Class_Notes07_Stock_valuation_2013 (1).pdf - Bond and Stock...

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1 Bond and Stock Valuation - Basics Goals Understand what bonds are, how to value them, and be able to price them Examine the risks inherent in bonds and how they vary Understand how to value stocks, be able to price them Why do we care? Bonds are a major source of financing all over the world Bonds are issued by corporations, government agencies, and governments of all levels Understanding risks of bonds allows us to make informed investment decisions Valuing stocks and bonds will help us later when trying to determine cost of capital © 2008, Sandeep Dahiya and Lee Pinkowitz. Do not copy or use these notes without permission.
2 TIME VALUE OF MONEY TOOLS CAN BE APPLIED TO VALUE FINANCIAL ASSETS Bonds Stocks Bonds can be valued as the combination of TWO STREAMS of cash flows: Annuity of promised interest payments (called coupon payments, usually paid every 6 months (semiannually)) Final repayment of Principal (called the face value, usually $1,000) Dividends are cash flows received by the stockholders, could be paid either annually or more typically quarterly. Since corporations are technically infinitely lived, dividends can be considered to be paid forever. If dividends are assumed to be constant then we can value stock as a PERPETUITY. Usually dividends are assumed to grow at some constant rate and thus stock can be valued as a GROWING PERPETUITY
3 TIME VALUE OF MONEY TOOLS CAN BE APPLIED TO VALUE FINANCIAL ASSETS Stocks Stock represents an ownership interest in the firm and is also known as EQUITY What are the cash flows from stocks? How do we value those cash flows? Slides 3-26 are covered in the Stock Valuation lecture video (25:00 long)
4 Stock Valuation 1. Common stock has uncertain cash flows Equity is the residual claim on the firm’s cash flows. Shareholders get paid only after everyone else does. They get whatever is left over. 2. There is no maturity on common stock The life of the firm is (technically) forever 3. The rate of return on stocks is not easily observed Building on our bond valuation mechanics There are three main differences in valuing stock. BOTTOM LINE - Valuing common stock is difficult!
5 Dividend Discount Model (DDM) You own a share of stock today. What do you get for holding it for one period? Dividend (if any) Price when you sell the stock in one period What is the present value of those cash flows? ) 1 ( P D = Price = PV 1 1 0 0 r Where D represents dividends, P represents price and r is the rate of return investors require to buy the stock.
6 Some Notation We assume that dividends are paid at the end of the period while prices are at the beginning of the period.

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