Asset Valuation: Basic Bond and Stock Valuation Models
Valuation is the process of determining the fair value of a financial asset. The process is also referred to as “valuing” or “pricing” a financial asset. The fundamental principle of valuation is that the value of any financial asset is the present value of the expected cash flows. This principle applies regardless of the financial asset. Thus, the valuation of a financial asset involves the following three steps: (1) estimate the expected cash flows; (2) determine the appropriate interest rate or interest rates that should be used to discount the cash flows; and (3) calculate the present value of the expected cash flows using the interest rate or interest rates.
In this chapter, we apply the principles of valuation to value bonds and common stock. In the appendix, we explain how convertible bonds are valued.
It is important to remember that the user of any valuation model is exposed to modeling risk. This is the risk that the output of the model is incorrect because the assumptions on which it is based are incorrect. Consequently, it is imperative that the results of a valuation model be stress-tested for modeling risk by altering the assumptions.
Valuation begins with the estimation of the cash flows. Cash flow is simply the cash that is expected to be received at some time from an investment. In the case of a bond, the cash flows consist of interest and principal repayment. It does not make ...