8th Semester IMBA

Security Analysis and Portfolio Management

Topic : Stock ,Bond

Return and Valuation

Nirmal Kumar Routra

Asst. Prof. -Finance
 Chapter Objectives

 To understand the concept of stock return and

valuation
 To understand the constant growth model
 To explain the two stage growth model
 To understand the concept of price-earnings ratio

 To explain the concept of preferred stock valuation

 Concept of Stock Return

 It is a return which includes current income and

capital gain that is caused by increase in the price.
 The current income and capital gain are expressed as
a percentage of the money invested in the beginning.
 An investor before investing in securities must
properly analyze the returns associated with the
securities.
 Anticipated Return

 It is the expected rate of return an investor will get in

future on his investments.
 The anticipated rate of return can be calculated with
the help of probability.
 Probability refers to the likelihood occurrence of an
event.
 It can be calculated as:
N
E(R) =  (Probability P ) (Return R )
t=1
t t
 Multiple Year Holding Period
 If the holding period is more than a year, it is called multiple
year holding period.
 The formula for calculating the multiple year holding period is
as follows:

 N [(e0 )d / e] (1 + g) n   (P / E) [ (e0 )(1 + g) N + 1 ] 

P0 =   n  + 
n=1 (1 + r)   (1 + r) N 

where g = annual expected growth in earnings, dividends and price

e = most recent earnings per share
d / e = dividend pay out
r = required rate of return
P / E = price-earnings ratio
N = holding period in years
 Constant Growth Model

 The basic assumption of this model is that the

dividends are expected to grow at the same rate.
 It is calculated as:

D1
P0 =
r g
where P0 = Present value of the stock
r = Required rate of return
g = Growth rate
D1 = Next year’s dividend
 Two Stage Growth Model
 It is an extended form of constant growth model, where the
growth stages are divided into:
 A period of remarkable growth
 A period of constant growth
 It is calculated as:
N
D0 (1 + g s ) t D N+1 1
P0 =  + ×
t=1 (1 + rs ) t (rs - g n ) (1 + rs ) N

where D0 = Dividend of the previous period

gs and gn = Above normal and normal growth rate
rs = Required rate of return
N = Period of above normal growth
 Valuation through
Price-Earnings Ratio
 P/E ratio indicates price per rupee of share earnings.
 The advantages of price earning ratio are as:
 It helps in comparing the stock prices that have
different earnings per share.
 It helps in estimating the stocks of those companies
that do not pay the dividends.
 The formula for calculating P/E ratio is as:

d/e
P/E =
r – ROE (1 – d/e)
 Preferred Stock Valuation

 Preferred stocks are those stocks that provide a

steady rate of return.
 Preferred stocks can be calculated with the help of
the following formula:
D
P0 =
r
where D = dividend paid
r = required rate of return
 Concept of Bond

 It is a contract between a borrower and a lender in

which the borrower is required to pay a certain
amount of interest income to the lender.
 In general, bonds carry a fixed payment of interest
till the maturity date.
 The rate of interest is also known as coupon rate.
 Bond Risk
 Bonds are considered to be quite safe but they also
carry a certain amount of risk.
 Types of bond risk:
 Interest rate risk: The value of bonds changes due to
variability of the market interest rates.
 Default risk: The borrower fails to pay the agreed value of
debt instrument on time.
 Marketability risk: There is difficulty in liquidating the
bonds in the market.
 Callability risk: There is an uncertainty created in the
returns of the investor by the issuer’s right to call the bond
any time.
 Bond Return

There are several ways of describing a rate of return

on bond. Some of them are:
 Holding period return
 The current yield

 Yield to maturity
 Holding Period Return

 It is a return in which an investor buys a bond and

liquidates it in the market after holding it for a
definite period of time.
 The formula for calculating holding period of return is
as follows:
Price gain + Coupon payment
Purchase price
 It can be calculated on a daily, monthly or annual
basis.
 The Current Yield

 It is a measure through which the investors can easily

figure out the rate of cash flow on the investments
made by them every year.
 It is calculated as:

Annual Coupon Payment

Purchase Price
 Yield to Maturity
 It is the single discount factor that makes the present
value of future cashflows from a bond equivalent to
the current price of the bond.
 The following assumptions are used to calculate yield
to maturity:
 There should not be any default.
 The interest payments are reinvested at yield to maturity.
 The investor has to hold the bond till its maturity.
 It is calculated as:

Coupon1 Coupon 2 (Coupon n + Face value)

Present value = 1
+ 2
+....+
(1+y) (1+y) (1+y) n
 Bond Value Theorems
 These are evolved on the basis of three factors:
(i) coupon rate (ii) years to maturity (iii) expected rate of return.
 The five bond value theorems are as follows:
 Theorem 1: If the bond’s market price increases then its yield declines
and vice versa.
 Theorem 2: If the bond’s yield remains constant over its life, then the
discount or premium depends on the maturity period.
 Theorem 3: If the yield remains constant over its life, the discount and
premium on bonds will decline at an increasing rate as its life gets
shorter.
 Theorem 4: A raise in the bond’s price for a decline in the bond’s yield
is greater than the fall in the bond’s price for a raise in the yield.
 Theorem 5: The percentage change in the bond’s price owing to
change in its yield will be small if the coupon rate is high.
 Duration
 It measures the time structure and interest rate risk
of the bond.
 The formula for calculating the duration is as follows:
T
Pv (C t )
D= 
t =1 P0
×t
where D = Duration
C = Cashflow
R = Current yield to maturity
T = Number of years
Pv(ct) = Present value of the cashflow
P0 = Sum of the present value of cashflow
 Immunisation

 It is a technique that makes a bondholder relatively

certain about the promised cash stream.

 An immunisation can be achieved by reinvesting the

coupons in the bonds that offer higher interest rate.
 Chapter Summary

By now, you should have:

 Understood the concept of stock return and valuation
 Understood the constant growth model
 Learnt the two stage growth model
 Understood the concept of price-earnings ratio
 Understood the concept of preferred stock valuation
 Understood the basics of bond
 Understood the concept of bond return and valuation
 Learnt about the types of bond risks
THANK YOU