The Relationship Between Bond Ratings and Yield-to-Maturity
The yield-to-maturity rises when the bond rating falls; for example, the A-rated bond (Exxon Mobil) yields less (2.88%) than the C-rated bond (Chesapeake, 8.01%). The ratings analyze bond issuers' ability and desire to pay regular interest and repay principal at maturity (Henry, Kisgen, & Wu, 2015). Bonds issued by financially solid and stable corporations are rated "investment-grade," indicating that there is no possibility of default. In this situation, Exxon Mobil has an A-rating, indicating that it is of high quality and that the danger of interest and principal default is low (almost zero). As a result, the investors have less exposure to risk and according to the risk-return trade-off, the lower the risk, the lower the expected return.
The Relationship Between Bond Ratings and Risk-Adjusted Returns
However, as the rating descends to B, the risk of default increases and for the case of Hess Corporation, it is not an investment grade (Henry et al. 2015). Such a bond is speculative, and in such a circumstance, investors will expect a higher return for the increased risk. On the other hand, Chesapeake Energy Corp. has a C-rating which means that it is of poor quality and there is a higher probability that it might default. Therefore, the company must pay a higher interest rate to attract investors for the increased risk. Also, the investors demand a higher return to compensate for the higher risk.
The Impact of Interest Rate Changes on Bond Prices
When the coupon rate is greater than the YTM, the bond is trading at a premium and when YTM>coupon rate, the bond trades at a discount (Malkiel, 2015). The coupon is fixed (investor receives same annual coupon payment), but the interest rates are always changing. The issue is that if the interest rate increases, an investor would be forced to sell a bond at a lower price in efforts to attract buyers. For instance, a Hess corporation investor will receive a coupon rate of 4.300% till maturity. An increase in interest rates to 5% would mean that buyers now have the opportunity to earn a higher return (5% over 4.30%) and in such a case, he has to sell the bond at a lower price (discount). The discounted price makes up for the fact that the new buyer receives a lower return (he could be earning a higher return in the market). Therefore, an increase in the interest rates causes the bond price to fall in compensation for the lower return (YTM) the new buyer will receive from the bond (Malkiel, 2015).
Analysis of Stock Valuation
From the Gordon growth model analysis, the stock with a higher dividend has a lower required rate of return and consequently, the greatest stock value (Belo, Colin-Dufresne, & Goldstein, 2015). On the other hand, the stock with the lowest dividend paid has the least growth rate, the highest required rate of return, and the smallest value. Investors in a company have two primary interests: a high dividend payout ratio or greater capital growth. They expect that a firm should distribute its earnings in the form of dividends and if not so, the company will reinvest the earnings retained in growth opportunities that maximize shareholder wealth (appreciation in the stock price). As such, investors in a firm that pays a smaller amount of dividends (Chesapeake) will demand a higher return in the form of capital gains. On the other hand, investors will require a lower rate of return in a firm that pays a regular high dividend such as in the case of Exxon Mobil.
The Impact of Required Rate of Return on Stock Price
The value of a stock is extremely sensitive to the required rate of return, and this shows the maximum price that the investor should pay for a stock. The higher the rate of return, the lower the value of the stock, that is, an investor is willing to pay a lower price. A higher required rate of return points out that the investor demands a higher risk premium to compensate for the increase in risk exposure. Therefore, the greater the risk, the higher the risk premium, the higher the required rate of return and the lower the price the investor will pay for the stock.
Limitations of the Gordon Growth Model
The Gordon Growth Model is extremely valuable in the valuation of stable-growth, dividend paying businesses (Stowe, 2007). Also, it is useful in valuing broad-based equity indexes as well valuing the entire stock market. The model also is useful in the estimation of the expected rate of returns in the presence of efficient prices. However, the model has some limitations with the fact that it is not applicable to non-dividend paying stocks the primary weakness. Also, the dividend growth rate is assumed to be constant and therefore, it has no application to firms whose dividends grow at different rates. As pointed earlier, the stock price is sensitive to the required rate of return, and slight changes in the k-g (denominator) changes the valuation by a significant value. In such situations, it forces an analyst to carry out sensitivity analysis where valuation is under different returns and growth rates.
The Price-Earnings Ratio and Stock Valuation
The P/E ratio indicates the price the market is willing to pay for a stock based on the current earnings. It is a measure of the market’s future expectation of a company’s performance. When the earnings are expected to increase in the future, investors will be willing to pay a higher price for the stock. For instance, Exxon has a P/E ratio of 34.12 meaning that an investor is willing to pay $34.12 for every dollar of its earnings. Since P/E ratio is the stock price divided by the earnings per share, the price of the stock will be the P/E ratio* the expected EPS. The higher the expectations of an increase in earnings, the higher the amount investors would pay for the promise of those earnings, and the higher the price.
References
Belo, F., COLLIN‐DUFRESNE, P. I. E. R. R. E., & Goldstein, R. S. (2015). Dividend dynamics and the term structure of dividend strips. The Journal of Finance, 70(3), 1115-1160
Henry, T. R., Kisgen, D. J., & Wu, J. J. (2015). Equity short selling and bond rating downgrades. Journal of Financial Intermediation, 24(1), 89-111
Malkiel, B. G. (2015). Term structure of interest rates: expectations and behavior patterns. Princeton University Press
Stowe, J. D. (2007). Equity asset valuation
