Is the Valuation of Bonds Harder or Easier Than the Valuation of Equity Securities?

In finance, stocks are often referred to as equity securities, because they make the holder part owner of the corporation, or provide an equity stake. Bonds, on the other hand, are lending instruments. The company owes the bondholder a specific sum of money, but the bonds do not entitle the investor to have a say in how the company is run. Furthermore, the bondholder will not be paid more than what he is owed if the company does unexpectedly well. Due to these reasons, bonds are generally easier to value than stocks, though exceptions exist.

Equity Securities

Equity securities come in various types. The most basic one is common stock, issued by all companies whose shares change hands in a public exchange, such as the New York Stock Exchange. Common stock allows the holder to receive a part of the cash disbursements to shareholders, also known as dividends, approved by the company's board of directors. Common shareholders also meet once a year and vote on critical matters that concern the company, including the election of the board of directors. Some companies issue special share classes, often labeled as "Class A" or Class B" shares, that have special voting powers. Whereas each common share may entitle the owner to one vote, a special class share may entitle the holder to two or three votes, for example.

Preferred Stock

Despite their name, preferred shares are more like bonds than shares. The holder of a preferred share is entitled to a fixed annual payment every year. The main differences between bonds and preferred shares is that the latter does not expire, while bonds have an expiration date. Furthermore, unpaid bondholders can sue the company and confiscate its assets. The board of directors, however, can suspend payments to preferred stockholders during financial emergencies. The preferred stockholders have no legal recourse in such situations and must wait until the situation improves. However, until the preferred stockholders are paid in full, the common shareholders cannot receive a dividend. Preferred stockholders cannot vote in the annual shareholder meeting.

Bonds

A bond promises to reward the owner with a percentage of the bond's original issue value for a fixed period. The percentage is referred to as the coupon and the original issue value is known as the par value; bonds also have an expiration date. A bond with par value of $500 and coupon rate of 7 percent will pay 7 percent of $500, or $35, each year. On the expiration date, the bondholder will return the bond and receive her original $500 back. A small subset of bonds are "convertible." The owner of such a bond can surrender the bond to the issuing company and in its place obtain a specific number of common shares. Each bond may be exchangeable for three common shares, for example.

Valuation

A simple bond is easier to value than a common stock. All that the analyst needs to know is whether the company has enough cash to honor the interest and the face value payments on the bond. Since the bondholder cannot receive more than a fixed sum, further corporate profits are of no concern to the bondholder. The stock analyst, however, must more precisely estimate the company's profits, because the more money the company earns, the more of it shareholders can receive as dividends. A preferred stock and bond are basically equally hard to value, however, because their cash-flow streams are similar. A convertible bond, on the other hand is just as challenging to value as common stock, since it can potentially turn into common stock.

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