Chapter 5 of 5
Valuation, bonds and the cost of capital
Understand discounting, valuation multiples and why a change in required returns affects both shares and bonds.
In this chapter
Value is an estimate of future benefits #
A valuation translates uncertain future cash flows into a present estimate. Discounting recognizes time and risk: present value = future cash flow ÷ (1 + discount rate)years. The result depends on assumptions about growth, reinvestment, financing and the required return.
A precise spreadsheet output does not make those assumptions precise. Small changes in a long-term growth or discount rate can have large effects. A valuation should explain its sensitivity instead of presenting a single number as an objective market destination.
Multiples are shortcuts with assumptions #
A price-to-earnings ratio compares equity value with earnings. A low ratio may reflect weak growth, temporary earnings, high risk or a genuine difference in valuation. A high ratio may reflect stronger expectations that can still disappoint. One ratio cannot establish suitability or a recommendation.
Debt and equity claims have different priorities. Bond valuation discounts contractual payments while also considering the chance of default and recovery. Coupon rate is not the same as yield: buying the same fixed cash flows at a different price changes the return implied by that price.
Higher yields and fixed cash flows #
For a conventional fixed-rate bond, a rise in the required yield generally lowers the value of its remaining fixed payments. Longer effective duration means greater sensitivity, with qualifications for credit changes and embedded options. Holding to maturity does not remove default risk or the opportunity cost of committing capital.
Equity valuations can also respond to discount rates, but operating earnings and risk expectations change at the same time. Avoid a mechanical claim that every rate change produces the same share-price movement.
Decision lab: Valuation is a sensitivity exercise #
Suppose a hypothetical constant cash flow of 10 has a perpetuity value of 100 at a 10% discount rate and 125 at 8%, ignoring growth. A two-percentage-point rate change produces a 25% model-value difference. It does not establish which discount rate the market should use.
Create a two-dimensional sensitivity table for cash flow and discount rate. Explain which economic assumption dominates the range and test a permanent impairment scenario. A precise spreadsheet output should not hide uncertain inputs or a fragile terminal value.
Hypothetical worked example
Discount one payment, then change the assumption
A hypothetical payment of ₹1,100 one year from now has a present value of ₹1,000 at a 10% discount rate. At a 12% rate, its value is about ₹982.14. The payment has not changed; the rate used to value it has.
If a fictional share trades at ₹200 with annual earnings per share ₹10, its P/E is 20. If earnings fall to ₹5 while price is unchanged, P/E doubles to 40. The earlier ratio did not create protection against an earnings decline.
A sound analysis separates what is known today from what is being assumed. These examples teach relationships and do not identify a security to purchase.
Common mistakes
- Comparing coupon with yield as if they were identical.
- Treating a low multiple as an independent reason to buy.
If the required yield rises, what normally happens to a plain fixed-rate bond’s price, other things equal?
Make this chapter useful
Can you defend the reasoning?
Before moving on, answer the self-check in your own words and write why each alternative fails. Use the worked example to test that explanation. Then apply it in the module research task; keep the assumptions and the evidence that could change your answer.
Sources and further reading
Further-reading references from the curriculum source list. Contract sizes, expiry calendars, settlement references, margin parameters and tax treatment can change; verify the current operative documents for the actual product. Worked figures are illustrative, not current quotes.
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General financial education. No securities recommendation, assured outcome or personal advice. Read the risk disclosures.