A Trader’s Guide to Bond and Stock Valuation Methods
The financial market continuously grows in size as more time passes. Two of the most prominent markets are the stock market and bond market. And in order to use its full potential, you must learn the different methods of stock valuation and bond valuation.
Today, we will be discussing the various methods you can use when it comes to valuation of stocks and bonds.
What is Stock Valuation?
There are numerous types of valuation method you can use when attempting to give value to a stock. Especially today, as investors, it can be quite a shock to learn the overwhelming number of choices. There are methods that are simple-to-use and ones that requires more involvement. Some examples of these methods are the comparables method and the discounted cash flow method.
Every situation you might find yourself in will require you to choose another valuation method. Each stock and industry sector has unique properties that might require different valuation approaches.
Valuation Model for Common Stocks: Two Main Categories
Most of the valuation methods for common stocks are classified into two main categories: absolute and relative.
Learn more about why investors buy common stocks.
Absolute Valuation Model
With these models, you’ll be attempting to find the intrinsic value of the investment through the use of fundamentals alone. This means, you only need to focus on things like dividends, cash flow, and growth rate for a single company. You then should not concern yourself with other companies.
The valuation models that fall under this category include:
- Dividend Discount Model,
- Discounted Cash Flow Model,
- Residual Income Models, and
- Asset-based Models
Relative Valuation Model
When using these models, you’ll be comparing the company with other similar companies. Most of the time, these methods will involve the calculation of multiple of ratios like the price-to-earnings multiple. You then proceed to comparing them to the multiples of other related firms.
If you look at it, this type of valuation is considerably easier and faster compared to the absolute valuation method. Numerous investors and analysts decide to use this method to begin their analysis.
Valuation Model for Preferred Stocks
Preferred stocks are known to have the qualities of both stocks and bonds. This in itself makes the valuation slightly different when compared to that of a common share.
Read more: Advantages of Buying Preferred Stocks
Preferred stocks have fixed dividends which are not guaranteed in common shares. You’ll be able to calculate the value of these stocks by discounting each payment to the present day. Take the payments and determine the sum of the present values into perpetuity in order to identify the stock value. Each issued dividend payment in the future must be discounted back to the present. Once you finish doing this, each value can then be added together.
Here’s the valuation formula:
V = (D_{1} / 1 + r) + (D_{2} /( 1 + r)^{2}) + (D_{3} / (1 + r)^{3}) + … (D_{n} / 1 + r)^{n}) |
Where:
- V stands for the value;
- D_{1 }stands for the dividend next period; and
- r stands for the required rate of return
Despite having guaranteed that the preferred shares are given dividends, there is still a possibility for the payment to be cut. This can happen if company no longer has enough earnings to accommodate a distribution.
The risk of a payment cut needs to be put in consideration. Remember that the higher the payout ratio gets, the higher the risk of a payment cut happening.
Pros and Cons of Stock Valuation
Pros of Stock Valuation
- Use it as a basis on whether or not a stock is undervalued. This will help you decide if you should buy or sell.
- There are numerous valuation methods you can use for every situation.
Cons of Stock Valuation
- No one stock valuation method is perfect for every situation.
- You need to learn how to use as much methods or models as you can. This is to avoid any unwanted situations.
- Less useful when it comes to fast-growing, unpredictable companies.
What is Bond Valuation?
Bond valuation stands by the principle that the bond’s value is equivalent to the present value of its expected (future) cash flows.
What is a Bond?
A bond is identified as a debt instrument that provides investors a steady stream of income through coupon payments. The full face value of the bond is repaid to the bondholder once a maturity date is reached. A regular bond has the following characteristics:
Characteristics of a Bond
Coupon rate
Some of the bonds have interest rates, or most commonly known as coupon rate. These are paid to the bondholders semi-annually. It is known as the fixed return that investors earn periodically until the bond matures.
Maturity date
There is no bond exempted from having a maturity date. The difference lies in the length; there are some short-term and some long-term. Once the bond reaches maturity, the bond issuer will repay the investors with the full face value of the bond.
Face Value
The term face value does not necessarily refer to the invested principal or purchase price of the bond. In the U.S., when it comes to the corporate bonds, the face value is normally at $1,000. Meanwhile, government bonds usually have $10,000 face value.
Current Price
This depends on the level of interest rate in the environment. The investor can end up purchasing a bond at par, below par, or above par.
Just remember that, as the bondholder, you will be paid the bond’s full face value at maturity. Purchasing it for less than the par value will not affect this fact.
Call Provisions
This is also known as an embedded option since you can buy or sell it separately from the bond. Most of the bonds contain provisions that will allow the issuer to buy-back the bond from the holder at a pre-determined price prior to maturity. This is most commonly known as the call price. When a bond contains a call provision, then the bond is referred to as callable.
With this provision, issuers can lessen the interest costs in case the rates fall after a bond is issued. Once this is done, existing bonds can be replaced with lower yielding bonds.
Regardless, you should note that a call provision is disadvantageous to the bond holder. This is mainly the reason why the bond will offer a higher yield than an identical bond with no call provision.
What is Bond Valuation? (Continued)
There are three steps involved when it comes to the valuation process. You must first estimate the amount of estimated cash flows. Secondly, determine the suitable interest rate or rates that need to be used in order to discount the cash flows. And lastly, calculate the present value of the expected cash flows found in the first step. This can be achieved through the use of interest rate or rates found in the second step.
The minimum interest rate an investor should accept is the yield for a risk-free bond. This normally comes in the form of Treasury bond for U.S. investors. The most commonly used Treasury security is the on-the-run issue. This is mostly due to its features where it reflects the latest yields and is the most liquid.
Corporate bonds are a type of non-Treasury bonds. For these bonds, the required rate or yield are different. Aside from the on-the-run government security rate, there should also be a premium that will account for the additional risks brought about by the non-Treasury bonds.
When it comes to maturity, you could use the final maturity date of the issue compared to the Treasury security. It’s advisable to use maturity that will match the individual cash flows since each one is unique in its timing.
Computation of a Bond’s Value
When it comes to computing the value of a bond, you should first find the present value (PV) of the bond’s future cash flows. The term present value pertains to the amount you need to invest today to produce the said future cash flow. Then, in order for the bond price to be determined, you just have to add the figures together.
PV at time T = expected cash flows in period T / (1 + I) to the T power |
Once you’re able to determine the expected cash flows, you’ll need to add individual cash flows. You can use this formula:
Value = present value @ T1 + present value @ T2 + present value @Tn |
It’s important to note that the value of the bond can change. This happens when rates increase or decrease, meaning that the discount rate is also bound to change.
Additionally, the closer the bond gets to its maturity date, the higher possibility that its price will move close to par.
There are three possible scenarios that you should remember:
- Bonds at a premium will see their prices decline over time, moving towards its par value.
- A Bond at a discount will see their prices increase over time, moving towards its par value.
- Bonds that are already at par will simply remain the same.
Conclusion
There are various bond and stock valuation methods that you can choose from. They offer you different advantages especially when it comes to varying situations. You just have to figure out which method will work best for you and study it well.
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