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VALUATION

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 INTRINSIC VALUE

Intrinsic value of a security is the actual value of a security, as
opposed to its market price.

It is based on an underlying perception of its true value including

all aspects of the business, in terms of both tangible and
intangible factors.

Value investors use a variety of analytical techniques in order to

estimate the intrinsic value of securities in hopes of finding
investments where the true value of the investment exceeds its
current market value.
 OVERVALUED & UNDERVALUED

OVERVALUED :
A stock with a current price more than its estimated intrinsic
value and, therefore, is expected to drop in price. Hence it
should be sold.

UNDERVALUED:
A stock that is trading below its intrinsic value and, therefore is
expected to rise in price. Hence it should be bought.

BUY UNDERVALUED , SELL OVERVALUED

 FEW IMP FINANCIAL RATIOS

EARNING PER SHARE (EPS)

EPS = Profit After Tax

No. of outstanding shares

It shows the profitability of the firm on a per share basis.

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 FEW IMP FINANCIAL RATIOS

DIVIDEND PER SHARE (DPS)

DPS = Dividends paid over a year

No. of outstanding shares

 Dividends are a form of profit distribution to the shareholder.

 Having a growing dividend per share can be a sign that the
company's management believes that the growth can be
sustained.

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 FEW IMP FINANCIAL RATIOS

RETURN ON EQUITY (ROE)

ROE = Profit After Tax * 100

Equity (Net Worth)

Net Worth = Paid-up equity capital + share premium + reserves and

surpluses – accumulated losses

It is also known as Return on Net Worth (RONW)

Return on equity measures a corporation's profitability by revealing
how much profit a company generates with the money shareholders
have invested.

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 FEW IMP FINANCIAL RATIOS

RETURN ON CAPITAL EMPLOYED (ROCE)

ROCE = EBIT * 100

Capital Employed

Capital Employed = Total Assets- Current Liabilities

= Net Worth + Secured Loans + Unsecured Loans

It shows the business gain from its assets & liabilities.

 COMPARISON BETWEEN ROCE AND RONW

ROCE is an appropriate measure to get an idea of the overall

profitability of the companies operations

while

RONW is appropriate to judging the return that a

shareholder gets on his investments.
 APPROACHES TO EQUITY VALUATION

Discounted Cash Flow Model

Capital Asset Pricing Model
Dividend Discount Model
P/E Approach
Earning Yield

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 SOURCE OF CAPITAL

 Equity
 Preference
 Debt

Calculate weighted average cost of Capital. WACC is used

as the hurdle rate for finalising any decision for new project.

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 COST OF EQUITY

The cost of equity is the minimum rate of return a firm must offer
to its shareholders to compensate for waiting and bearing some
risk or the rate of return that investors requires to make an equity
investment in a firm.

It reflects the opportunity cost of investment for individual
shareholders.

Cost of equity = Dividend per share + Growth rate of dividends

Market price of stock

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 PROBLEMS IN EQUITY VALUATION

• Stocks do not have a finite maturity.

• Uncertainty about future cash flows, i.e., dividends.

• Finding an appropriate discount rate for these cash flows.

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 DISCOUNTED CASH FLOW MODEL

In DCF all future cash flows are estimated and discounted to give
their present values.

The discount rate reflects two things:

 1. the time value of money (risk rate)

 2. a risk premium (risk premium rate)

The discounted cash flow formula is derived from the future value
formula for calculating the time value of money and compounding
returns.
FV = PV (1+ke)n
where,
FV = Future value
PV = Present Value
ke = Discount rate
n = Time period for which discounting is done
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 DISCOUNTED CASH FLOW MODEL

Thus the discounted present value is expressed as :

PV = FV
(1+ke)n

where,
FV = Future value
PV = Present Value
ke = discount rate
n = Time period for which discounting is done

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 DIVIDEND DISCOUNT MODEL

oAccording to this model, the value of a stock is the present value of

expected dividends on it.
oExpected cash flows from a stock:
Dividends during the holding period,
Expected price of the stock at the end of the holding period

P0 = P1 + D1
(1+ke) (1+ke)

P1 = Price of the share after 1 year

D1 = Expected dividend after 1 year
ke = Required rate of return

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 Gordon Growth Model

P0 = D1
ke – g

D1 = Expected Dividends one year from now

ke = Required rate of return
g = Growth rate in dividends forever

Assumptions:
1. Dividend grows at a constant rate in perpetuity
2. Growth rate is less than the required rate of return

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 PROBLEM

Suppose that the expected dividend per share of Tata Tele is Rs. 2.
The dividend has grown over the years at 5% per year. This growth
rate is expected to continue in future. Find the fair estimate of the
intrinsic value of the share if the required rate of return is 10% per
annum. Current market price of Tata Tele is Rs. 45.

P0 = D1
ke – g
P0 = ____2_____
(0.10 – 0.05)
= Rs. 40

Hence we can say that it is an overvalued stock and should be sold.

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 TWO STAGE DIVIDEND DISCOUNT MODEL
• This model is based upon two stages of growth:
 An extraordinary growth phase that lasts for n years
 A stable growth phase that lasts forever afterwards

PV of the stock = PV of dividends during extraordinary growth phase + PV

of terminal price

DPSt = Expected Dividends Per Share in year t

ke = Cost of equity; (hg = High growth period, st = stable growth period)
Pn = Price (terminal value) at the end of year n
g = Extraordinary growth rate for the first n years
gn = Steady state growth rate forever after year n

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 MULTI-PERIOD VALUATION
Since equity shares do not have a fixed maturity period,
they may be expected to bring a dividend stream of
infinite duration. Hence,

P0 = D1 + D2 + ….. + Dn + Pn
(1+ke) (1+ke)2 (1+ke)n (1+ke)n

D1,2,n = Expected Dividends

ke = Required rate of return
Pn = Price at the end of period n

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PROBLEM
Praj Industries is currently paying a dividend of Rs. 2 per share.
The dividend is expected to grow at 15% per annum for 3 years,
then at 10% p.a. for the next 3 years, after which it is expected to
grow at 5% p.a. forever. What is the present value of the share if
the capitalization rate is 9%? Current market price = Rs.70

1 2 3 4 5 6
Expected
2.30 2.64 3.04 3.35 3.68 4.05
Dividend
PV of
2.11 2.22 2.35 2.37 2.39 2.41
Dividend

The present value is computed by discounting the dividends at

9%.

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PV at the end of year 6 = D7 = 4.05(1.05)
ke - g 0.09 – 0.05
= Rs. 106.25

PV of Rs. 106.25 today at 9% discount rate = 106.25 = Rs 63.33

(1.09)6
PV of the share today = 2.11 + 2.22 + 2.35 + 2.37+ 2.39 + 2.41 + 63.33
= Rs. 77.18

Hence the stock is under valued in the market.

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 PRICE EARNINGS APPROACH

It is a measure of the price paid for a share relative to the

profit earned by the firm per share.

P0 = E1 * P/Ei

P0 = Estimated price
E1 = Estimated earning per share
P/Ei = Price-earning ratio of the industry

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According to constant growth model,

P0 = D1
ke – g

D1 = E1 (1 – b)

P0 = E1 (1 – b) [g = ROE * b]
ke – g

Dividing both sides by E1,

P0 = (1 – b)
E1 ke - (ROE * b)

ROE = Return on equity

b = Retention ratio of dividend / plough back ratio
(1 – b) = Dividend payout ratio
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 TYPES OF P/E RATIOS

TRAILING P/E RATIO : It is the P/E ratio for the past one year.

CURRENT P/E RATIO: It is the P/E ratio for the last quarter.

FORWARD P/E RATIO: It is the P/E ratio projected for the next
year.

Forward P/E = P____

EPS (1+g)

Where,
P = Price of the security
g = projected growth rate
 EARNING YIELD

 The inverse of P/E is know as earning yield.

 Higher is the P/E, lower is the earning yield. We have to
see the earning yield in line with the PEG.

PEG = (P/E)________
Growth in earning (EPS)

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 PROBLEM

Calculate the price of Bank of India share if EPS = RS. 58. The
PE of a public sector bank is 7.8 . Current Market price = Rs.
440

P0 = E1 * P/Ei

P0 = 58 * 7.8
= Rs 452.4

Hence the stock is under valued in the market.

THANK YOU

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