Foundations of Financial Management: An Analysis (part 38)

 “The individual investor should act consistently as an investor and not as a speculator.” 

– Ben Graham

Valuation and Rates of Return (part H)

by

Charles Lamson

 Summary and Review of Formulas

The primary emphasis in this section of the analysis was on valuation of financial assets: bonds, preferred stock, and common stock. Regardless of the security being analyzed, valuation is normally based on the concept of determining the present value of future cash flows. Thus we draw on many of the time-value-of-money techniques developed in earlier posts. Inherent in the valuation process is a determination of the rate of return that investors demand. When we have computed this value, we have also identified what it will cost the corporation to raise new capital. Let's specifically review the valuation techniques associated with bonds, preferred stock, and common stock.

Bonds

The present value of the principal payment at maturity is:

Table 2   Present value of a single amount

We add these two values together to determine the price of the bond. We use both annual and semiannual analysis.

The value of the bond will be strongly influenced by the relationships of the yield to maturity in the market to the interest rate on the bond and also the length of time to maturity.

If you know the price of the bond, the size of the interest payments, and the maturity of the bond, you can solve for the yield to maturity through a trial and error approach (discussed in Part 33 of this analysis), by an approximation approach as presented in Formula 2 from Part 34, or by using financially oriented calculators or appropriate computer software.

Preferred Stock

In determining the value of preferred stock, we are taking the present value of an infinite stream of level dividend payments. This would be a tedious process if the mathematical calculations could not be compressed into a simple formula. The appropriate equation is Formula 4.

If, on the other hand, we know the price of the preferred stock and the constant annual dividend payment, we can solve for the required rate of return on preferred stock as:

Common Stock

The value of common stock is also based on the concept of the present value of an expected stream of future dividends. Unlike preferred stock, the dividends are not necessarily level. The firm and shareholders may experience: 

1. No growth in dividends.

2.  Constant growth in dividends.

3.  Variable or supernormal growth in dividends.

In using Formula 9 all we need to know is the value of the dividend at the end of the fiscal year, the required rate of return, and the discount rate. Most of our valuation calculations with common stock utilize Formula 9.

The first term represents the dividend yield on the stock and the second term the growth rate. Together they provide the total return demanded by the investor. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 288-290*

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