Lecture Objective

To discuss about return of securities.

To discuss about different techniques
of stock valuation.

10/6/16

Ekta Singh (NBS, GREATER NOIDA)

Lecture Content
Stock return
Stock valuation

10/6/16

Ekta Singh (NBS, GREATER NOIDA)

Stock Return and Valuation

Return :
The return( r) from the stock includes
both current income and capital gain
caused by the appreciation of the
price.
Price change + cash
dividend
r =
---------------------------------------- X 100
purchase price
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

Stock Return and Valuation

Expected Return :
The expected return of the
investment is the probability
weighted average of all the possible
returns.
It is the sum of the products of
possible returns with their respective
probabilities.
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

Stock Return and Valuation

expected return - Example
Q 1 :Suppose a share is currently selling at
Rs.120. An investor who is interested in the share
anticipates that the company will pay a dividend of
Rs.5 in the next year .Moreover, he expects to sell
the share at Rs.175 after one year. Calculate the
expected return.
Forecasted dividend + Forecasted end of the period stock

price
R= ---------------------------------------------------------------------------------------1
Initial Investment

5 + 175
R = --------------------- - 1 = 0.5 or 50 percent
120
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

EQUITY VALUATION
Different techniques for stock
valuation:
1. Balance- Sheet Valuation
2. Dividend discount models
3. Price earning method

10/6/16

Ekta Singh (NBS, GREATER NOIDA)

Balance- Sheet Valuation

1. Book Value:
The book value per share is
simply the net worth of the
company (which is equal to paid
up equity capital plus reserves
and surplus) divided by the
number of outstanding equity
shares.
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

Balance- Sheet Valuation

1. Book Value:
For example, if the net worth of
Zenith Limited is Rs 37 lakhs and the
number of equity shares of Zenith is
2 lakhs; the book value per share
works out to Rs 18.50 (Rs 37 lakhs
divided by 2 lakhs).

10/6/16

Ekta Singh (NBS, GREATER NOIDA)

Balance- Sheet Valuation

2. Liquidation Value
Value realized from liquidating all the
assets of the firm less the Amount to
be paid to all the creditors and
preference shareholders & divided by
the Number outstanding equity shares
there are two serious problems in
applying it.
a. It is very difficult to estimate what
amounts would be realised from the
liquidation of various assets
b. The liquidation value does not

10/6/16

Ekta Singh (NBS, GREATER NOIDA)

Balance- Sheet Valuation

2. Liquidation Value
To illustrate, assume that Pioneer
Industries would realize Rs 45 lakhs from
the liquidation of its assets and pay Rs
18 lakhs to its creditors and preference
shareholders in full settlement of their
claims. If the number of outstanding
equity shares of Pioneer is 1.5 lakhs, the
liquidation value per share works out to:
Rs 45lakhs- Rs 18lakhs
--------------------------- =Rs.18 lakhs
1.5
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Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

According to the dividend discount
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.

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Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

assumptions:
i. Dividends are paid annually; and
ii. The first dividend is received one
year after
the equity share is
bought.

10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

I Single Period Valuation Model:
The price of the equity share will be:
Po = D1/(1+r) + P1 /(1+r)
Where:
Po is the current price of the equity
share
D1 is the dividend expected next year
P1 is the price expected next year
r is the rate of return required on the
equity share
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Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

I Single Period Valuation Model:
Example:
Assume that the equity share of a
company is expected to provide a
dividend of Rs 2 and fetch a price of
Rs 18 a year hence. What price
would it sell for now if investors
required rate of return is 12%.
Po = 2.0/(1.12)+18/(1.12) = Rs
17.86

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Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

I Single Period Valuation Model:
If the company is expected to grow
at a rate of g every year. Then:
Po = D1/(1+r) + Po (1+g)/(1+r)
Or
Po = D1/(r-g)
The expected rate of return equal to:
r = (D 1/Po)+g

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Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

I Single Period Valuation Model:
Example:
Suppose that the expected
dividend per share of a company is
Rs 2. The dividend per share has
grown over the past years @ 5% per
year. The required rate is 15%.
Po = 2/(0.15-0.05) = Rs 20

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Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

II Multi-Period Valuation Model

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:
Po = D1/(1+r) + D2/(1+ r)2 + D3/(1+ r)3
+ - - - - - - - - + (Dn+Pn) /(1+ r)n
Where:
Po is the price of the equity share today
D1 is the dividend expected a year hence
D2 is the dividend expected two years
hence
Dn is the dividend expected n years
hence
10/6/16
Ekta Singh (NBS, GREATER NOIDA)
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Dividend Discount Model

II Multi-Period Valuation Model:
Assumptions are as follows:
1. The dividend per share remains constant
forever, implying that the growth rate is nil
(the zero growth model).
2. The dividend per share grows at a
constant rate per year forever (the constant
growth model).
3. 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).
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

II Multi-Period Valuation Model:
Zero growth Model : A special case of the
constant growth model calls for an
expected growth rate, g, of zero.
This is the fixed amount of dividend.
D0 = D1 = D2 = D = Constant
If we assume that the dividend per share
remains constant year after year at a
value of D, the equation becomes
Po = D/r
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

II Multi-Period Valuation Model:
Zero growth Model :

Example:
Hindustan Manufacturing Ltd.
Has
distributed a dividend of Rs. 30 on
each Equity share of Rs 10.The
expected rate of return is 35% .
Calculate current market price of
share ?
30/0.35 = Rs 85.71
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

II Multi-Period Valuation Model:
Constant Growth Stock Valuation
(Gordon Model)
A constant growth stock is a
stock whose dividends are expected
to grow at a constant rate (g) in the
foreseeable future.
Do(1+g)/(r-g)
10/6/16

Po = D1/(r-g) or
* Dn = Do(1+g)n

Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

II Multi-Period Valuation Model:
Example:
Assume that you have purchased the
shares of a company, which is expected
to grow at the rate of 6% per annum. The
dividend expected on your share a year
hence is Rs 2.What price will you put on
it if your required rate of return for this
share is 14%.The price for your share can
be calculated as:
Po = 2.00/(0.14-0.06) = Rs 25
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

II Multi-Period Valuation Model:
Two Stage Growth Model
The growth stages are divided into two,
namely, a period of extraordinary
growth (or decline) and a constant
growth period of infinite nature. The
extraordinary growth period(V1) will
continue for some period followed by the
constant growth period(V2).
Po =V1+V2
V1=D1/(1+r) + D2/(1+ r)2 + D3/(1+
r)3 +
+ Dn /(1+ r) n
V2=Dn(1+g) /(r- g) (1+ r) n
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Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

II Multi-Period Valuation Model:
Two Stage Growth Model
Example:
A company paid a dividend of Rs.1.75
per share during the current year .It is
expected to pay a dividend of Rs.2 per
share during the next year. Investors
forecast a dividend of Rs.3 and Rs.3.50 per
share respectively during subsequent
years. After that it is expected that annual
dividends will grow at 10 percent per year
into an indefinite future .If the investors
required rate of return is 20 percent ,
calculate the intrinsic value of the share?
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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Dividend Discount Model

II Multi-Period Valuation Model:
Two Stage Growth Model
Solution:
V1=2/(1+0.2) + 3/(1+ 0.2)2 +
3.50/(1+ 0.2)3= Rs.5.78
V2=3.50(1+0.1) /(0.2-0.1) (1+
0.2)3
= 3.85/(0.1)(1.2)3=Rs.22.28
Po=V1+V2=5.78+22.28=Rs.28.06

10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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P/E Ratio or Earnings Multiplier

Approach
Many investors and analysts value shares by
estimating an appropriate multiplier for the
share . The price earning ratio is the most
popular multiplier used for the purpose. The
price-earnings ratio is given by the expression:
Share Price
P/E ratio= -----------------------Earning per share
The intrinsic value of a share is taken as the
current earning per share or the forecasted future
earnings per share times the appropriate P/E ratio
for the share.
Share Price=P/E ratio *Earning per share
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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P/E Ratio or Earnings Multiplier

Approach

Example :if the current EPS of a

share is Rs.8 and if the investor feels
that the appropriate P/E ratio for the
share is 12, then the intrinsic value
of the share would be taken as Rs.96.
Investment decision to buy or sell the
share would be taken after
comparing this intrinsic value with
the current market price of the share.
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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P/E Ratio or Earnings Multiplier

Approach
Different approaches may be adopted for the
determination of the appropriate P/E ratio :
(i) Statistical Approach: the broad determinants of
share prices such as earnings , growth , risk and
dividend policy may be used to estimate the
appropriate P/E ratio with the help of statistical
analysis (regression analysis).
(ii) The mean of the historical P/E ratios of the
company in the past may be taken as the
appropriate P/E ratio for share valuation.
(iii) The median P/E ratio of companies in the same
industry may be taken as the appropriate P/E
ratio.
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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CASE 1
You have decided to buy 500 shares of
an IT company with the intention of selling
out at the end of five years . You estimate
that the company Will pay Rs.3.50 per
share as dividends for the first two years
and Rs. 4.50 per share for the next three
years . You further estimate that , at the
end of the five year holding period , the
shares can be sold for Rs.85 .What would
you willing to pay today for these shares if
your required rate of return is 12 per cent ?

10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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CASE 1 - solution
Po = D1/(1+r) + D2 / (1+r)2 + D3 /
(1+r)3 +----------Dn /(1+r)n +Pn / (1+r)n
D1= D2=Rs.3.50
D3 = D4 = D5 =4.50
n=5
Pn= 85
Ans.62.762

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Ekta Singh (NBS, GREATER NOIDA)

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CASE 2
A company paid dividends amounting
to Rs.0.75 per share during the last year
.The company is expected to pay Rs.2 per
share during the next year .Investors
forecast a dividend of Rs. 3 per share in the
year after that .Thereafter ,it is expected
that dividends will grow at 10 per cent per
year into an indefinite future .Would you
buy/ sell the share if the current price of
the share is Rs.54? Investor's required rate
of return is 15 per cent.
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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CASE 2
Ans. V1=1.74+2.27=4.01 ( D1=Rs.2
D2=Rs.3 n=2 g=10%)
V2=49.91
( r=15%)
P0=53.92

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Ekta Singh (NBS, GREATER NOIDA)

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CASE-3
A chemical company paid a
dividend of Rs.2.75 during the
current year. Forecast suggest that
earnings and dividends of the
company are likely to grow at the
rate of 8 percent over the next five
years and at the rate of 5 percent
thereafter .Investors have
traditionally required a rate of return
of 20 percent on these shares .What
is the present value of the stock?
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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CASE-3
D0=Rs.2.75 ;
n=5 ;
r=20%
g (for first five years) = 8%
g (after five years) = 5%
Hence,D1=D0(1+g)1=2.97
D2=D0(1+g)2=3.21
3.46
3.74
4.04
V1 = 10.13
V2 = 11.36
P0 = 21.49
10/6/16

Ekta Singh (NBS, GREATER NOIDA)

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