Shares and Their Valuation

8/10/2019 Shares and Their Valuation

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Shares and their valuation

Explaining the features of equity

Determining the value of equity shares Providing insights to the Dividend Discount

Model (DDM) and its variants

Explaining the impact of growth on the valueof equity shares

Source: Financial Management-Rajiv

Srivastava Prof. IIFT, Anil Misra, Asso.Prof.MDI & Brealey Myers


2/87

Shares and their valuation

Establishing the relationship between returns

expected by shareholders and growth estimate

Explaining the meaning of P/E multiple and how it

can be used in valuation of equity

Presenting the efficient market hypothesis and

explaining the various forms of market efficiency

Explaining the implications of efficient markethypothesis on the fundamental valuation,

technical analysis, and for portfolio managementSource: Financial Management-Rajiv



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Features of equity

Equity shares are characterized by-

a) Ownership and management

b) Entitlement to residual cash flowsc) Limited liability

d) Infinite life and

e) Substantially different risk profile




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Issues in valuation of equity

Infinite life, uncertain return and substantially

different risk profile makes valuation of equity

difficult

Listing and trading on the exchanges provide

an exit route to investors

One investor gets replaced by another

The value of such replacement takes place is

the key issue in share valuation




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Issues in valuation of equity

In valuation of equity shares one does not

know the discount rate that is appropriate.

It is a financial instrument characterized by

indefinite life with the owner of the

instrument bearing total responsibility for

managing the business and entitled to only

the residual that is unknown.




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Methods of valuationDividend

Discount Models - SINGLE PERIOD

Dividend discount model for valuation of

equity is an extended application of the

concept of time value of money.

Two important inputs for valuation of equity

share are

(a) the cash flows attached to the equity

(b) the discount rate that is appropriate for

finding present value of the cash flows




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Methods of valuationdividend

discount models - SINGLE PERIOD

As compared to bonds equity valuation is

difficult because cash flows of equity last for

indefinite period of time, unlike bond cash

flows end with the redemption.

Debt has a definite life, but equity lasts

forever

Cash flows attached with equity are uncertain




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Investor holds on to the asset for one period

the current price of the equity share, P0 is

equal to the dividend expected during the

holding period, D1 and the price of the asset at

the end of the holding period P1




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+ + (Eq:1)

Here the current price is a function of :

the dividend expected in next period

The expected price of the share at the end of the period

The return expected by the investor, all of which must be

projected Eq:1 is more of a justification for the current price rather

than its determination




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CASE:

The equity owner of a firm ABC limited need a return of12%. The current performance of the firm leads to abelief that a dividend of Rs.5 would be paid and after a

year the price of the share would be Rs.20.a) If the current price of the share is Rs.22. do you think

the share is worth buying

b) How do you justify that the positive return would be

generated despite the price falling to Rs.20 after ayear?

c) What maximum price do you think that the investorshould pay today for a share of ABC Ltd?




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The current price of the share using Eq:1 that wouldprovide a return of 12% is Rs. 22.32.

(a) The current price of the share is Rs.22 and buying atthis price would provide a return in excess of desiredrate of 12%. Hence the share is worth buying

(b) Despite falling price, the returns are in excess of 12%due to cash flows of dividend of Rs. 5. this more thancompensates the loss in value.

(c) The maximum price that can be paid for the share isRs. 22.32. any price above Rs. 22.32 would result inlesser than required return of 12%.




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Dividend yield and capital gain Eq:1 may be re-arranged to express the return in

the form of dividend yield and capital gains. Dividend yield is the return provided by dividend

due to ownership of share.

Capital gain is the result of difference in price

Over the investment P0 the investor would havethe dividend of D1 and the capital gain of P1-P0.the following equation gives the return

r = Eq:2Dividend Yield + Capital Gain




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Required rate of return

CASE:

The share price of Reliance Industries Limited

is currently trading at Rs.700. financial

analysts have projected a price of the share at

Rs. 800 at the end of the year during which a

dividend of Rs.25 is also expected. What rate

of return is implied by the market for Relianceshares?




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Required rate of return

By using the Eq: 2 the return is expected to be

17.85%.

The return consists of 3.57% of dividend yield

and 14.28% of capital gains.




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Share price and Growth

Some times it is easier to project the growth

in the share price rather than its absolute

estimate. Given the growth in share price g

Eq:1 and Eq:2 may be modified to incorporatethe growth.

we can estimate the share price with the help

of:




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( )

( ) ( )

( )

By rearranging we get,

()

Eq:3

and

Eq:4Source: Financial Management-Rajiv



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CASE:

The earnings of Indian Jet Airlines have beengrowing at 10% for the last 3 years and the same

growth is expected to continue in future. Thedividends and the share price too have beenconsistent with the growth in earnings. Last yearthe firm paid a dividend of Rs.10. if investors

expectation from the firm is a return of 20% whatdo you think is the worth of the share of Indian JetAirlines?




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The last yearsdividend is Rs.10. the expected

dividend for next year D1

if assumed to grow

at 10% would be Rs.11 (10X1.10).

The worth of the share today is Rs. 110.

0 1/( ) (10 1.10)/(0.20 0.10)




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discount models - MULTI-PERIOD

According to dividend discount model (DDM) thecurrent price of the equity share is equal to thepresent value of the infinite stream of dividendexpected.

To calculate the price of the share if the holdingperiod extends beyond one, Eq:1 may bereproduced for the price at the end of period 1.

Just as the current price P0 is given by dividend

and price of period 1, P1 depends upon dividendin Period 2 and price at the end of Period 2.

Mathematically this can be expressed as:Source: Financial Management-Rajiv



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Substituting the value of P1 in Eq:1

+

+

+




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Similarly the price at the end of Period 2, P2 can beexpressed as:

Again substituting the value of P2 and continuing inthis fashion for indefinite period of time, thedividend discount model for equity share price is asgiven in Eq:5




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The dividend discount model for equity share is as:

+ + + + Eq:5

Alternatively, for indefinite period of time this maybe abbreviated as:

+

Eq:6Source: Financial Management-Rajiv



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The dividend discount model is a manifestation of

the discounted cash flow approach.

It conforms to the idea that the value of any asset is

equal to the discounted cash flows attached to it.

The owners of equity shares are entitled to the

reward of dividend for as long as they want to hold

on to the investment, and the price paid by theinvestor would be equal to the discounted value of

the dividends on the share.




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To value the current price of the equity sharewe need to estimate the dividend that wouldbe distributed over infinite period of time ;

indeed an impossible task The valuation of equity as given by Eq:6 is

known as the dividend discount model:




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VARIANTS OF DDM

CONSTANT DIVIDENDNO GROWTH

Value of equity needs projection of dividend for infiniteperioda requirement difficult to fulfill.

Shareholders would see business grow and, therefore,the dividends grow with time.

We make an extremely simplifying assumption ofconstant amount of dividend in each period, i.e.,dividends are constant in each period and do not varyor grow with time.

If the dividend for all times to come is assumedconstant, then the current price of the share is simplythe current dividend divided by the capitalization rate.

Eq: 5 can be rewritten as :




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VARIANTS OF DDM


+ + + + Eq: 7This is further simplified as

Eq: 80 +

+

+

+ (a)

Multiplying the above Equation (a) by (1+r), we get

1 0 + + + + + ++ + (b)

Subtracting (a) from (b) and rearranging, we get

0 Source: Financial Management-Rajiv



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VARIANTS OF DDM


The simplest of valuation model as given in Eq: 8states that the value of equity is given by theexpected dividend divided by the expected discountrate.

For example, if the expected dividend on a share isRs. 5 and the expectation of the returns on theinvestor is 10%, then the expected price would beRs. 50.

Stated differently, if one buys the stock for Rs. 50,he/she would receive a return of Rs. 5 that is 10%on the investment made.




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VARIANTS OF DDM


DDM incorporates only dividend in thevaluation of equity and leads to a belief that itignores the capital appreciation on the prices.

It is a misconception because the formulationhas been done for infinite life and it merelyreplaces the future price in terms of dividend.

The price of the equity at any point of timeshall be driven by the dividends subsequent toinvestment, i.e, the expected dividend




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VARIANTS OF DDM


The past dividends are immaterial to the price.

An investor who decides to sell the equityafter holding for 4 periods when the price of

the share is P4.

The price P0 then can be stated as:




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VARIANTS OF DDM


P0= + + + + + Eq: 8 (a)

Here again the price P4 can be said to be equal to the

dividends accruing from period 5 onwards and expressedas:

+ +

+

+

+ ++

+ Eq:8 (b)

Replacing the value of P4 in Eq: 8 (a) would lead to Eq:7 i.e.,




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VARIANTS OF DDM

CONSTANT DIVIDENDCONSTANT GROWTH

It is difficult to assume that the dividend ofthe firm would remain constant.

Investors choose to invest in equity because of

the growth anticipated in the earnings and thedividends

Recognizing the growth and again making a

simplifying assumption that dividend grow ata continuous rate of g, Eq: 5 can be restatedas:




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VARIANTS OF DDM


+ +

+ +

+ +

+

+

+ +

+ Eq:9




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VARIANTS OF DDM


Here dividend in next period is D. for convenience, wemay denote it by D1, the dividend period in period 1.

The dividend in subsequent period 2 is D1*(1+g), andin period thereafter is D1*(1+g)*(1+g) =

,

and so on.

Upon simplification Eq:9reduces to:

: 3 Eq: 10 The expected rate of return would be:

Eq: 11Source: Financial Management-Rajiv



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VARIANTS OF DDM


Valuation model as per Eq: 11 states that the

expected returns are given by the dividend

yield and growth expected.

For example, if the dividend expected in the

next period is Rs. 2 and is expected to grow at

10% while the stock trades at Rs. 50 then the

expected return is 14% (4% dividend yield+10% growth)




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Implications of DDMexpectations

cannot be less than growth

Constant dividend growth model, known as GordonModel, is the same as discounted cash flow approach.

This applies only when g


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Implications of DDMthe price grows

as much as dividend

The model also implies that the price of the

stock grows at the same rate of growth as for

dividends.

For example, assume that a firm is expected to

pay a dividend of Rs. 20 in the next period.

With the expected return of 20% and assumed

growth of 15%, the stock price would beRs.400. (Eq: 10)


Srivastava Prof. IIFT, Anil Misra, Asso.Prof.

MDI & Brealey Myers


37/87

Implications of DDMthe price grows

as much as dividend

The price of Rs.400 must grow by 15% to

Rs.460 at the end of the period. This is

confirmed by using Eq:3

20 1.150.200.15 . 460Source: Financial Management-Rajiv


MDI & Brealey Myers


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Implications of DDMdifferent

growth estimates cause price volatility

To some extent the model provides an

explanation for the divergent opinions of

financial analysts regarding valuation of the

same share.

For example, an analyst may value a stock at

Rs. 400 based on expected dividend of Rs. 20,

expected return of 20%, and growth of 15%.



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Implications of DDMdifferent

growth estimates cause price volatility

However another analyst disagreeing with the

first one may estimate the growth at 18% and

value the same stock at Rs.1000, i.e., 2.5 times

the earlier valuation, since the sensitivity ofthe value with respect to estimated growth is

very high, any small revision in the growth

potential explains the wild movements in thestock price.



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Implications of DDMstock pays no

dividend too has value

According to DDM the price of non-dividendpaying stock must be Zero.

In fact, all stock, irrespective of whether the

dividend is paid or not, have some marketvalue.

One plausible explanation for non-zero priceof share that does not pay dividend is theassumption that it is the expectation ofdividend that drives the price .



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Dividend and growth

Under constant growth model we assumed aconstant growth in dividend without botheringabout the source of dividend growth.

Another convenient assumption was thedistribution of all the earnings in the form ofdividend.

To propel growth a firm needs funds, which, it

must get by retaining a part of the earnings anddeploying them into assets that provide growth inearnings.



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Dividend and growthwould a cut in dividend

result in decline in the price of the share?

To fund growth, the firm must necessarilycurtail dividend.

A mere look at the DDM would lead to an

inference that cut in dividend leads to declinein price of the share.

However, it is not necessarily so.

Impact on share price would depend on thesuccessful deployment of retained earnings bythe firm.



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CASE: Assuming a firm presently earns Rs. 20 per share,

which it distributes entirely to its shareholders,implying that the growth rate of dividend is zero.

Further assume that the required rate of returnsby the shareholders is 20% and , therefore theprice of the share is Rs.100., as constant flow ofRs. 20 as dividend each year provides a 20%

return. The DDM provides the value of the share at

Rs.100 using Eq:4 with g=0.



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Now, company has some business opportunitiesavailable for providing growth to the earningsand hence add to the shareholders wealth.

Consider three options A, B and C.

Option A is an opportunity to make productcalled Square that provides a return of 25%.

Option B is an expansion of the project forexisting products and would give return 20%

Option C is to produce low technology productcalled Round that would generate a return of15%.



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For simplicity of understanding, we assumethat all the projects are scalable, mutuallyexclusive and would only be funded through

equity. The alternative available to fund any of the

projects is to reduce dividend pay out to 50%.

This means the dividend would be curtailedfrom existing Rs.20 per share to Rs.10 pershare.



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The retained part of the dividend would beused to fund the selected projects and providegrowth in future dividends.

That must enhance the price. Value of the share is closely linked to the

growth opportunities available with the firm,the re-investment rate, the shareholdersexpectations and proportions of earningsretained in the business.



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Under the three different projects, the growth

provided depends upon

(a) How much earnings have been

retained, denoted by b.

(b) The return on equity offered by the

project, ROE.



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For the three projects the dividend growthprovided is :

For Square : g = b*ROE = 0.50*25% = 12.5%

For Expansion : g= b*ROE = 0.50*20%=10.0%

For Round: g=b*ROE = 0.50*15%=7.5%

Current status is as follows:

Dividend (in Rs.) = 20Expected return = 20%

Return on Equity = 20%

Current price, P0 = D/r = 20/0.2 = Rs.100Source: Financial Management-RajivSrivastava Prof. IIFT, Anil Misra, Asso.Prof.

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Options Square Expansion Round

Dividend (Rs.) 10 10 10

Expected Return, r 20% 20% 20%

Return on Equity(ROE) 25% 20% 15%

Growth rate, g =

b*ROE

(b= retention

ratio=50%)

12.5% 10.0% 7.5%

New share price 0 1 0 1 0

1

Rs.133.33 Rs.100 Rs.80Source: Financial Management-RajivSrivastava Prof. IIFT, Anil Misra, Asso.Prof.

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The value of the share would rise if the firmaccepted the Square project, remain the same ifthe Expansion of the existing selected and fall ifthe Round project was implemented.

Square offered return in excess of required. In case of expansion project, the price remained

same because the return offered by the projectwas exactly equal to expected rate of return

In case of Round, the price declined because thereturn offered by the project was less than theexpected return



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P t l f th t iti


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Present value of growth opportunities

(PVGO)

If the retained earnings of the firm are

redeployed at a rate higher than expected any

announcement of dividend policy in favor of

retention would be greeted positively.

For example, if the firm decided to retain 75%

instead of 50% to implement Square, the

share price would further jump to Rs.400(5/0.20-0.1875)



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P t l f th t iti


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Present value of growth opportunities

(PVGO) Share price is the sum of the value of the firm already in

place, the value with zero growth and the present value ofthe growth opportunities.

Value of the share = No growth value + PV of growthopportunities

Eq: 12 in case of Round, the value of the share would decline since

the present value of the project is negative (the projectoffers only 15% against the expected rate of 20%) that

brings down the price. If there are no growth opportunities then the value of the

share is earnings, E1 discounted at r.



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DDM MULTI STAGE GROWTH


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DDMMULTI-STAGE GROWTH

MODELS

Value based on the constant growth of dividend is agreatly simplifying assumption that helps explain someof the complex phenomena of valuation.

It also explains the reasonable extent why the prices

change as they do A more reasonable and realistic assumption would be

to assume high growth during the initial few years, asopportunities for extraordinary growth are availableonly for limited time.

Slowly there opportunities dry up and firms startregistering a rather normal growth consistent with restof the economy.



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MODELS

The price of the share is equal to the present

value of cash flows.

we segregate the cash flows of the firm in two

distinct phaseshigh growth phase lasting for

n years and normal growth phase continuing

thereafter.

The cash flows of the firm can be representedas:



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MODELSTWO STAGE

[ + ++ +

+ +

+ ]+

High Growth Phase of n years

Normal Growth



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MODELSTWO STAGE

Where D1 represents dividend expected in

next period 1, g1 represents the high-growth

rate lasting for n years, and Pn is the price of

the share at the end of high-growth period.



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MODELSTWO STAGE

CASE:ABC limited, an IT firm, is having a current level ofearnings of Rs.10 per share. Due to extremely goodprospects and opportunities in this field, the firm is

experiencing a high growth phase and therefore, paysonly 25% of its earnings as dividend and retained thebalance. ABC limited is expected to register a high growthof 20% over the next 5 years. Thereafter the growth inearnings is expected to settle down at 6%-- the rate at

which the economy is growing. Investors of ABC Ltdexpect a return of 15%. To find the current value of theshare, by applying the dividend discount model.



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MODELSTWO STAGE

Project the dividend separately for each of the

next five years at 20% growth and thereafter

applying a constant growth of 6%, using a

discount rate of 15%.

Current level of dividend, D0= Rs. 2.50

Dividend expected in the next period

D1= (1+g) *D0 = 1.20 *2.50 = Rs.3.00



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MODELSTWO STAGE Assuming 20% growth for 5 years, the value of the share can be

estimated as:

0 .+. . +.

+. +. +.

+. +. +.

+. +. +.

+. +

+.

=..

.. +

.. +

.. +

.. +

.

=2.61+2.72+2.84+2.96+3.09+ .

This value is equal to the present value of all dividend streams fornext five years growing at 20% and discounted at 15% PLUS theprice of the share expected at the end of period 5.



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MODELS-TWO STAGE

The price at the end of period 5, P5 may be obtainedfrom constant growth model with the assumption ofnormal growth at 6%.

With dividend expected in period 6 at Rs. 6.22 (1+0.06)

the price expected is: P5 =

=

. +... .73.27

This price must be discounted back in todays terms at15% discount rate, which gives the price of ABC as Rs.

50.65. P0 = 2.612.722.842.963.09(.. )=

50.65Source: Financial Management-Rajiv


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MODELSTHREE STAGE

A number of valuation models are based on thepremise that the growth rate will taper offeventually.

The transition might be from a present above

normal growth rate one that is considered normal.If the dividends per share expected to grow atnormal growth rate to one that is considerednormal.

If the dividends per share were expected to grow ata 14% compound rate for 10 years and then grow ata 7% rate. The equation would become



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MODELSTHREE STAGE

0 0 1.14

1 10(1.07)

1

=

=

Note that the growth in dividends in the second

phase uses the expected dividend in period 10

as its foundation. Therefore, the growth-term

exponent is t-10,which means that in period 11 itis period 1, in period 12 it is 2, and so forth.



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MODELSTHREE STAGE

In the three phase example, suppose the

present dividend is Rs.2 per share and the

present market price is Rs.40. therefore,

.40 . + .

+ .

+ ===



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MODELSTHREE STAGE

In multiphase growth situation like this, solving for therate of return that equates the stream of expectedfuture dividends with the current market price isarduous.

Start by employing the middle growth rate in aperpetual growth model to approximate the actual r.

With an initial growth of 14%, the expected dividend atthe end of year 1 is Rs.2.00(1+1.14)^1 = 2.28.

Using perpetual growth rate (Eq:11 )r r= . 11% 16.7%

Employ 16 % as a starting discount rate:Source: Financial Management-Rajiv


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MODELSTHREE STAGE

Phase 1 and Phase 2: present value of the

dividend received over first 10 years with a

growth rate of 14% and 11%.

The expected rate of return that equates the

stream of expected future dividends with the

market price is approximately 15%



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MODELSTHREE STAGE

Process for finding the value of a supernormal growthstock:

(a) Estimate the expected dividends for each year duringthe period of non-constant growth

(b) Find the expected price of the stock at the end of thenon-constant growth period, at which point it hasbecome a constant growth stock

(c) Find the present values of the expected dividendsduring the non-constant growth period and the

present value of the expected stock price at the endof the non-constant growth period. Their sum is theintrinsic value of the stock, P0



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MODELSTHREE STAGE

For any stream of expected future dividends,

we can solve for the rate of discount that

equates the present value of this stream with

the current share price. If enough computations are involved, it is

worthwhile program a computer algorithm.



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DDM MULTI-STAGE GROWTH


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MODELSTHREE STAGE

Approximation Model for Three-Phase Growth

RusselJ. Fuller and Chi-Cheng Hsia, A simplified

Common Stock Valuation Model,Financial Analysts

Journal, 40 (September-October 1984),40-56.has derived an approximation formula for

determining the required rate of return when the

dividend discount model involves three phasesgrowth.

They call their formula the H model.Source: Financial Management-Rajiv


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MODELSTHREE STAGE

RusselJ. Fuller and Chi-Cheng Hsiasuggested the following model to calculate intrinsic value ofthe share

0

0

1

gabeginning growth rate

gn-long-run growth rate

Hhalfway point for the period of above normal growth rate

0 ... 10.07 5 0.140.07 =40.57



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MODELSTHREE STAGE

H model has several pleasing features.

There are no exponential terms; solving for P0

involves only simple arithmetic.

To solve analytically for the discount rate,

rearrange the equation as follows

0

0 1



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MODELSTHREE STAGE

D0= Present dividend per shareP0=Present Market price per share

gn= Long-run growth rate in final phase

H = halfwaypoint for the period of above normal growth rate

ga= Growth rate in phase 1For our previous example, the formula is expressed as:

00 1

240 1 0.07 5 0.14 0.07 0.07 14.97%Source: Financial Management-Rajiv


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Other approaches to value the shares-


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Other approaches to value the shares

Book value approach

This approach uses the Book Value Per Share(BVPS) as the basis of valuation of shares.

The BVPS is the net worth (equity capital plus

reserves and surplus) divided by the numberof outstanding equity shares.

Alternatively, the BVPS is the amount pershare on the sale of the assets of the companyat their exact book value minus all liabilitiesincluding preference shares.



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Book value approach

CASE:Total assets of Alert Company is Rs. 60 crore, totalliabilities including preference shares of Rs. 45 crore and10,00,000 shares. Calculate the book value of the share.

Solution:Book value = 15 crore/10,00,000= Rs. 150

The BVPS is not a good proxy for true investment value.

This approach relies on historical balance sheet data.

It ignores the expected earnings potential.

BVPS has no true relationship to the market value ofthe firm



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Liquidation value approach

This approach to valuation of shares is based on the liquidation valueper share

LVPS=(value realized from liquidating all assets)-(amount to be paid to all creditors and preferenceshareholders)/number of outstanding shares

LVPS is more realistic measure than book value. But it ignores theearnings power of the assets of the firm

It is difficult to estimate the liquidation value of going concern



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Price/Earnings (P/E) Multiples Ratio

The price earnings based approach is extremely popularamong other valuation techniques.

=()

Some analysts believe that the current market pricediscounts not the present earnings but future earningstoo, rely more on another ratio called leading P/E ratio.

It is calculated on the basis of expected earnings in the

next period

=()



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P/E multiple and growth:

The P/E ratio of the firm is said to represent its

growth prospects.

0 1 1 1 Or

01 1 Source: Financial Management-Rajiv


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Price/Earnings (P/E) Multiples

CASE:Multi-products limited has been following adividend payout of only 20% so that the fundsneeded for the growth of the firm targeted at 10%

is retained., the market expectations of return are12%.

a) At what rate the market is discounting thecurrent and future earnings of company?

b) If the current level of earnings are Rs.10 pershare at what price the shares of the firm arebeing traded?



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79/87



Retention ratio, b = 80%

Required return, r = 12%

Growth rate, g = 10%

P/E ratio based on current earnings

=

...= Rs. 10 (E0)

P/E ratio based on expected earnings (E1)

10(1+0.10) = Rs.11Source: Financial Management-Rajiv


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Current earnings, E0 = 10.00

Growth rate, g = 10%

Required return, r = 12%

Expected Earnings, E1 = Rs. 11.00

Retention ratio, b = 80%

Price = = ... = Rs. 110



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CASE:

Consider two firms namely slow growth and

fast growth with same earnings at Rs.10 per

share and same dividend of Rs.5 per share.

Slow growth offers a growth of 5% while fast

growth has opportunities to grow at 15%.

The expected return by investors is 20%



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Slow growth Fast growth

Earnings (Rs. per share) 10 10

Dividend (Rs. per share) 5 5

Market Capitalization (%) 20 20

Growth Potential (%) 5 15

Value of the share (Rs.) 5/(0.20-0.05) = 33.33 5/(0.20-0.15) = 100.00

Dividend yield 5/33.33 = 15% 5/100 = 15%

Capital gain = growth 5 15

P/E ratio 33.33/10 =3.33 100/10 = 10.00



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Price/Earnings (P/E) Multiple

P/E reflects a composite measure of dividendpolicy, retention ratio, b; re-investment rate, k;and market expectations r

The P/E would increase if kand bincrease as long

as k>r If the market places a higher value on the firm, it

is reflected in its P/E multiple.

The firm has the capability to re-invest the funds

at a rate higher than what the investors can do bythemselves and this value would be higher if theretention ratio is increased.



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A higher value of r translates into a lowervalue of P/E multiple.

Effectively it means that earnings would be

more volatile if discounted at higher rate,reflecting the increased risk with cash flows.

Firms with more stable cash flows would have

higher P/E multiple.



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Riskier firms have low P/E multiple while firmswith stable cash flows have higher P/E multiple.

Valuation based on P/E ratio is extremely popularand often provides a basis of comparison of firmswithin the same industry. The management andinvestors confidence can be measured by the P/Emultiple.

All other things remaining constant, a higher P/Emultiple means greater confidence reposed bythe market in the management of the firm.



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Price/Earnings (P/E) MultiplesThe P/E approach follows these steps in valuing a share:

Find out the industry of the firm whose shares are to be valued

Find the P/E multiple of the industry

Project the relative position of the firm in the industry into broadclass of good, average, and below average

Project the earnings of the firm

Project the value of the asset by using the appropriate multiples

Example: a firm in the cement sector has estimated earnings of Rs.10 per share. The average P/E multiple of the cement sector asreflected in the data obtained from the market is 5.25.

Therefore value of the share = 10*5.25 = 52.50



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Application

Analyze the dividend of a public limited companyfor the last 10 years. Project the growth individend and then apply dividend discount modelwith constant growth to project its price for the

next year. Collect the 10-year earnings, dividends and other

financial data for any five companies. Usealternative approaches to value the shares of

these companies. How have these companiesperformed in terms of market values and P/Eratios?

Documents

Shares and Their Valuation