Download Valuation of equity shares

MBA & MBA – Banking and Finance
(Term-IV)
Course : Security Analysis and Portfolio
Management
Unit II: Valuation of Securities
Valuation of equity shares
Motives for investing in equity


Ownership and Control
Periodic gain and appreciation
SINGLE-PERIOD VALUATION MODEL
It is the case where the investor expects to hold the
equity share for one year. The present value of the
equity share will be:
Po = D1
(1+r)
+
P1
(1+r)
Where Po = present value of the equity share
D1 = dividend expected a year hence
P1 = price of the share expected a year hence
r = rate of return required on the equity share
PROBLEMS


Prestige’s equity share is expected to provide a
dividend of Rs 2.00 and fetch a price of Rs 18.00 a
year hence. What price would it sell for now if
investors’ required rate of return is 12 percent?
The stock of ABC Limited is expected to provide a
dividend of Rs 4.00 and fetch a price of Rs 40 a year
hence. What price would it sell for now if the
investor’s required arte of return is 15%?
ZERO GROWTH MODEL
It is assumed in this model that the dividend per
share remains constant year after year for ever.
Po = D + D
+
(1+r) (1+r)2
D
+
(1+r)n
On simplification, it becomes:
PO = D
r
PO= Present Value/Intrinsic Value
D = Dividend per share
r = required rate of return
…...∞
PROBLEM
An equity stock is expected to earn
dividend at the rate of Rs. 6 per share
annually for ever. What is the worth of
the stock today if the investors’
required rate of return is 10%.
CONSTANT GROWTH MODEL
In this model, the basic assumption is that dividends will grow at
the same rate (g) for an indefinite period.
P0 =
D(1+g) + D(1+g)2 + D(1+g)3 +…+ D(1+g)N …∞
(1+r)
(1+r)2
(1+r)3
P0 = D1
r–g
P0 = Present value of stock
D = Dividend paid during last year
D1 = Dividend expected one year hence
r = Required rate of return
g = rate of growth of dividend
(1+r)N
PROBLEMS


The ABC company’s next year dividend per share is expected
to be Rs 3.50. the dividend in subsequent years is expected
to grow at a rate of 10% per year forever. If the required
rate of return is 15% per year, what should be its price?
The share of a certain stock paid a dividend of Rs. 2.00 last
year. The dividend is expected to grow at a constant rate of 6
per cent in the future indefinitely. The required rate of return
on this stock is considered to be 12 per cent. How much
should this stock sell for now? Assuming that the expected
growth rate and required rate of return remain the same, at
what price should the stock sell 2 years hence?
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 continues for some
period followed by the constant growth rate.
Present Value of stock = Present Value of dividend during
above-normal growth period
+
Value of stock price at the end of
above-normal growth period
discounted back to present
TWO STAGE GROWTH MODEL
(contd)
P
t
D
(1+g
)
O =
0
s
∑
t=1
(1+rs)t
N
+
DN+1 X
1
(rs –gn) (1+rs)N
P0 = Present Value/Intrinsic Value
D0 = dividend of the previous period
gs = above normal growth rate
gn = normal growth rate
rs = required rate of return
N = period of above normal growth
PROBLEMS


Sigma Company limited paid a cash dividend of Rs.
0.71 per share last year. The dividend is expected
to increase by 15 percent a year for ten years and
thereafter at 10 percent a year indefinitely. If a
stockholder’s required rate of return is 16 percent,
what is the fair price of this Company’s stock?
Determine the intrinsic value of an equity share,
given the following data:
Last year dividend (D0)
: Rs. 2.00
Growth rate for the next 5 years
: 15 percent
Growth rate beyond 5 years
: 10 percent
The required rate of return is 18 percent.

The Commonwealth Corporation’s earnings and
dividends have been growing at a rate of 12 per cent
per annum. This growth rate is expected to continue
for 4 years. After that the growth rate will fall to 8
per cent for the next 4 years. Beyond that the growth
rate is expected to be 5 per cent forever. If the last
dividend per share was Rs. 1.50 and the investors’
required rate of return on the stock of
Commonwealth is 14 per cent, how much should be
the market value per share of Commonwealth
Corporation’s equity stock?
PROBLEMS
Vardhaman Limited’s earnings and dividends have been
growing at a rate of 18 per cent per annum. This
growth rate is expected to continue for 4 years. After
that the growth rate will fall to 12 per cent for the next
4 years. Thereafter, the growth rate is expected to be 6
per cent forever. If the last dividend per share was Rs.
2.00 and the investors’ required rate of return on
Vardhman’s equity is 15 per cent, what is the intrinsic
value per share?


The equity stock of Max Limited is currently selling
for Rs. 32 per share. The dividend expected next is
Rs 2.00. The investors’ required rate of return on this
stock is 12 percent. Assume that the constant growth
model applies to Max Limited. What is the expected
growth rate of Max Limited?
Fizzle Limited is facing gloomy prospects. The
earnings and dividends are expected to decline at the
rate of 4%. The previous dividend was Rs 1.50. If
the current market price is Rs 8.00, what rate of
return do investors expect from the stock of Fizzle
Limited?
MULTIPLE YEAR HOLDING PERIOD
If the holding period of the stock is more than
one year, the following formula is used:
P=[
n]
[(e
)(d/e)]
(1+g)
0
∑
n=1
(1+r)n
N
+
[ (P/E)(e0) (1+g)N+1]
(1+r)N
g = annual expected growth in earnings, dividends and price
e0 = most recent earnings per share
d/e = dividend pay out
r = required rate of return
P/E = price-earnings ratio
N = holding period in years
PROBLEMS
Following is the data relating to a stock of Olsen
Company for five years:
Annual expected growth in earnings, dividends and price= 6%
Recent Earnings per Share = Rs 1.886
Dividend payout = 50%
Required rate of return = 10%
Price-Earnings Ratio = 12.5
Holding period in years = 5
Calculate the present value of the stock using the Multiple year
holding period model.
PROBLEMS
The Grace and Co has common shares
outstanding in the market with price earnings
ratio of 15. The annual expected growth in
earnings, dividends and price is 7 percent.
The earnings per share is Rs. 2.5, the
dividend payout is 60% and the investor
wants to hold the stock for 4 years. The
required rate of return is 15 percent. What
would be the present value?