fin mgmt valuation of shares

SHARES AND THEIR VALUATIONCHAPTER 7

CONTENTS2 CONTENTS2

Introduction Features of Equityq y Issues in Valuation of Equity Dividend Discount Models

DDM with Constant Dividend DDM with Constant Growth

Dividend and Growth Dividend and Growth DDM with Multi‐Stage Growth

RELATIVE VALUATION RELATIVE VALUATION Price Earning Ratio/Multiple PE Multiple and Growth

h l l Other Relative ValuationSHARES AND THEIR VALUATION CHAPTER 7

CONTENTS3 CONTENTS3

EFFICIENT MARKET HYPOTHESIS (EMH) Weak Form of EMH Weak Form of EMH Semi‐strong Form of EMH Strong Form of EMH

Approaches to Valuation EMH and Technical Analysis

H d d l A l i EMH and Fundamental Analysis EMH and Portfolio Management EMH d P tf li M EMH and Portfolio Manager Limitations of EMH

SHARES AND THEIR VALUATION CHAPTER 7

EQUITY AND FEATURES4 EQUITY AND FEATURES4

Equity shares are characterised by

1 ownership & management1. ownership & management

2. entitlement to residual cash flows

3. limited liability

4. infinite life and

5. substantially different risk profile.

Infinite life uncertain return and Infinite life, uncertain return and substantially different risk profile makes valuation of equity difficult.


METHODS OF VALUATION5 METHODS OF VALUATION5

Value of equity share can be found

1. by estimating its intrinsic worth by valuing its cash flows using models, g gsuch as dividend discount models, or

2 in relation to a the market price of the2. in relation to a the market price of the comparable asset, called relative valuationvaluation.


DIVIDEND DISCOUNT MODELS6 DIVIDEND DISCOUNT MODELS6

Two important inputs for valuation of i hequity share are

1. the cash flows attached to the equity and1. the cash flows attached to the equity and

2. the discount rate that is appropriate for f d l f h h flfinding present value of the cash flows.

PD)1()1(

110 r

Pr

DP


DIVIDEND DISCOUNT MODELS7 DIVIDEND DISCOUNT MODELS7

According to Dividend Discount Model (DDM) the current price of the equity share is equal to the p q y qpresent value of the infinite stream of dividend expected.

PDP 22

)r+1(+

)r+1(=P 22

1

221

22

1 PDD)r+1(P

+)r+1(

DD

P 22

2211

0 )r+1(+

)r+1(+

)r+1(=

)r+1()r+1()r+1(+

)r+1(=P

n54321 D+

D+

D+

D+

D+

DP n

n5

54

43

32

210 )r+1(

+...............)r+1(

+)r+1(

+)r+1(

+)r+1(

+)r+1(

=P

$

0 )1( nnD

P

SHARES AND THEIR VALUATION

10 )1( nr

CHAPTER 7

DDM WITH CONSTANT8

DIVIDEND – NO GROWTH8

If dividend for all times to come is assumed constant then the current priceassumed constant then the current price of the share is simply the current dividend divided by the capitalisation ratedivided by the capitalisation rate.

DDDDDDP $54320 )1(...............

)1()1()1()1()1( rrrrrrP

rDP 0


rCHAPTER 7

DDM WITH CONSTANT9

GROWTH9

With growth rate ‘g’ in dividends the value of equity is given by:q y g y

rPg

rD

rP

rDP

)1()1(

)1()1()1(0111

0

g)-(rD=P

rrrr

10

)1()1()1()1(

PP-P+

PD= rReturn, 011

g)(r

Gain Capital+Yield Dividend=PP 00


DDM WITH CONSTANT GROWTH10 DDM WITH CONSTANT GROWTH10

The value of equity share is dependent upon the expected dividend, the growth expected in dividend and the shareholders expectations of return.

$432 )1()1()1()1()1( gDgDgDgDgDD $54320 )1()1(...............

)1()1(

)1()1(

)1()1(

)1()1(

)1( rgD

rgD

rgD

rgD

rgD

rDP

g)-(rD=P 1

0


IMPLICATIONS OF GORDON’S11

DIVIDEND DISCOUNT MODEL11

Investors’ expectations cannot be lesser than growth.

Price rises with reduced expected return.

The price grows as much as dividend growth The price grows as much as dividend growth.00.Rs.400=

0.15)-(0.2020=

g)-(rD=P 1

0

The volatility in prices results from differences in

00.Rs.460=0.15)-(0.20

20(1.15)g)-(r

g)(1D=g)-(r

D=P 121

The volatility in prices results from differences in growth estimates .

Stock that pays no dividend too has value Stock that pays no dividend too has value.


VALUE AND GROWTH12

OPPORTUNITIES12

Value of the share is closely linked toy

the growth opportunities available with the firmfirm,

the re‐investment rate,

the shareholders expectations and

proportions of earnings retained in business proportions of earnings retained in business.


VALUE AND GROWTH13

OPPORTUNITIES13

Options Current SQUARE FLAT ROUND

Dividend (Rs.) 20 10 10 10

Expected Return, ‘r’20% 20% 20% 20%

Return on Equity 20% 25% 20% 15%Growth Rate, g = b x RoE 0% 12.5% 10.0% 7.5%

rD

=P0 = 20/0.20 =Rs. 100r

Rs.133.33=0.125)-(0.20

10

Rs.100.00=0.10)-(0.20

10

Rs.80.00=0.075)-(0.20

10

E1/r + PVGO


DDM - MULTI-STAGE14

GROWTH MODELS14

With current dividend of Rs. 2.50, growth rate of 20% for first 5 years and 6% forever, and using a y gdiscount rate of 15% The value of the share is: Current level of dividend, D0 = Rs. 2.50i id d d i h i d ( )Dividend expected in the next period, D1 = (1+g)xD0

= 1.20 x 2.50 = Rs. 3.00

nn

-1n11

4

311

3

211

2111

0 )r+1(Pn

+)r+1()g+1(D

+.......)r+1()g+1(D

+)r+1()g+1(D

+)r+1(

)g+1(D+

)r+1(D

=P

Rs.73.27=0.096.59

=0.06-0.150.06)+6.22(1

=g)-(r

D=P 6

5


DDM - MULTI-STAGE15

GROWTH MODELS15

n43

3

2

2

0 )15.0+1(Pn

+)20.0+1(00.3)20.0+1(00.3

)15.0+1()20.0+1(00.3

+)15.0+1(

)20.0+1(00.3+

)15.+1(00.3

=P

3

2

2

54

Pn+

+)15.1(

)20.1(00.3+

)15.1()20.1(00.3

+)15.1(

00.3

)()15.0+1(

)20.0+1(00.3+

)15.0+1()20.0+1(00.3

+

n

5

4

4

3

Pn+

22.6+

18.5+

32.4+

60.3+

00.3

)15.1(+

)15.1()20.1(00.3

+)15.1(

)20.1(00.3)()()(

=

Pn

n5432

)15.1(Pn

+09.3+96.2+84.2+72.2+61.2=

)15.1(+

)15.1(+

)15.1(+

)15.1(+

)15.1(+

)15.1(=

65.50.Rs=43.36+22.14=15127.73

+22.14=

)15.1(P

+09.3+96.2+84.2+72.2+61.2=P

5

nn

0

CHAPTER 7SHARES AND THEIR VALUATION

15.1

RELATIVE VALUATION16 RELATIVE VALUATION16

While DDM based valuation focuses on the finding the intrinsic value relative valuationfinding the intrinsic value relative valuation attempts pricing based on the market value of the comparable assets. p

Even if the markets were inefficient in valuing the equivalent asset we presume that as long asequivalent asset we presume that as long as similar inefficiencies persist, the valuation on the basis of the comparable, too would be close to p ,the market value.


PRICE EARNING (PE) MULTIPLE17 PRICE EARNING (PE) MULTIPLE17

The most common relative valuation is based on the PE multiple defined as ratio of marketon the PE multiple defined as ratio of market price to the earnings.

0

0

EP

=SharePer Earning

Price Market=Ratio Earning Price

1

0

EP

=SharePer Earning Expected

Price Market=Ratio Earning Price Leading


PE MULTIPLE AND GROWTH18 PE MULTIPLE AND GROWTH18

SLOW GROWTH FAST GROWTH

Earnings (Rs. per share) 10 10g ( p )

Dividend (Rs. per share) 5 5

Market Capitalisation (%) 20 20Market Capitalisation (%) 20 20

Growth Potential (%) 5 15

Value of the Share (Rs.)

Dividend Yield 15% (5/33.33) 5% (5/100)

Capital Gain = growth 5% 15%

PE Ratio 3.33 10


PE MULTIPLE AND GROWTH19 PE MULTIPLE AND GROWTH19

PE multiple reflects the growth prospects f h fi d b h kof the firm as assessed by the market.

Riskier firms have low PE multiple while Riskier firms have low PE multiple while firms those with stable cash flows have higher PE multiple.higher PE multiple.

orbk)-(r

b)-(1Eg)-(r

D=P 110 ,

bk)-(rb)-(1

EP

bk)-(rg)-(r

1

0


)(1

CHAPTER 7

OTHER RELATIVE VALUATIONS20 OTHER RELATIVE VALUATIONS20

Besides PE multiple other popular relative valuations are done on market price multiples of p pbook value, return on net worth and sales.

g)+b)(1-(1E=

D=P 01

g)+b)(1-RoE(1=

g)+b)(1-(1/BE=

PB share,per valuebook by sides both Dividing

,g)-(r

=g)-(r

=P

000

0

0

g)-(r=

g)-(r=

B00

0

0

,g)-(r

g)+b)(1-(1E=

g)-(rD

=P 010

g)-(rg)+b)(1-RoSales(1

=g)-(r

g)+b)(1-(1/SE=

SP

,S share,per Sale by sides both Dividingg)(rg)(r

00

0

0

0


RELATIVE VALUATION21 RELATIVE VALUATION21

The success of relative valuation is dependent upon

finding a comparable assets and finding a comparable assets and

efficiency of capital markets.


EFFICIENT MARKET22

HYPOTHESIS22

Random Walk theory states that price changes are random and unpredictable

There are three form of market efficiency There are three form of market efficiency

weak,

semi‐strong and

strong, strong,

based on level of information discounted in the current pricein the current price


FORMS OF EMH23 FORMS OF EMH23

Weak form of market efficiency states

that current price discounts all past information

Semi‐strong form of market efficiency g yassumes

that current price discounts all past and publicly that current price discounts all past and publicly available information

Strong form of market efficiency says that Strong form of market efficiency says that

all information – past, public and private is discounted in price of the shares.discounted in price of the shares.


APPROACHES TO VALUATION24 APPROACHES TO VALUATION24

The two distinct and basic approaches to valuation arevaluation are

fundamental analysis and

technical analysis

Fundamental analysis is focussed on finding the Fundamental analysis is focussed on finding the intrinsic worth,

T h i l l i h i d t ti Technical analysis emphasises on detecting discernable patterns in past prices and making future prediction based on these patterns.future prediction based on these patterns.


EMH AND TECHNICAL25

ANALYSIS25

Technical analysts believe that prices and volumes of trading form patterns that arevolumes of trading form patterns that are discernible, recurrent and predictable.

Analysts identify these patterns and predict the next move with respect to timing, direction and quantum of change in pricequantum of change in price.

These predictions can be exploited by taking i bl i i i hsuitable investment positions to have returns

better than normal.


EMH AND TECHNICAL26

ANALYSIS26

The philosophy of technical analysis is completely opposite to that of efficientcompletely opposite to that of efficient market hypothesis i.e. one can make abnormal returns on the basis of pastabnormal returns on the basis of past information of price and volume of trading. g

If technical analysts can outperform the markets the markets cannot be said to bemarkets the markets cannot be said to be efficient even in the weakest form.


EMH AND FUNDAMENTAL27

ANALYSIS27

According to efficient market hypothesis the fundamental analysis cannot lead to portfolio performance better than the market,

Complicated mathematical models can only influence investors but not the prices of securities

Efficient market hypothesis suggests that analysts yp gg ywith unique insight only get rewarded.

Fundamental analysis unless super‐imposed with Fundamental analysis unless super imposed with new information would not yield super normal returns.


EMH AND PORTFOLIO28

MANAGEMENT28

Efficient market hypothesis foresees no yprole for active portfolio management and the portfolio managers.p g


LIMITATIONS OF EMH29 LIMITATIONS OF EMH29

inherent volatility of the market,

choices of selection of securities,

f timings of investment

would always remain andwould always remain and

make it difficult to prove or disprove efficient market hypothesis.


fin mgmt valuation of shares

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