Question

19.3 Why is the valuation process generally easier to apply to bonds than to stocks?

Answer 1

Valuation is the analytical process of determing the quantitative fair value of an asset.

Bonds are long term Debt Securities ( Fixed Income Securities ) that are issued by corporations and government entities ,guaranteeing periodic interest payments ( Coupon payments ) until maturity when the Face Value of bond is also received. Bondholders are basically lenders to the company. They neither have voting rights , nor the rights to have a say in the way the company functions , and nor a share in the excess profits that the company makes. They are only entitled to the predetermined coupon payments over the face value of the bonds and the face value at maturity ,  and can obviously sue the company for failure of payment. They have no share in the profits made by the company.

Stocks on the other hand are the most fundamental units of ownership in a company. There are many types of stocks like preferred stocks or stocks that guarantee greater voting rights. But the most common type is the Common Stock. Ownership of common stock provides the right to vote in the Annual General Meetings (AGM) that usually convenes to elect Directors for the Board of Directors. The Board decides that in view of profits , whether or not more money should be distributed among the shareholders via dividends alongside cash payments. Thus stocks provide a share in the profits that the company makes. Obviously profits fluctuate every year, so the dividend amount is not fixed and can even be legally denied if the Board deems it necessary . Owning common stock does not always necessarily mean earning more than bonds .

Preferred Stock is a mix of Bond and Stock. It is basically a stock that guarantees a certain minimum annual payment every year , indefinitely . Bonds expire , preferred stocks do not. However , preferred stockholders can also be legally denied payments if the Board cites financial emergency.

Bonds are much easier to value. The only information required is whether the issuing company has enough funds to provide the coupon payments and ultimately the face value of the bond. Since the bondholder is not entitled to anything more than the bond stipulates , profits or losses incurred by the company is immaterial to bondholder. If bondholder is not given his due - he can sue. Preffered stocks and bonds are similar , so they are similarly easy to value.

Stocks are more difficult to value. This is because information about the profits made the company is required to calculate how much dividend is to be issued , if at all. Greater the profits declared , greater will be the dividend demand in stockholders. Also , it is possible to sell only voting rights but keep the shares intact. This is important in times of critical decisions- when elected Directors play pivotal roles. Convertibles that are basically bonds/ preferred stocks but can change to common stocks are equally hard to value.

THUS IN GENERAL STOCKS ARE MORE DIFFICULT TO VALUE THAN BONDS.