UNIT VI - Equity _ Bond Valuations and Investment Strategies - Sep 10

7/23/2019 UNIT VI - Equity _ Bond Valuations and Investment Strategies - Sep 10

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Equity and BondValuations AndInvestment Analysis



Equity Valuationand Analysis



Equity Valuation

Equity Valuation is complex as the returns areuncertain and can change from time totime.

It is the size of the return and the degree offluctuation (risk) which together determinesthe value of a share to the investor.

Therefore forecasting abilities are far morecrucial in equity valuation.

An analyst can either follow an active or apassive strategy of investment.



Active & Passive Equity InvestmentStrategy

Active strategy It is based on the premise that stock markets

are not totally efficient.All historical and current information is not

correctly reflected in the current price ofevery stock.Hence there exist stocks that are

undervalued, fairly valued or overvalued.

Passive strategyBy contrast, an investor/equity manager

who believes the market is efficient tends tofavor a passive strategy, with indexing beingthe most common form of passive strategy.



Active versus Passive

Three basic activities performed by themanager

Portfolio Construction

Trading of SecuritiesPortfolio Monitoring



Equity management

ActiveSubjective

Complex Rules

Few names

Appropriate weightings

PassiveObjective

Simple rules

Many names

Precise weightings

Trading

Active

Worked transactions

Few names

Cash reserves

Passive

Programme transactions

Many names

Fully vested

Monitoring

Active

Infrequent

Approximate

Passive

Constant

Detailed



Top-Down Investment Process

Economic Forecast

Financial markets

Stock MarketOther Assets Market

Equity Portfolio

Sector Analysis

Asset allocation



Equity Valuation



Basic Models



Gordon’s model



Other Methods

2. CAPM

3. P/E multiples

Harvard Case Study - Walmart



Debenture: It is legal document containing anacknowledgement of indebtedness by acompany. It contains a promise to pay a

stated rate of interest for a defined periodand then to repay the principal at a givendate of maturity

Bonds: It is a non secured debt issued for aperiod of not less than three years.

Debt Instruments



Reasons for Issuing Bonds

To reduce the cost of capital

To gain the benefit of leverage

To effect tax savings

To widen the sources of fundsTo preserve control



Bond Features

Indenture: A legal document containing the restrictions,pledges and promises of the contract.

It involves 3 parties:

Debtor corporate

Bond holder

Trustee

Maturities: Short term, Medium term and Long term.

Interest Payments: Either quarterly, semi-annually orannually.

Call features



Some Terms

YTM: is the discount rate that equates the PV of allthe bond’s expected cash flows with the currentmarket price of the bond (it is some sort of IRR).

Face Value (Principal Value): Normally face valueand maturity date (when it is to be repaid) areprinted on the bond and do/can not change duringthe life of the bond.

Coupon rate: The return on face value, expressed aspercentage.

Coupon: It is the product of coupon rate and facevalue.



Current Yield

The current yield on a bond is the annualinterest due on it dividend by the bond’s

market price

Current yield= Annual interest

Market price



Holding Period Yield

HPYb = It +ΔPP0

t – stands for time and refers to aholding period

It – the bonds coupon interest ratepayment during the holding period t

P0 – the bonds price at the beginning of

the holding period tΔP – Change in bond price over the

period



Yield To Maturity

P0 = ∑ It + Pt

(1+r)t (1+r)n

P0 – Cost of Bond

Pt – Terminal price or value

It – Annual interest in Rupees

R - Discount rate (IRR) which is yield to maturity

T – Time period



Numerical

Example: coupon rate = 8%, maturity = 3 years, face value = Rs. 1000,discount rate (YTM) = 10% (generally spot rates)

3

PV = ∑ 80/(1.1)n +1000/(1.1)3 = 2.487*80 + 0.712*1000

n=1

Value of a bond

n

PV = ∑ (Coupon)/(1+coupon rate)n +(Face value) / (1+coupon rate)n n=1

For the bond which is already in circulation, YTM (rather thaninterest rate) is used for discounting purposes, OR

n

PV = ∑ (Coupon)/(1+YTM)n +(Face value) / (1+YTM)n

n=1



Bond Analysis

Bond prices and yields (interest rates) keep on changing continuously. Thesefluctuations are due to:

a. External factors/Exogenous factors affecting all bonds simultaneously.

The demand and supply for credit

The inflation rate

The ebb and flow of business cycle

Central Bank policy

Government deficit policy

b. Internal factors

Generally related to default risk

Market interest rates → Discount rates → Risk -adjusted cost of capital →Investors’ RRR



I. During economic expansion

Unemployment rate ↓

Business activity quickens

Business borrows money for plants and equipment inventory

Demand for credit ↑, Interest rate ↑

II. During economic slowdown (recession)

Unemployment rate ↑

Manufacturing/business activity ↓

Demand for credit ↓, Interest rate ↓



III. Effect of Government Deficit:

Heavy borrowing → Interest ↑ → crowding out ofbusiness borrowings

(Example: During the tenure of Ronald Reagan,government deficit ↑ due to tax cut but nocorresponding cut in government spending → heavyborrowings by US Government.

IV. Effect of Central BankControl of money supply → Interest ↑ or ↓





Yield Curves (or TermStructure of Interest Rates)

As pointed out, the level of interest goes up or down dueto various factors. But the level of interest is different fromthe term structure of interest rates.

For a given bond issuer, the structure of nominal interestrates for a set of bonds that differ only with respect to thelength of time till maturity is called the term structure ofinterest rates or yield curve.

Normally yield curve rises with longer maturity because ofincrease in risk. But it need not be necessary so short-terminterest may be greater than long-term interest rates.



Riding the yield curve: this strategy is buy-and-hold inwhich the bond investor purchases a long-term bondwhen the yield curve is sloped upward and is expected tomaintain the same level and slope.

The bond purchased is simply held in order to obtaincapital gains that occur in the years remaining until itsmaturity decrease and the bond moves along towardsthe lower end of the upward sloping yield curve. Thus, inaddition to coupon, the investor gets capital gains as theinterest rates are lowered as he rides down the slope.



Shape of the Yield Curve

The interest rate levels are determined by theavailability and demand of loanable funds as wellas liquidity preferences.

The classical shape of the curve is a rectangularhyperbola. But the short-term rates fluctuate more

than long-term ones. For example, short-termones moved from 6% to 9% while long-term (over20 years) moved from 8.5% to 9.1% only.



Normally what is observed is:a. Short-term rates fluctuate more violently than long-

term over a business cycle.

b. The shape of the curve at recession, recovery and

boom phases moves from upward to horizontal todownward sloping.

The yield on long-term instruments is lower than short-term, it implies that investors expect a fall in interest

rates for three reasons: 1. They think inflation will dropsubstantially reducing inflation premium; 2. They thinkgovernment deficit will be reduced, lowering interestrates; 3. They expect the economy to slow down

(recession), cutting the potential demand forca ital.



Causes of Term Structure(Yield Curve)

Three hypotheses try to explain the term structure – - Expectation hypothesis

- Liquidity-premium hypothesis

- Segmented-market hypothesisA. Expectation Hypothesis:

The current structure of interest rates is determined bythe consensus on future interest rates.

(1+r today for 2 years) = √ (1+r1)(1+r2); where r1 and r2 are one-yearrates in year 1 and year 2.

(1+r today for 3 years) =3√ (1+r1)(1+r2) (1+r3); where r1 , r2 and r3 are

one-year rates in year 1, 2 and 3.



Example: a 2-year bond has 7% interest while 1-year bond has6%. This means the investor expects 8% yield for 1-year instrumentto be bought next year. That is 7% is combination of 6% this yearand 8% expected next-year rate, OR

(1.07)= √(1.06)(1.08)

So, as per this hypothesis –

- An upward sloping curve indicates that investors expect interestrates to rise.

- A flat yield curve implies the investors expect rates to remain thesame.

- A downward sloping curve indicates investors expect rates tofall.



B. Liquidity-Premium hypothesis:This hypothesis recognizes that investors are not indifferent to risk.

Long-term maturity bonds have greater interest rate risk and theinvestors would like to be compensated for that.

This hypothesis may make a yield curve to slope upward even

when investors expect the rates to fall or decline.

C. Segmented-Market hypothesis:

Groups of investors regularly prefer bonds with certain maturity

ranges in order to hedge their liabilities.

Example: insurance companies buy long-term bonds, commercialbanks buy short-term instruments.

So in these ranges, the yields are likely to be lower while bond

prices will be higher .



Systematic Risk in Bonds

Purchasing power risk

Interest rate risk

Reinvestment rate risk

a. Purchasing power risk

Generally commodity price levels are positively correlated withinterest rates, a. when commodity prices rise, investors requirehigher interest rates to protect purchasing power of the debtincome, b. also, rising commodity prices increase nominalcredit demands, leading to increase in interest rates.

The lender expects a premium+cover for expected inflation.



Example: Price level=100, expected inflation=6%, rate of interest=4%.

So next year, the worth is 1(1.04)/1.06=98.11 (a loss)

Thus, the investor expects to cover 6%+premium. Hence, interest rates to be >6%.

If the expected inflation is uncertain, a little higher premium may be required.

B. Interest rate risk: price volatility because of changing interest rates.

Bond price theorems – the relationship between bond’s term to maturity andduration or elasticity or interest rate risk.

Theorem 1: Bond’s prices move inversely to bond’s YTM or dp/dYTM <0.Theorem 2a: If all other factors are held constant, a bond’s interest rate risk

(price volatility) increases with the length of time remaining until it matures.

Note: the difference between premium and discount prices widens as thenumber of years to maturity increase.



Theorem 2b: a bond’s price (price volatility) ↑or ↓ at a diminishing rateas the time remaining to maturity ↑.

Theorem 3: the price change that results from an equal sized ↑or ↓ inbond’s YTM is asymmetrical. That is, for any given maturity, a

decrease in yields causes a price rise that is larger than the price lossthat results from an equal increase in yields (Assumption: The yieldschange from the same starting value whether they move up ordown).

Theorem 4: the price volatility ↑ as the yields level (from which changis made) increases.

Theorem 5: price volatility increases as the coupon declines, for the

same change in yield.



C. Reinvestment rate risk:

Coupon income should earn the same interest as at thetime of investment; otherwise the yield will be different.As, the interest rates do fluctuate and hence the rate

of reinvestment vary.



Bond Analysis

Unsystematic Risk

(Default Risk – Combination of Business + Financial risk)

Analytical thrust of high-grade bond selection is different from commonstock selection, although earning power is the fundamental basis of

value for both.

- High-grade bond selection emphasizes continuity of income andprotection against loss of principal.

- Conscious stock selection emphasizes earnings and dividend growth

and capital appreciation potential.- High-grade bonds may undergo an impairment in their quality due to

decrease in earning potential or fluctuations.

- Second – rate bonds may improve in quality over time due toincreased earnings and asset protection.



Default Risk (Business + Financial risk)

Corporate bonds sell at higher yields than government, mainlybecause of business and financial risk.

Government bonds do not have business and financial risk becauseof monopoly status of the government.

Business and financial risk combined is referred to as default risk. Default: In investment terms, it refers to the probability that the return

realized will be less than the promised, rather than, to the total loss.

Example: Face value=Rs.1000 of 10 year maturity, Coupon=10% per yr.So yield expected=10%.

But, if coupon payments are delayed upto the end of 10 years, then theyield <10%.

Yield will be 1000=(1000+10*100)/(1+YTM)10

-

Or YTM=(2000/1000)

1/10

-1 = <10%



Default can be of different degrees:

- Extension of time to make payments

- Rescheduling of amount/timing

- Legal liquidation of debtors

Default results from inadequate liquidity (weak cash flow management)or inadequate earnings due to inadequate revenue – opportunitycost relationship (business risk) or too much borrowings (financial risk).

Grading

Moody’s Aaa Aa A Baa Ba B Caa Ca C

S&P’s AAA AA A BBB BB B CCC CC C

(Best) (High) (High Medium)



Major Factors in Bond Rating Process

Indenture provisions

Earnings power and leverage

Liquidity

Management

a. Indenture provisions: aspects such as liquidation, creation ofadditional debt, limitation on sale and lease back of assets, etc.



b. Earnings Power:Interest coverage = EBIT/Interest charge

Debt Service coverage = EBIT/Interest+Sinking fund payments/(1-T)

Or = EAT+Depreciation/Sinking FundPreference Dividend coverage = EBIT/I+Preference

Dividend./(1+T) or EAT+Depreciation/Preference Dividend.

c. Liquidity: internal cash generation (netIncome+depreciation+amortization+deferred taxes), sale ofequity (external financing), sale of fixed assets.

d. Management’s programme/plan: whether company beingin a state of flux, company involved in actual acquisition

programme, company is small player, company acquiring



Sinking fund is the amount retired from a bond every year.

Since sinking fund payments are not expenses but returns onprincipal, they are not reported on the Income Statement. They arepaid out of PAT+Depreciation.

Case: McDonald

Observations:

1. 2/3rds of MacD’s capital comes from equity financing.

2. Cash flow can pay at least 45% of long-term debt in a year. (CashFlow/LTD=45%)

3. Negative working capital is area of concern (as CR<1) but not anarea of anxiety since current assets are highly liquid (the nature ofbusiness being cash transactions).



Example: ($m)

Revenues:$200

Operating expenses:

- variable: $40

- fixed: $100 (including depreciation of $25)

EBIT=60

6% first mortgage bond:$75

10% sub. Debt: $50 I=4.5+5=9.5

8% preference stock:$80 Dp=6.4

Common equity:$600

Combined sinking fund payment(for both)=$6

Tax rate=0.4



Calculate1. Interest coverage ratio=EBIT/I=60/9.5

2. Debt Service coverage ratio=EBIT/(I+Sinkingfund/(1-T))=60/(9.5+6/(0.6))=60/9.5+10=3

3. Preference div. coverage ratio=EBIT/(I+Pref.div./(1-T))=60/(9.5+6.4/(0.6))=60/9.5+10.7=60/20.2

=nearly 3

Which ratio would you like to see to know whetherbond (debt) can be safely serviced by thecompany or not?

Answer: both interest coverage ratio and debt

service coverage ratio.



Bond Portfolio Management Strategies

5 groups

1. Passive

a. Buy and hold

b. Indexing

2. Active

a. Interest rate anticipation

b. Valuation analysis

c. Credit analysis

d. Yield spread analysis

e. Bond swaps



Bond Portfolio Management Strategies

3. Core plus management

4. Matched funding technique

a. Dedicated portfolio, optimal cash match

b. Dedicated portfolio, optimal cash match and reinvestment

c. Classical (pure immunization)

d. Horizon matching

5. Contingent procedures (structured active management)

a. Contingent immunizationb. Other contingent procedures

6. Global fixed-income investment strategy



Bond Management Strategies

Passive (buy-and-hold) Active (switching and swapping)

1 .Passive: this strategy is preferred primarily by income maximizinginvestors who are interested in the largest coupon income (steady)

over a desired horizon. They include – retired persons, endowmentfunds, bond mutual funds (debt mutual funds), insurancecompanies seeking the maximum yield over an extended period oftime.

Laddering: building a bond ladder means buying bonds scheduled to

come due at several different dates in the future rather than in thesame year.

Laddering will not produce as much income currently as buying thehighest yielding long-term bonds, the diversification makes it safer.

Good for – conservative investors who are not sure of interest rate

movements.



4c. Immunization strategy: interest fluctuations result into price changesof bonds and the reinvestment rate of coupon income.

1. If rates ↑, since the time of purchase of the bond, the price receivedfor the bond in the market would be below expectation (price risk).

2. If rates ↓, it will not be possible to reinvest interest-payments at theproposed yield-to-maturity but they will be reinvested at lower ratesand the ending sum would be below what was expected(reinvestment rate risk).

Thus price risk and reinvestment rate risk resulting from interest ratevariation have an opposite effect on the investors’ ending wealth

portion. Strategy of immunization is adopted to eliminate theseopposite effects.

A bond investment is said to be immunized if the realized return on aninvestment in bonds is sure to be at least as large as the yield initiallyenvisaged.



Duration: it is a measure of the average maturity ofthe stream if payments generated by a financialasset. mathematically, duration is the weightedaverage of the lengths of time until the asset’sremaining payments are made. The weights in thiscalculation are the proportion of the asset’s presentvalue represented by the present value of therespective cash flows.



Immunization and MD

Macaulay’s Duration (MD) – (∆P/P)/(∆YTM/(1+YTM))

Apart from time to maturity, there is another time

dimension of a bond – average time to maturity (orduration).

MD = ∑n. Wn, where Wn=Cn/(1+YTM)n/P0

A bond’s duration is defined as weighted averagenumber of years until the cash flows occur, with therelative PVs of each cash flow used as the weight.



Properties of MD

1. Coupon paying bond’s MD is less than or equal tomaturity or MD<=N.

2. For a zero coupon bond or discount bond (i.e. theprincipal and interest payment done at the end) –

MD=N.3. For a coupon paying bond, the limiting value of MD

(LVMD) is defined as LVMD=1+YTM/YTM

4. Duration of a perpetual bond is LVMD.



Note: MD is considered to be a better measure of its time structure

than its years-to-maturity as MD reflects the amount and timing ofevery cash flow rather than merely the length of time until finalpayment occurs.

MD measures bond’s interest rate risk.

Interest rate risk = elasticity (EL) = MD

MD= (∆P/P)/(∆YTM/(1+YTM)) = %change in bond’s price/% change in(1+YTM)

Thus, MD and EL are both conceptually and numerically equivalentmeasures of bond’s interest rate risk – they measure the sensitivity of abond’s price to change in the market interest rates.

They are fairly good measures of a bond’s total risk because thesystematic fluctuations in market interest rates that affect all bonds

are the main source of risk in high-quality bonds (Of course, in low-grade bonds, there is also default risk).



Immunizing Interest Rate Risk

MD has an important application in immunizing interest rate risk.

Immunization provides a compound rate of return over theimmunized period that equals the YTM; regardless of thefluctuations in market interest rates during this period.

Two opposing forces act on a bond’s total returns - a. bond’smarket rate fluctuations and b. interest on interest. Say themarket rate jumps from 9% to 11%. (T-bond of face valueRs.1000, maturing in 10 years with a YTM of 9%). The capital loss

occurs right after the bond is purchased. At what point infuture will this loss be made up by reinvesting coupon incomeat higher interest rate of 11%?



The offsetting effects of price change andreinvestment return exactly offset each other whenthe bond investment has been continuouslymaintained for the DURATION of the bond.

Alternative way: suppose we want to lock in aninterest rate (YTM) of 9% for 10 years, then we willhave to select a bond with DURATION of 10 years(not maturing of 10 years). The maturity for such apar bond will be approximately 23 years. That is, youbuy a bond of face value of Rs. 1000, maturing in 23years with a coupon rate of 9%.



Example: suppose a bond is bought for face value of Rs. 1000 with a YTM(coupon) of 10%. This means that the end of the period wealth should be1000(1+0.1)N. This can happen only if the coupon payments received arereinvested at the same rate as YTM (i.e. 10%).

But if the interest rates fluctuate the coupon payments will not earn the same

rate as YTM and as a result the end-wealth will not be the same after N yearsas expected or initially envisaged (i.e. 1000(1+0.1)N ). Yet, there is a period(called MD) for which if the bond is held, the end-wealth remains unaffecteddespite the changes in reinvestment rates.

And MD = (∑(n.Cn/(1+YTM)n ) + NF/(1+YTM)N ) / (∑Cn/(1+YTM)n + F/(1+YTM)N )

So if the end-of-period wealth is expected to be completed by the initial YTM,then the bond that is to be acquired is the one that will have MD of N yearsand not the maturity of N years.

Documents

UNIT VI - Equity _ Bond Valuations and Investment Strategies - Sep 10