A Beginners Manual For Valuation Of Stocks And Bonds

Posted on September 4, 2010
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There are many methods that stock market analyst use to measure what the true and fair market value of a stock or bond should be. They then use this information to invest and give investment advice according to whether they believe the stock is overvalued or undervalued currently. One of the most important and frequently used calculation that these analysts use is known as discounted Present Value. Let me illustrate this calculation with an example. Assume that you have a friend who needs a loan. He guarantees that after two years he will pay you a sum of Rs1210. The present rate of interest that is applicable is ten percent. You should loan this person a sum of Rs1000 today as this is the discounted present value of Rs1210.

This figure is called the discounted present value of Rs 1210. This is also often known as the present value technique. The amount that is payable in two years is brought down to or ‘discounted’ to an equivalent amount today. The basic formula that you need to know here is that the Discounted Present Value or DPV henceforth, is calculated as follows.

There are three main things to keep in mind to calculate the Present Value. One is the rate of return or the interest rate. This is symbolized by the letter ‘r’ in this formula. The second variable is ‘n’ which is the number of years you are trying to calculate the amount for. The last variable is the amount of promised payment, Rs 1210 in the example above. The formula is as follows: Present Value = Promised payment/(1+r)to the power ‘n’. To add to this example, let’s say that your friend has offered to pay you after the first year a sum of Rs1100 and after the second year a sum of Rs1210. Now you should loan your friend Rs2000. You can get this figure by applying the same formula. Simply treat each year as separate. First apply for year one, then apply for year two and add them both up.

The Present Value method can also be applied to value assets such as bonds and stocks. The fair value of these kinds of assets depends upon their future cash flow discounted at a rate that is reflective of the riskiness of these expected cash flows. This simply means how reliable are these expected cash flows and what is the certainty that expectations will be fulfilled.

Let’s take the example of bonds first. If you wanted to buy a bond, the future cash flow each year (they have annual payments) is expected to be Rs 60. This is known as ‘coupons’ in the world of bonds. The maturity value is also known with as much certainty and let’s says this is Rs 1000. You now apply the same formula at the risk free rate that the bond is supposed to give and you will get the correct value of the bond. In some cases the market price quoted by some dealers is below the fair value, but this will increase demand and it will soon be equal to the fair value.

Stocks are also an asset class that can be valued to some extent with the use of the Present Value technique. In the case of stocks, since they are a riskier asset class than bonds, there are two kinds of risks that have to be factored into the interest rate. One is the risk free rate and then in addition to that is another amount that reflects how risky that stock really is. This is known as a risk premium. Once you know these, apply the same formula and get a number that is a fair reflection of the stock in this point in time.

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