Valuation and Characteristics
Valuation and Characteristics
The exam tests pricing bonds, preferred stock, and common stock, and understanding the features that shift required returns.
Bond rules
- Price = PV of coupon payments + PV of par value, discounted at the yield to maturity.
- Coupon < YTM → bond trades at a discount; coupon > YTM → premium; equal → par.
- Current yield = annual coupon/market price. YTM is the IRR of the bond's cash flows.
- Price and yield move inversely; interest-rate sensitivity rises with maturity and falls with coupon size-this is duration.
- Features: callable (issuer's option, raises yield), convertible (holder's option, lowers yield), sinking fund, indenture covenants.
Equity rules
- Preferred stock: fixed dividend with priority over common, usually no voting rights; value = Dp/rp as a perpetuity.
- Common stock, constant growth: P0 = D1/(r − g), where D1 = D0(1 + g). Zero growth: P0 = D/r.
- P/E = price/EPS; a higher P/E implies higher expected growth or lower perceived risk.
- Book value reflects accounting cost; market value reflects expected future cash flows and risk.
Worked example
An 8% annual coupon bond with $1,000 par maturing in 5 years, when the YTM is 6%: Price = 80 × [1 − 1.06^−5]/0.06 + 1,000/1.06^5 = 80(4.2124) + 747.26 = 336.99 + 747.26 = $1,084.25. It trades at a premium because the 8% coupon exceeds the 6% yield. Current yield = 80/1,084.25 = 7.38%, between the coupon and the YTM. For a stock with D0 = $2.00, g = 5%, r = 11%: D1 = $2.10 and P0 = 2.10/(0.11 − 0.05) = $35.00.
Traps
- Using D0 in the Gordon model numerator instead of next year's D1.
- Confusing coupon rate, current yield, and yield to maturity.
- Applying constant growth when g ≥ r or when near-term growth is supernormal.
- Assuming preferred dividends are tax-deductible or guaranteed; they are neither.
- Thinking a call feature raises the price-it benefits the issuer, so investors demand a higher yield.