Question

a.)What are Stocks and Bonds? Describe how you could estimate their values. If you are investing in the stock market, which would you invest in and why?

b.)select a stock in which you are interested. Calculate its per share value using the DDM . Then, find the current market value of a share of the stock. Compare the two. Can you explain the similarity or difference?

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Answer 1

Stocks and bonds represent two different ways for an entity to raise money to fund or expand their operations. When a company issues stock, it is selling a piece of itself in exchange for cash.When an entity issues a bond, it is issuing debt with the agreement to pay interest for the use of the money.

Stocks are simply shares of individual companies.Each share of stock represents an ownership stake in a company – meaning the owner shares in the profits and losses of the company - someone who invests in the stock can benefit if the company performs very well and its value increases over time. At the same time, he or she runs the risk that the company could perform poorly and the stock could go down – or, in the worst-case scenario (bankruptcy) – disappear altogether.

Bonds, on the other hand, represent debt. A government, corporation, or other entity that needs to raise cash borrows money in the public market and subsequently pays interest on that loan to investors.Each bond has a certain par value (say, $1000) and pays a coupon to investors. For instance, a $1000 bond with a 4% coupon would pay $20 to the investor twice a year ($40 annually) until it matures. Upon maturity, the investor is returned the full amount of his or her original principal except for the rare occasion when a bond defaults (i.e., the issuer is unable to make the payment).

The P/E Method of Valuing Stocks

You can value stocks by comparing the price (P) to the company’s earnings (E). To do this, you must know the average P/E ratio for the industry the company is in. Many financial sites publish the current P/E ratio for each industry. Multiply the industry P/E ratio times the earnings per share (EPS) on your stock. Financial sites commonly publish EPS figures for each stock. Industry P/E times your stock’s EPS equals the stock price you should pay. You may pay a premium if you think the EPS is likely to go up.

Valuing Dividend Stocks

If a stock pays a dividend, divide the dividend by the current market price, and you will know the expected percentage yield on your investment in this stock. The value of the stock may rise or fall depending on how attractive that percentage yield is. If interest rates rise, for example, and investors can get a better rate of return on bonds or other investments, your dividend stock could drop in price. If interest rates drop, however, your dividend stock could rise in price. In addition, if the stock increases its dividend, the price will rise.

Rule-of-Thumb Method for Stocks

This method requires an estimate of future earnings per share for the stock. Multiply future earnings times 10 (assuming a desired 10 percent return), and you arrive at a price the stock may be worth.

Bond Values

A bond is affected by three primary factors. The first is the coupon interest rate. This is simply the percentage amount the bond pays in interest. The company or organization issuing the bond sets this interest rate. The second factor is the time to maturity. Bonds with long maturities, such as 30 years, will not pay back the original investment for a long time, whereas bonds with short maturities, such as five years, offer the investor his original investment back in a relatively short time. Bonds with short maturities tend to be valued higher for this reason. The third factor affecting bond values is fluctuation in interest rates. If interest rates rise above the rate your bond pays, investors will not place a high value on your lower-interest bond.

They are at the two ends of the risk vs return spectrum. All the points that were discussed above is summarised in the following table.

So where should you invest: Stocks or bonds?

The short answer is both. The long answer is - it is complicated. It depends upon various factors such as your risk tolerance, your time in the market and other such things.

The dividend discount model (DDM) seeks to estimate the current value of a given stock on the basisof the spread between projected dividend growth and the associated discount rate. The DDM calculates this present value in the following manner:

Present Stock Value = Dividend_Share / (R_Discount – R_{Dividend Growth})

In the DDM, a present stock value that is higher than a stock's market value indicates that the stock is undervalued and that it is a good time to purchase shares.

To illustrate, suppose stock XYZ declares a dividend of two dollars per share and is currently valued at $125 in the market. Based on the stock's dividend history, a broker determines a dividend growth rate for the stock of five percent per year and a discount rate of seven percent. The present stock value is calculated as follows:

Present Stock Value = $2.00 per share / (0.07 discount – 0.05 dividend growth)
= $2.00 / 0.02
= $100

With a calculated present value of $100 against a market value of $125, stock XYZ is overvalued in this instance and represents an opportunity to sell.

Another illustration is given below-

Marion analyzes a stock that pays an annualized dividend of $1.20 per share. By looking at the stock’s historical data, Marion finds out that the company has raised its dividendconsecutively for 15 years at an average dividend growth rate of approximately 7% annually. However, due to the ongoing financial crisis, the dividend growth has slowed down over the last five years. Therefore, Marion estimates an average dividend growth rate of 4% annually.

The second step is to estimate r. With a stock that pays an annualized dividend of $1.20 per share and has a stable dividend growth of 4% annually, Marion estimates an expected rate of return of 10%. By discounting the annualized dividend of $1.20 per share at an expected rate of return 10%, she gets an expected dividend of $1.32 per share.

The third step is to calculate the fair value of the stock. So, Marion plugs in the numbers and finds that

P = D1 / (r – g) = $1.32 / (10% – 4%) = $1.32 / 6% = $22

Therefore, the fair value of the stock based on the dividend discount model is $22. If the stock trades above $22, it is overvalued. If the stock trades under $22, it is undervalued.