Capital Markets I – ECN226

Lecture 2: How to Value Bonds and

Common Stocks
 Lecture 2 Overview

1. Valuing bonds
• Valuation of bonds: Prices and Yield
• Yield to maturity
• The yield curve
• Duration and Volatility

2. Valuing common stocks

• As present value of future dividends
• As present value of future free cash flows

Bodie, Kane and Marcus

parts of Chapter 14, ‘Bond Prices and Yields',
parts of Chapter 15: The Term Structure of Interest Rates’
parts of Chapter 16: Managing Bond Portfolios’
parts of Chapter 22: ‘Equity Valuation Models’ 2
What is a bond

• A bond is a security issued in relation with a borrowing agreement.

The arrangement obligates the issuer to make specified payments
to the bond- holders on specified dates.

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 Who issues bonds?

• Bonds are issued by companies,

municipalities and governments.

• Different degrees of risk:

– companies and municipalities may
not be able to repay their bonds;
– governments repay their bonds in full
and on time. (Usually!)

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Bond Terminology

• Bond Certificate or Covenant

– States the terms of the bond

• Face Value
– Notional amount used to compute the interest payments

• Maturity Date
– Final repayment date

• Term
– The time remaining until the repayment date

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Bond Terminology (Cont’d)

• Coupon Rate
– Determines the amount of each coupon payment, expressed as an APR

• Coupon Payment

Coupon Rate  Face Value

CPN 
Number of Coupon Payments per Year

• Most bonds pay 2 coupons per year

• Semiannual coupon just half annual coupon (no adjustment for
compounding)

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Bond Example

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Coupon Bonds

• Coupon Bonds
– Pay face value at maturity
– Pay regular coupon interest payments
– Pay semi-annually

• Treasury Notes (Gilts in the UK)

– U.S. Treasury coupon security with original maturities of 1–10 years
• Treasury Bonds (Gilts in the UK)
– U.S. Treasury coupon security with original maturities over 10 years
• Denomination for US
– can be as small as $100, but $1,000 is more common.
– Bid price of 100:08 means 100 8/32 or $1002.50

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VALUING BONDS: BOND PRICING AND YIELD

9
Valuation of bonds

• Bond value is the present value of the coupon payments plus the present value of
the bond face value:
𝑷𝑽𝑩 = 𝑷𝑽𝑪𝑷 + 𝑷𝑽𝑭

• Consider a bond paying coupons annually, with a maturity date 𝑻. The 𝑷𝑽 of the
coupon payment is:
𝑻
𝟏
𝑷𝑽𝑪𝑷 = 𝒕
𝑪𝑷
(𝟏 + 𝒓)
𝒕=𝟏

• The 𝑷𝑽 of the face-value is:

𝟏
𝑷𝑽𝑭 = 𝑭
(𝟏 + 𝒓)𝑻

where 𝒓 is the return offered by similar securities or the required market interest
rate on the bond.
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Valuation of bonds

Hence the present value of the bond writes:

𝑻
𝟏 𝟏
𝑷𝑽𝑩 = 𝒕
𝑪𝑷 + 𝑻
𝑭
(𝟏 + 𝒓) (𝟏 + 𝒓)
𝒕=𝟏

By applying the annuity formula:

𝟏 𝟏 𝟏
𝑷𝑽𝑩 = − 𝑻
𝑪𝑷 + 𝑻
𝑭
𝒓 𝒓(𝟏 + 𝒓) (𝟏 + 𝒓)

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The price of bonds

• In a competitive market, the price of the bond corresponds to the

present value of the coupons and the present value of the face
value.

• The price of a bond is usually expressed as a percentage of the face

value.

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Example

Example: On the 1st of January 2012 you buy a (German) bond

with face value 100 euros, with a coupon of 3 euros paid annually. The
bond matures at the end of 2016. The return on similar securities is
2%. Find the price of this bond.
Notice that the first coupon payment will be in December 2012.

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Example

The present value of the coupons is:

𝟏 𝟏
𝑷𝑽𝑪𝑷 = 𝟑 × − 𝟓
𝟎. 𝟎𝟐 𝟎. 𝟎𝟐 𝟏 + 𝟎. 𝟎𝟐
= 𝟏𝟒. 𝟏𝟒
The present value of the face value is:
𝟏𝟎𝟎
𝑷𝑽𝑭 = 𝟓
𝟏 + 𝟎. 𝟎𝟐
= 𝟗𝟎. 𝟓𝟕
The present value of the bond is hence:
𝑷𝑽𝑭 = 𝟏𝟒. 𝟒 + 𝟗𝟎. 𝟓𝟕 = 𝟏𝟎𝟒. 𝟕𝟏
The price of the bond is 104.71 or 104,71%.
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Example: Zero coupon bond

Example: Find the value of a 30-year zero-coupon bond (i.e. 𝐂𝐏=𝟎)

with a $𝟏𝟎𝟎𝟎 face value and a required market interest rate of 𝟔%.
This is:
𝟏
𝑷𝑽 = 𝑻
𝑭
𝟏+𝒓
𝟏
= 𝟑𝟎
𝟏𝟎𝟎𝟎 = 𝟏𝟕𝟒. 𝟏𝟏
𝟏 + 𝟎. 𝟎𝟔

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Example: Semi-annual coupons

Example: Consider a 4% US treasury note (a US bond that matures in

10 years or less) issued in June 2008, maturing in June 2011. The face
value is $1000. Coupons are paid semi-annually. The investors require a
semi-annual return of 2.48%.

12/2008 06/2009 12/2009 06/2010 12/2010 06/2011

Cash flows 20 20 20 20 20 1,020

𝟏 𝟏 𝟏𝟎𝟎𝟎
𝑷𝑽 = 𝟐𝟎 − 𝟔
+ 𝟔
𝟎. 𝟎𝟐𝟒𝟖 𝟎. 𝟎𝟐𝟒𝟖 𝟏 + 𝟎. 𝟎𝟐𝟒𝟖 𝟏 + 𝟎. 𝟎𝟐𝟒𝟖
= 𝟗𝟕𝟑. 𝟓𝟒
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Accrued interest and quoted bond prices

• The bondholder is usually entitled to:

– A coupon (CP): is an interest payment made (semi)annually for the life of
the bond.
– At maturity the bond-holder receives the final coupon and the face
value F (or par value) of the bond.

• Typical time line (buyer’s cash flow) for a bond looks as follows:

• At time 0, the bond is purchased for some price P.

– The price paid, P, is in general not equal to the Face Value of the bond, although the
coupon rate is usually set such that the price and the Face Value are close.
– When they are equal, the bond is selling at ‘par’.
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 Accrued Interest

• Coupon Payment
– Whoever is the registered owner of the bond on a specified day receives the
whole coupon, even if they only purchased the bond the day before.
• Accrued Interest
– Since a bond just prior to coupon is more valuable than one that has just paid
out, the purchaser pays more. This extra is accrued interest.

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Accrued interest and quoted bond prices

If a bond is purchased between coupon payments, the buyer must pay the
seller for accrued interest.

For a bond paying coupons semi-annually, the accrued interest formula is:
𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝑷 𝑫𝒂𝒚𝒔 𝒔𝒊𝒏𝒄𝒆 𝒍𝒂𝒔𝒕 𝒄𝒐𝒖𝒑𝒐𝒏 𝒑𝒂𝒚𝒎𝒆𝒏𝒕
𝑨𝒄𝒄𝒓𝒖𝒆𝒅 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 = ×
𝟐 𝑫𝒂𝒚𝒔 𝒃𝒆𝒕𝒘𝒆𝒆𝒏 𝒄𝒐𝒖𝒑𝒐𝒏 𝒑𝒂𝒚𝒎𝒆𝒏𝒕𝒔
Price

Dirty Price

Dirty Price = Clean Price + accrued

Accrued
Interest

Clean Price
Coupon Coupon Coupon
Time
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Example: Price are quoted as % of pat value

1,000,000 X 100.388% =
1,003,880

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The yield to maturity

Rather than finding the value of a bond the alternative problem is: For
a given price of a bond 𝑷, find the return 𝒚 expected by investors.
In such a case, we need to find the return 𝒚 that solves the following:
𝟏 𝟏 𝟏 𝟏
𝑷= 𝑪𝑷 + 𝟐
𝑪𝑷 + ⋯ + 𝑻
𝑪𝑷 + 𝑻
𝑭
(𝟏 + 𝒚) (𝟏 + 𝒚) 𝟏+𝒚 (𝟏 + 𝒚)

𝒚 is the yield to maturity of the bond. If you buy a bond at a

price 𝑷 and keep it to its maturity, you will earn a return of 𝒚% over
the 𝑻 years.

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Example: yield to maturity

Example: If the price of the bond is 104.7%; the face value is 100. The
bond is issued in January 2012 and comes to maturity at the end of
2016, and the annual coupon rate is 3%. Find the yield to maturity of
this bond.
𝟑 𝟑 𝟑 𝟏𝟎𝟎
𝟏𝟎𝟒. 𝟕 = + 𝟐
+ ⋯+ 𝟓
+
𝟏 + 𝒚 (𝟏 + 𝒚) 𝟏+𝒚 𝟏+𝒚 𝟓
𝒚 = 𝟐%

How to find the yield to maturity? Trial and error!

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The yield to maturity

• The current yield of a bond is the bond’s annual coupon payment

divided by the bond’s price.
• In the example above:
𝟑
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒊𝒆𝒍𝒅 = = 𝟐. 𝟖𝟔%
𝟏𝟎𝟒. 𝟕

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The yield to maturity

• Bonds selling at par value (Price = Par value):

– coupon rate = current yield = yield to maturity

• Premium bonds (Price > Par value):

– coupon rate > current yield > yield to maturity

• Discount bonds (Price < Par value):

– coupon rate < current yield < yield to maturity

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Bond prices vary with interest rates

• Now assume that we are back to our US bond example, but the six-
month market interest rate is 1.5% (rather than 2.48%). The
new price of the bond is:
𝟏 𝟏 𝟏𝟎𝟎𝟎
𝑷𝑽 = 𝟐𝟎 − 𝟔
+
𝟎. 𝟎𝟏𝟓 𝟎. 𝟎𝟏𝟓 𝟏 + 𝟎. 𝟎𝟏𝟓 (𝟏 + 𝟎. 𝟎𝟏𝟓)𝟔

The bond is offered at a higher price.

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Bond prices vary with interest rates

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Price and Yield for 10% 10 Year Bond

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Bond prices vary with interest rates

• There is a negative relationship between interest rates and bond

prices:
– If the market interest rate increases, the bond price decreases.
– If the market interest rate decreases, the bond price increases.

• We also notice that:

– An increase in the interest rate results in a price decline
that is smaller than the price gain resulting from a decrease
in the interest rate.
– Progressive increases in the interest rate result in
progressively smaller reductions in the bond price.

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Bond prices vary with interest rates

• Interest rate fluctuations represent the main source of risk for fixed-
income securities.

• Keeping all other factors the same, the longer the maturity of the
bond, the stronger the sensitivity of the price to fluctuations in the
interest rate.

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Bond prices vary with interest rates

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 Prices over Time of 30-Year Maturity, 6.5% Coupon Bonds

Capital losses due to

decreasing number of high
rate coupons

Capital gains due to

decreasing number of low
rate coupons

What happens if interest rates fluctuates?

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 Bond Prices with a Spreadsheet

• There is a specific formula for finding bond prices on a

spreadsheet
– PRICE(Settlement,Maturity,Rate,Yld,Redemption, Frequency,Basis)
– YIELD(Settlement,Maturity,Rate,Pr,Redemption, Frequency,Basis)
– Settlement and maturity need to be actual dates
– The redemption and Pr need to given as % of par value

• Play with the “Bond Calculator” excel spreadsheet !

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THE TERM STRUCTURE OF INTEREST RATE

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 Yield Curves

• Yield curve describes the relationship between bond yields and bond
maturity
– More precisely it plots the yield to maturity of a zero-coupon bond at different maturities
(the zero-coupon yields are derived from coupon bonds)
– Though benchmark and par curves are often simply fitted through coupon bond yields
• Information on expected future short term rates can be implied from
the yield curve.

Yield

Maturity of
Bond
Check live data ! http://markets.ft.com/Research/Markets/Bonds

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 Treasury Yield Curves - examples

Yield curve – graphical representation of the term structure

Normal – upward-sloping, long-term yields are higher than short-term yields.
Inverted – downward-sloping, long-term yields are lower than short-term yields.
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Term Structure of Interest Rates: Bond pricing

• Problems:
– Yields on different maturity bonds are not all equal. How do we value coupon bonds
that make payments at many different times?

– We need to consider each bond cash flow as a stand-alone zero-coupon bond.

– Bond stripping (selling coupons as stand-alone security) and bond reconstitution offer
opportunities for arbitrage.
– The value of the bond should be the sum of the values of its parts.

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Valuing Coupon Bonds

• Value a 3 year, 10% coupon bond using discount rates from Table 15.1:
$100 $100 $1100
Price   2

1.05 1.06 1.07 3
• Price = $1082.17 and YTM = 6.88%
• 6.88% is less than the 3-year rate of 7%.
• A three year coupon bond can be thought as a portfolio of 3 zero-
coupon bonds
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Valuing Coupon Bonds - Example

• Calculate the price and yield to maturity of a 3-year bond with a

coupon rate of 4% making annual coupon payments:

$40 $40 $1040

Price   2

1.05 1.06 1.07 3
• Price = $922.65 and YTM = 6.945%
• Observation: The price is lower, the YTM closer to a 3-year zero-
coupon bond than is the YTM of the 10% coupon bond. (Of course, the
coupon rate is lower!)
• Question: what if a bond with the same coupon and maturity in the
market is trading at different price?
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Two Types of Yield Curves : summary

Pure Yield Curve On-the-run Yield Curve

• The pure yield curve uses • The on-the-run yield curve
stripped or zero coupon uses recently issued
Treasuries. coupon bonds selling at or
• The pure yield curve may near par.
differ significantly from • The financial press
the on-the-run yield typically publishes on-the-
curve. run yield curves.

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MANAGING BOND PORTFOLIOS

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Bond Pricing Relationships

1. Bond prices and yields are inversely related.

2. An increase in a bond’s yield to maturity results in a smaller price change than a decrease of
equal magnitude.
3. Long-term bonds tend to be more price sensitive than short-term bonds.
4. As maturity increases, price sensitivity increases at a decreasing rate.
5. Interest rate risk is inversely related to the bond’s coupon rate.
6. Price sensitivity is inversely related to the yield to maturity at which the bond is selling.

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Two Interpretations of Duration

1. Duration is the slope of

the price-yield curve.

2. Duration is the average

time to get future cash
flow.

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Duration

• A coupon bond that matures at year 3 makes payments in each of

years 1 through 3. So the average time to each cash flow is less than
3 years.

• The duration (Macaulay duration) of a bond is the weighted

average time to each payment made by the bond.

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Duration

• The weight of each payment is the proportion of the total value of the
bond accounted for by that payment:
𝑪𝑭𝒕
(𝟏 + 𝒓)𝒕
𝒘𝒕 =
𝑩𝒐𝒏𝒅 𝒑𝒓𝒊𝒄𝒆

𝑪𝑭𝒕 is the cash flow in period 𝒕 (coupon and/or face value).

• The duration of the bond is given by:

𝑻

𝑫= 𝒘𝒕 × 𝒕
𝒕=𝟏

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Coupons and Duration

Consider a three-year bond paying a coupon of 5% a year and with a

face value of $1,000. Find the duration of the bond.
𝑷𝑽(𝑪𝒕 ) 𝑷𝑽(𝑪𝒕 )
t 𝑪𝒕 𝑷𝑽(𝑪𝒕 ) at 3% ×𝒕
𝑽 𝑽

1 50 48.54 0.046 0.046

2 50 47.13 0.045 0.089

3 1050 960.9 0.909 2.73

V=1056.57 Duration =2.86

The weighted average time to each cashflow is 2.86 years.

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Coupons and Duration

Let us consider another 3 year bond with a coupon of 7%.

𝑷𝑽(𝑪𝒕 ) 𝑷𝑽(𝑪𝒕 )
t 𝑪𝒕 𝑷𝑽(𝑪𝒕 ) at 3% ×𝒕
𝑽 𝑽

1 70 67.96 0.06 0.06

2 70 65.98 0.059 0.12

3 1070 979.20 0.88 2.64

V=1113.14 Duration =2.82

Notice that there exists a negative relationship between coupon

payment and duration of the bond.
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Duration and Volatility

𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏
𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚 =
𝟏 + 𝒀𝒊𝒆𝒍𝒅
𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏
• 𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚 = = 𝑫∗ is also called modified duration.
𝟏+𝒀𝒊𝒆𝒍𝒅
• The modified duration (or volatility) is a measure of the bond’s
exposure to changes in interest rates.
∆𝑷
= −𝑫∗ × ∆𝒚
𝑷

47
What determines duration?

• The duration of a zero coupon bond is its time to maturity.

• Holding maturity constant, a bond’s duration is lower when the

coupon rate is higher.

• Holding the coupon rate constant, a bond’s duration generally

increases with its time to maturity.

• Holding other factors constant, the duration of a coupon bond

is higher when the bond’s yield to maturity is lower.

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Convexity

• Although modified duration is an accurate way of calculating price sensitivity in

response to small yield changes, it becomes increasingly inaccurate when considering
large yield changes.
Price

Non-Linear (Convex) relationship

(a 1% increase in yield from point X has a smaller
impact on price than a 1% decrease)

Linear relationship
(a 1% increase in yield from
point X has an equal and
opposite impact on price as a
1% decrease)

Yield

49
Convexity

• It can then be used to get a more accurate measure of the expected

change in price for a given change in yield

P
  D  y  1 [Convexity  (y ) 2 ]
P 2
• When Δy is small , we are back to previous equation
• Convexity is an attractive property of a bond since it gives it more
upside (price response to yield falls) than downside (price response
to yield rises)

50
Though convexity adjustment still an approximation!

• The Modified duration is the slope of the price-yield curve(first derivative) as a

fraction of bond price.
• The convexity of a bond equals the second derivative (the rate of change of the
slope) of the price-yield curve divided by bond price:
• Convexity = 1/P X 𝑑 2 𝑃/𝑑𝑦 2

51
Bond prices over time

• Holding-period return (HPR):

𝑬𝒏𝒅𝒊𝒏𝒈 𝒑𝒓𝒊𝒄𝒆 − 𝑩𝒆𝒈𝒊𝒏𝒏𝒊𝒏𝒈 𝒑𝒓𝒊𝒄𝒆 + 𝑪𝑷
𝑯𝑷𝑹 =
𝑩𝒆𝒈𝒊𝒏𝒏𝒊𝒏𝒈 𝒑𝒓𝒊𝒄𝒆

When the yield to maturity is unchanged over the period, the rate of
return on the bond will equal that yield.

An increase (resp. decrease) in the yield to maturity reduces (resp.

increases) the price of the bond, and the HPR will be lower (resp.
higher) than the initial yield.

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VALUING COMMON STOCKS

53
Basic concepts

• Common Stocks are ownership shares in publicly held corporations.

• New shares are traded in the primary market.

• Trade of existing shares occurs in the secondary market (Ex: NYSE).

• Stocks are also traded over the counter by dealers who display their
prices on Nasdaq, for example.

54
Common stocks

• The value of an asset is the present value of its expected future cash
flows.

• For stocks the cash flows are:

– dividends;

– capital gains/losses.

55
Common stocks as present value of future dividends

Suppose that the current price of a share is 𝑷𝟎 , the expected price at

the end of the year is 𝑷𝟏 and that the expected dividend per share is
𝑫𝑰𝑽𝟏 .

The expected holding period return is:

𝑫𝑰𝑽𝟏 + 𝑷𝟏 − 𝑷𝟎
𝒓=
𝑷𝟎
𝑫𝑰𝑽𝟏
is called Dividend Yield.
𝑷𝟎

𝑷𝟏 −𝑷𝟎
is called Capital Gain.
𝑷𝟎

56
Common stocks as present value of future dividends

If you are given a forecast of the future dividend and price and if 𝒓 is
the expected return on securities with similar risk, then we compute
the price of the share as:
𝑫𝑰𝑽𝟏 + 𝑷𝟏
𝑷𝟎 =
𝟏+𝒓

The idea is that at each point in time all securities in an equivalent risk
class are priced to offer the same expected return.
This is a condition of equilibrium in well-functioning capital markets.

57
Common stocks as present value of future dividends

𝑫𝑰𝑽𝟏 𝑷𝟏 𝑫𝑰𝑽𝟐 𝑷𝟐
𝑷𝟎 = + , 𝑷𝟏 = +
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝟏+𝒓
Therefore:
𝑫𝑰𝑽𝟏 𝑫𝑰𝑽𝟐 𝑷𝟐
𝑷𝟎 = + 𝟐
+
𝟏 + 𝒓 (𝟏 + 𝒓) (𝟏 + 𝒓)𝟐
For a holding period of n years the current price of the stock can be
represented as follows:
𝑫𝑰𝑽𝟏 𝑫𝑰𝑽𝟐 𝑫𝑰𝑽𝒏 + 𝑷𝒏
𝑷𝟎 = + + ⋯+
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝒏
𝒏
𝑫𝑰𝑽𝒕 𝑷𝒏
= 𝒕
+
𝟏+𝒓 𝟏+𝒓 𝒏
𝒕=𝟏

58
Common stocks as present value of future dividends

For an infinite number of periods the present value of the terminal

price tends to zero:
𝑷𝒏
𝐥𝐢𝐦
𝒏→∞ (𝟏 + 𝒓)𝒏

This implies that for long time horizons the current price of a share is
the present value of the expected future dividends.

𝒏
𝑫𝑰𝑽𝒕
𝑷𝟎 =
(𝟏 + 𝒓)𝒕
𝒕=𝟏

This is called the Dividend Discount Model (DDM) of stock prices.

59
Common stocks as present value of future dividends

If the expected future dividends are constant then we are dealing with
a perpetuity:
𝑫𝑰𝑽
𝑷𝟎 =
𝒓
If the expected dividends are growing at a constant rate g :

𝑫𝑰𝑽𝟏
𝑷𝟎 =
𝒓−𝒈

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Common stocks as present value of future dividends

Implications of the constant-growth DDM:

– Stock’s value will be greater, the larger its expected dividend per
share.
– Stock’s value will be greater, the higher the expected growth rate
of dividends.
– The stock price is expected to grow at the same rate as dividends

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Common stocks as present value of future dividends

Let’s prove the third result: the stock price is expected to grow at the
same rate as dividends.

We know that:
𝑫𝑰𝑽𝟏
𝑷𝟎 =
𝒓−𝒈
𝑫𝑰𝑽𝟐 𝑫𝑰𝑽𝟏
𝑷𝟏 = = (𝟏 + 𝒈)
𝒓−𝒈 𝒓−𝒈
From the two equations:
𝑷𝟏 = 𝑷𝟎 (𝟏 + 𝒈)

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Common stocks as present value of future dividends

Two ways of forecasting 𝒈:

– Base the forecast on historical data.
– Use some accounting relationships.

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Common stocks as present value of future dividends

The Plowback ratio (earnings retention ratio) is the fraction of

earnings reinvested in the firm:
𝑬𝑷𝑺 − 𝑫𝑰𝑽
𝑷𝒍𝒐𝒘𝒃𝒂𝒄𝒌 𝒓𝒂𝒕𝒊𝒐 = = 𝟏 − 𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐
𝑬𝑷𝑺
If the firm reinvests some of the earnings, the dividends will initially
fall.
Is this going to decrease the share price?
No, subsequent growth due to the reinvestment policy will generate
growth in future dividends.
How much will dividends grow?

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Common stocks as present value of future dividends

By definition the Return on Equity (ROE) is:

𝑬𝑷𝑺
𝑹𝑶𝑬 =
𝒃𝒐𝒐𝒌 𝒆𝒒𝒖𝒊𝒕𝒚 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

The growth rate of dividend can be calculated as:

𝒈 = 𝑹𝑶𝑬 × 𝑷𝒍𝒐𝒘𝒃𝒂𝒄𝒌 𝒓𝒂𝒕𝒊𝒐

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Common stocks as present value of future dividends

There exists a link between the stock price and the EPS:

𝑫𝑰𝑽
𝑷𝟎 =
𝒓

Assume that all the earnings are paid out as dividends (𝑬𝑷𝑺 = 𝑫𝑰𝑽 ).
Therefore:
𝑬𝑷𝑺𝟏
𝑷𝟎 =
𝒓
𝑬𝑷𝑺𝟏
corresponds to the ‘No-growth value per share’.
𝒓

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Common stocks as present value of future dividends

The price can also be expressed as:

𝑬𝑷𝑺𝒕
𝑷𝟎 = + 𝑷𝑽𝑮𝑶
𝒓

where 𝑷𝑽𝑮𝑶 stands for the net present value of growth opportunities.

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Example

Example: assume 𝒓 = 𝟏𝟓% and the company will pay a dividend of $5

in the first year and thereafter the dividend will grow at a constant rate
of 10% a year. 𝑬𝑷𝑺𝟏 = 𝟖. 𝟑𝟑 and 𝑹𝑶𝑬 = 𝟐𝟓%.
– Find the price of the stock.
– Find the plowback ratio.
– Find the no-growth value per share
– Find PVGO

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Example

In this case, the price of the stock will be:

𝑫𝑰𝑽𝟏 𝟓
𝑷𝟎 = = = $𝟏𝟎𝟎
𝒓 − 𝒈 𝟎. 𝟏𝟓 − 𝟎. 𝟏

If
𝑫𝑰𝑽𝟏 𝟓
𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐 = = = 𝟎. 𝟔
𝑬𝑷𝑺𝟏 𝟖. 𝟑𝟑

the company’s plowback ratio is 𝟏𝟎𝟎% − 𝟔𝟎% = 𝟒𝟎%, i.e. 𝟒𝟎% of

earnings per share are reinvested.

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Example

The present value of earnings per share without growth is:

𝑬𝑷𝑺𝟏 𝟖. 𝟑𝟑
= = $𝟓𝟓. 𝟓𝟔
𝒓 𝟎. 𝟏𝟓

The 𝑷𝑽𝑮𝑶 is:

𝑷𝑽𝑮𝑶 = 𝟏𝟎𝟎 − 𝟓𝟓. 𝟓𝟔 = 𝟒𝟒. 𝟒𝟒

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Example

• ALTERNATIVELY, we can also compute the PVGO without knowing the stock price:
The company reinvests: 𝟎. 𝟒 × 𝟖. 𝟑𝟑 = 𝟑. 𝟑𝟑.
By assumption 𝑹𝑶𝑬 = 𝟎. 𝟐𝟓, so each investment creates additional value (growth) of
𝟎. 𝟐𝟓 × 𝟑. 𝟑𝟑 = 𝟎. 𝟖𝟑𝟑 per share every year, starting from year 2.
The 𝑵𝑷𝑽 of this investment is:
𝟎. 𝟖𝟑
𝑵𝑷𝑽𝟏 = −𝟑. 𝟑𝟑 + = 𝟐. 𝟐𝟐
𝟎. 𝟏𝟓

• when reinvested at 𝒈 = 𝟏𝟎%, 𝟐. 𝟐𝟐(𝟏 + 𝟎. 𝟏) = 𝟐. 𝟒𝟒. Which is reinvested again

and again in perpetuity.
Hence:
𝑵𝑷𝑽𝟏 𝟐. 𝟐𝟐
𝑷𝑽𝑮𝑶 = = = $𝟒𝟒. 𝟒𝟒
𝒓 − 𝒈 𝟎. 𝟏𝟓 − 𝟎. 𝟏

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Common stocks as present value of future free cashflows

𝒏
𝑭𝑪𝑭𝑬𝒕
𝑴𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 =
(𝟏 + 𝒓)𝒕
𝒕=𝟏

𝑭𝑪𝑭𝑬𝒕 stands for free cashflow to equity-holders.

Note: more about free cash flows and this approach in Corporate
Finance 1 module

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