Week 3- Bonds and Equity Valuation - Mutual Investment Club of ...

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Mutual Investment Club of Cornell

Week 3: Bonds, Equity and Basic
Valuation

February 22, 2012

Mutual Investment Club of Cornell

For today…


Basic Investment
Types


Bonds


Equity


Basic Research and Valuation Techniques


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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.

Mutual Investment Club of Cornell

Primary Asset Types: Bond


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

Period

Payment

1

$50

2

$50





N
-
1

␵A

N

␱〵A

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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)

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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

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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)

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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

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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



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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
) = CF
1
/(1 + r) + … + CF
T
/(1 + r)
T



Mutual Investment Club of Cornell

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.

Mutual Investment Club of Cornell

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 = CF
1
/(1 + r) + CF
2
/(1 + r)
2

+ CF
3
/(1 +r)
3


= 100/(1.05) + 150/(1.05)
2

+ 50/(1.05)
3


$274.48

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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%

Year

Cash Flow

Present

Value

1

50

47.62

2

50

45.35

3

50

43.19

4

50

41.13

5

1050

822.70

Total

1000

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Valuation Example


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


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

Year

Cash Flow

Present

Value

1

50

47.16

2

50

44.50

3

50

41.98

4

50

39.60

5

1050

784.62

Total

957.86

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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

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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.

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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.

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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

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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

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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

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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

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Valuing Common Stock


PV = D
1
/(1 + r) + D
2
/(1 + r)
2

+ D
3
/(1 + r)
3

+
D
4
/(1 + r)
4

+ (D
5

+ P
5
)/(1 + r)
5
, where P
5

= D
5
/(r


g)

Year

Cash Flow

Present

Value

1

D1

D
1
/(1 + r)

2

D2

D
2
/(1 + r)
2

3

D3

D
3
/(1 + r)
3

4

D4

D
4
/(1 + r)
4

5

D5

+ P5

(D
5

+ P
5
)/(1 + r)
5

Present

Value

Total of above

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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: P
5

= 13/(.05) = 260

Year

Cash Flow

Present

Value

1

3

2.78

2

5

4.29

3

10

7.94

4

12

8.82

5

13 + 260

185.80

Total

209.62

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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.

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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.)

Mutual Investment Club of Cornell

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?

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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

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Answers


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


Mutual Investment Club of Cornell

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

Mutual Investment Club of Cornell

Macroeconomic Team

Types of Investing

Investing Perspective

What makes us different?

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Questions or Concerns?


Mutual Investment Club of Cornell

Next Week


Macroeconomics and Research Reports


Basics of macroeconomics


Industry overviews
in reports