Question

2.How are equity valuation models analogous to the yield-to-maturity calculation for a bond?

Answer 1

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures.

Solving the equation by hand requires an understanding of the relationship between a bond’s price and its yield, as well as of the different types of bond pricings. Bonds can be priced at a discount, at par, or at a premium. When the bond is priced at par, the bond’s interest rate is equal to its coupon rate. A bond priced above par, called a premium bond, has a coupon rate higher than the interest rate, and a bond priced below par, called a discount bond, has a coupon rate lower than the interest rate. So if an investor were calculating YTM on a bond priced below par, he or she would solve the equation by plugging in various annual interest rates that were higher than the coupon rate until finding a bond price close to the price of the bond in question.

Calculations of yield to maturity (YTM) assume that all coupon payments are reinvested at the same rate as the bond’s current yield, and take into account the bond’s current market price, par value, coupon interest rate, and term to maturity. YTM is a complex but accurate calculation of a bond’s return that can help investors compare bonds with different maturoties and coupons.