Understanding Bonds, Stocks, and Market Valuation

Posted on Apr 6, 2025 in Finance

As time passes, interest rates change in the markets, which affects the present value of a bond. When interest rates increase, the present value of the bond decreases, and when interest rates fall, the bond is worth more. There is an inverse relationship between interest rates and bond prices.

Yield to Maturity (YTM) is the opportunity rate for bonds of similar characteristics, the interest rate required in the market on a bond, and the rate implied by the current bond price. The YTM represents the yield (annual rate of return) that an investor will receive if the bond is bought at the current market price and held until maturity. YTM = REQUIRED RETURN = MARKET RETURN. YTM is also the nominal rate. Current yield = Annual coupon / current price

Bond Pricing

Par value: Market Price = Face Value; YTM = Coupon Rate (C)

Discount bond: Market Price < Face Value / Par Value; YTM > C

Premium bond: Market Price > Face Value / Par Value; YTM < C

Bond Price Sensitivity

The sensitivity of a bond price to interest rate changes depends on two factors: time to maturity and the coupon rate. All else being equal:

The longer the time to maturity, the greater the interest rate risk.
The lower the coupon rate, the greater the interest rate risk.

Debt vs. Equity Characteristics

Debt Characteristics:

Not an ownership interest.
Creditors do not have voting rights.
Interest is considered an expense and is tax-deductible.
Creditors have legal recourse if interest or principal payments are missed.
Excess debt can lead to financial distress and bankruptcy.
The return is limited to the interest paid.

Equity Characteristics:

Ownership interest.
Common stockholders vote to elect the board of directors and on other issues.
Dividends are not considered an expense and are not tax-deductible.
Dividends are not a liability to the firm until declared. Stockholders have no legal recourse if dividends are not declared.
An all-equity firm cannot go bankrupt.
Has a residual claim.
There is no limit.

Types of Debt

Short-term debt: less than one year. Long-term debt: greater than 1 year.

Debenture: unsecured debt (for which no specific property has been pledged as security) which generally matures in ten years or more.

Note: unsecured debt that generally matures in less than ten years.

Public issue: debt issue which is sold to the general public. In a private issue, terms are negotiated directly between borrower and lender, and the security is issued directly to the lender.

Indenture

Indenture is the written agreement between the corporation (the borrower) and its creditors (the lenders) detailing the terms of the debt issue. Characteristics:

The basic terms of the bonds.
The total amount of bonds issued.
A description of property used as security.
The repayment arrangements.
The call provisions.
Details of the protective covenants.

When interest payments on a bond are made directly to the owner of record, the bond is said to be in registered form. The company’s appointed registrar mails interest payments directly to the owners of registered bonds. However, when interest payments are made to whoever holds the bond, the bond is said to be in bearer form. Bearer bonds have dated coupons attached, and the bondholder detaches a coupon and mails it to the firm, which then makes the payment.

Fallen angel: a bond that was previously rated as investment grade but has been downgraded to a junk bond.

Collateral is a general term that frequently means securities (for example, bonds and stocks) that are pledged as security for payment of debt. However, the term collateral is commonly used to refer to any asset pledged on a debt.

Mortgage securities are secured by a mortgage on the real property of the borrower, usually real estate, land, or buildings.

Seniority indicates priority of payment to creditors in the event of bankruptcy. If a debt is subordinated, it means that other creditors must be paid first in the event of bankruptcy.

Bond Repayment

Early repayment is more typical and is often handled through a sinking fund. A sinking fund is an account managed by the bond trustee for the purpose of redeeming bonds early. It requires the corporation to make annual payments to the bond trustee, who then either repurchases bonds in the open market or selects by lottery and redeems bonds at a specified price.

Call provision is the right of the bond issuer to repurchase the bond at a predetermined price prior to maturity. The call premium is the amount by which the call price exceeds the par value. A deferred call provision is the provision that prohibits a bond issuer from repurchasing a bond for a period of time after issue. A call protected bond is a bond that currently cannot be redeemed by the issuer.

Protective covenants are the stipulations in a bond indenture agreement which limit the actions a firm can take while the bond issue is still outstanding. Examples: The firm must limit the amount of dividend it pays, cannot issue additional long-term debt, and cannot merge with another firm.

Negative covenant: restricts the issuer’s actions. Positive covenant: requires that certain actions be taken by the corporation.

Bond Ratings

Bonds are rated according to the likelihood of default and the protection creditors have in the event of default. Bond ratings are concerned only with the possibility of default. The highest ratings are AAA, AA for S&P and Aaa, Aa for Moody’s: indicate a very low probability of default. Bonds that are rated at least BBB (S&P) or Baa (Moody’s) are considered investment grade. While lower rated bonds are referred to as low-grade, high-yield, or junk bonds.

Treasury and Municipal Securities

Treasury securities: The federal government borrows by issuing Treasury bonds, notes, and bills. T-bills are pure discount bonds with an original maturity of one year or less. T-notes are coupon debt with an original maturity between one and ten years. T-bonds are coupon debt with an original maturity greater than ten years. The U.S. Treasury issues, unlike essentially all other bonds, have no default risk. Treasury issues are exempt from state income taxes but still subject to federal income taxes. The U.S. Treasury market is the largest securities market in the world.

Municipal securities: State and local governments also borrow money by selling notes and bonds, called municipal bonds or notes or just “munis” for short. Municipal issues have varying degrees of default risk and are rated much like corporate issues. Municipal issues coupon payments are exempt from federal income taxes, which makes them very attractive to high-income, high-tax bracket investors. Due to the tax break, yields on municipal bonds are much lower than the yields on taxable bonds.

Special Types of Bonds

ZERO COUPON BONDS: These are pure-discount bonds that pay no annual coupon interest. The principal and all interest are paid at maturity, and the bond is issued at a price below face value. The difference between the face value and the original issue price constitutes the interest paid.

FLOATING RATE BONDS: Coupon payments on a floating-rate bond (also called floaters) are adjusted as market interest rates change. Most of these bonds have a floor-and-ceiling provision, specifying the minimum and maximum coupon rates over the bond’s life. They also have a put provision, which gives the holder the option to sell the bond back to the issuer at a specified price. This provision takes effect following a specified period after issuance. When the coupon floats, it is less likely to differ substantially from the yield to maturity, so there is less interest rate risk with floating rate bonds.

INCOME BONDS: Coupons are paid only when sufficient income is made.

CONVERTIBLE BONDS: Can be exchanged for a specified number of the issuing firm’s common stocks.

Bond Markets and Pricing

Bond markets: Most bond transactions take place over the counter (OTC). Bond dealers are connected electronically. There is an extremely large number of bond issues, but generally low daily volume in a single issue. Corporate bonds trade less frequently than common stocks, and thus obtaining current bond values can be difficult sometimes.

Bond price reporting: Bid price is the price at which you can sell a bond to the dealer, and asked price is the price a dealer is willing to take for a security. Bid-Ask spread is the profit that a dealer earns on the purchase and subsequent resale of a bond.

CLEAN PRICE: Excluding any accrued interest. It is the quoted price.

DIRTY / FULL / INVOICE PRICE: Price including any accrued interest to date.

Real vs. Nominal Rates and the Fisher Effect

Real rates are interest rates that have been adjusted for inflation. The real rate of return indicates the actual change in purchasing power. The nominal rate is the rate you earn on an investment before adjusting for inflation.

FISHER EFFECT: 1 + R = (1 + r) × (1 + h) where R is the nominal rate, r is the real rate, and h is the inflation rate.

Term Structure of Interest Rates

The term structure of interest rates is the relationship between nominal interest rates on default-free pure discount securities and time to maturity; that is, the pure time value of money. These rates are pure interest rates because they involve no risk of default.

The nominal rates reflected in the term structure (or in its graphical representation, the yield curve) comprise (a) the real rate of return, (b) the inflation premium, and (c) the interest rate risk premium.

Characteristics of the Yield Curve

The yield curve is the graphical representation of the term structure.
The Treasury yield curve is the curve that results from plotting the yields of treasury notes and bonds in relation to their respective times to maturity.
Inflation premium is the compensation investors require to offset expected future prices.
Interest rate risk premium is the compensation investors require for their assumption of the risk related to changes in interest rates.
Default risk premium is the portion of a bond yield that compensates investors for the possibility that the bond’s interest or principal might not be paid.
Taxability premium is the compensation that investors demand for a corporate bond over that of a comparable municipal bond.
Liquidity premium is the portion of a nominal interest rate that represents compensation for the lack of the ability to sell the bond at its fair value in a timely manner.

Common Stock Valuation

There are three factors complicating the valuation of common stocks.

First, dividend payments are not fixed over time and can change substantially from one year to another.
Second, a share of common stock has neither a maturity date nor a maturity value, unlike a bond which has a maturity date and a future value.
Third, quite similar to bond valuation, it is difficult to estimate the appropriate required rate of return for a stock.

Discounted Dividend Valuation

Dividend discount models (DDMs) discount the cash flows (dividends) to be received by the shareholders.

Advantages of DDMs:

The shareholder’s investment today is worth the present value of the expected future cash flows, and using the dividends as cash flows is theoretically justified. Even when the shareholder decides to sell the stock before receiving all the expected dividends, he will get from the buyers the present value of the expected future dividends.
Dividends are less volatile than other measures of cash flows such as earnings.

Disadvantages of DDMs:

DDMs cannot be used for firms that don’t currently pay dividends.
DDMs are appropriate for firms where the controlling shareholders dictate a dividend policy that is consistent with the firm’s underlying profitability. However, DDMs are inappropriate if the firm’s dividend policy is not in synergy with the firm’s ability to create value.

We define the Capital gain yield as the rate at which the value of an investment grows; it is equal to the dividend growth rate. The assumption of non-constant growth is more realistic for many firms. The non-constant growth model allows for the growth rate to be greater than the required rate of return for some years. In reality, this cannot happen forever, and for this reason, we assume that after some number of years the dividend will grow at a constant rate. In a sense, the idea behind this model is that dividends change at different rates in different periods, until, at a specified future date, the growth rate settles at some constant equilibrium rate.

Strengths of DDM:

The models have the flexibility to estimate the value of a firm under virtually an infinite number of scenarios.
The models make it easier to see the relationship between assumptions and resulting estimates of value; therefore, analysts can identify the impact of different assumptions on stock value.

Limitations of DDM:

Like in any forecasting exercise, the models are only as good as the assumptions and projections used as inputs.
The estimate of stock value is very sensitive to the assumptions of the growth rate and the required return, which are in turn often difficult to estimate accurately.

Free Cash Flow Valuation Models

Free cash flow to the firm (FCFF) is the cash flow resulting from the firm’s business operations that is not required to be reinvested within the firm to continue to operate at its current level. Specifically, FCFF is the cash available to the firm’s investors (shareholders and bondholders) after the firm sells products and services, pays its operating expenses, and makes working capital investments and long-term investments. With the FCFF, the firm will first pay its bondholders and meet all of its obligations to its other investors, and then the amount left thereafter is called the free cash flow to equity, which belongs to the shareholders. The firm has discretion over what to do with that money, either pay all or some of it out in dividends or plow it back into the firm for future needs.

Free cash flow to equity (FCFE) is therefore defined as the cash flow available to shareholders after funding capital requirements, debt financing requirements, and working capital needs.

Advantages of Free Cash Flow Valuation Models:

They are applicable to almost any firm regardless of the firm’s dividend policy or capital structure.
They are most suitable for firms that do not have a clearly defined dividend policy or a dividend policy that is not related to the firm’s earnings.
Free cash flow valuation is more appropriate from the perspective of controlling shareholders who have the ability to influence the distribution of the firms’ free cash flows (dividend policy). However, it is pertinent to use free cash flow valuation when the valuation perspective is that of a minority shareholder since the firm can be acquired for a market price equal to the value to the controlling shareholders. The reason we distinguish between controlling and minority shareholders is that some investors are willing to pay a premium for control of the firm.

Limitations of Free Cash Flow Valuation Models:

Firms may need significant capital investments if the industry is experiencing a major technological revolution, which may result in negative free cash flow for many years in the future.

Zero Growth or constant dividend: A stock with constant dividends is perpetuity. The stock is assumed to pay the same amount of dividend forever.

Residual Income Valuation

RESIDUAL INCOME VALUATION: Residual income, or economic profit, is defined as the amount of earnings that exceed the shareholders’ required return. The concept of economic profit is not reflected in traditional accounting income measures, whereby a firm can report a positive net income but not meet the return required by its shareholders.

Advantages of Residual Income Valuation:

Can be applied to dividend and non-dividend paying firms and to firms with negative free cash flows. They are also appropriate when the cash flows are volatile.
Residual income models use accounting data, which is usually easily accessible.
Valuation with residual income models is relatively less sensitive to terminal value estimates, as in the case with dividend and free cash flow valuation models, which reduces forecast errors.
These models focus on economic profitability rather than just on accounting profitability.

Disadvantages of Residual Income Valuation:

The reliance on accounting that can be manipulated by management.
These models can be more difficult to apply since they require significant adjustments, an in-depth analysis of the firm’s accounting accruals; therefore, they are more appropriate for firms with high-quality earnings and transparent financial reporting.

Stock Valuation Using Multiples

It is obvious that the Dividend Discount Model cannot be applied to companies that don’t pay dividends. There are other models that can be applied in that case like: the Free cash flow valuation model, the residual income valuation model and the price multiples. We briefly discussed two of the common price multiples below:

Price-to-Earnings (P/E) Ratio

There are three advantages in using the price-to-earnings (P/E) ratios in valuation:

Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
The P/E ratio is popular in the investment community.
Empirical research shows that P/E differences are significantly related to long-run average stock returns.

Shortcomings of the P/E Ratio:

The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts.
Earnings can be negative, which produces a meaningless P/E ratio.
Management discretion in the accounting practices can distort reported earnings and impair the comparability of P/Es across firms.

We can define two versions of the P/E ratio; a trailing and a leading P/E. The difference between the two is how earnings (the denominator) are calculated. Trailing P/E uses earnings over the most recent 12 months period in the denominator. Leading P/E ratio (also known as forward or prospective P/E) uses next year’s expected earnings.

Notice: Trailing P/E is not useful for forecasting and valuation if the firm’s business has changed. Whereas, Leading P/E may not be relevant if earnings are sufficiently volatile so that next year’s earnings are not easy to forecast with accuracy.

Price-to-Sales (P/S) Ratio

Advantages of P/S Ratios:

P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and P/B ratios, which can be negative.
Sales revenue is not easy to manipulate or distort as EPS and book value, which is significantly affected by accounting conventions.
P/S is not as volatile as P/E multiples.
P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and start-up companies with no record of earnings.
Like P/E and P/B ratios, empirical research finds that differences in P/S are significantly related to differences in long-run average stock returns.

Disadvantages of P/S Ratios:

High growth in sales does not necessarily indicate high operating profits as measured by earnings and cash flow.
P/S ratios do not capture differences in cost structures across companies.
Revenue recognition practices can still distort the sales forecasts.

Common Stock Characteristics

Stock that has no special preference either in paying dividends or in bankruptcy.
Shareholders control the corporation by electing directors who then hire the managers to run the corporation. Therefore, shareholders control the corporation through the right to elect the directors.
Normally, each share entitles the shareholder to one vote.
A shareholder may cast his votes in person at the annual meeting, or by Proxy.
A proxy is the authority granted by a shareholder that permits another individual to vote the share.
Straight voting: a procedure in which a shareholder may cast all votes for each member of the board of directors. With straight voting the directors are elected one at a time.
Cumulative voting: a procedure in which a shareholder may cast all votes for one member of the board of directors. With cumulative voting, the directors are elected all at once. The total number of votes that each shareholder may cast is determined by multiplying the number of shares (owned or controlled) by the number of directors to be elected.
Cumulative voting allows minority shareholders to have more chance in electing directors.
If there are N directors up for election in a cumulative voting, then 1/(N+1) percent of the stock plus one stock will guarantee you a seat.
Staggering elections is a devise used to minimize the effect of the cumulative voting. To stagger the voting for the board of directors is to put a fraction of the directorship up for election at a particular time.
Staggering makes it more difficult for minority to elect a director and makes takeover attempts less likely to be successful.
A corporation may have different classes of stock each with different voting rights.

Shareholders generally have rights to:

The right to share proportionally in dividends paid.
The right to share proportionally in assets remaining after liquidation.
Vote on stockholder matters.

Corporations, at the discretion of the board of directors, pay cash dividends to shareholders, but are not legally obligated to do so. Dividends, once declared, are liabilities of the firm. Dividends paid by the firm are not deductible for tax purposes.
Preemptive right is the right of the shareholder to buy a new issue of stock to maintain proportional ownership.

Preferred Stock Characteristics

PREFERED STOCK: a stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights.

Normally, preferred stocks don’t have a voting right, so a firm which issues preferred stock raises equity without affecting control of the corporation.
Dividends payable on preferred stock are either cumulative or non-cumulative. A corporation is not legally obligated to pay dividends on preferred stock. If dividends are cumulative, then any dividends not paid are accumulated and the entire amount must be paid before any dividends on common stock can be paid.
Unpaid preferred dividends are not debts of the firm. Directors can elect to defer preferred dividends indefinitely. In such a case, common shareholders must also forgo dividends.

Stock Market Operations

STOCK MARKET:

Primary market: is a market in which new securities are originally sold to investors (initial public offering).
Secondary market: is a market in which previously issued securities are traded among investors.
A dealer: maintains an inventory of securities and stands ready to buy and sell at any time.
A broker: is an agent who arranges security transactions among investors. In a sense, he brings buyers and sellers together and does not maintain an inventory.

Organization of the NYSE:

A member of the NYSE is the owner of a seat on the NYSE.
Commission brokers are NYSE members who execute customer orders to buy and sell stock transmitted to the exchange floor.
A specialist is a NYSE member acting as a dealer in a small number of securities on the exchange floor. He is also called a market maker.
A specialist’s post is a fixed place on the exchange floor where the specialist operates.
Floor brokers are NYSE members who execute orders for commission brokers on a fee basis.
Floor traders are NYSE members who trade for their own accounts, trying to anticipate temporary price fluctuations.
SuperDOT system is an electronic NYSE system allowing orders to be transmitted directly to the specialist.
Order flow is the flow of customer orders to buy and sell securities.

NASDAQ Operations:

An electronic network without a single physical exchange floor. It is also a system of multiple market makers. There are approximately 4,000 securities listed on NASDAQ. All the trading is done through dealers.

Non-Constant Growth in Stock Valuation

Non-constant Growth: The assumption of non-constant growth is more realistic for many firms. The non-constant growth model allows for the growth rate to be greater than the required rate of return for some years. In reality, this cannot happen forever, and for this reason, we assume that after some number of years the dividend will grow at a constant rate. In a sense, the idea behind this model is that dividends change at different rates in different periods until, at a specified future date, the growth rate settles at some constant equilibrium rate. The present value becomes the sum of the discounted values of all expected cash flows:

Key Concepts and Definitions

The total return on a share of stock has two components: the dividend yield and the capital gains yield. TRUE.
The stock valuation method that determines the price of a stock by dividing the next period’s dividend by the discount rate less the dividend growth rate is called the: dividend growth model.
When using the dividend growth model, all else the same: I- the higher the required rate of return, the lower the stock price II- the higher the dividend growth rate, the higher the stock price.
The dividend yield is the next year’s expected annual dividend divided by the current stock price.
The capital gains yield is the rate at which the stock price is expected to grow.
The procedure in which a shareholder may cast all votes for one member of the board of directors is called: cumulative voting.
According the dividend growth model, an increase in which of the following will increase the current stock price I- dividend growth rate III- current dividend IV- number of future dividends