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Questions and Answers
What is the primary reason why relative valuation is preferred over discounted cash flow valuation in certain scenarios?
What is the primary reason why relative valuation is preferred over discounted cash flow valuation in certain scenarios?
Why is the median preferred over the mean in relative valuation?
Why is the median preferred over the mean in relative valuation?
What is a potential issue with selecting comparables in relative valuation?
What is a potential issue with selecting comparables in relative valuation?
How can market conditions affect relative valuation?
How can market conditions affect relative valuation?
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What is a potential issue with comparing companies with different growth rates in relative valuation?
What is a potential issue with comparing companies with different growth rates in relative valuation?
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What is an assumption of non-linear regression in relative valuation?
What is an assumption of non-linear regression in relative valuation?
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What is the implication of multi-collinearity on the coefficients of a regression model?
What is the implication of multi-collinearity on the coefficients of a regression model?
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What is the primary difference between a zero coupon bond and a regular bond?
What is the primary difference between a zero coupon bond and a regular bond?
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What happens to the bond price when the market interest rate increases, and the YTM also increases?
What happens to the bond price when the market interest rate increases, and the YTM also increases?
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What is the assumption of the Pure Expectations Theory regarding investors' behavior?
What is the assumption of the Pure Expectations Theory regarding investors' behavior?
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What is the typical shape of the yield curve when investors expect stronger economic growth and potentially higher inflation in the future?
What is the typical shape of the yield curve when investors expect stronger economic growth and potentially higher inflation in the future?
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What is the characteristic of a bond when its coupon rate is lower than the YTM?
What is the characteristic of a bond when its coupon rate is lower than the YTM?
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What is the implication of a downward sloping yield curve on the economy?
What is the implication of a downward sloping yield curve on the economy?
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What is the primary reason why investors prefer long-term bonds in a downward sloping yield curve?
What is the primary reason why investors prefer long-term bonds in a downward sloping yield curve?
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What can be inferred from a negative forward rate?
What can be inferred from a negative forward rate?
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What is the relationship between interest rates and bond prices?
What is the relationship between interest rates and bond prices?
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What is the primary assumption of the Liquidity Preference Theory?
What is the primary assumption of the Liquidity Preference Theory?
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What is the implication of a higher discount rate on bond prices?
What is the implication of a higher discount rate on bond prices?
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What is the purpose of using forward rates in bond analysis?
What is the purpose of using forward rates in bond analysis?
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What is the primary difference between the Liquidity Preference Theory and the Pure Expectations Theory?
What is the primary difference between the Liquidity Preference Theory and the Pure Expectations Theory?
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Why might high-growth companies appear overvalued compared to low-growth companies in relative valuation?
Why might high-growth companies appear overvalued compared to low-growth companies in relative valuation?
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What is a consequence of choosing comparables that are not truly similar to the asset being valued?
What is a consequence of choosing comparables that are not truly similar to the asset being valued?
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What is an assumption made in non-linear regression in relative valuation?
What is an assumption made in non-linear regression in relative valuation?
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Why is relative valuation more likely to reflect market perceptions and moods than discounted cash flow valuation?
Why is relative valuation more likely to reflect market perceptions and moods than discounted cash flow valuation?
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What can lead to valuation discrepancies in relative valuation?
What can lead to valuation discrepancies in relative valuation?
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Why is the median preferred over the mean in relative valuation?
Why is the median preferred over the mean in relative valuation?
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What is the implication of a multi-collinearity issue in a regression model?
What is the implication of a multi-collinearity issue in a regression model?
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What happens to the bond price when the market interest rate decreases, and the YTM also decreases?
What happens to the bond price when the market interest rate decreases, and the YTM also decreases?
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What is the primary characteristic of a convertible bond?
What is the primary characteristic of a convertible bond?
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What is the primary difference between a municipal bond and a treasury bond?
What is the primary difference between a municipal bond and a treasury bond?
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What is the primary assumption of the Pure Expectations Theory?
What is the primary assumption of the Pure Expectations Theory?
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What is the typical shape of the yield curve when investors expect weaker economic growth and potentially lower inflation in the future?
What is the typical shape of the yield curve when investors expect weaker economic growth and potentially lower inflation in the future?
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What can be inferred from an upward sloping yield curve?
What can be inferred from an upward sloping yield curve?
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What is the relationship between interest rates and bond prices?
What is the relationship between interest rates and bond prices?
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What is the primary assumption of the Liquidity Preference Theory?
What is the primary assumption of the Liquidity Preference Theory?
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What is the implication of a negative forward rate?
What is the implication of a negative forward rate?
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What happens to bond prices when market interest rates decrease?
What happens to bond prices when market interest rates decrease?
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What is the primary difference between shorter-term and longer-term securities?
What is the primary difference between shorter-term and longer-term securities?
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What is the purpose of using forward rates in bond analysis?
What is the purpose of using forward rates in bond analysis?
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What is the implication of a flat yield curve?
What is the implication of a flat yield curve?
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What is the effect of a decrease in the market interest rate on the price of a bond with a coupon rate higher than its YTM?
What is the effect of a decrease in the market interest rate on the price of a bond with a coupon rate higher than its YTM?
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What is the primary difference between a callable bond and a convertible bond?
What is the primary difference between a callable bond and a convertible bond?
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What is the implication of a multi-collinearity issue in a regression model?
What is the implication of a multi-collinearity issue in a regression model?
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What is the primary assumption of the Pure Expectations Theory regarding the yield curve?
What is the primary assumption of the Pure Expectations Theory regarding the yield curve?
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What is the primary advantage of using relative valuation in scenarios where market perceptions and moods are important?
What is the primary advantage of using relative valuation in scenarios where market perceptions and moods are important?
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What is the characteristic of a bond when its coupon rate is equal to its YTM?
What is the characteristic of a bond when its coupon rate is equal to its YTM?
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What is the primary issue with selecting comparables in relative valuation?
What is the primary issue with selecting comparables in relative valuation?
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How do market conditions influence the prices of comparables in relative valuation?
How do market conditions influence the prices of comparables in relative valuation?
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What is the primary implication of comparing companies with different growth rates in relative valuation?
What is the primary implication of comparing companies with different growth rates in relative valuation?
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What is the primary difference between relative valuation and discounted cash flow valuation?
What is the primary difference between relative valuation and discounted cash flow valuation?
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What does an inverted yield curve suggest about the future economic conditions?
What does an inverted yield curve suggest about the future economic conditions?
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Why are forward rates considered useful in bond market analysis?
Why are forward rates considered useful in bond market analysis?
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According to Liquidity Preference Theory, why are investors compensated more for holding long-term securities?
According to Liquidity Preference Theory, why are investors compensated more for holding long-term securities?
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What does a negative forward rate indicate in bond market analysis?
What does a negative forward rate indicate in bond market analysis?
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What is the implication of an increase in bond prices when interest rates are low?
What is the implication of an increase in bond prices when interest rates are low?
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What is a major assumption in relative valuation?
What is a major assumption in relative valuation?
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What is a potential consequence of using non-linear regression in relative valuation?
What is a potential consequence of using non-linear regression in relative valuation?
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Why might small companies trade at different multiples compared to larger companies in relative valuation?
Why might small companies trade at different multiples compared to larger companies in relative valuation?
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What is a potential issue when comparing companies with different growth rates in relative valuation?
What is a potential issue when comparing companies with different growth rates in relative valuation?
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What is a characteristic of relative valuation that makes it more likely to reflect market perceptions and moods?
What is a characteristic of relative valuation that makes it more likely to reflect market perceptions and moods?
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Why might the overall regression model still be reliable despite multicollinearity among the independent variables?
Why might the overall regression model still be reliable despite multicollinearity among the independent variables?
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What characterizes a bond sold at a premium?
What characterizes a bond sold at a premium?
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How does the Pure Expectations Theory describe the shape of the yield curve?
How does the Pure Expectations Theory describe the shape of the yield curve?
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What happens to bond prices when market interest rates rise and the yield to maturity increases?
What happens to bond prices when market interest rates rise and the yield to maturity increases?
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Which of the following bonds requires higher yields for longer maturities due to greater exposure to rate changes and inflation risk?
Which of the following bonds requires higher yields for longer maturities due to greater exposure to rate changes and inflation risk?
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Which factor primarily influences the shape of the yield curve according to market expectations?
Which factor primarily influences the shape of the yield curve according to market expectations?
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What does an inverted yield curve most likely indicate about future economic conditions?
What does an inverted yield curve most likely indicate about future economic conditions?
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Why might investors prefer long-term bonds in a downward sloping yield curve?
Why might investors prefer long-term bonds in a downward sloping yield curve?
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According to the Liquidity Preference Theory, why are investors compensated with a higher return premium for long-term securities?
According to the Liquidity Preference Theory, why are investors compensated with a higher return premium for long-term securities?
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What does the presence of a negative forward rate suggest?
What does the presence of a negative forward rate suggest?
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Study Notes
Relative Valuation
- In relative valuation, an asset's price is compared to the prices of similar or comparable assets
- Market prices are standardized to create price multiples
- Reasons for popularity: easier to justify and reflects market perceptions and moods
- Median is preferred over mean due to its reliability and resistance to extreme outliers
Issues in Relative Valuation
- Choice of comparables: subjective selection can significantly affect valuation
- Market conditions: can influence prices of comparables and lead to inaccurate valuations
- Differences in growth rates: comparing companies with different growth rates can be misleading
- Scale and size of companies: comparing companies of different sizes can lead to valuation discrepancies
Bonds
- Bonds raise long-term capital for corporations and governments
- Investors pay the initial cost, receive coupon (interest) periodically, and face value when the bond matures
- Types of bonds: convertible, indexed, callable, perpetual, treasury, and municipal
- Bond pricing and YTM: YTM reflects market's required return on the bond
Yield to Maturity (YTM)
- If market requires higher return than coupon rate, bond price drops (discount)
- If market requires lower return than coupon rate, bond price increases (premium)
- Changes in market interest rates affect YTM and bond prices
- Relationship between YTM, coupon rate, and time to maturity:
- Bond price increases when YTM decreases
- Bond price decreases when YTM increases
- Bond price increases as time to maturity increases
- Bond price decreases as time to maturity decreases
Characteristics of Bonds
- Par value bond: coupon rate = YTM
- Discount bond: coupon rate < YTM
- Premium bond: coupon rate > YTM
Pure Expectations Theory
- Assumes yield curve reflects investors' expectations of future short-term interest rates
- Long-term interest rates determined by market's expectation of future short-term interest rates (forward rates)
- Investors indifferent between holding short-term or long-term securities with the same total return
Yield Curve Shape
- Normal (upward sloping): long-term bonds have higher yields, indicating expectations of stronger economic growth and inflation
- Inverted (downward sloping): short-term bonds have higher yields, indicating expectations of slower economic growth or recession
- Flat yield curve: rarely seen, indicates changes in the economy
Discount Factors, Spot Rates, and Forward Rates
- Discount factor: determined from market price and cash flows of a bond
- Forward rates: market expectations of interest rates in the future
- Comparing forward rates to spot rates indicates market expectations of future interest rate changes
- Short-term bonds have less interest rate risk, while long-term bonds are more sensitive to risk
High and Low Interest Rates
- High interest rates: decrease in bond prices, providing an opportunity for investors
- Low interest rates: increase in bond price, making bonds more valuable
- Shape of yield curve determined by market expectations of future interest rate movements
Liquidity Preference Theory
- Investors are compensated for time and take on more risk when investing for longer periods
- Liquidity preference theory assumes current yield curve reflects investors' expectations of future short-term interest rates and their preference for liquidity
- Investors prefer shorter-term securities, which are exposed to less interest rate risk, and require a premium for investing in long-term securities with higher risk
Relative Valuation
- Relative valuation compares the price of an asset to the prices of similar or comparable assets.
- Market prices are converted into standardized prices, creating price multiples.
- Reasons for popularity:
- Easier to justify using relative valuation.
- More likely to reflect market perceptions and moods.
- Advantage when market perceptions are important.
- Median is preferred over mean:
- Median is a more reliable comparison point.
- Median is unaffected by extreme outliers or non-symmetric distributions.
- Median is a better representation of the true average with outliers.
Issues in Relative Valuation
- Choice of comparables:
- Selecting appropriate comparables is subjective and affects valuation.
- Inaccurate valuation if comparables are not similar.
- Market conditions:
- Market conditions influence prices of comparables.
- Valuations may reflect temporary market conditions rather than intrinsic value.
- Differences in growth rates:
- Comparing companies with different growth rates.
- High-growth companies may appear overvalued compared to low-growth companies.
- Scale and size of companies:
- Comparables may differ significantly in scale and size.
- Smaller companies may trade at different multiples compared to larger companies.
Non-linearity Regression
- Assumes a linear relationship between the multiple and its fundamentals.
- Issues:
- Non-stationarity: relationship between multiple and financial variables may not be stable.
- Multi-collinearity: independent variables are correlated, making coefficients unreliable.
Bonds
- Issued by corporations and governments to raise long-term capital.
- Bond characteristics:
- Par value: coupon rate equals yield to maturity (YTM).
- Discount bond: coupon rate is less than YTM.
- Premium bond: coupon rate is greater than YTM.
Bond Pricing and YTM
- YTM reflects the market's required return on the bond.
- Bond price changes:
- If market requires a higher return than the bond's coupon rate, bond price drops.
- If market requires a lower return than the bond's coupon rate, bond price increases.
- Interest rate changes:
- When market interest rates rise, YTM increases, and bond prices fall.
- When market interest rates fall, YTM decreases, and bond prices rise.
Relationship Between YTM, Coupon Rate, and Time to Maturity
- (Expensive/Premium) Bond:
- If coupon rate is higher than YTM, bond is sold at a price above face value.
- As time to maturity decreases, bond price decreases.
- As time to maturity increases, bond price increases.
- (Cheaper/Discount) Bond:
- If coupon rate is lower than YTM, bond is sold at a price below face value.
- As time to maturity decreases, bond price increases.
- As time to maturity increases, bond price decreases.
Pure Expectations Theory
- Assumes current yield curve reflects investors' expectations of future short-term interest rates.
- Long-term interest rates are determined by market expectations of future short-term interest rates.
- Investors are indifferent between holding short-term or long-term securities, provided the same total return is given over the same investment period.
Yield Curve Shapes
- Normal (Upward Sloping):
- Long-term bonds have higher yields compared to short-term bonds.
- Investors expect stronger economic growth and potentially higher inflation in the future.
- Yield curve indicates market participants expect interest rates to rise in the future.
- Inverted (Downward Sloping):
- Short-term bonds have higher yields compared to long-term bonds.
- Investors expect slower economic growth or a recession in the future.
- Yield curve indicates market participants expect interest rates to decrease in the future.
- Flat Yield Curve:
- Rarely seen, only during economic changes.
- Indicates a shift towards either an upward or downward sloping yield curve.
Discount Factors, Spot Rates, and Forward Rates
- Discount Factor: determined from the market price and cashflows of a bond, used to obtain the corresponding spot rate and create a yield curve.
- Forward Rates: market expectations of interest rates in the future.
- Comparing forward rates to spot rates: indicator of what the market thinks will happen in the future.
Liquidity Preference Theory
- Assumes the current yield curve reflects investors' expectations of future short-term interest rates and their preference for liquidity.
- Investors prefer shorter-term securities, which are exposed to less interest rate risk.
- Investors are willing to pay extra for reducing this risk exposure.
- Implications:
- Shorter-term securities: lower risk, lower return (discount rate).
- Long-term securities: higher risk, higher return (discount rate).
Relative Valuation
- Compares the price of an asset to the prices of similar or comparable assets in the market
- Market prices are converted into standardized prices, creating price multiples
- Preferred over discounted cash flow valuation because it reflects market perceptions and moods
- The median is preferred over the mean due to its reliability and immunity to extreme outliers and non-symmetric distributions
Issues in Relative Valuation
- Choice of comparables: selecting appropriate comparables can significantly affect the valuation
- Market conditions: temporary market conditions can influence the prices of comparables, affecting the valuation
- Differences in growth rates: comparing companies with different growth rates can lead to misleading conclusions
- Scale and size of companies: comparing companies of different sizes can lead to valuation discrepancies
Bonds
- Raises long-term capital for corporations and governments
- Investor pays initial cost, receives coupon (interest) periodically, and face value at maturity
- Types of bonds:
- Convertible bonds: can be converted into a predetermined number of stocks
- Indexed bonds: rate of return is eroded by inflation
- Callable bonds: seller can buy the bond back from the investor
- Perpetual bonds: has no maturity date
- Treasury bonds: issued by the federal government
- Municipal bonds: issued by state or government agencies
Bond Pricing and YTM
- YTM reflects the market's required return on the bond
- If the market requires a higher return, the bond's price drops; if the market requires a lower return, the bond's price increases
- Interest rate changes affect YTM and bond prices
- Relationship between YTM, coupon rate, and time to maturity:
- Expensive/Premium bond: sold at a price above face value, with a higher coupon rate than YTM
- Cheap/Discount bond: sold at a price below face value, with a lower coupon rate than YTM
Characteristics of Bonds
- Par value bond: coupon rate equals YTM
- Discount bond: coupon rate is less than YTM
- Premium bond: coupon rate is greater than YTM
Pure Expectations Theory
- Assumes the current yield curve reflects investors' expectations of future short-term interest rates
- Long-term interest rates are determined by the market's expectation of future short-term interest rates
- Investors are indifferent between holding short-term or long-term securities, provided the same total return is achieved
Yield Curve Shape
- Normal/Upward-sloping: long-term bonds have higher yields, indicating expected stronger economic growth and higher inflation
- Inverted/Downward-sloping: short-term bonds have higher yields, indicating expected slower economic growth or recession
- Flat yield curve: rare, indicates a changing economy
Discount Factors, Spot Rates, and Forward Rates
- Discount factor: determined from the market price and cashflows of a bond
- Spot rate: used to create a yield curve
- Forward rate: market expectations of interest rates in the future
- Comparing forward rates to spot rates indicates market expectations
- Short-term bonds have less interest rate risk, while long-term bonds are more sensitive to risk
Liquidity Preference Theory
- Investors are compensated for time and take extra risk when investing for longer
- Liquidity preference: investors prefer shorter-term securities with lower interest rate risk
- Investors require a higher return premium for investing in long-term securities with higher interest rate risk
- Implications:
- Shorter-term securities: lower risk, lower return, higher prices
- Long-term securities: higher risk, higher return, lower prices
Relative Valuation
- In relative valuation, the price of an asset is compared to the prices of similar or comparable assets.
- Market prices are converted into standardized prices, creating price multiples.
- Reasons why relative valuations are popular:
- Easier to justify using relative valuation
- More likely to reflect market perceptions and moods than discounted cash flow valuation
- Median is preferred over the mean in relative valuation because:
- The median is a more reliable comparison point
- It's unaffected by extreme outliers or non-symmetric distributions of scores
- The median is a better representation of the true average if the sample has outliers
Issues in Relative Valuation
- Choice of comparables:
- Selecting appropriate comparables is subjective and can significantly affect the valuation
- Impact: Inaccurate valuation if chosen comparables are not truly similar to the asset being valued
- Market conditions:
- Impact: Valuations based on comparables might reflect temporary market conditions rather than the intrinsic value of the asset
- Differences in growth rates:
- Impact: High-growth companies may appear overvalued compared to low-growth companies, leading to misleading conclusions
- Scale and size of companies:
- Impact: Smaller companies might trade at different multiples compared to larger companies, leading to valuation discrepancies
Bonds
- Raise long-term capital for corporations and governments
- Bond characteristics:
- Coupon rate (interest rate)
- Face value (initial cost)
- Maturity date
- Types of bonds:
- Convertible bonds
- Indexed bonds
- Callable bonds
- Perpetual bonds
- Treasury bonds
- Municipal bonds
Bond Pricing and YTM (Yield to Maturity)
- YTM reflects the market's required return on the bond
- If the market requires a higher return than the bond's coupon rate, the bond's price will drop (discount)
- If the market requires a lower return than the bond's coupon rate, the bond's price will increase (premium)
- Interest rate changes:
- When market interest rates rise, YTM increases, and bond prices fall
- When market interest rates fall, YTM decreases, and bond prices rise
- Relationship between YTM, coupon rate, and time to maturity:
- (Expensive/Premium) bond: If coupon rate is higher than YTM, sold at a price above face value
- (Cheaper/Discount) bond: If coupon rate is lower than YTM, sold at a price below face value
Pure Expectations Theory
- Assumes the current yield curve solely reflects investors' expectations of future short-term interest rates
- Long-term interest rates are determined by the market's expectation of future short-term interest rates (forward rates)
- Investors are indifferent between holding short-term or long-term securities provided any combination of investment gives the same total return over the same investment period
Yield Curve Shape
- Normal (Upward Sloping):
- Long-term bonds have higher yields compared to short-term bonds
- Indicates that market participants expect interest rates to rise in the future
- Inverted (Downward Sloping):
- Short-term bonds have higher yields compared to long-term bonds
- Indicates that market participants expect interest rates to decrease in the future
- Flat Yield Curve:
- Rarely seen, only when the economy is changing, as it either heads down or upwards sloping
Discount Factors/Spot Rates/Forward Rates
- Discount factor is determined from the market price and cash flows of a bond
- Forward rates are market expectations of interest rates in the future
- If you compare the forward rate to spot rate, it's a good indicator of what the market thinks will happen in the future
Liquidity Preference Theory
- Assumes the current yield curve reflects investors' expectations of future short-term interest rates and their preference for liquidity
- Investors prefer to hold shorter-term securities, which are exposed to less interest rate risk
- Investors are willing to pay extra for reducing this risk exposure
- Implications:
- Shorter-term securities: Lower risk, lower return (discount rate)
- Long-term securities: Higher risk, higher return (discount rate)
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Description
Learn about relative valuation, a method of estimating asset prices by comparing them to similar assets. Discover its advantages and how it reflects market perceptions.