The presentation slide is on stock valuation. We have tried to present the various techniques to stock valuation under which different methods are discussed with illustrations. Key concepts:
Zero Growth Model
Balance sheet Technique
Constant Growth Model
Two-stage growth Model
Feel Free to comment.
2. Introduction
Capital
The long-term funds of a firm ; all items on the right-hand side of the firm’s balance sheet,
excluding current liabilities.
Debt Capital
All long-term borrowing incurred by a firm, including bonds.
Equity Capital
The long-term funds provided by the firm’s owners, the stock-holders.
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3. Stock
• Common Stock represents shares of ownership in a corporation and stockholders claim
dividends on a portion of profits.
• Investors get right to elect the board members, who oversee the major decisions made
by management.
In case of insolvency and bankruptcy, common shareholders are the last one to recover the
money.
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4. Stock
• Preferred Stock is hybrid instrument with some degree of ownership in a company but
doesn’t come with the same voting right.
• Preferred Share investors are usually guaranteed a fixed dividend forever.
Preferred shareholders are paid off before he common shareholders during insolvency and
bankruptcy.
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5. Common Stock Valuation
A share of common stock is more difficult to value in practice than a bond because:
• Common Stocks do not have promised cash flows in advance.
• The life of investment is essentially forever because common stock has no maturity.
• There is no easy way to observe the rate of return that market requires.
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6. Common Stock Valuation
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Techniques Methods
Balance Sheet Techniques • Book Value
• Liquidation Value
Discounted Cash Flow Technique • Dividend Discount Model
• Free Cash Flow Model
Relative Valuation Technique • Price Earning Ratio
• Price-Book Value Ratio
• Price Sales Ratio
7. Balance Sheet Techniques
Book Value
The book value per share is simply the net worth of the company divided by the number
of outstanding equity share.
Book value per share =
𝐍𝐞𝐭 𝐖𝐨𝐫𝐭𝐡
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠 𝐬𝐡𝐚𝐫𝐞
Illustration:
The net worth of the Company A is Rs. 27 million and the number of outstanding equity
share of Company A is 2 million. What is the book value per share of the Company A?
Solution: Net worth of the company = Rs. 27 million
No. of Outstanding Shares = 2 Millions
Book Value Per Share =
27 million
2 millions
= Rs. 13.50
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8. Balance Sheet Techniques
Liquidation Value:
Liquidation value is the total worth of company’s asset if it were to go out of business and
assets sold.
𝐋𝐢𝐪𝐮𝐢𝐝𝐚𝐭𝐢𝐨𝐧 𝐕𝐚𝐥𝐮e
=
Value realised from liquidation of all the assets − Amount to be paid to all the creditors and preference shareholder
Number of outstanding equity shares
Illustration: Value Realised from liquidation of assets = Rs. 45 million
Amount to be paid to creditors = Rs. 18 million
Outstanding equity share = 1.5 millions
Liquidation Value =
45−18
1.5
= Rs. 18.00/share
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9. Discounted Cash Flow Technique
Cash Flows Valuation: The value of a share of common stock is equal to the present
value of all the future cash flows(dividends) that it is expected to provide over an
infinite time horizon.
𝑷𝒐 =
𝑫𝟏
(𝟏+𝑲𝒔) 𝟏 +
𝑫𝟐
(𝟏+𝑲𝒔) 𝟐 +
𝑫𝟑
(𝟏+𝑲𝒔) 𝟑 + ⋯ +
𝑫
(𝟏+𝑲𝒔)
Po = Value of common stock
Dt = Per share dividend expected at the end of year t
Ks = Required return on common stock
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10. Common Stock Valuation
Cash Flows Valuation: Illustration
You want to sell a stock after one year. You predict the stock will worth Rs. 70 at that time with
dividend of Rs. 10 per share at the end of the year. If the required rate of return is 25%, then what
is the value of share? (Single Year Calculation)
Solution: Total Expected Cashflow =Rs. 80
Required rate of return = 25 %
𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐬𝐭𝐨𝐜𝐤 =
𝐂𝐚𝐬𝐡 𝑭𝒍𝒐𝒘
(𝟏+𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧)
=
(70+10)
(1+.25)
=
80
1.25
= Rs. 64
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11. Gordon Growth Model
Zero Growth Model assumes that dividend stay the same year in and year out, and they are
expected to do so in the future. This is simply the capitalized value of its annual dividends.
𝐏𝐨 =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬
𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧
Po = Value of a share of stock
Illustration: If a stock paid a (constant) dividend of Rs. 80 a share and one wanted to earn 8% on the
investment. What will be the value of the stock?
Solution: Annual Dividend = Rs. 80
Required Rate of Return = 8%
Value of share of stock =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬
𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧
=
𝟖𝟎
𝟎.𝟎𝟖
= Rs. 1000
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12. Gordon Growth Model
Constant growth Model: Here we assume that the growth rate will remain same and the
dividend grows at a constant rate
𝑷𝒐 =
𝑫𝟏
(𝟏+𝒓) 𝟏 +
𝑫𝟏(𝟏+𝒈) 𝟏
(𝟏+𝒓) 𝟐 +
𝑫𝟏(𝟏+𝒈) 𝟐
(𝟏+𝒓) 𝟑 +……..+
𝑫𝟏(𝟏+𝒈) 𝒏
(𝟏+𝒓) 𝒏+𝟏 +………
The above formula simplifies to :
𝑷𝒐 =
𝑫𝟏
𝒓 − 𝒈
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13. Gordon Growth Model
Illustration: Company A’s is listed at $40 per share. Furthermore, Company A requires a rate of
return of 10%. Currently, Company A pays dividends of $2 per share for the following year which
investors expect to grow 4% annually. Thus, the stock value can be computed:
𝑷𝒐 =
𝟐
𝟎.𝟏−𝟎.𝟎𝟒
𝑷𝒐 = $33.33
This result indicates that Company A’s stock is overvalued since the model suggests that the
stock is only worth $33.33 per share.
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14. Two Stage Growth Model
Extension of Constant growth Model: The two-stage dividend discount model requires very little
information to calculate. All that is needed is the anticipated dividend payment one year from the
current date, the required rate of return, and the anticipated dividend growth rates.
𝑷𝒐 = [
𝑫𝟏
(𝟏+𝒓) 𝟏 +
𝑫𝟏(𝟏+𝒈𝟏) 𝟏
(𝟏+𝒓) 𝟐 +
𝑫𝟏(𝟏+𝒈𝟏) 𝟐
(𝟏+𝒓) 𝟑 +……..+
𝑫𝟏(𝟏+𝒈𝟏) 𝒏−𝟏
(𝟏+𝒓) 𝒏+𝟏 ] +
𝑷𝒏
(𝟏+𝒓) 𝒏
The above formula simplifies to :
𝑷𝒐 = 𝑫𝟏[
𝟏−{
𝟏+𝒈𝟏
𝟏+𝒓
} 𝒏
𝒓−𝒈𝟏
]+[
𝑫𝟏(𝟏+𝒈𝟏) 𝒏−𝟏 (𝟏+𝒈𝟐)
𝒓−𝒈𝟐
] [
𝑷𝒏
(𝟏+𝒓) 𝒏 ]
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15. Gordon Growth Model
Illustration: The current dividend on an equity share of x is 2. x is expected to enjoy an above
normal growth rate of 20% for 6 years. Thereafter the growth rate will fall and stablise at 10%.
Equity investors require a return of 15%. What is the intrinsic value of x’s equity share?
g1 = 20%
g2 = 10%
n= 6 years
r = 15 years
Answer= 70.76
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16. Relative Valuation Technique
Price Earning Ratio: PE Ratio is the relationship between a company’s share price and earning
per share (EPS)
Price Earning Ratio =
𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐬𝐭𝐨𝐜𝐤
𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐏𝐞𝐫 𝐒𝐡𝐚𝐫𝐞
Illustration: Current Market Price of the Stock of A Ltd. = Rs. 90
Earning Per Share = Rs. 9
Price Earning Ratio =
90
9
= 10
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17. Relative Valuation Technique
Price to Sales Ratio: Price to Sales Ratio compares the price of a share to the revenue per share.
Price to Sales Ratio =
𝐏𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
Price to Sales Ratio =
𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩𝐢𝐭𝐚𝐥𝐢𝐳𝐚𝐭𝐢𝐨𝐧
𝐒𝐚𝐥𝐞𝐬 𝐑𝐞𝐯𝐞𝐧𝐮𝐞
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