🗃️Corporate Finance Unit 5 – Valuing Stocks and Bonds

Key Concepts and Definitions

• Intrinsic value represents the true underlying value of an asset based on its expected future cash flows and risk profile
• Market value refers to the current price at which an asset trades in the financial markets, which may differ from its intrinsic value
• Coupon rate is the stated interest rate on a bond, determining the periodic interest payments to bondholders
• Yield to maturity (YTM) measures the total return earned by holding a bond until its maturity date, considering both coupon payments and capital appreciation or depreciation
• Dividend discount model (DDM) values a stock based on the present value of its expected future dividend payments
• Capital asset pricing model (CAPM) describes the relationship between an asset's expected return and its systematic risk (beta) relative to the market portfolio
• Efficient market hypothesis (EMH) suggests that asset prices fully reflect all available information, making it difficult to consistently outperform the market

Time Value of Money Principles

• Money has a time value because of the opportunity cost of capital, inflation, and risk
  • Opportunity cost represents the potential returns foregone by investing in a particular asset instead of alternatives
  • Inflation erodes the purchasing power of money over time, making future cash flows less valuable than present ones
• Present value (PV) is the current worth of a future sum of money or stream of cash flows, discounted at the appropriate rate
• Future value (FV) represents the value of a present sum of money or investment at a specified future date, assuming a certain rate of return
• Discounting is the process of determining the present value of future cash flows using the appropriate discount rate
• Compounding refers to the growth of an investment over time due to reinvestment of returns, leading to exponential growth
• Annuities are series of equal cash flows occurring at regular intervals (e.g., monthly mortgage payments or bond coupon payments)
• Perpetuities are annuities that continue indefinitely, with no end date (e.g., preferred stock dividends)

Bond Valuation Techniques

• Bond valuation involves determining the fair price of a bond based on its expected cash flows (coupon payments and principal repayment)
• The value of a bond is the present value of its future cash flows, discounted at the appropriate yield or required rate of return
• Yield to maturity (YTM) is the discount rate that equates the bond's price with the present value of its future cash flows
  • YTM considers the coupon rate, face value, market price, and time to maturity
  • It assumes that all coupon payments are reinvested at the same rate
• Current yield measures the annual coupon payment relative to the bond's market price, providing a simple measure of the bond's income
• Duration measures the sensitivity of a bond's price to changes in interest rates, expressed as the weighted average time to receive the bond's cash flows
• Convexity captures the non-linear relationship between bond prices and interest rates, complementing duration in assessing bond price sensitivity
• Credit ratings (assigned by agencies like Moody's or Standard & Poor's) assess the creditworthiness of bond issuers and their ability to meet debt obligations

Stock Valuation Methods

• Dividend discount model (DDM) values a stock as the present value of its expected future dividend payments
  • Gordon growth model assumes a constant dividend growth rate in perpetuity: $P_0 = \frac{D_1}{r - g}$
  • Multi-stage models allow for varying growth rates over different periods (e.g., high initial growth followed by stable growth)
• Discounted cash flow (DCF) analysis values a stock based on the present value of its expected future free cash flows to equity (FCFE)
  • FCFE represents the cash available for distribution to shareholders after capital expenditures, working capital changes, and debt payments
• Relative valuation compares a stock's valuation multiples (e.g., price-to-earnings, price-to-sales) to those of similar companies or industry benchmarks
• Asset-based valuation estimates a company's intrinsic value based on the fair market value of its underlying assets minus liabilities
• Earnings-based models focus on a company's expected future earnings, such as the price-to-earnings (P/E) ratio or the enterprise value-to-EBITDA multiple
• Residual income model values a stock as the sum of its book value and the present value of its expected future residual income (earnings above the required return on equity)

Risk and Return Considerations

• Risk refers to the uncertainty of future returns, typically measured by the variability or dispersion of possible outcomes
• Systematic risk (or market risk) affects all assets in the market and cannot be diversified away (e.g., interest rate changes, economic recessions)
• Unsystematic risk (or firm-specific risk) is unique to a particular company or industry and can be reduced through diversification (e.g., labor strikes, management changes)
• Expected return is the probability-weighted average of all possible returns, reflecting the anticipated compensation for bearing risk
• Standard deviation measures the dispersion of returns around the expected return, providing a quantitative measure of risk
• Beta coefficient measures an asset's sensitivity to market movements, reflecting its systematic risk relative to the overall market
• Capital asset pricing model (CAPM) describes the relationship between an asset's expected return and its beta: $E(R_i) = R_f + \beta_i[E(R_m) - R_f]$
  • $R_f$ is the risk-free rate, $E(R_m)$ is the expected market return, and $\beta_i$ is the asset's beta coefficient

Market Efficiency and Asset Pricing

• Efficient market hypothesis (EMH) suggests that asset prices fully reflect all available information, making it difficult to consistently outperform the market
  • Weak-form efficiency implies that prices reflect all historical price and volume data
  • Semi-strong form efficiency suggests that prices quickly adjust to all publicly available information
  • Strong-form efficiency asserts that prices reflect all public and private information
• Arbitrage pricing theory (APT) is a multi-factor model that explains asset returns based on their exposure to various macroeconomic factors (e.g., inflation, GDP growth)
• Fama-French three-factor model expands CAPM by adding size (market capitalization) and value (book-to-market ratio) factors to explain stock returns
• Behavioral finance challenges the EMH by incorporating psychological biases and irrational investor behavior in explaining asset prices and market anomalies
• Market anomalies are patterns in asset returns that appear to contradict the EMH (e.g., small-firm effect, value premium, momentum)
• Adaptive market hypothesis (AMH) reconciles EMH with behavioral finance, suggesting that market efficiency varies over time and across markets due to changing investor behavior and market conditions

Practical Applications in Corporate Finance

• Capital budgeting decisions involve evaluating investment projects based on their expected cash flows and risk, using techniques like net present value (NPV) and internal rate of return (IRR)
• Optimal capital structure refers to the mix of debt and equity financing that maximizes a firm's value while minimizing its weighted average cost of capital (WACC)
• Dividend policy decisions involve determining the portion of earnings to be distributed to shareholders as dividends versus retained for reinvestment
• Mergers and acquisitions (M&A) require valuation of target companies to determine fair prices and potential synergies
• Initial public offerings (IPOs) involve valuing a company's shares before listing them on a stock exchange for public trading
• Stock-based compensation (e.g., employee stock options) requires valuation techniques to determine the fair value of the options granted
• Value-based management focuses on maximizing shareholder value by aligning managerial decisions with the firm's intrinsic value drivers

Common Pitfalls and Misconceptions

• Focusing on short-term market fluctuations rather than long-term intrinsic value can lead to suboptimal investment decisions
• Relying solely on historical data and neglecting forward-looking analysis can result in inaccurate valuations and forecasts
• Ignoring the impact of inflation on future cash flows can overstate the value of long-term projects and investments
• Failing to properly assess and incorporate risk in valuation models can lead to mispricing of assets and poor risk management
• Overreliance on market multiples and comparable company analysis without considering firm-specific factors and growth prospects can result in misvaluations
• Neglecting the effect of dilution on per-share value when evaluating stock-based compensation and financing decisions can overestimate shareholder returns
• Assuming that markets are always efficient and that asset prices always reflect intrinsic value can lead to missed opportunities and potential losses during periods of market inefficiency or irrationality