Investors try to determine the value of a security such as a common stock or a bond so they can compare it to the current market price to see whether it is a good buy at the current levels. There are several reasons why it is easier to determine the value of a bond than of a stock.
Bond Face Value
Bonds are issued with a face value – a contractual amount to be repaid at maturity. If an investor buys a bond and holds it to maturity, he knows exactly how much money he will collect in annual interest and how much he will eventually get back. Bond values are linked to the face value and the amount of annual interest and are therefore easier to calculate.
Things get trickier with bonds when a company gets into financial trouble. If there is a real risk of bankruptcy, or if a company has declared bankruptcy, bondholders are not likely to get back the full face value of their holdings. The question becomes: How much can they expect to get? Investors who can accurately estimate the amount they can get for a distressed bond can make money by buying the bond below that value and either reselling it at a higher price or collecting on it through bankruptcy proceedings.
Variables and Multiples
Stocks are perpetual securities with no face value that investors can use as a basis for their calculations. Stock valuation is based on multiple variables, such as current and future earnings and dividends, price-to-earnings ratio, and a company’s business prospects and financial condition. External factors such as economic and market conditions, political developments and investor sentiment can also impact the current and future stock price. Even if the estimates are accurate, it is next to impossible to combine all these variables into a workable valuation formula to get an accurate forecast. Depending on their opinions and outlooks, investors use different estimates and multiples and arrive at different values.
Convertible bonds can be converted into shares of common stock under certain conditions. An investor must use both the bond’s and the underlying stock’s information to determine the value of a convertible bond. If upon conversion an investor stands to realize a capital gain, the bond will be valued on the basis of the underlying stock’s value at conversion; if not, it will be valued like a regular bond.
- “PassTrak Series 7: General Securities Representative License Exam”; Dearborn Financial Services; 2003