How bonds and common stocks are valued

When you own a bond, you receive a fixed set of cash payoffs. Each year until the bond matures, you get an interest payment and then at maturity you also get back the face value of the bond. The face value of the bond is known as the principal. Therefore, when the bond matures, the government pays you principal and interest.

The cash payoff to owners of common stocks comes in two forms: (1) cash dividends and (2) capital gains or losses. Usually investors expect to get some of each. The return that is expected by investors is often called the market capitalization rate.

Common stocks do not expire of old age. Barring such corporate hazards as bankruptcy or acquisition, they are immortal. Price in any period is determined by expected dividends and capital gains over the next period. We might be tempted to conclude that the total value of a company’s common stock must be equal to the discounted stream of all future dividends paid by the company. But we need to be a little careful here. We must only include the dividends that will be paid on existing stock. The company may at some future date decide to sell more stock and this will be entitled to its share of the subsequent dividend stream.

Investors often use the terms growth stocks and income stocks. They seem to buy growth stocks primarily for the expectation of capital gains, and they are interested in the future growth of earnings rather than in next year’s dividends. On the other hand, they buy income stocks primarily for the cash dividends.

Since all the earnings are paid out as dividends, the expected return is also equal to the earnings per share divided by the share price (i.e. the earnings-price ratio). The expected return for growing firms can also equal the earnings-price ratio.

Stock prices today reflect investors’ expectations of future operating and investment performance. Growth stocks sell at high price-earnings ratios because investors are willing to pay now for expected superior returns on investments that have not yet been made.

Some companies have such extensive growth opportunities that they prefer to pay no dividends for long periods of time because any cash paid out to investors would have meant either slower growth or raising capital by some other means.

1. Match each of the words on the left with the correct explanation on the right:

capitalization	a method of making small payments by post
to tender	the stock of money (cash and liquid resources) required by a business to continue producing or trading
capital gains	a group or collection of similar persons or things
working capital	a short-term bill sold by the government to commercial banks, usually to regulate the money supply
batch	to make an offer for a contract
payoff	the aggregate stock market price of all a company’s ordinary shares
Treasury bill	profits from the sale of assets
postal order	recompensation or return

2. Complete the text by inserting the following words in the gaps:

banking system, customer, discount, discount houses, face value, finer, interest return, money markets, ordinary commercial bill, per annum

The discount market provides a daily market for buying and selling bills between the ......(1) as a whole and the public authorities so that the banking system can be provided with cash when it expects to be short of cash.

A Treasury bill of £100 ......(2) will not be issued by the government for £100. Like other bills, it is sold at a ......(3) since only the £100 is payable in 91 days time: the discount provides the interest which the buyer would otherwise lose if he paid £100 now and received £100 back in 91 days time. Most Treasury bills are sold to the ......(4) which bid for the bills. If a bid of, say, £97 per £100 91 day Treasury bill is accepted by the Bank on behalf of the government, the discount would be £3 for a 3 month IOU, giving an approximate rate of discount of 12% ......(5). This would be an ......(6) or yield to the buyer of the bill, who earns interest of £3 on the £97 he invests for 91 days.

Commercial bills are also discounted when a bank agrees to accept a bill on behalf of ......(7), i.e. the bill is drawn on the bank itself. It is an IOU commitment of the bank and is known as a bank bill. A major advantage of a bank bill over an ......(8) is that since the bank should be a very secure creditor, bank bills can be sold at a ......(9) rate of discount. In addition, the bills of eligible banks can be discounted by the Bank of England. In other words, the Bank might agree to buy the bill of these eligible banks from the ......(10).