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.
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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
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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.
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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.)
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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
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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
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Macroeconomic Team
Types of Investing
Investing Perspective
What makes us different?
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Questions or Concerns?
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Next Week
Macroeconomics and Research Reports
Basics of macroeconomics
Industry overviews
in reports
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