equity valuation

INTRODUCTION TO EQUITY VALUATION

Equity shares can be described more easily than fixed income securities. However, they

are more difficult to analyse. Fixed income securities typically have a limited life and a

well-defined cash flow stream. Equity shares have neither. While the basic principles of

valuation are the same for fixed income securities as well as equity shares, the factors of

growth and risk create greater complexity in the case of equity shares .

As our discussion of market efficiency suggested, identifying mispriced

securities is not easy. Yet there are enough chinks in the efficient market hypothesis and

hence the search for mispriced securities cannot be dismissed out of hand. Moreover,

remember that is the ongoing search for mispriced securities by any army of equity

analysts that contributes to a high degree of market efficiency.

Equity analysts employ two kinds of analysis. They are as follows :

Fundamental Analysis

Technical Analysis

Fundamental analysts assess the fair market value of equity shares by examining the

assets, earnings prospects, cash flow projections, and dividend potential. Fundamental

analysts differ from technical analysts who essentially rely on price and volume trends

and other market indicators to identify trading opportunities.

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Equity Valuation : Equity valuation has different models .They are as follows .

Balance Sheet Valuation :

Balance sheet of the firm to get a handle on some valuation measures . The

three measures derived from the balance sheet are as follows :

Book Value

Liquidation Value

Replacement Cost

Dividend Discount Model :In Dividend discount model the dividends are

paid annually and the first dividend is received one year after the equity share is bought.

Single –period Valuation Model

Expected Rate of Return

Multi –period Valuation Model

Zero Growth Model

Constant Growth Model (Gordon Model)

Two Stage Growth Model

H Model

Earnings Multiplier Approach

Earnings-Price Ratio , Expected Return , And Growth

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OBJECTIVES:

To comprehend the conceptual determinants of equity by applying

various approaches of valuation. .

To focus on the intrinsic value of a stock using the zero growth

model, the constant growth model, the two-stage growth model

and the H model.

To examine the growth of dividends and the earnings per share and

its impact.

To identify the price of the equity share and the required rate of

return.

To analyze the determinants of the P/E ratio and its effect on

equity.

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RESEARCH METHODOLOGY

STUDY TOOLS:

Data is collected from primary data and secondary data.

PRIMARY DATA:

Data collected from Brokers and Magazines, Annual Reports.

Data collected from Hyderabad Stock Exchange.

SECONDARY DATA

Data collected from various Books, Newspapers and Internet.

Data provided by Hyderabad Stock Exchange as a Part of the class

undertaken.

Detailed calculation of different Equity Valuation Models has been

given in Annexures.

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THE HYDERABAD STOCK EXCHANGE LIMITED:

ORIGIN:

Rapid growth in industries in the erstwhile Hyderabad State

saw efforts at starting the Stock Exchange. In November, 1941

some leading bankers and brokers formed the share and stock

Brokers Association. In 1942, Mr.Gulab Mohammed, the Finance

Minister formed a Committee for the purpose of constituting Rules

and Regulations of the Stock Exchange. Sri Purushothamdas

Thakurdas, President and Founder Member of Hyderabad Stock

Exchange performed the opening ceremony of the Exchange on

14.11.1943 under Hyderabad Companies Act, Mr.Kamal Yar Jung

Bahadur was the first President of the Exchange. The HSE started

functioning under Hyderabad Securities Contract Act of No. 21 of

1352 under H.E.H. Nizam’s Government as a Company Limited by

guarantee. It was the 6th Stock Exchange recognized under

Securities Contract Act, after the premier Stock Exchanges,

Ahmedabad, Bombay, Calcutta, Madras and Banglore stock

Exchange. All deliveries were completed every Monday or the

next working day.

The Securities Contracts (Regulation) Act, 1956 was enacted

by the Parliament, passed into Law and the rules were also framed

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in 1957. The Act and the Rules were brought into force from 20th

February 1957 by the Government of India.

The HSE was first recognized by the Government of India on

29th September 1958 as Securities Regulation Act was made

applicable to twin cities of Hyderabad and Secunderabad from

that date. In view of substantial growth in trading activities, and

for the yeoman services rendered by the Exchange, the Exchange

was bestowed with permanent recognition with effect from 29th

September 1983.The Exchange has a significant share in

achievements of erstwhile State of Andhra Pradesh to its present

state in the matter of Industrial development.

OBJECTIVES:

The Exchange was established on 18th October, 1943 with

the main objective to create, protect and develop a healthy capital

market in the state of Andhra Pradesh to effectively serve the

public and investors interest.

The property, capital and income of the Exchange, as per

the Memorandum and Articles of Association of the Exchange,

shall have to be applied solely towards the promotion of the

objects of the exchange. Even in case of dissolution, the surplus

funds shall have to be devoted to any activity having the same

objects, as exchange or be distributed in charity, as many be

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determined by the exchange or the high court of judicature. Thus,

in short, it is a charitable institution.

The Hyderabad stock Exchange Limited is now on its stride

of completing its 59th year in the history of capital ‘Markets’

serving the cause of saving and investments. The Exchange has

made its beginning in 1943 and today occupies a prominent place

among the Regional Stock Exchanges in India. The Hyderabad

Stock Exchange has been promoting the mobilization of funds into

the Industrial sector for development of industrialization in the

State of Andhra Pradesh.

GROWTH:

The Hyderabad Stock Exchange Ltd., established in 1943 as a

Non-profit making organization, catering to the needs of investing

population started its operations in a small way in a rented

building in Koti area. It had shifted into Aiyangar Plaza, Bank

Street in 1987. In September 1989, the then Vice-President of

India, Hon’ble Dr. Shankar Dayal Sharma had inaugurated the own

building of the Stock exchange at Himayathnagar, Hyderabad.

Later in order to bring all the trading members under one roof, the

exchange acquired still a larger premises situated 6-3-654/A;

Somajiguda, Hyderabad – 82, with a six storied building and a

constructed area of about 4,86842sft (including cellar of 70,857sft).

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Considerably, there has been a tremendous perceptible growth

which could be observed from the statistics.

The number of members of the Exchange was 55 in

1943, 117 in 1993 and increased to 300 with 869 listed

companies having paid up capital of Rs.19128.95 crores as on

31/03/2000. The business turnover has also substantially

increased to Rs. 1236.51 crores in 1999-2000.The Exchange

has got a very smooth settlement system.

SEBI NOMINEE DIRECTORS:

Sri R.P.Singh, IAS - Joint Secretary (DF)

Dept. of Defence Prod. &Supplies, Ministry of Defence

Sri.N.S.Ponnunambi - Registrar of Companies [Govt.of

India]

PUBLIC NOMINEE DIRECTORS:

Dr. N.R.Sivaswamy - Former CBDTC Chairman

(Chairman, HSE)

Justice V.Bhaskara Rao - Retd. Judge High Court.

Sri P.Muralimohan Rao - Mogili&Co.-Charatered

Accountant

Dr B.Brahmaiah - Professor

EXECUTIVE DIRECTOR:

Sri S SARVESHWAR REDDY

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COMPUTERIZATION:The Stock Exchange business operations are equipped with

modern communication systems. Online computerization for simultaneously carrying out the trading transactions, monitoring functions have been introduced at this Exchange since 1988 and the Settlement and Delivery System has become simple and easy to the Exchange members.The HSE On-line Securities Trading System was built around the most sophisticated state of the art computers, communication systems, and the proven VECTOR Software from CMC was and was one of the most powerful SBT Systems in the country, operating WAN environment, connected through 9.6 KBPS 2 wire Leased Lines from the offices of the Members to the office of the Stock Exchange at Somajiguda, where the Central System CHALLENGE-L DESK SIDE SERVER made of Silicon Graphics (SGI Model No. D-95602-S2) was located and connected all the members who were provided with COMPAQ DESKPRON 2000/DESKTOP 5120 Computers connected through MOTOROLA 3265 v. 354 MANAGEABLE STAND ALONE MODEMS (28.8 kbps) for carrying out business from computer terminals located in the offices of the members.

The Host System enabled the Exchange to expand its operations later to other prime trading centers outside the twin cities of Hyderabad and Secunderabad but also to link itself into the Inter-connected Market System (ICMS) proposed by the Federation of Indian Stock Exchanges(FISE) to inter-connect various Regional Stock Exchanges in various states.

In the age of electronic trading, on-line information on rates from other major markets was an essential input for efficiency.

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HSE provided on-line rates from BSE and NSE which not only enchanged the ability of HOST terminals to attract the investors but also enables the members to avail arbitraging opportunities between exchanges.

CLEARING HOUSE:

The Exchange set-up a Clearing House to collect the Securities from all the Members and distribute to each member, all the securities due in respect of every settlement. The whole of the operations of the Clearing House were also computerized. At present through DP all the settlement obligations are met.

INTER-CONNECTED MARKET SYSTEM (ICMS):

The HSC was the convener of a Committee constituted by the Federation of Indian Stock Exchanges for implementing an Inter-connected Market System(ICMS) in which the Screen Based Trading systems of various Stock Exchanges was inter-connected to create a large National Market. SEBI welcomed the creation of ICMS.

The HOST provided the net-work for HSE to hook itself into the ISE. The ISE provided the members of HSE and their investors, access to a large national network of Stock Exchanges. The Inter-connected Stock Exchange is a National Exchange and all HSE Members could have trading terminals with access to the National Market without any fee, which was a boon to the Members of an

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Exchange/Exchanges to have the trading rights on National Exchange (ISE) without any fee or expenditure.

ON-LINE SURVEILLANCE:HSE pays special attention to Market Surveillance and monitoring exposures of the members, particularly the mark to market losses. By taking prompt steps to collect the margins for mark to market losses, the risk of default by members is avoided. It is hearting that there have been no defaults by members in any settlement since the introduction of Screen Based Trading.

IMPROVEMENT IN THE VOLUMES:It is heartening that after implementing HOST, HSE’s daily turnover has fairly stabilized at a level of Rs. 20.00 crores. This sound enable in improving our ranking among Indian Stock Exchanges for 14th position to 6th position. We shall continuously strive to improve upon this to ensure a premier position for our Exchange and its members and to render excellent services to investors in this region.The number of transactions, turnovers of the Exchange, number of listed companies and the paid up capital listed have grown up substantially as may be seen from the following figures.

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Year Number of

Transactions in

Thousands

Turnover Rs. in Crores

Listed Companies

Market Capital Rs. In Crores

1991-92

515.949 587.75 236 2740.56

1992-93

421.985 676.00 274 10228.48

1993-94

603.635 984.46 372 13156.15

1994-95

860.642 1160.48 668 18588.71

1995-96

720.521 1107.30 727 20159.31

1996-97

240.64 479.98 851 22050.69

1997-98

427.83 1860.86 852 18705.10

1998-99

513.168 1269.90 856 18753.93

1999-2000

5134.440 1236.51 869 19128.95

2000-01

427.205 977.83 934 14717.08

2001-02

34.326 41.26

2002-03

4.203 4.58

2003-04

2.277 2.73 856 22126.65

2004-05

4.401 14.13 820 14456.95

SETTLEMENT GUARANTEE FUND: The Exchange has introduced Trade Guarantee Fund on

25/01/2000. This will insulate the trading member from the counter-party risks while trading with another member. In other words, the trading member and his investors will be assured of the timely completion of the pay-out of funds and securities notwithstanding the default, if any, of any trading member of the Exchange. The shortfalls, if any, arising from the default of any trading member met out of the Trade Guarantee Fund. Several pay-ins worth of cores of rupees in all the settlements have been successfully completed after the introduction of Trade Guarantee Fund, without utilizing any amount from the Trade Guarantee Fund.

The Trade Guarantee Fund had strict rules and regulations to be complied with by the members to avail the guarantee facility. The HOST system facilitated monitoring the compliance of members in respect of such rules and regulations.

CURRENT DIVERSIFICATIONS:

A ) DEPOSITORY PARTICIPANT

The Exchange has also become a Depository Participant with National Securities Depository Limited (NSDL) and central Depository Services Limited(CDSL). Our own Depository participant is fully operational and the execution time will come down substantially. The depository functions are undertaken by the Exchange by opening the accounts at Hyderabad of investors, members of the Exchange and other Exchanges. The

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trades of all the Exchanges having on-line trading which get into National depository can also be settled at Hyderabad by this exchange itself. In short all the trades of all the investors and members of any Exchange at Hyderabad in dematerialized securities can be settled by the Exchange itself as a participant of NSDL and CDSL.

B) FLOATING OF A SUBSIDIARY COMPANY FOR THE MEMBERSHIP OF MAJOR STOCK EXCHANGES OF THE COUNTRY:

The Exchange had floated a subsidiary company in the name and style of M/S HSE Securities Limited for obtaining the membership of NSE and BSE. The subsidiary had obtained membership of both NSE and BSE. About 113 sub-brokers may registered with HSES, of which about 75 sub-brokers are active. Turnover details are furnished here under.

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YEAR NSE CASH Rs.In LAKHS

NSE F&O Rs. INLAKHS

BSE CASH Rs.INLAKHS

2001-02 338236.81 ----- ------

2002-03 426143.50 16657.08 -----

2003-04 617808.46 312203.56 17558.59

2004-2005

484189.11 354370.71 39519.96

C) FACILITY TO TRADE AT NSE, DERIVATIVES TRADING, NET TRADING ETC

The Exchanges has incorporated a Subsidiary “HSE securities Limited “ with a paid up capital of Rs. 2.50 crores initially to take NSE Membership, so that the members of the exchange will have access to the NSE’s Trading Screen as Sub-brokers, Derivatives Trading and Net Trading etc. The members of this Exchange will also have equal opportunity of participating in such trading like any other NSE member.

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INTRODUCTION TO SECURITY ANALYSIS AND

PORT FOLIO MANAGEMENT

Security :

Equity Shares, bonds, debentures or any other marketable instruments are popularly

termed as securities. There are various sources by which corporate raises funds from

public.

Security Analysis :

For making proper investment involving both risk and return the investor has to make

study of the alternative avenues of the investment their risk and return characteristics

make a proper projection or expectation of the risk an return of alternative investment

under consideration. He has to tune the expectation to this preference of the risk and

return for making proper investment choice. The process of analyzing the individual

securities in the market as whole an estimating the risk and return expected from each of

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the investments with view to identify under values securities for buying and over values

securities for selling its both and art and a science that is called “security analysis”.

There three important functions of Security Analysis and are categorized as

descriptive, valuation and critical. Descriptive analysis and Marshal Analysis interprets

the important facts relating to issue and present this information in a coherent, readily

intelligible manner.

This analysis requires a thorough probing of companies to understanding the

causes of past and present profitability and to intercept their relationship to future

profitability. The second function of security analysis is to develop value estimates or

stock and bonds.

The value of the security is determined by its earning about worth of stock

independent of its current markets value and its relative value.

In the critical function of a security analysis is concerned with these practices and polices

of the corporate that effect to the investor.

FIXED INCOME SECURITIES :

It refers to securities such as debentures, saving certificates, bonds, etc., which earns

interest are dividend at fixed rates for a stipulate period of time usually the life of a 12%

bond of rupees 1000/- means that the issue has to pay the bond holder Rs.120/- per year

for the use of money. The different types fixed income securities that are available in

India are as follows:

1. Bank Deposits: Deposits with bank are the safest mode of investment and

earns a fixed rate of interest. Fixed deposits upto Rs. 1,00,000/-, in individual

accounts covered by deposits insurance scheme. They are highly liquid as

fixed deposits receipts can be enchased premature at discount of 1% on

interest. They are neither tradable nor transferable. Nomination facilities are

available.

2. Company deposits: The deposits are the manufacturing and non banking

financial companies and earns a fixed rate of interest usually higher than bank

fixed deposits rate. These deposits are neither secured nor guaranteed by RBI

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and noted for untimely payment of principal amount. They are not exactly

liquid. These are neither tradable nor transferable. They are without

nomination facility.

3. Small Saving Schemes: These are the most safest mean of investment an

initial investment gets doubled in 5 to 6 years time. In the section 88, they are

not tradable and most instruments are accepted by banks as collateral.

4. Debentures and bonds: These are long-term debt investments usually yields

high rate of interest. The safety factor with these investment can be analyzed

by considering credit ratings. They are freely tradable and transferable and

hence provides for liquidity. Fixed income securities provide investors with

two kinds income i.e.

i) Current income

ii) Capital gains

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PORTFOLIO MANAGEMENT

INTRODUCTION TO PORT FOLIO MANAGEMENTConcept of Portfolio:

Portfolio is the collection of financial or real assets such as equity shares,

debentures, bonds, treasury bills and property, etc. Port Folio is a combination of assets

or it consists of collection of securities. These holdings are the result of individual

preferences, decisions of the holders regarding risk, return and a host of other

consideration.

Portfolio Management:

An investor considering investment in securities is faced with the problem of

choosing from among a large no. of securities. His choice depends upon the risk return

characteristics of individual securities. He would attempt to choose the most desirable

securities and like to allocate his funds over his group of securities. Again he faced with

the problem of deciding which securities to hold and how much to invest in each.

Portfolio management is primarily concerned with the process of building and

management such portfolios.

OBJECTIVE OF PORTFOLIO MANAGEMENT:

The objectives of investment / portfolio management can be classified into two categories

follows:

1. Basic objectives: The basic objectives of investment / portfolio management are:

i. To maximize yield

ii. To minimize the risk

2. Secondary Objectives: The following are the other ancillary objectives are:

a) Regular return

b) Stable income

c) Appreciation of capital

d) Safety of investment

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e) More liquidity

f) Tax benefits

EQUITY VALUATION: The investor takes a no. of decisions in the process of

investment. The investor has to decide about his bought whether they are equity

(common stock) or bonds or real estates.

With the common stock is chosen by the investor, he has to decide which

companies stock he has to by. The stocks are selected on the basis of their return and

risk. The analysis of risk and return of holding a particular common stock is known as

equity valuation.

FUNDAMENTAL ANALYSISFundamental analysis is an approach to determine ‘what ought to be price’ otherwise

known as ‘intrinsic’ or ‘true’ value of a security. Its objective is to identify the under

priced and over priced securities in the market so that the investment decisions (Buying

and Selling) can be made. A security is said to be under price if its current market value

is below the intrinsic value and conversely, it is an over priced security if its current

market value above its intrinsic value. By buying an under priced security and selling an

over priced security, an investor would be able to make profits.

1. Macro Economic analysis

2. Industry analysis

3. Company analysis

MACRO ECONOMIC ANALYSIS :

The macro economy is the over all economic environment in which all firms operate.

The key variables commonly used to describe the state of macro economy are

a) Gross Domestic Product: GDP indicates the rate of growth of the

economy. GDP represents the aggregate value of the goods and services

produced in the economy. The GDP growth of the economy points out the

prospects for the industrial sector and return investors can expect from

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investment in shares. The higher growth rate is more favorable to the stock

market.

b) Agriculture and Monsoon: Agriculture accounts for about a quarter of

the Indian economy and has important linkages, direct and indirect with

industry .The increase or decrease of agriculture production has a

significant bearing on industrial production and corporate performance.

A spell of good monsoon imparts dynamism to the industrial sector and buoyancy to the stock market. Likewise, a stock of bad monsoons casts its shadow over the industrial sector and the stock market.

c) Savings an Investment: Stock market is a channel through which the

savings of the investors are made available to the corporate bodies.

Savings are made available to the corporate bodies. Savings are distributed

over various assets like equity shares, deposits, mutual funds units, real

estate and bullion. The savings and investment patterns of the public affect

the stock to a great extent.

d) Government Budget and Deficit: Government plays an important role in

most economies , including the Indian economy .The central budget as

well as the state budgets prepared annually provides information on

revenues, expenditures and deficit or surplus .A deficit budget may lead to

high rate of inflation and adversely affect the cost of production . Surplus

budget may result in deflation .Hence , balanced budget is highly

favourable to the stock market .

e) Price level and inflation: With the increase in inflation rate, the real rate

of the growth would be very little. The in the consumer product industry is

significantly affected. If there is a mild level of inflation, it is good to the

stock market but high rate of inflation is harmful to the stock market.

f) Interest Rates: Interest rates vary with maturity, default risk, inflation

rate, productivity of capital, special features and so on .

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INDUSTRY ANALYSIS:

An industry is a group of firms that have similar technological structure of

production and produce similar products. An analysis of industry helps in

identifying opportunities for investment purpose and requires careful assessment

of its ability to maintain its profitability in the long run to deserve investment .

Industry Life Cycle :

Many industrial economists believe that the

development of almost every industry may be analyzed in terms of a life cycle

with four well-defined stages.

1. Pioneering stage

2. Rapid growth stage

3. Maturity and stabilization stage

4. Declining stage

1. Pioneering stage : The prospective demand for the product is promising in

this stage and the demand for the product attracts many producers to produce

the particular product leading to severe competition. This stage may offer

higher returns to the investor but also offers the greatest risk.

2. Rapid Growth Stage: This stage starts with the appearance of surviving

firms from the pioneering stage. These companies grow strongly in market

share and financial performance as the cost of production is low and they

have good quality products. It is advisable to invest in the shares of these

companies because of growth in potential returns and decrease in the risk of

failure.

3. Maturity and Stabilisation Stage: In this stage, the growth rate tends to be

moderate. Sales may increase but at the slower rate than before Symptoms

of obsolescence may appear in the technology. Products may become more

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standardized and less innovative and the market place is full of competitors.

Earnings are stable and hence investors may get high dividend but must be

avoided by those who are primarily interested in capital gains.

Declining Stage: The demand for the product and earnings decline in this stage. It is

better to avoid investing in the shares of these industry staged companies as it will lead to

erosion of capital.

COMPANY ANALYSIS:

The economy analysis provides the investor a broad outline of the prospects of growth in

the economy. The industry analysis helps in investor to select the industry in which

investment would be rewarding. Now he has to decide the company in which he should

invest the money. Company analysis provides the answer to this question.

Company Analysis deals with the estimation of return and risk of individual shares. This

call for information, Regarding Companies which can be broadly classified into two

broad groups: internal and external. Internal information consists of data and events

made public by companies concerning their operations.

The internal information sources include annual reports to shareholders, public and

private statements of officers of the company, the company’s financial statements, etc.

External sources of information are those generated independently outside the company.

These are prepared by investment services and the financial press.

In Company Analysis, the analyst tries to forecast the future earnings of the company

because there is strong evidence that earnings have a direct and powerful effect upon

share prices.

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TECHNICAL ANALYSIS:

Investors may adopt two different approaches to equity investment. They may buy stocks

at a certain point of time and simply hold these stocks over a period of time, without

restructuring their portfolio. Such a passive approach to investment is also called the buy

and hold policy.

Alternatively investors may adopt an active statement strategy constantly evaluating their

holdings, and reshuffling the stocks they hold. This approach requires constant

evaluation of the market. It is a well established fact that stock markets also potray

cyclical movements akin to business cycle. An active investor who is able to identify the

turns in the market would be able to buy at bottoms (low prices) and sell at peaks (high

prices) and make substantial gains out of cyclical investments.

Technical analysis studies the characteristics which may be expected at major market

turning points and their objective assessment. It provides information about future stock

price movements by taking historical price movements of shares into its consideration.

The rationale behind technical analysis is that share price behaviour repeats itself

overtime and the analyst attempts to drive methods to predict this repetition so that

buying and selling decisions of shares can be made.

The technical analyst believes that share prices are determined by the demand and supply

forces operating in the market. These demand and supply forces in turn are influenced by

a number of fundamental factors as well as psychological or emotional factors. Many of

these factors cannot be quantified.

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MODELS IN EQUITY VALUATION:

BALANCE SHEET VALUATION:

The balance sheet of the firm to get a handle on some valuation measures. Three

measures derived from the balance sheet are:

1. Book Value

2. Liquidation Value

3. Replacement Cost

1. Book Value: The book value per share is simply the net worth of the company

(which is equal to paid up equity plus reserves and surplus divided by the number

of outstanding equity shares. Balance sheet figures rarely reflect earning power

and hence the book value per share cannot be regarded as a good proxy for true

investment value.

2. Liquidation Value: The liquidation value per share is equal to :

Value realized from liquidating _ Amount to be paid to all the creditors

and all the assets for the firm preference shareholders

Number of outstanding equity shares

3. Replacement Cost: Another balance sheet measure considered by analysts in

valuing a firm is the replacement cost of its asset less liabilities. The use of this

measure is based on the premise that the market value of a firm cannot deviate too

much from its replacement cost. If it did so, competitive pressures will tend to

align the two.

This idea seems to be popular among economists. The ratio of market price to

replacement cost is called Tobin q, after James Tobin a Noble Laureate in

economics. The proponents of replacement cost believe that in the long run

Tobin’s will tend to 1. The empirical evidence, however, is that this ratio can

depart significantly from 1 for long periods of time.

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The major limitation of the replacement cost concept is that organizational capital,

a very valuable asset, is not shown on the balance sheet. Organisational capital is

the value created by bringing together employees, customers, suppliers, managers

and others in a mutually beneficial and productive relationship.

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Dividend Discount Model

According to the dividend discount model, conceptually a very sound and appealing

model, the value of an equity share is equal to the present value of dividends expected

from its ownership plus the present value of the sale price expected when the equity share

is sold. For applying the dividend discount model, we will make the following

assumptions:

i. Dividends are paid annually – this seems to be a common practice for business

firms in India; and

ii. The first dividend is received one year after the equity share is bought.

Single Period Valuation Model:

Let us begin with the case where the investor expects to hold the equity share for one

year. The price of the equity share will be

Where Po = Current price of the equity share

D1 = Dividend expected a year hence

P1 = Price of the share expected a year hence

r = rate of return on the equity share.

Expected Rate of Return:

The intrinsic value of an equity share, given information about

i. The forecast values of dividend and share price, and

ii. The required rate of return

r = D1 / P0 + g

where r = rate of return on the equity share.

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P0 = Current price of the equity share

g = Expected growth of EPS

Multi-period Valuation Model:

The basics of equity share valuation in a single-period framework, we now discuss the

more realistic, and also the more complex, case of multiperiod valuation.

Since equity shares have no maturity period, they may be expected to bring a dividend

stream of infinite duration. Hence, the value of an equity share may be put as:

where P0 = Price of the equity share today


D2 = Dividend expected a two years hence

D = Dividend expected at the end of infinity’

r = expected return

Zero Growth Model:

If we assume that the dividend per share remains constant year after year at a value of D,

on simplification becomes:

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Po =

Constant Growth Model (Gordon Model):

One of the most popular dividend discount models, called the Gordon model as it was

originally proposed by Myron J. Gordon, assumes that the dividend per share grows at a

constant rate (g). The value of a share, under this assumption, is:

Applying the formula for the sum of a geometric progression, the above expression

simplifies to:

P0 =

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Two Stage Growth Model:

The simplest extension of the constant growth model assumes that the extraordinary

growth (good or bad) will continue for a finite number of years and thereafter the normal

growth rate will prevail indefinitely.

Assuming that the dividends move in line with the growth rate, the price of the equity share will be:

where Po = Current price of the equity share D1 = dividend expected a year hence

g1 = extraordinary growth rate applicable for n years. Pn = Price of the equity share at the end of year n.

The first term on the right hand side is the present value of a growing annuity. Its value is equal to:

Po =

Since the two-stage growth model assumes that the growth rate after n years remains constant, Pn will be equal to :

where Dn+1 = dividend for year n+1 g2 = growth rate in the second period.

Dn+1, the dividend for year n+1 may be expected in terms of the dividend in the first stage.Dn+1 = D1 (1+g1)n-1(1+g2)

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Substituting the above expression, we have:

Po =

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H Model:

The H model of equity valuation is based on the following assumptions:= while the current dividend growth rate, ga is greater than gn, the normal long-run growth rate declines linearly for 2H years.

= After 2H years the growth rate becomes gn

= At H years the growth rate is exactly halfway between ga and gn,

Growth rate

ga

gn

H 2H Time

While the derivation of the H model is rather complex, the valuation equation for the H model is quite simple:

Po = Do [(1+gn) + H(ga -gn)] r-gn

where Po = intrinsic value of the share Do = current dividend per share r = rate of return expected by investors

gn = normal long-run growth rate ga = current above-normal growth rate

H = one-half of the period during which ga will level off to gn

Equation may be re-written as : Po = Do (1+gn) + DoH(ga -gn)

r-gn r-gn

33

EARNINGS MULTIPLIER APPROACH:

An approach to valuation, practiced widely by investment analysts, is the P/E ratio or the earnings multiplier approach. The value of a stock, under this approach, is estimated as follows:

Po = E1 x Po / E1

where Po = estimated price

E1 = estimated earning per share

Po / E1 = justified price-earning ratio

Determinants of the P/E Ratio:

The determinants of the P/E ratio can be derived from the dividend discount model, which is the foundation for valuing equity stocks.

Let us start with the constant growth dividend discount model:

Po = D1

r-gIn this model D1 = E1(1-b), b stands for the ploughback ratio, and g = ROE x b. Note

that ROE is return on equity. Making these substitutions we find that:

Po = E1 (1-b)r-ROExb

Dividing both the sides by E1, we get:

P0 / E1 = (1-b)

r-ROExb

34

Equation indicates that the factors that determine the P/E ratio are :

= The dividend payout ratio, (1-b)

= The required rate of return, r

= The expected growth rate, ROE x b

P/E Ratio and Ploughback Ratio: Note that b, the ploughback ratio, appears in the

numerator as well as the denominator of the ratio on the right hand side of equation.

What is the effect of a change in b on the P/E ratio? It depends on how ROE compares

with r. IF ROE is greater than r, an increase in b leads to an increase in P/E; if ROE is

equal to r an increase in b has no effect on P/E; if ROE is less than r an increase in b

leads to decrease in P/E.

P/E Ratio and Interest Rate: The required rate of return on equity stocks reflects

interest rate and risk. When interest rates increase, required rates of return on all

securities, including equity stocks, increase, pushing security prices downward. When

interest rates fall security prices rise. Hence there is an inverse relationship between P/E

ratios and interest rates.

P/E Ratio and Risk : Other things being equal , riskier stocks have lower P/E

multiples. This can be easily by examining the formula for the P/E ratio of the constant

growth model:

Riskier stocks have higher required rate of return (r) and hence lower P/E multiplies.

This is true in all cases, not just the constant growth model. For any expected earnings

and dividend stream, the present value will be lower when the stream is considered to be

riskier. Hence the P/E multiple will be lower.

P/E Ratio and Liquidity: Other things being equal, stocks which are highly liquid

command higher P/E multiples and stocks which are highly illiquid command lower P/E

35

multiples. The reason for this is not far to seek. Investors value liquidity just the way

they value safety and hence are willing to give higher P/E multiples to liquid stocks.

Other Influences: In addition to the above factors, there are some other influences too

that seem to have a bearing on the price-earnings multiple. These are described below:

= Size of the company: Other things being equal, a larger company

(measure, say, in terms of paid-up capital) tends to command a higher

price-earnings multiple because of greater investor interest in it.

= Reputation of management : If the management of a company is repute

for its integrity and investor-friendliness, its shares are likely to command

a higher price-earnings multiple.

36

EARNINGS – PRICE RATIO, EXPECTED RETURN AND GROWTH

We often hear about growth stocks and income stocks. Growth stocks are supposed to

provide return primarily in the form of capital appreciation whereas income stocks are

expected to provide returns mainly in the form of cash dividends.

Expected return = Dividend yield = Earnings-price ratio

= D1 = E1

Po Po

The Price is equal to:

Po = D1 = E1

r rwhere r = Expected return.

D1 = Dividend yield

E1 = Earnings per share

37

ANALYSIS

&

INTEPRETATION

38

EQUITY VALUATION

DIVIDEND DISCONT MODEL

SINGLE PERIOD VALUATION:

Formula : Po = D1 + P1

1+r 1+r



P1 = Price of the share expected a year hence

r = rate of return on the equity share.

Table 1:

Name of the Company D1 P1 r Po

Aurobindo Pharma Ltd. 1.50 169.8 0.39 123.22

Gati Ltd 3.50 21.4 0.95 12.76

Pokarana Ltd. 3.50 125.7 0.08 119.62

Premier Explosives Ltd 1.50 20.5 0.15 19.13

Source : HSE, Online Trading, Annual Reports

39

EXPECTED RATE OF RETURN:

FORMULA : r = D1 / P0 + g

where r = rate of return on the equity share.


P0 = Current price of the equity share

g = Expected growth of EPS

Table 2:

Name of the Company D1 Po g r

Aurobindo Pharma Ltd. 1.50 123.22 0.5 0.01%

Gati Ltd 3.50 12.76 0.5 0.26%

Pokarana Ltd. 3.50 119.62 0 0.02%

Premier Explosives Ltd 1.50 19.13 0 0.07%

40

MULTI PERIOD VALUATION:

FORMULA :

where P0 = Price of the equity share today


D2 = Dividend expected a two years hence

D = Dividend expected at the end of infinity’

r = expected return

Table 3:

Name of the Company D1 D2 D3 r Po

Aurobindo Pharma Ltd. 1.50 1.00 4.50 0.39 5.68

Gati Ltd 3.50 3.00 2.70 0.95 2.94

Pokarana Ltd. 3.50 3.50 3.50 0.08 9.01

Premier Eplosives Ltd 1.50 1.50 1.20 0.15 3.41

41

Zero Growth Model:

FORMULA :


D = Dividend expected a year hence

R = Rate of return on the equity share.

Table 4:

Name of the Company D1 r Po

Aurobindo Pharma Ltd. 1.50 0.39 3.84

Gati Ltd 3.50 0.95 3.68

Pokarana Ltd. 3.50 0.08 43.75

Premire Explosives Ltd 1.50 0.15 10.00

42


FORMULA :

Where Po = Price of equity share

D1 = Dividend expected a year

r = Rate of return

g = growth of dividend

TABLE 5 :

Name of the Company D1 r g Po

Aurobindo Pharma Ltd. 1.50 0.39 0.33 25

Gati Ltd 3.50 0.95 0.14 4.33

Pokarana Ltd. 3.50 0.08 0 3.42

Premier Explosives Ltd 1.50 0.15 0 10

43


Po =

where Po = Current price of the equity share D1 = Dividend expected a year hence

g1 = Extraordinary growth rate applicable for n years. g2 = Normal growth rate applicable for n years. r = Rate of return

TABLE 6 :

Name of the Company D1 g1 g2 r n P0

Aurobindo Pharma Ltd. 1.50 0.20 0.10 0.39 6 6.18

Gati Ltd. 3.50 0.30 0.20 0.95 6 5.14

Pokarana Ltd. 3.50 0.06 0.01 0.08 6 60.8

Premier Explosives Ltd 1.50 0.10 0.05 0.15 6 35.2

44

The above table has been depicted in the following graphical presentation:

Picture 6:

INTERPRETATION:

In the evaluation of Two Stage Growth Model, it is observed that CMC Ltd., has the

highest issue price of equity share (Po) of Rs.193.38 as compared to Infosys & Gati Ltd.

Therefore, CMC Ltd., has recorded the highest dividend (D1) of 6.82, growth rate of (g1)

of 0.30 and (g2) of 0.20. The other companies have been recorded the lesser dividend and

the growth rate.

45


FORMULA : Po = E1 x Po / E1

where Po = estimated price

E1 = estimated earning per share

Po / E1 = justified price-earning ratio

Table 7:

Name of the Company E1 Po/ E1 Po


Gati Ltd 2.8 7.64 21.39

Pokarana Ltd. 3.6 7.95 45.29

Premier Explosives Ltd 3.6 5.69 20.49

46

The above table has been depicted in the following graphical presentation:Picture 7:

INTERPRETATION:

In this approach, it is observed that Aurobindo Pharma Ltd., has the highest estimated price (Po) of Rs.287.12 as compared to Infosys & CMC Ltd. Aurobindo Pharma Ltd., has recorded the lesser price-earnings ratio due to this the estimated price (Po) has gone down.

47

DETERMINANTS OF P/E RATIO

FORMULA :

Where P/E = Price-earnings ratio 1-b = Dividend payout ratio r = Required rate of ratio g = Expected growth rate

Table 7:

Name of the Company 1-b r g P/E

Aurobindo Pharma Ltd. 1.50 0.39 0.5 13.63

Gati Ltd. 3.50 0.95 0.5 7.77

Pokarana Ltd. 3.50 0.08 0 43.75

Premier Explosives Ltd 1.50 0.15 0 10.00

48

The above table has been depicted in the following graphical presentation:Picture 7:

0

5

10

15

20

25

30

35

40

45

AurobindoPharma

Gati Pokarana PremierExplosives

INTERPRETATION:

In the determinants of P/E ratio, it has been observed that Infosys has the highest price

earnings ratio (P/E) of 54% as compared to Aurobindo Pharma Ltd., and CMC Ltd.

Infosys has recorded the highest growth rate (g) –5.53 as compared to Aurobindo Pharma

Ltd.

49

EARNINGS – PRICE RATIO, EXPECTED RETURN AND GROWTH

Formula :

Expected return = Dividend yield = Earnings-price ratio

= D1 = E1

Po Po

where r = Expected return.

D1 = Dividend yield

Po = Price of equity share

Table 8:

Formula :

Where r = Expected return.

Po = Price of equity share

E1 = Earnings per share

Table 9:

50

Name of the Company D1 P0 R


Gati Ltd 3.50 12.76 0.27

Pokarana Ltd. 3.50 119.62 0.02


Name of the Company E1 P0 r


Gati Ltd. 2.8 12.76 0.21

Pokarana Ltd. 15.8 119.62 0.13


51

The above table has been depicted in the following graphical presentation:

Picture 10:

0

0.05

0.1

0.15

0.2

0.25

AurobindoPharma

Gati Pokarana PremierExplosives

INTERPRETATION:

In this model, it is observed that Infosys has the highest expected rate or return ® of 0.38

as compared to Aurobindo Pharma Ltd., and Gati Ltd.. Infosys has the highest earnings

price ratio (E) of Rs. 68.52 due to this it recorded the highest rate of return. But

Aurobindo Pharma Ltd., has recorded highest price of equity share of (Po) Rs. 242.15 and

has lesser earnings price ratio of (E1) Rs. 6.91 due to this is recorded lesser rate of return.

52

FINDINGS AND CONCLUSIONS:

Issue price of equity shares (Po) of a scrip can be determined on P1 R, D1.

In expected rate of return (r) can be determined on D1, Po and g.

In multi-period valuation model the dividends are considered for three years for

determining the price of the equity share.

The dividend per share remains constant forever, implying that the growth rate is

nil (zero growth model).

The dividend per share grows at a constant rate per year forever (the constant

growth model).

The dividend per share grows at a constant extraordinary rate for a finite period,

followed by a constant normal rate of growth forever thereafter (the two-stage

model).

The dividend per share, currently growing at an above-normal rate, experiences a

gradually declining rate of growth for a while. Thereafter, it grows at a constant

normal rate (the H model).

While the current dividend growth rate, ga, is greater than gn, the normal long-run

growth rate, the growth rate declines linearly for 2H years.

As the expected growth in dividend increases, other things being equal, the

expected return depends more on the capital gains yield and less on the dividend

yield.

As the expected growth rate in dividend increases, other things being equal, the

price-earnings ratio increases.

High dividend yield and low price –earnings ratio imply limited growth prospects.

Low dividend yield and high price-earnings ratio imply considerable growth

prospects.

The P/E ratio can be easily examined by the formula for the P/E ratio of the

constant growth model

In this model (r) expected return is determined on the basis of D1 E1 and Po.

54

BIBILIOGRAPHY Books:

Financial Management – I.M.Pandey

Security Analysis and Portfolio Management – Prasana Chandra

Financial Management-Prasana Chandra

Security Analysis and Portfolio Management- Punithavathy Pandian

Security Analysis and Portfolio Management-Fisher&Jordan

WEBSITE:

www.nseindia .com

www.bseindia .com

www.hse.org.com

www.shcil.com

www.google.com

HSE Reports 2002-2005 Records & Reports

Annual Reports

Online Trading on HSE

JOURNALS:

Financial Express

Economic Times

Fortune India

Capital Market

Dalal Street

DIVIDEND DISCOUNT MODEL

55

http://www.google.com/

http://www.shcil.com/

http://www.hse.org.com/

http://www.bseindia/

http://www.nseindia/

SINGLE-PERIOD VALUATION MODEL:

Aurobindo Pharma Ltd:


1+r 1+r

D1 = 1.50P1 = 169.8r = Net Income = 67.0 = 0.39

Book Value 169.8

Gati Ltd:


1+r 1+r

D1 = 3.50P1 = 21.4r = Net Income = 20.4 = 0.95

Book Value 21.4

Pokarana Ltd:

56


1+r 1+r

D1 = 3.50P1 = 125.7r = Net Income = 10.1 = 0.08

Book Value 125.7

Premier Explosives Ltd:


1+r 1+r

D1 = 1.50P1 = 20.5r = Net Income = 3.1 = 0.15

Book Value 20.5

57

EXPECTED RATE OF RETURN:


Formula : r = D1

PO+g

D1 = 1.50Po = 123.22G = 1.50-1.00=0.5

Gati Ltd:

Formula : : r = D1

PO+g

D1 = 3.50Po = 12.76G = 3.50-3.00=0.5

58

Pokarana Ltd:

Formula : r = D1

PO+g

D1 = 3.50Po = 119.62g = 3.50-3.50 = 0

Premier Explosives:

Formula : r = D1

PO+g

D1 = 1.50Po = 20.5g = 1.50-1.50=0

59

MULTI- PERIOD VALUATION MODEL:


FORMULA :

where D1 = 1.50

D2 = 1.00

D3 = 4.50

r = 0.39

Gati Ltd:

FORMULA :

where D1 = 3.50

D2 = 3.00

D3 = 2.70

r = 0.95

60

Pokarana Ltd:

FORMULA :

where D1 = 3.50

D2 = 3.50

D3 = 3.50

r = 0.08

61

Premier Explosives:

FORMULA :

where D1 = 1.50

D2 = 1.50

D3 = 1.20

r = 0.15

62

ZERO GROWTH MODEL:


FORMULA :

where D = 1.50

r = 0.39

Gati Ltd:

FORMULA :

where D = 3.50

r = 0.95

63

Pokarana Ltd:

FORMULA :

where D = 3.50

r = 0.08

Premier Explosives:

FORMULA :

where D = 1.50

r = 0.15

64



FORMULA :

Where D1 = 1.50

r = 0.39

g = Current dividend – Previous dividend

Current dividend

Gati Ltd:

FORMULA :

Where D1 = 3.50

r = 0.95


Current dividend

65

Pokarana Ltd:

FORMULA :

Where D1 = 3.50

r = 0.08


Current dividend

66

Premier Explosives:

FORMULA :

Where D1 = 1.50

r = 0.15


Current dividend

67



FORMULA :

Po =

where D1 = 1.50 g1 = 0.20 g2 = 0.10 r = 0.39 n = 6.00

5

5 1

5

1 0.2011(1 0.20) (1 0.10) 11 0.191

0.19 0.20 0.19 0.10 (1 0.19)

Gati LTD:

FORMULA :

68

Po =

where D1 = 3.50 g1 = 0.30 g2 = 0.20 r = 0.95 n = 6

Pokarana LTD:

FORMULA :

Po =

where D1 = 3.50 g1 = 0.06 g2 = 0.01 r = 0.08 n = 6

69

Premier Explosives LTD.

FORMULA :

Po =

where D1 = 1.50 g1 = 0.10 g2 = 0.05 r = 0.15 n = 6

0.432

70



FORMULA : Po =

where E1 = 40.3

Po / E1 = =

Po =

Gati Ltd:

FORMULA : Po =

where E1 = 2.8

Po / E1 =

Po =

Pokarana Ltd:

FORMULA : Po =

where E1 = 15.8

Po / E1 = =

Po =

72

Premier Explosives:

FORMULA : Po =

where E1 = 3.6

Po / E1 = =

Po =

73

DETERMINANTS OF P/E RATIO


FORMULA :

Where 1-b = 1.50 r = 0.39 g = 1.50-1.00=0.5

Gati Ltd:

FORMULA :

Where 1-b = 3.50 r = 0.95 g = 3.50-3.00=0.5

74

Pokarana Ltd:

FORMULA :

Where 1-b = 3.50 r = 0.08 g = 3.50-3.50=0

Premier Explosives:

FORMULA :

Where 1-b = 1.50 r = 0.15 g = 1.50-1.50=0

75

EARNINGS – PRICE RATIO, EXPECTED RETURN AND GROWTHAurobindo Pharma Ltd:Formula :

Where D1 = 1.50

Po = 123.22

E1 = 12.4

Gati Ltd:Formula :

Where D1 = 3.50

Po = 12.76

E1 = 2.8

77

Pokarana Ltd:Formula :

Where D1 = 3.50

Po = 119.62

E1 = 15.8

Premier Explosives:Formula :

Where D1 = 1.50

Po = 19.13

E1 = 3.6

78

equity valuation

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