Chapter 2. Aesthetics of Price and Value: Valuation of Stocks and Bonds

Welcome back. Last time, we learned about the heart of finance: ‘Time Value of Money.’ Today, we go to the field where that heart pumps—Valuation of stocks and bonds.

Warren Buffett said, “Price is what you pay. Value is what you get.” The most important skill for a financial manager is to see through the ‘price’ floating in the market and identify the asset’s true ==“Intrinsic Value.”== Let’s master the magic formulas that pull future cash flows into the present.

1. Promises of Payment: Bond Valuation

A bond is a IOU where the issuer promises to pay ‘interest’ and ‘principal.’

(1) Logic of Bond Value

The value of a bond is the sum of discounted future interest and principal at the market interest rate (discount rate). The fundamental law: ==“When interest rates rise, bond prices fall.”== Why? Because when new bonds offering higher interest appear, your old bond with lower interest becomes less attractive, so it must be sold at a discount.

🔄 See-saw Relationship: Bond Prices and Interest Rates

graph TD
    A[Market Interest Rate Rises] --> B[Existing Bond's Attractiveness Falls]
    B --> C[Bond Price Falls]
    D[Market Interest Rate Falls] --> E[Existing Bond's Attractiveness Rises]
    E --> F[Bond Price Rises]
    C --> G{Inverse Relationship}
    F --> G

2. Price Tags of Dreams: Stock Valuation

Valuing stocks is much harder than bonds. There is no maturity, and dividends are uncertain. This is why it’s said that stocks live on ‘dreams.’

(1) Dividend Discount Model (DDM)

The value of a stock is the present value of all dividends the company will pay until the end of time.

Gordon Growth Model: Assumes dividends grow at a constant rate (g) every year.
==Stock Price ( $P_0$ ) = $D_1 / (k - g)$ == (D: Dividend, k: Required return, g: Growth rate)

Tip

The Magic of Growth (g): In the formula, even a small increase in the growth rate (g) in the denominator can cause the stock price to skyrocket. This is mathematical proof for why the market is obsessed with ‘growth stocks.’

(2) Reinterpreting P/E Ratio (PER)

The P/E ratio is a summary of stock valuation. From a financial perspective, it is a scorecard assigned by the market on ==“how low the risk is and how high the growth will be.”==

3. Deep Dive: Intrinsic Value vs. Market Price

A sharp financial manager always compares these two:

Intrinsic Value > Market Price: Undervalued. Time to Buy.
Intrinsic Value < Market Price: Bubble. Time to Sell.

Important

Reflecting Risk: While bond value depends on ‘interest rates,’ stock value depends on ‘risk.’ If risk increases, we demand a higher required return (k), which causes the denominator to grow and the intrinsic value to plummet.

4. Conclusion: Look Beyond Numbers to See Value

Remember: formulas are just tools. Behind bond valuation lies ‘trust,’ and behind stock valuation lies ‘hope for the future.’

==“Value is a joint venture between future cash flows and the patience to wait for them.”== Whether you are investing or running a firm, I hope you have the insight to see the deep sea of ‘value’ flowing beneath the waves of ‘price.’

📚 Prof. Sean’s Selected Library

[The Intelligent Investor] - Benjamin Graham: The classic that first introduced ‘intrinsic value’ and ‘margin of safety.’
[Investment Valuation] - Aswath Damodaran: A rigorous guide to valuing everything from stocks to startups.
[One Up on Wall Street] - Peter Lynch: Practical wisdom on finding great ‘growth stocks’ through everyday observation.

Next time, we will tackle the most important moment for any firm—‘Capital Budgeting: Making Investment Decisions using NPV and IRR.’