Intrinsic Value and Bond Valuation

This is Part 1 of a Series

The intrinsic value of an asset is only worth the sum of the present values of all the future cash flows it provides. This is the assumption of bond analysis and valuation. When you buy a bond, you are offered interest or coupon payments which you receive in varying intervals (e.g. monthly, quarterly, semi-annually, annually, etc.). You pay upfront for the principal, receive interest payments, and finally receive that principal you initially paid for upon maturity (i.e. expiration date of the bond).

Coupon Bonds. In bond analysis, a bond is only worth the sum of the present values of all its coupon payments and principal upon maturity.

What is Present Value? It is the discounted value of a cash you’d be receiving in the future. It is based on the premise that as rational capitalists, we give more value to cash we can hold, spend, or invest now (at the present time) than the same cash amount we would receive in the future. It does make sense if we observe an extreme example: were you offered a million pesos, would you rather have it now or have it 10 years later? Most definitely, that Php1M is worth more to you now than it is (at the same amount) 10 years after!

How about Discounting? Discounting is a technical, finance-slang term akin to your more familiar, layman’s interest rate. Say you have a Php100 and you offered it to me as a loan with 10% interest per annum. After a year, assuming I stay true and make good our original terms, your Php100 would be worth Php110.

FEU’s Cash Hoard. And They Said School is Boring...

This is Part 3 of a Series. Go to Part 2: So Where Have All Those Free Cash Flow Gone?

Majestic Campus. FEU is one of those few quality businesses that routinely produce and hoard free cash for the wealth enrichment of its owners.

I can’t blame anyone who thinks school is boring. Be it on what one may have experienced back in high school or college (e.g. boring classes and teachers/professors), or in stocks (i.e. boring, illiquid issues that hardly move in the market). But let’s take on the shoes of a prospecting investor interested in the fundamental cash-generating dynamics of a school as a business.

Disclosure: I'm currently a shareholder of Far Eastern University—yes, it is listed in the Philippine Stock Exchange (PSE: FEU).

Grasping the core business model of a school seems easy. Schools teach and prepare students for the real world, and in return collect tuition fees for this education service. As many are aware, they collect these fees upfront; before a student can walk into a classroom to learn, he must first pay the registrar a visit and write the accounting department a check. Not mentioning its other sidelines (such as leasing certain properties owned and deploying excess cash into other non-core business investments), that's how a school primarily makes its money.

Bonds and Yields Simplified

To those familiar with bonds, how often do we hear that when interest rates go up, bond prices go down? Why does the price of bond move opposite its yield? The relationship is naturally inverse but why?!

Perhaps it's not so easy to digest because the idea of interest rates being the one responsible (or the one causing the movement) of bond prices doesn't have so much concrete/obvious logic into it. So how about putting it this way instead: Bond price dictates yield. Just like the relationship of stock price and its dividend yield, intuitively, we know that when a stock price shoots, the prospect of dividend yield drops.

Going back to bonds, let's try a very simple, straightforward example to put things into perspective:

Let's say I'm a very popular listed company about to issue some debt instruments; I needed more capital since I'm aggressively growing my business. I issued Php 100 worth of debt (principal) maturing in 10 years at the coupon rate of 10%. Knowing that I have good credit standing making my debt or bond issues marketable in the secondary market (e.g. PDEX), you availed of all bond issues at the cost of Php 100 (it isn't at a premium or discount since your acquisition cost is the same as the original principal issue). Effectively, your yield is equal to the coupon rate of 10% and you're assured of a Php 10 interest annually.

Now, a friend came along and knew about the bond you're holding. He's very interested in buying it since he knows the issuer is of good credit standing. You two bargained for a trade price to where you both agreed at Php 110—he will be buying your Php 100 worth of bonds at Php 110 (at a premium). What will happen to his yield? Obviously, it will be lower. From the original 10% yield, his yield will just be 9.09%. (Php 10/110). That's why yields go up and down. For me, the yield is dictated by the price, not the other way around—although most bond market traders (being so conscious of interest rate movements) have been psyched to think otherwise.