Equity and fixed income valuation
Equity and fixed income valuation tests whether you can convert forecasts into intrinsic value and translate yield changes into price changes.
Core rules
- Dividend discount model: V0 = D1/(r − g), valid only when r > g and growth is stable. D1 is next year's dividend.
- Multiples need like-for-like comparables: forward P/E, or EV/EBITDA for capital-structure-neutral comparison.
- Bond price is the present value of coupons and principal at the yield to maturity; price and yield move inversely.
- Modified duration estimates percentage price change ≈ −D_mod × Δy; convexity improves the estimate for large yield moves.
Worked example
A stock just paid D0 = 2.00. Dividends grow 4% forever and the required return is 9%. D1 = 2.00 × 1.04 = 2.08, so V0 = 2.08/(0.09 − 0.04) = 41.60. Reasoning: using D0 would give 40.00 and understate value because the buyer receives next year's dividend. If the market price were 45, implied growth = 0.09 − 2.08/45 = 4.38%, above 4%, so the stock screens rich.
Traps that cost marks
- Applying constant growth to a high-growth firm or to a negative r − g.
- Forgetting that a 50 bp yield rise cuts price by roughly 5% at modified duration 10.
- Comparing P/E across firms with different leverage or accounting policies.
- Treating yield to maturity as a reinvestment-free return.