices move in
  opposite directions

Climb!
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End of chapter
Jump and Climb!