Investment Analysis and Portfolio Management,

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CHAPTER FOUR
STOCK OR EQUITY VALUATIN
You may recall from your studies in accounting, economics, or corporate finance that the value of an asset is
the present value of its expected returns. Specifically, you expect an asset to provide a stream of returns
during the period of time you own it. To convert this estimated stream of returns to a value for the security,
you must discount this stream at your required rate of return.
 This process of valuation requires estimates of: (1) the stream of expected returns and (2) the required
rate of return on the investment (its discount rate).
 An estimate of the expected returns from an investment encompasses not only the size but also the
form, time pattern, and uncertainty of returns, which affect the required rate of return.
Form of Returns The returns from an investment can take many forms, including earnings, cash flows,
dividends, interest payments, or capital gains (increases in value) during a period.
Time Pattern and Growth Rate of Returns You cannot calculate an accurate value for a security unless you
can estimate when you will receive the returns or cash flows. Because money has a time value, you must
estimate the time pattern and growth rate of returns (cash flows) from an investment.
 The theory of value provides a common framework for the valuation of all investments. Different
applications of this theory generate different estimated values for alternative investments because of
the different payment streams and characteristics of the securities. The interest and principal payments
on a bond differ substantially from the expected dividends and future selling price for a common
stock.
 Stock Valuation is more difficult than Bond Valuation because stocks do not have a finite maturity and
the future cash flows, i.e., dividends, are not specified. Therefore, we use different techniques for
stock valuation as mentioned as;
Common stock
The common stockholders are the owners of a corporation, and as such they have certain rights and privileges
as discussed in this section.
 control of the firm
 Preemptive Right
 High profit potential
 risk
TYPES OF COMMON STOCK
 Although most firms have only one type of common stock, in some instances classified stock
is used to meet the special needs of the company.
 Generally, when special classifications are used, one type is designated Class A, another
Class B, and so on.
 Small, new companies seeking funds from outside sources frequently use different types of
common stock. For example, when Genetic Concepts went public recently, its Class A stock
was sold to the public and paid a dividend, but this stock had no voting rights for five years.
 Its Class B stock, which was retained by the organizers of the company, had full voting rights
for five years, but the legal terms stated that dividends could not be paid on the Class B stock
until the company had established its earning power by building up retained earnings to a
designated level. The use of classified stock thus enabled the public to take a position in a
conservatively financed growth company without sacrificing income,
 while the founders retained absolute control during the crucial early stages of the firm’s
development. At the same time, outside investors were protected against excessive
withdrawals of funds by the original owners. As is often the case in such situations, the Class
B stock was called founders’ shares.
PREFERRED STOCK
 Preferred stock is a hybrid—it is similar to bonds in some respects and to common stock in
others.

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 The hybrid nature of preferred stock becomes apparent when we try to classify it in relation to
bonds and common stock.
 Like bonds, preferred stock has a par value and a fixed amount of dividends that must be paid
before dividends can be paid on the common stock.
 However, if the preferred dividend is not earned, the directors can omit (or “pass”) it without
throwing the company into bankruptcy. So, although preferred stock has a fixed payment like
bonds, a failure to make this payment will not lead to bankruptcy.
Equity valuation models
Because of the complexity and importance of valuing common stock, various valuation techniques
have been devised over time. These techniques fall into one of two general approaches: (1) the
discounted cash flow valuation techniques, where the value of the stock is estimated based upon the
present value of some measure of cash flow, including dividends, operating cash flow, and free cash
flow; and (2) the relative valuation techniques, where the value of a stock is estimated based upon its
current price relative to variables considered to be significant to valuation, such as earnings, cash
flow, book value, or sales
Broadly it classified in to:
 Balance- Sheet model
 Dividend discount models
 Free cash flow method
 Earning multiplier model
An important point is that both of these approaches and all of these valuation techniques have several
common factors. First, all of them are significantly affected by the investor’s required rate of return
on the stock because this rate becomes the discount rate or is a major component of the discount rate.
Second, all valuation approaches are affected by the estimated growth rate of the variable used in the
valuation technique—for example, dividends, earnings, cash flow, or sales. Both of these critical
variables must be estimated.
As a result, different analysts using the same valuation techniques will derive different estimates of
value for a stock because they have different estimates for these critical variable inputs. Put another
way, you should assume that most investors are aware of the valuation models and it is the inputs to
the models that make a difference—that is, your estimates of the discount rate and the growth rate of
earnings and cash flows. If you are better at estimating these inputs, you will be a superior analyst.
Why and when to use the discounted cash flow valuation approach
 These discounted cash flow valuation techniques are obvious choices for valuation. because
they are the essence of how we describe value—that is, the present value of expected cash
flows. The major difference between the alternative techniques is how one specifies cash
flow—that is, the measure of cash flow used.
 The cleanest and most straightforward measure of cash flow is dividends because these are
clearly cash flows that go directly to the equity investor, which implies that you should use
the cost of equity as the discount rate.
 However, this dividend technique is difficult to apply to firms that do not pay dividends
during periods of high growth, or that currently pay very limited dividends because they have
high rate of return investment alternatives available.
 On the other hand, an advantage is that the reduced form of the dividend discount model
(DDM) is very useful when discussing valuation for a stable, mature entity where the
assumption of relatively constant growth of dividends for the long term is appropriate (a good
example is the aggregate stock market).
Why and when to use the relative valuation techniques
 The benefit but also a potential problem with the discounted cash flow valuation models is
that it is possible to derive intrinsic values that are substantially above or below prevailing
prices depending on how you adjust your estimated inputs to the prevailing environment.

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 An advantage of the relative valuation techniques is that they provide information about how
the market is currently valuing stock at several levels—that is, the aggregate market,
alternative industries, and individual stocks within industries.
 The good news is that this relative valuation approach provides information on how the
market is currently valuing securities.
 The bad news is that it is providing information on current valuation. The point is, the
relative valuation approach provides this information on current valuation, but it does not
provide guidance on whether these current valuations are appropriate—that is, all valuations
at a point in time could be too high or too low.
 For example, assume that the market becomes significantly overvalued. If you were to
compare the value for an industry to the much overvalued market, you might contend based
on such a comparison that an industry is undervalued relative to the market.
 Unfortunately, your judgment may be wrong because of the benchmark you are using—that
is, you might be comparing a fully valued industry to a much overvalued market.
 Alternatively, if you compare an undervalued industry to an aggregate market that is grossly
undervalued, the industry will appear overvalued by comparison. the relative valuation
techniques are appropriate to consider under two conditions:
 You have a good set of comparable entities—that is, comparable companies that are similar
in terms of industry, size, and, it is hoped, risk.
 The aggregate market and the company’s industry are not at a valuation extreme—that is,
they are not either seriously undervalued or seriously overvalued.
BALANCE- SHEET MODEL/TECHNIQUES
Analysts often look at the balance sheet of the firm to get a handle on some valuation measures.
Three measures derived from the balance sheet are: book value, liquidation value, and
replacement cost.
 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.
 How relevant and useful is the book value per share as a measure of investment
value?
The book value per share is firmly roofed in financial accounting and hence can be established
relatively easily. Due to this, its proponents argue that it represents an ‘objective’ measure of
value. A closer examination, however, quickly reveals that what is regarded as ‘objective’ is based
on accounting conventions and policies which are characterized by a great deal of subjectivity and
arbitrariness. An allied and a more powerful criticism against the book value: measure, is that the
historical balance sheet figures on which it is based are often very divergent from current
economic value. 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. Eg. ABC company has the
following balance sheet results
The book value of ABC was $9.76 per share ($32,535 million divided by 3,334 million shares). On
that same date, ABC stock had a market price of $82.3125. In light of this staggering difference
between book and market value, would it be fair to say ABC stock was overpriced?
Dividend Discount Model

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As we have already discussed in our previous lectures, the intrinsic value of corporate security is
equal to the present value of the payment stream on the security discounted at an appropriate
discount rate
Dividend discount models are designed to compute the intrinsic value of a share of common stock
under specific assumption as to the expected growth pattern of future dividends and the appropriate
discount rate to employ. 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. For applying the dividend discount model, we
will make the following assumptions:
i. Dividends are paid annually
ii. The first dividend is received one year after the equity share is bought.
I. 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:
Po = D1/ (1+ r) + P1 (1+ r)
Where:
Po = is the current price of the equity share
D1 = is the expected dividend expected next year P1 is the price expected next
year
r = is the rate of return required on the equity share.
Let’s take an example. Assume that the equity share of a company is expected to provide a
dividend of Br 2 and fetch a price of Br 18 a year hence. At What price would it sell for now if
investors’ required rate of return is 12%?
Po = 2.0÷(1.12) + 18÷ (1.12) = Br 17.86
In summary, you have estimated the dividend at $1.10 (payable at year’s end), an ending sale price of
$38, and a required rate of return of 10 percent. Given these inputs, you would estimate the value of
this stock as follows:
II Multi-Period Valuation Model
If you anticipate holding the stock for several years and then selling it, the valuation estimate is
harder. You must forecast several future dividend payments and estimate the sale price of the stock
several years in the future.
Value of common stock=D1÷ (1+r) + D2÷ (1+r) 2
+ p÷ (1+r) 2
Example: an investor plans to hold a stock for 2 years. The company expects to pay its shareholders
common equity, Br 0.25 per share over the next two years. The investor anticipates that a stock will
close the end of that time period at Br 40 per share. Given a rate of return 10%, what is the value of
the stock having two year time period?
Vs = 0.25÷ (1.1) + 0.25÷ (1.1)2
+ 40 ÷ (1.1)2
= Br 33.5
III Infinite Period Model
Zero growth Model
A special case of the constant growth model calls for an expected growth rate, g, of zero. Here
the assumption is that dividends will be maintained at their current level forever.

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The dividend per share is expected on the current market price per share. The amount of dividend
does not grow. This is the fixed amount of dividend.
D0 = D1 = D2 = D = Constant
In this case, the model reduces to perpetuity.
If we assume that the dividend per share remains constant year after year at a value of D, the
equation becomes
Vs = D/ r
It means that the present value interest factor of perpetuity is simply 1 divided by the interest rate
expressed in decimal form. Hence, the present value of the perpetuity is simply equal to the
constant annual payment divided by the interest rate. For example, the present value of a
perpetuity of Rs 10,000 if the interest rate is 10%will be equal to: 10,000/ 0.10 = Rs 1,00,000.
The reason is that an initial sum if invested at a rate of interest of 10% provides a constant annual
income of Rs 10,000 forever without any impartment of the capital value. The no-growth case is
equivalent to the valuation process for preferred stock because dividend amount remains
unchanged.
Note: This is a straightforward application of the present value of perpetuity formula.
Let’s take at an example: Hindustan Manufacturing Ltd. Has distributed a dividend of Br. 30 on
each Equity share of Br 10. The expected rate of return is 35%. Calculate current market price of
share substituting in the formula;
Vs = 30/ 0.35 = Br 85.71
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. This condition fits many established firms, which tend to grow over the
long run at the same rate as the economy, fairly well.
Here:
Value of stock = D1/(r-g)
Let’s take another example to understand the constant growth model. 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 Br 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) = Br 25
Investment Decision Process:
To ensure that you receive your required return on an investment, you must estimate the intrinsic
value of the investment at your required rate of return and then compare this estimated intrinsic value
to the prevailing market price. You should not buy an investment if its market price exceeds your
estimated value because the difference will prevent you from receiving your required rate of return
on the investment. In contrast, if the estimated intrinsic value of the investment exceeds the market
price, you should buy the investment. In summary:
 If Estimated Intrinsic Value > Market Price, Buy or Hold it if you Own It.
 If Estimated Intrinsic Value < Market Price, Don’t Buy or Sell it if you Own It.
For example, assume you read about a firm that produces athletic shoes, and its stock is listed on the
NYSE. Using one of the valuation models we were discuss and making estimates of the earnings, or
cash flows, and the growth of these variables based on the company’s annual report and other
information, you estimate the company’s intrinsic stock value using your required rate of return as
$20 a share. After estimating this value, you look in the paper and see that the stock is currently
being traded at $15 a share. You would want to buy this stock because you think it is worth $20 a
share and you can buy it for $15 a share. In contrast, if the current market price were $25 a share, you

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would not want to buy the stock because, based upon your valuation, it will cost more than you
estimate it is worth—it is overvalued.