bond’s face value is also known as its par value, or principal.

Like a good detective, you need to become

the basic terms used in finance as well as their aliases.

The term coupon rate comes from the detachable coupons that are affixed to bearer bond certificates,
which, when

presented to a paying agent or the issuer, entitle the holder to receive the interest due on that date.
Nowadays,

registered bonds, whose ownership is registered with the issuer, allow the registered owner to receive
interest by check

through the mail.

4 The Valuation of Long-Term Securities

75

••

Bond A long-term debt

instrument issued by

a corporation or

government.

Face value The stated

value of an asset. In

the case of a bond,

the face value is

usually $1,000.

Coupon rate The

stated rate of interest

on a bond; the annual

interest payment
divided by the bond’s

face value.

Consol A bond that

never matures; a

perpetuity in the form

of a bond.

FUNO_C04.qxd 9/19/08 17:14 Page 75

(4.1)

= I(PVIFAkd,∞) (4.2)

which, from Chapter 3’s discussion of perpetuities, we know should reduce to

V = I /k d (4.3)

Thus the present value of a perpetual bond is simply the periodic interest payment divided

by the appropriate discount rate per period. Suppose you could buy a bond that paid $50 a

year forever. Assuming that your required rate of return for this type of bond is 12 percent,

the present value of this security would be

V = $50/0.12 = $416.67

This is the maximum amount that you would be willing to pay for this bond. If the market

price is greater than this amount, however, you would not want to buy it.

Bonds with a Finite Maturity

Nonzero Coupon Bonds. If a bond has a finite maturity, then we must consider not only

the interest stream but also the terminal or maturity value (face value) in valuing the bond.

The valuation equation for such a bond that pays interest at the end of each year is

(4.4)

= I(PVIFAkd,n) + MV(PVIFkd,n) (4.5)

where n is the number of years until final maturity and MV is the maturity value of the bond.
We might wish to determine the value of a $1,000-par-value bond with a 10 percent

coupon and nine years to maturity. The coupon rate corresponds to interest payments of

$100 a year. If our required rate of return on the bond is 12 percent, then

= $100(PVIFA12%,9) + $1,000(PVIF12%,9)

Referring to Table IV in the Appendix at the back of the book, we find that the present value

interest factor of an annuity at 12 percent for nine periods is 5.328. Table II in the Appendix

reveals under the 12 percent column that the present value interest factor for a single payment

nine periods in the future is 0.361. Therefore the value, V, of the bond is

V = $100(5.328) + $1,000(0.361)

= $532.80 + $361.00 = $893.80

The interest payments have a present value of $532.80, whereas the principal payment at

maturity has a present value of $360.00. (Note: All of these figures are approximate because the

present value tables used are rounded to the third decimal place; the true present value of the

bond is $893.44.)

V = + ++ + . . . $100

(1.12)

$100

(1.12)

$100

(1.12)

$1,000

(1.12) 12 99

VI

I
k

MV

MV

nn

=+

++

=+

+=+∑

()()...()()

()()
11 1 1

11

dd

1dd

VI

kt

=+

++

=+

=
∞

()()...()

()

11 1

1d

Part 2 Valuation

76

••

FUNO_C04.qxd 9/19/08 17:14 Page 76

If the appropriate discount rate is 8 percent instead of 12 percent, the valuation equation

becomes

= $100(PVIFA8%,9) + $1,000(PVIF8%,9)

Looking up the appropriate interest factors in Tables II and IV in the Appendix, we determine

that

V = $100(6.247) + $1,000(0.500)

= $624.70 + $500.00 = $1,124.70

In this case, the present value of the bond is in excess of its $1,000 par value because the

required rate of return is less than the coupon rate. Investors would be willing to pay a
premium to buy the bond. In the previous case, the required rate of return was greater than

the coupon rate. As a result, the bond has a present value less than its par value. Investors

would be willing to buy the bond only if it sold at a discount from par value. Now if the

required rate of return equals the coupon rate, the bond has a present value equal to its par

value, $1,000. More will be said about these concepts shortly when we discuss the behavior of

bond prices.

Zero-Coupon Bonds. A zero-coupon bond makes no periodic interest payments but

instead is sold at a deep discount from its face value. Why buy a bond that pays no

interest? The answer lies in the fact that the buyer of such a bond does receive a return.

This return consists of the gradual increase (or appreciation) in the value of the security from

its original, below-face-value purchase price until it is redeemed at face value on its maturity

date.

The valuation equation for a zero-coupon bond is a truncated version of that used for a

normal interest-paying bond. The “present value of interest payments” component is lopped

off, and we are left with value being determined solely by the “present value of principal

payment at maturity,” or

(4.6)

= MV(PVIFkd,n) (4.7)

Suppose that Espinosa Enterprises issues a zero-coupon bond having a 10-year maturity

and a $1,000 face value. If your required return is 12 percent, then

= $1,000(PVIF12%,10)

Using Table II in the Appendix, we find that the present value interest factor for a single

payment 10 periods in the future at 12 percent is 0.322. Therefore:

V = $1,000(0.322) = $322

If you could purchase this bond for $322 and redeem it 10 years later for $1,000, your initial
investment would thus provide you with a 12 percent compound annual rate of return.

Semiannual Compounding of Interest. Although some bonds (typically those issued in

European markets) make interest payments once a year, most bonds issued in the United

States pay interest twice a year. As a result, it is necessary to modify our bond valuation

V = $1,000

(1.12)10

V MV

kn=()1+d

V = + ++ + . . . $100

(1.08)

$100

(1.08)

$100

(1.08)

$1,000

(1.08) 12 99

4 The Valuation of Long-Term Securities

77

••

Zero-coupon bond

A bond that pays no

interest but sells

at a deep discount

from its face

value; it provides
compensation to

investors in the form

of price appreciation.

FUNO_C04.qxd 9/19/08 17:14 Page 77

equations to account for compounding twice a year.3 For example, Eqs. (4.4) and (4.5) would

be changed as follows

(4.8)

= (I/2)(PVIFAkd /2,2n) + MV(PVIFkd /2,2n) (4.9)

where kd is the nominal annual required rate of interest, I/2 is the semiannual coupon payment, and 2n
is the number of semiannual periods until maturity.

Take Note

Notice that semiannual discounting is applied to both the semiannual interest payments

and the lump-sum maturity value payment. Though it may seem inappropriate to use

semiannual discounting on the maturity value, it isn’t. The assumption of semiannual

discounting, once taken, applies to all inflows.

To illustrate, if the 10 percent coupon bonds of US Blivet Corporation have 12 years to

maturity and our nominal annual required rate of return is 14 percent, the value of one

$1,000-par-value bond is

V = ($50)(PVIFA7%,24) + $1,000(PVIF7%,24)

= ($50)(11.469) + $1,000(0.197) = $770.45

Rather than having to solve for value by hand, professional bond traders often turn to bond

value tables. Given the maturity, coupon rate, and required return, one can look up the present value.
Similarly, given any three of the four factors, one can look up the fourth. Also,

some specialized calculators are programmed to compute bond values and yields, given the

inputs mentioned. In your professional life you may very well end up using these tools when

working with bonds.

Remember, when you use bond Eqs. (4.4), (4.5), (4.6), (4.7), (4.8), and (4.9), the variable

MV is equal to the bond’s maturity value, not its current market value.

Preferred Stock Valuation

Most preferred stock pays a fixed dividend at regular intervals. The features of this financial

instrument are discussed in Chapter 20. Preferred stock has no stated maturity date and, given

the fixed nature of its payments, is similar to a perpetual bond. It is not surprising, then, that

we use the same general approach as applied to valuing a perpetual bond to the valuation of

preferred stock.4 Thus the present value of preferred stock is

V = Dp /k p (4.10)

VI

MV

kt

n=+

+=+∑/

/) /)

1 (1 2 (1 2 d

3
Even with a zero-coupon bond, the pricing convention among bond professionals is to use semiannual
rather than

annual compounding. This provides consistent comparisons with interest-bearing bonds.

Virtually all preferred stock issues have a call feature (a provision that allows the company to force
retirement), and

many are eventually retired. When valuing a preferred stock that is expected to be called, we can apply
a modified

version of the formula used for valuing a bond with a finite maturity; the periodic preferred dividends
replace the

periodic interest payments and the “call price” replaces the bond maturity value in Eqs. (4.4) and (4.5),
and all the

payments are discounted at a rate appropriate to the preferred stock in question.

Part 2 Valuation

78

••

Preferred stock

A type of stock that

promises a (usually)

fixed dividend, but at

the discretion of the

board of directors. It

has preference over

common stock in the

payment of dividends

and claims on assets.

FUNO_C04.qxd 9/19/08 17:14 Page 78

4 The Valuation of Long-Term Securities

79

where Dp is the stated annual dividend per share of preferred stock and k p is the appropriate

discount rate. If Margana Cipher Corporation had a 9 percent, $100-par-value preferred stock

issue outstanding and your required return was 14 percent on this investment, its value per

share to you would be

V = $9/0.14 = $64.29

Common Stock Valuation

The theory surrounding the valuation of common stock has undergone profound change

during the last few decades. It is a subject of considerable controversy, and no one method for

valuation is universally accepted. Still, in recent years there has emerged growing acceptance

of the idea that individual common stocks should be analyzed as part of a total portfolio of

common stocks that the investor might hold. In other words, investors are not as concerned

with whether a particular stock goes up or down as they are with what happens to the overall

value of their portfolios. This concept has important implications for determining the

required rate of return on a security. We shall explore this issue in the next chapter. First,

however, we need to focus on the size and pattern of the returns to the common stock

investor. Unlike bond and preferred stock cash flows, which are contractually stated, much

more uncertainty surrounds the future stream of returns connected with common stock.

l l l Are Dividends the Foundation?

When valuing bonds and preferred stock, we determined the discounted value of all the cash

distributions made by the firm to the investor. In a similar fashion, the value of a share of

common stock can be viewed as the discounted value of all expected cash dividends provided

by the issuing firm until the end of time.5 In other words,

This model was first developed by John B. Williams, The Theory of Investment Value (Cambridge, MA:
Harvard

University Press, 1938). And, as Williams so aptly put it in poem form, “A cow for her milk/A hen for her
eggs/And

a stock, by heck/For her dividends.”

Common stock

Securities that

represent the

ultimate ownership

(and risk) position in

a corporation.

QWhat’s preferred stock?

AWe generally avoid investing in preferred stocks, but

we’re happy to explain them. Like common stock,

a share of preferred stock confers partial ownership

of a company to its holder. But unlike common stock,

holders of preferred stock usually have no voting privileges. Shares of preferred stock often pay a
guaranteed

fixed dividend that is higher than the common stock

dividend.

Preferred stock isn’t really for individual investors,

though. The shares are usually purchased by other corporations, which are attracted by the dividends
that give

them income taxed at a lower rate. Corporations also like

the fact that preferred stockholders’ claims on company

earnings and assets have a higher priority than that

Chair Co. (ticker: WOOPS) goes out of business. Many

people or firms with claims on the company will want

their due. Creditors will be paid before preferred stockholders, but preferred stockholders have a higher
priority

than common stockholders.

Ask the Fool

Source: The Motley Fool (www.fool.com). Reproduced with the permission of The Motley Fool.

FUNO_C04.qxd 9/19/08 17:14 Page 79

(4.11)

(4.12)

where Dt is the cash dividend at the end of time period t and ke is the investor’s required

return, or capitalization rate, for this equity investment. This seems consistent with what we

have been doing so far.

But what if we plan to own the stock for only two years? In this case, our model becomes

where P2 is the expected sales price of our stock at the end of two years. This assumes that

investors will be willing to buy our stock two years from now. In turn, these future investors

will base their judgments of what the stock is worth on expectations of future dividends

and a future selling price (or terminal value). And so the process goes through successive

investors.

Note that it is the expectation of future dividends and a future selling price, which itself is

based on expected future dividends, that gives value to the stock. Cash dividends are all that

stockholders, as a whole, receive from the issuing company. Consequently, the foundation for

the valuation of common stock must be dividends. These are construed broadly to mean any

cash distribution to shareholders, including share repurchases. (See Chapter 18 for a discussion of share
repurchase as part of the overall dividend decision.)
The logical question to raise at this time is: Why do the stocks of companies that pay

no dividends have positive, often quite high, values? The answer is that investors expect to

sell the stock in the future at a price higher than they paid for it. Instead of dividend income

plus a terminal value, they rely only on the terminal value. In turn, terminal value depends on

the expectations of the marketplace viewed from this terminal point. The ultimate expectation is that
the firm will eventually pay dividends, either regular or liquidating, and that

future investors will receive a company-provided cash return on their investment. In the

interim, investors are content with the expectation that they will be able to sell their stock

at a subsequent time, because there will be a market for it. In the meantime, the company is

reinvesting earnings and, everyone hopes, enhancing its future earning power and ultimate

dividends.

l l l Dividend Discount Models

Dividend discount models are designed to compute the intrinsic value of a share of common

stock under specific assumptions as to the expected growth pattern of future dividends

and the appropriate discount rate to employ. Merrill Lynch, CS First Boston, and a number

of other investment banks routinely make such calculations based on their own particular

models and estimates. What follows is an examination of such models, beginning with the

simplest one.

Constant Growth. Future dividends of a company could jump all over the place; but, if

dividends are expected to grow at a constant rate, what implications does this hold for our

basic stock valuation approach? If this constant rate is g, then Eq. (4.11) becomes

(4.13)

where D0 is the present dividend per share. Thus the dividend expected at the end of period n

is equal to the most recent dividend times the compound growth factor, (1 + g)

. This may
not look like much of an improvement over Eq. (4.11). However, assuming that ke is greater

VDg

Dg

Dg

k=+

++

()

()()

()...()

()

2
e

VD

k=+

()+()()

e
2

2111

==+

∑)

t 1 (1 e

VD

k=+

++

∞()()...()

1
e

2111e

Part 2 Valuation

80

••

FUNO_C04.qxd 9/19/08 17:14 Page 80

than g (a reasonable assumption because a dividend growth rate that is always greater than the

capitalization rate would imply an infinite stock value), Eq. (4.13) can be reduced to6

V = D1 /(ke − g) (4.14)

Rearranging, the investor’s required return can be expressed as

ke = (D1 /V) + g (4.15)

The critical assumption in this valuation model is that dividends per share are expected to

grow perpetually at a compound rate of g. For many companies this assumption may be a fair

approximation of reality. To illustrate the use of Eq. (4.14), suppose that LKN, Inc.’s dividend

per share at t = 1 is expected to be $4, that it is expected to grow at a 6 percent rate forever, and

that the appropriate discount rate is 14 percent. The value of one share of LKN stock would be

V = $4/(0.14 − 0.06) = $50

For companies in the mature stage of their life cycle, the perpetual growth model is often

reasonable.

TIP•TIP

A common mistake made in using Eqs. (4.14) and (4.15) is to use, incorrectly, the firm’s

most recent annual dividend for the variable D1 instead of the annual dividend expected by
the end of the coming year.

Conversion to an Earnings Multiplier Approach With the constant growth model, we

can easily convert from dividend valuation, Eq. (4.14), to valuation based on an earnings

multiplier approach. The idea is that investors often think in terms of how many dollars they

are willing to pay for a dollar of future expected earnings. Assume that a company retains a

constant proportion of its earnings each year; call it b. The dividend-payout ratio (dividends

per share divided by earnings per share) would also be constant. Therefore,

(1 − b) = D1 /E1 (4.16)

and

(1 − b)E1 = D1

where E1 is expected earnings per share in period 1. Equation (4.14) can then be expressed as

V = [(1 − b)E1]/(ke − g) (4.17)

If we multiply both sides of Eq. (4.13) by (1 + ke)/(1 + g) and subtract Eq. (4.13) from the product, we get

Because we assume that ke is greater than g, the second term on the right-hand side approaches zero.
Consequently,

V(ke − g) = D0(1 + g) = D1

V = D1 /(ke − g)

This model is sometimes called the “Gordon Dividend Valuation Model” after Myron J. Gordon, who
developed it

from the pioneering work done by John Williams. See Myron J. Gordon, The Investment, Financing, and
Valuation of

the Corporation (Homewood, IL: Richard D. Irwin, 1962).

4 The Valuation of Long-Term Securities

81

••

FUNO_C04.qxd 9/19/08 17:14 Page 81

that LKN, Inc., has a retention rate of 40 percent and earnings per share for period 1 are

expected to be $6.67. Therefore,

V = [(0.60)$6.67]/(0.14 − 0.06) = $50

Rearranging Eq. (4.17), we get

Earnings multiplier = V/E1 = (1 − b)/(ke − g) (4.18)

Equation (4.18) thus gives us the highest multiple of expected earnings that the investor

would be willing to pay for the security. In our example,

Earnings multiplier = (1 − 0.40)/(0.14 − 0.06) = 7.5 times

Thus expected earnings of $6.67 coupled with an earnings multiplier of 7.5 values our

common stock at $50 a share ($6.67 × 7.5 = $50). But remember, the foundation for this

alternative approach to common stock valuation was nevertheless our constant growth

dividend discount model.

No Growth. A special case of the constant growth dividend model calls for an expected

dividend growth rate, g, of zero. Here the assumption is that dividends will be maintained at

their current level forever. In this case, Eq. (4.14) reduces to

V = D1 /ke (4.19)

Not many stocks can be expected simply to maintain a constant dividend forever. However,

when a stable dividend is expected to be maintained for a long period of time, Eq. (4.19) can

provide a good approximation of value.7

Growth Phases. When the pattern of expected dividend growth is such that a constant

growth model is not appropriate, modifications of Eq. (4.13) can be used. A number of valuation models
are based on the premise that firms may exhibit above-normal growth for a number of years (g may
even be larger than ke during this phase), but eventually the growth rate

will taper off. Thus the transition might well be from a currently above-normal growth rate to

one that is considered normal. If dividends per share are expected to grow at a 10 percent
compound rate for five years and thereafter at a 6 percent rate, Eq. (4.13) becomes

(4.20)

Note that the growth in dividends in the second phase uses the expected dividend in period 5

as its foundation. Therefore the growth-term exponent is t − 5, which means that the exponent in period
6 equals 1, in period 7 it equals 2, and so forth. This second phase is nothing

more than a constant-growth model following a period of above-normal growth. We can

make use of that fact to rewrite Eq. (4.20) as follows:

(4.21)

If the current dividend, D0, is $2 per share and the required rate of return, ke, is 14 percent,

we could solve for V. (See Table 4.1 for specifics.)

= $8.99 + $22.13 = $31.12