Question

Is Stock valuation is more difficult than bond valuation? Please explain why this is so. **Must provide examples.

Answer 1

The value of any asset is the present value of its cash flows.

Present value is calculated by discounting the asset's cash flows at the appropriate discount rate.

For a bond, the cash flows are its coupon payments and the redemption value. These are usually fixed at the time of issuing the bond itself, and are therefore certain in their values. The time period of the cash flows is also certain because the maturity of the bond is known. The only complexity involved is estimating the appropriate discount rate. This is however made easier by analyzing the yield curve and yields of similar bonds.

However, stock valution involves many different judgements, estimates and assumptions which are not required for bond valuation. For example :

• The cash flows are uncertain because the cash flows (either dividends in case of dividend discount valuation, or FCF in case of DCF valuation) because the performance of the company is uncertain and subject to many risks such as business risk, financial risk, operational risk etc.
• The terminal value, or the stock price in the future is difficult to predict, and the actual value can vary widely from estimates
• The appropriate discount rate is complex to estimate, with many assumptions, judgements and estimates involved. There exist several models to estimate this, but none are very accurate

For these reason, stock valuation is more difficult than bond valuation.