Valuation
Introduction
One credible website that investors can use to find the present value of stocks and latest news about bonds being traded is www.nasdaq.com.
Valuation and Time Value of Money
Money has worth associated with time. A dollar today is worth more than a dollar in coming year. This is the foundation for the concept of time value of money. In order to make financial decisions, the concept of time vale of money is very essential. The concept of time value of money has many uses, starting from creating schedules for disbursing off loans to judgements about purchasing new assets. Hence in finance, no concept is more important than that of time value of money.
When a company, firm or a government decides to take money from public for a long period, it commonly does this by giving out or trading debt securities which are referred to as bonds. We can even define bond as a loan that is based only on interest, where the borrower is entitled to pay every period the interest amount but principal is repaid once the loan ends .
We can understand different terms associated with a bond with the help of an example. For example, John wants to lend $1000 for a total of 30 years and for example the interest rate on which he gets the bond is 12%. Now John pays 0.12 × $1,000 = $120 in interest each year for a total of 30 years. At the end of 30 years, John repays $1000. Hence in the above example, the $120 payments that John promises to make are referred to as coupon payments. The amount that will be repaid at the end of the loan is called as the par value or face value of the bond. The coupon is divide by the face value and the rate that we is called the coupon rate. $120/1,000
= 12% in this case. The number of years that are taken to pay the face value is called that maturity time. Now there are different types of bonds with different characteristics like corporate bonds, municipal bond and foreign bonds.
Cash flows associated with bonds
Based upon our definition of bonds, we can deduce that the bond holder will receive two kinds of cash flows, out of which one cash flow is the coupon interest payment and the other cash flow is the repayment at the maturity of the principal amount.
In financial asset, the fair value is actually the expected cash flow’s present value. Therefore, in bonds according to the definition the fair value of a bond is the present value of coupon payments as well as the repayment of the principal amount. We can write it like this:
Bond Fair Value = Present Value Coupon Payments + Present Value Principal Repayment
Conditions of a Bond
A bond is made up of different components as described earlier, hence we can say that by comparing the required rate of return and the coupon rate that is offered by the bond, we can approximate the actual price of bond. Let us first understand the required rate of return. The yield to maturity or required rate of return is that rate that will be earned by the investor if he or she decides to keep the bond till the time of maturity
Premium Bonds: Premium bonds are bonds that have a coupon rate higher than the required rate of return. Also the fair value of premium bonds is higher than the par value of the bond.
Discount Bonds: Discount bonds are bonds that have a greater required rate of return that the coupon rate. These bonds have a fair value lower than the par value.
Par Bonds: These are bonds where the required rate of return and the coupon rate are both equal. Hence the fair value and the par value are also equal.
Difference between common stock and preferred stock
All the stocks offered by the company are not the same. Organizations usually offer two types of stocks that are preferred and common stock. Both stocks have their pros and cons for the investors.
Owning a stock either common or preferred both signify some sort of ownership in the organization. Possessing a common stock gives the investor chance to vote in the board of director’s election. The payment of dividend is a guarantee for the owners of preferred stocks but there is no voting rights for the holders of preferred stock.
The value of bond is not known by the common stock holders before time, while the holders of preferred stocks receive dividends at a fix rate. The owners of preferred stocks have a greater right over the earnings and assets of the company. This statement is true in instances when an organization is facing a good time and has excess cash. In these times, preferred stockholders are paid the distributions before the common stockholders. And when an organization is facing bankruptcy the common stockholders are the last ones to be paid. One other major difference is that preferred stockholders dividends differ from those of common stockholders and are even greater at times.
Preferred stockholders when buy a stock, they know when to expect dividends as they receive it regularly. But this does not happen in case of common stockholders as it is upon the discretion of board of directors to pay a dividend or not.
References
Deardorff, A. (2009). Bond Prices and Interest Rates. Retrieved from http://www-personal.umich.edu/~alandear/courses/102/handouts/BondPrices.pdf
Gitman, L. J., & Zutter, C. J. (2010, July 18). Principles of Managerial Finance, 13/E. In L. J. Gitman, & C. J. Zutter, Principles of Managerial Finance, 13/E. Pearson.
