How to Value Stocks and Bonds
This article will briefly describe the ways an analyst or investor will attempt to value a stock or a bond. Comparing and contrasting the different models used during the process.
The process for valuing stocks and bonds have similarities and differences. Historically, bonds will pay interest payments and stocks will pay dividends and both will have some type of yield. These interest and dividend yields would define the basis for the valuation. However, double taxation has caused many companies to not pay dividend to their shareholders. This has provided a deviation in valuation methodologies for stocks.
Most analyst will use the dividend discount model for the basis of valuing a stock. The dividend discount model has a definition of a procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. When valuing a bond, two major components become paramount, the yield and the risk. Investors want to maximize their yield and minimize the risk. Independent rating companies will rank the bonds on risk from investment grade to junk status.
Stocks have the design to run into perpetuity whereas bonds have a fixed term. At issuance, bonds typically have 1,3, 5, 10, 20 or 30 year maturities. At maturity, the investor will receive the initial coupon amount back from the issuer. Since stocks have an on-going concern, analyst will estimate future dividend or cash flows and then add a terminal value which represent the value of the business continuing past these estimates.
Bonds can contain different calculated yields that will change the value. Some bonds contain call provisions and the investor will need to examine the yield to call. Bonds also will state a yield at issuance, however when the bond starts to trade on the exchange, the yield to maturity emerges as relevant. The yield to maturity will take into account the current price. When examining stocks, the onset of double taxation of the corporation caused a shift in the valuation models. Most analysts now will examine the Discounted Cash Flow Model as few corporation pay dividends any more.
The benefits in understanding the value of a bond or a stock provide investors indications when the security moves into an overvalued or undervalued status. Now the investor needs to examine their future estimates of interest rates for bonds or of dividends or cash flows for stocks. Certain company or economic announcements can influence the environment and change the previously calculated value.
Some money managers or investors will compare the value of stocks to bonds in order to make a choice on which investment class to allocate money. Many will examine the yield of the long-term government bond and the inverse of the P/E ratio of the S&P 500 to decide whether to invest into bonds or stocks. The inverse of the P/E ratio will closely represent a yield of a bond. Then comparing the two yield will help investors to know which investment class has a undervalued or overvalued status. Investors can track their investment at different financial sites.