Unit 4: Bond, Equity and Derivative Analysis

Bond, Equity, and Derivative Analysis

Bond Analysis

• Bonds are debt instruments where investors lend money to an entity (corporate/government) in return for periodic interest payments and the return of principal.

• Key concepts:

  • Coupon rate: Interest paid annually.

  • Yield to Maturity (YTM): Total return expected if held to maturity.

  • Credit rating: Measures bond risk.

  • Duration: Sensitivity of bond price to interest rate changes.

Equity Analysis

• Equity represents ownership in a company.

• Investors analyze:

  • Earnings (EPS)

  • Growth prospects

  • P/E ratio, ROE, Book Value

• Valuation is crucial to determine if a stock is overvalued or undervalued.

Derivative Analysis

• Derivatives derive value from underlying assets like stocks, indices, or commodities.

• Types:

  • Futures: Contracts to buy/sell at future date.

  • Options: Right, not obligation, to buy/sell.

• Used for hedging risk or speculation.

Valuation of Equity: Discounted Cash Flow (DCF) Techniques

DCF is a method to estimate the value of a company based on expected future cash flows, discounted to their present value using a discount rate.

A. Balance Sheet Valuation (Book Value Approach)

• Based on company’s net assets:

  • Equity Value = Total Assets – Total Liabilities

• Limitations:

  • Ignores future growth and earnings.

  • May not reflect market value or intangible assets.

B. Dividend Discount Model (DDM)

DDM values a stock by assuming it is worth the present value of all its future dividends.

1. Gordon Growth Model (Constant Growth DDM)

Used for companies with stable dividend growth.

$$\text{Value of Stock (P)} = \frac{D_1}{r - g}$$

Where:

• $D_1$ = Dividend expected next year

• $r$ = Required rate of return

• $g$ = Dividend growth rate

Suitable for mature companies like utilities.

2. Two-Stage Dividend Model

Used when a company has high initial growth, followed by stable growth.

• Stage 1: Project dividends during high-growth years.

• Stage 2: Use Gordon Model for stable period.

• Discount both stages to present value.

3. Limitations of DDM

• Assumes company pays dividends.

• Sensitive to estimation of $r$ and $g$.

• Not suitable for new/startup firms with irregular dividends.

Summary Table

Technique	Basis	Best For	Formula / Method
Balance Sheet Valuation	Book value of assets	Asset-heavy firms	Equity = Assets – Liabilities
Gordon Growth DDM	Constant dividend growth	Mature, stable dividend firms	$P = \frac{D_1}{r - g}$
Two-Stage DDM	Varying dividend growth	High-growth then stable firms	DCF for stage 1 + Gordon for stage 2
DCF (Free Cash Flow)	Cash flow forecast	Growth firms, no dividends	$\text{Value} = \sum \frac{FCF_t}{(1+r)^t}$

Intrinsic Value vs. Market Price

Intrinsic Value

• This is what a stock is truly worth based on its fundamentals (earnings, dividends, assets, etc.).

• Calculated using methods like DCF (Discounted Cash Flow), Dividend Models, or EVA.

Market Price

• This is the price at which the stock is currently trading in the stock market.

• Influenced by demand & supply, news, sentiment, etc.

📌 Example: If the intrinsic value of a stock is ₹150, but it's trading at ₹120, it means the stock is undervalued — a good buying opportunity.

If it's trading at ₹180, it’s overvalued.

Earnings Multiplier Approach (P/E Ratio Method)

• This method calculates the value of a stock based on its earnings and how much investors are willing to pay for ₹1 of earnings.

Formula:

$$\text{Value of stock} = \text{Earnings per share (EPS)} \times \text{P/E Ratio}$$

📌 Example:

• EPS = ₹10

• P/E Ratio (industry average) = 15

Then,

$$\text{Intrinsic Value}=10\times 15=\text{₹}150$$

If the current market price is ₹120, the stock is undervalued.

P/E Ratio (Price-to-Earnings Ratio)

• Tells how much investors are willing to pay for ₹1 of a company’s earnings.

Formula:

$$\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{EPS}}$$📌 Example:

• Market Price = ₹200

• EPS = ₹20

$$P\mathrm{/}E=\frac{200}{20}=10$$

🔍 Interpretation:
Investors are ready to pay ₹10 for every ₹1 the company earns.

• High P/E: Growth stock, expensive.

• Low P/E: Value stock, cheap or risky.

Price/Book Value Ratio (P/B Ratio)

• Compares stock price to book value (net assets per share).

✅ Formula:

$$\text{P/B Ratio}=\frac{\text{Market Price per Share}}{\text{Book Value per Share}}$$

📌 Example:

• Market Price = ₹100

• Book Value = ₹50

$$P\mathrm{/}B=\frac{100}{50}=2$$

🔍 Interpretation:
Investors pay ₹2 for ₹1 of company’s actual net worth.

• <1 means undervalued.

• >1 could mean strong brand or growth potential.

Price/Sales Ratio (P/S Ratio)

• Compares stock price to sales per share.

✅ Formula:

$$\text{P/S Ratio}=\frac{\text{Market Price per Share}}{\text{Sales per Share}}$$

📌 Example:

• Price = ₹150

• Sales per Share = ₹75

$$P\mathrm{/}S=\frac{150}{75}=2$$

🔍 Interpretation:
You are paying ₹2 for every ₹1 of sales.

• Low P/S (<1): Possibly undervalued.

• Useful for companies with no profits yet (e.g., startups).

Economic Value Added (EVA)

• Measures how much value a company has created beyond the cost of capital.

Formula:

$$\text{EVA}=\text{Net Operating Profit After Tax (NOPAT)}-(\text{Capital Employed}\times \text{Cost of Capital})$$

📌 Example:

• NOPAT = ₹50 lakh

• Capital Employed = ₹200 lakh

• Cost of Capital = 10%

$$EVA=50-(200\times 10\mathrm{\%})=50-20=\text{₹}30lakh$$

🔍 Interpretation:
Company has created ₹30 lakh extra value. Positive EVA = Good performance.

Summary Table

Concept	Meaning in Simple Words	Formula	Example Output
Intrinsic Value	True worth of the stock	Based on earnings, dividends, cash flow	₹150
Market Price	Price on stock exchange	-	₹120
Earnings Multiplier	Value using EPS and market P/E	EPS × P/E Ratio	₹150 (₹10 EPS × 15 P/E)
P/E Ratio	₹ you pay per ₹1 of earnings	Price ÷ EPS	10
P/B Ratio	₹ you pay per ₹1 of company’s net worth	Price ÷ Book Value per Share	2
P/S Ratio	₹ you pay per ₹1 of sales	Price ÷ Sales per Share	2
EVA	Extra value created after capital cost	NOPAT - (Capital × Cost of Capital)	₹30 lakh

Valuation of Debentures / Bonds

A bond or debenture is a loan given by an investor to a company or government. In return, the issuer pays regular interest (coupon) and repays the principal at maturity.

Think of it like giving a loan to a company. You get interest regularly and your money back at the end.

Nature of Bonds

Feature	Description
Issuer	Government, company, or financial institution
Face Value	Original amount (say ₹1,000) to be repaid at maturity
Coupon Rate	Fixed interest rate paid annually/semi-annually
Maturity	Period after which bondholder gets the principal back
Yield	Return the investor earns from the bond (based on purchase price)

Example:

• Face Value = ₹1,000

• Coupon Rate = 10%

• Maturity = 5 years

• So you get ₹100 per year for 5 years + ₹1,000 at end.

Valuation of Bonds

Bond value = Present value of all future interest payments + principal repayment, discounted at market rate.

Formula:

$$\text{Bond Price}=\sum \frac{C}{(1+r{)}^t}+\frac{F}{(1+r{)}^{\mathrm{n}}}$$

Where:

• $C$ = Annual Coupon

• $r$ = Market interest rate (discount rate)

• $F$ = Face Value

• $n$ = Number of years

📌 Example:

• Face Value = ₹1,000

• Coupon = ₹100

• Maturity = 3 years

• Market Rate = 8%

$$\text{Bond Price}=\frac{100}{(1.08{)}^1}+\frac{100}{(1.08{)}^2}+\frac{1100}{(1.08{)}^{\mathrm{3}}}$$

Calculate to get total bond value ≈ ₹1,026.59

Bond Theorems (Important Rules)

These are the laws or principles that tell how bond prices behave with interest rate changes.

Bond Theorem	Simple Explanation
Inverse relationship	When interest rates rise, bond prices fall and vice versa
Longer maturity = more risk	Long-term bonds are more sensitive to interest rate changes
Lower coupon = more sensitive	Bonds with low interest (coupon) are more affected by rate changes
Yield moves faster than price	Price changes are smaller than yield changes

Example:

If interest rate goes up from 8% to 10%, a bond that was worth ₹1,026 might now be worth ₹950.

Term Structure of Interest Rates (Yield Curve)

This shows the relationship between interest rates and time to maturity.

Types of Yield Curves:

Type	Meaning
Normal Curve	Long-term rates > Short-term (typical during growth)
Inverted Curve	Short-term rates > Long-term (may indicate recession)
Flat Curve	Short and long-term rates are nearly the same

📌 Example:

• 1-year bond rate = 5%

• 5-year bond rate = 7%

• 10-year bond rate = 8% → Normal yield curve

Summary Table:

Concept	Explanation in Simple Words
Bond/Debenture	A loan to company/government with fixed interest and maturity
Valuation	Present value of future interest + principal
Bond Theorem 1	Bond price falls when interest rates rise
Bond Theorem 2	Long-term bonds are more affected by rate changes
Term Structure (Yield Curve)	Shows how interest rate varies with time
Normal Yield Curve	Longer maturity = higher interest rate

Tags: INVESTMENT ANALYSIS & PORTFOLIO MANAGEMENT

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