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40 Financial Statement Analysis

Valuation Models

Valuation is an important outcome of many types of business and financial statement
IPO MISDEALS analysis. Valuation normally refers to estimating the intrinsic value of a company or its
Investment banking stock. The basis of valuation is present value theory. This theory states the value of a
institutions have recently debt or equity security (or for that matter, any asset) is equal to the sum of all expected
been investigated for
allegedly allocating hot- future payoffs from the security that are discounted to the present at an appropriate
selling IPO shares to discount rate. Present value theory uses the concept of time value of money—it simply states
favored executives to cut an entity prefers present consumption more than future consumption. Accordingly, to
more investment-banking value a security an investor needs two pieces of information: (1) expected future payoffs
deals instead of selling over the life of the security and (2) a discount rate. For example, future payoffs from
them to the highest
bidders. bonds are principal and interest payments. Future payoffs from stocks are dividends and
capital appreciation. The discount rate in the case of a bond is the prevailing interest
rate (or more precisely, the yield to maturity), while in the case of a stock it is the risk-
adjusted cost of capital (also called the expected rate of return).
This section begins with a discussion of valuation techniques as applied to debt secu-
rities. Because of its simplicity, debt valuation provides an ideal setting to grasp key valu-
ation concepts. We then conclude this section with a discussion of equity valuation.

Debt Valuation
The value of a security is equal to the present value of its future payoffs discounted at an
appropriate rate. The future payoffs from a debt security are its interest and principal pay-
ments. A bond contract precisely specifies its future payoffs along with the investment
horizon. The value of a bond at time t,orB t , is computed using the following formula:

I t 1 I t 2 I t 3 I t n F
B t n n
(1 r) 1 (1 r) 2 (1 r) 3 (1 r) (1 r)
where I t n is the interest payment in period t n, F is the principal payment (usually
MUTUAL FUNDS the debt’s face value), and r is the investor’s required interest rate, or yield to maturity.
The mutual-fund industry When valuing bonds, we determine the expected (or desired) yield based on factors
has more than $6 trillion in such as current interest rates, expected inflation, and risk of default. Illustration 1.5 offers
equity, bond, and money-
market funds. an example of debt valuation.

ILLUSTRATION 1.5 On January 1, Year 1, a company issues $100 of eight-year bonds with a year-end interest
(coupon) payment of 8% per annum. On January 1, Year 6, we are asked to compute the value of
this bond when the yield to maturity on these bonds is 6% per annum.
Solution: These bonds will be redeemed on December 31, Year 8. This means the remaining
term to maturity is three years. Each year-end interest payment on these bonds is $8, computed
as 8% $100, and the end of Year 8 principal payment is $100. The value of these bonds as of
January 1, Year 6, is computed as:
3
3
2
$8/(1.06) $8/(1.06) $8/(1.06) $100/(1.06) $105.35
Equity Valuation

Basis of Equity Valuation. The basis of equity valuation, like debt valuation, is the
present value of future payoffs discounted at an appropriate rate. Equity valuation,
however, is more complex than debt valuation. This is because, with a bond, the future