Equity Valuation

INNOVATIVE CONSULTANTS
TRUST . KNOWLEDGE . ETHICS
Complete Financial Solutions

VALUATION

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.

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.

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.

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

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.

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

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.

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
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

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

Gordon Growth Model
P0 = D1
ke – g
D1 = Expected Dividends one year from now

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

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.

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

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

Pn = Price at the end of period n

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%.

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.

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

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
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)

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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INNOVATIVE CONSULTANTS

TRUST . KNOWLEDGE . ETHICS

Complete Financial Solutions

Complete Financial Solutions

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

Value investors use a variety of analytical techniques in order to

BUY UNDERVALUED , SELL OVERVALUED

EARNING PER SHARE (EPS)

EPS = Profit After Tax

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

Complete Financial Solutions

DIVIDEND PER SHARE (DPS)

DPS = Dividends paid over a year

Dividends are a form of profit distribution to the shareholder.

Complete Financial Solutions

RETURN ON EQUITY (ROE)

ROE = Profit After Tax * 100

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

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

Complete Financial Solutions

RETURN ON CAPITAL EMPLOYED (ROCE)

ROCE = EBIT * 100

Capital Employed = Total Assets- Current Liabilities

It shows the business gain from its assets & liabilities.

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

RONW is appropriate to judging the return that a

Discounted Cash Flow Model

Complete Financial Solutions

Calculate weighted average cost of Capital. WACC is used

Complete Financial Solutions

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

Complete Financial Solutions

• Stocks do not have a finite maturity.

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

• Finding an appropriate discount rate for these cash flows.

Complete Financial Solutions

1. the time value of money (risk rate)

2. a risk premium (risk premium rate)

Thus the discounted present value is expressed as :

Complete Financial Solutions

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

P1 = Price of the share after 1 year

Complete Financial Solutions

D1 = Expected Dividends one year from now

Complete Financial Solutions

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

Complete Financial Solutions

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

DPSt = Expected Dividends Per Share in year t

Complete Financial Solutions

D1,2,n = Expected Dividends

Complete Financial Solutions

The present value is computed by discounting the dividends at

Complete Financial Solutions

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

Hence the stock is under valued in the market.

Complete Financial Solutions

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

Complete Financial Solutions

Dividing both sides by E1,