A Beginners Manual For Valuation Of Stocks And Bonds

Discounted present Value is one of the most important and relevant calculations anyone can use to get an indication of the value of a stock

. This is a metric used by stock analysts very often to try and find a stock that is undervalued or overvalued and act accordingly. Discounting is a total opposite of compounding, a metric most of us are familiar with. Let's try to understand this with the use of an example. Supposed someone offers to pay your Rs 1210 which is payable with complete certainty but only after two years. If the rate of interest is 10%, then how much would you be willing to pay that person as of today? The answer here is Rs1000.

This figure is called the discounted present value of Rs 1210. This is also often known as the present value technique. The amount that is payable in two years is brought down to or 'discounted' to an equivalent amount today. The basic formula that you need to know here is that the Discounted Present Value or DPV henceforth, is calculated as follows.

The basic formula for Present Value is as follows: PV=promised amount/ (1+r) to the power of 'n'. Here 'n' signifies the number of years and 'r' signifies the rate of interest. Now if we change it around a little, let's say that your friend is now offering to pay you Rs1100 after one year and Rs 1210 after two years. Now what would be the lending amount for you at the same rate of interest? Here the answer would be Rs2000 which you can get by the same formula, just add year one to year two and get a cumulative sum of Rs 2000. The interest rate which is an opportunity cost of money , if its positive, then the money that is given back at different points should be calculated at one point in time specifically like the end of the first year or second year I you prefer. It's important to keep it one specific point in time to do this calculation.

As I previously mentioned, this method of Present Value is often used to value stocks and bonds as well. The fair market value of stocks and bonds is dependent upon future expected cash flows which are then discounted at a rate that is equivalent to the amount of risk that this particular stock or bond faces. The reliability and certainty of the expected cash flows is the main concern and while this formula just deals with numbers, there are many other factors that go into valuing a company as well. Let's look at how stocks and bonds can be valued using this technique

Let's take the example of bonds first. If you wanted to buy a bond, the future cash flow each year (they have annual payments) is expected to be Rs 60. This is known as 'coupons' in the world of bonds. The maturity value is also known with as much certainty and let's says this is Rs 1000. You now apply the same formula at the risk free rate that the bond is supposed to give and you will get the correct value of the bond. In some cases the market price quoted by some dealers is below the fair value, but this will increase demand and it will soon be equal to the fair value.

Stocks are also an asset class that can be valued to some extent with the use of the Present Value technique. In the case of stocks, since they are a riskier asset class than bonds, there are two kinds of risks that have to be factored into the interest rate. One is the risk free rate and then in addition to that is another amount that reflects how risky that stock really is. This is known as a risk premium. Once you know these, apply the same formula and get a number that is a fair reflection of the stock in this point in time.

by: Chaitanya Kumar

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