7. VALUATION OF STOCKS AND BONDS
This chapter provides an overview of stocks and bonds, and the methods financial analysts
use to calculate the market price using the present value formula. Furthermore, corporations
issue a variety of bonds and stocks, and use them to expand business operations. Corporations
sell their bonds to investors who buy these bonds and stock for investment. They either hold the
bonds until maturity or sell the bonds and stock for a capital gain or loss. Consequently,
investors must know the difference between yield to maturity and the rate of return. This chapter
expands on Chapter 6, and we expand the present value formula to value a variety of bonds and
stocks.
Overview of Bonds
Corporations often borrow money by issuing bonds. A bond is similar to notes payable
because they are written promises to pay interest and principal. We show a picture of a bond in
Figure 1. Face value of this bond equals $1,000, and this bond matures on February 1, 2020.
Consequently, whoever holds this bond will receive $1,000 on this date, and the bondholder also
earns $100 ( 0.1 × $1,000) per year in interest. Most bonds pay interest twice annually or $50
every six months for this example.
Bond$1,00010%February 1, 2020Figure 1. A picture of a bond
Bonds, however, differ from notes payable. A notes payable is a loan from a single creditor
such as a bank, while a bond is a loan that corporations issue in denominations of $1,000,
$2,000, etc. Finally, bonds are standardized, and thus, investors can purchase them. Moreover,
investors can buy and sell these bonds on the financial markets before the bonds mature.
Bonds differ from corporate stock. A share of stock represents ownership in a corporation.
For instance, if a shareholder owns 1,000 shares out of 10,000, then he or she owns 10% of the
corporation’s equity. Moreover, the shareholder also receives 10% of the corporation’s earnings,
when the board of directors declares dividends. On the other hand, a bond represents a debt or a
liability to the corporation. For example, if a person owns a bond with a face value of $1,000