mutual investment club of cornell week 2: bonds, equity and basic valuation sept. 15, 2011

Mutual Investment Club of Cornell

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:

Period Payment

1 $50

2 $50

… …

N-1 $50

N $1050


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%Year Cash Flow Present Value

1 50 47.622 50 45.353 50 43.194 50 41.135 1050 822.70Total 1000


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 47.162 50 44.503 50 41.984 50 39.605 1050 784.62Total 957.86


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)

Year Cash Flow Present Value

1 D1 D1/(1 + r)

2 D2 D2/(1 + r)2

3 D3 D3/(1 + r)3

4 D4 D4/(1 + r)4

5 D5 + P5 (D5 + P5)/(1 + r)5

Present Value Total of above


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) = 260Year Cash Flow Present Value

1 3 2.782 5 4.293 10 7.944 12 8.825 13 + 260 185.80Total 209.62


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

mutual investment club of cornell week 2: bonds, equity and basic valuation sept. 15, 2011

Documents

r n slide

r t slide

r cf

years n years

rate r

bonds bonds

fv1 r n

later slide