Company Vs Stock

Company & Economy Growth company Speculative company Defensive Company Cyclical Company Stock & Market Growth stock Speculative stock Defensive stock Cyclical stock

Dr Raju Indukoori

Growth Company Vs Growth Stock

Growth stocks are not necessarily shares in growth companies
A growth stock has a higher rate of return than other stocks with similar risk Superior risk-adjusted rate of return occurs because of market under-valuation compared to other stocks

Studies indicate that growth companies have generally not been growth stocks

Dr Raju Indukoori

Defensive Company Vs Defensive Stock

Defensive companies future earnings are more likely to withstand an economic downturn
Low business risk Not excessive financial risk

Defensive stocks returns are not as susceptible to changes in the market

Stocks with low systematic risk

Dr Raju Indukoori

Cyclical Company Vs Cyclical Stock

Sales and earnings heavily influenced by aggregate business activity
High business risk Sometimes high financial risk as well

Cyclical stocks experience high returns is up markets, low returns in down markets
Stocks with high betas

Dr Raju Indukoori

Cyclical Company Vs Cyclical Stock

Speculative companies invest in assets involving great risk, but with the possibility of great gain
Very high business risk

Speculative stocks have the potential for great percentage gains and losses
May be firms whose current price-earnings ratios are very high

Dr Raju Indukoori

Equity Valuation

Why Equity Valuation?

To Find Under Valued Stock

Dr Raju Indukoori

Why Equity Valuation?

To Invest: To know intrinsic value of a stock Holding the stock: Evaluate performance of a
stock to make hold or sell decision

Dr Raju Indukoori

Components of equity valuation

Face value Market value EPS P/E Ratio D/P Ratio Dividend Payment Regularity of dividend payment Growth of dividend

Dr Raju Indukoori

Valuation Approaches
Historic
Book Value Replacement value Liquidation value

Market value / Price Business / Going concern value

Dr Raju Indukoori

Approaches to Equity Valuation

Discounted Cash Flow Techniques

Present Value of Dividends (DDM) Present Value of Operating Cash Flow Present Value of Free Cash Flow

Relative Valuation Techniques

Price/Earnings Ratio (PE) Price/Cash flow ratio (P/CF) Price/Book Value Ratio (P/BV) Price/Sales Ratio (P/S)

Dr Raju Indukoori

Assumptions in Equity valuation

100% DP Ratio (DDM) Dividends are paid annually Dividend is paid after 1 year of buying the stock

Dr Raju Indukoori

Decision Signals
Value IV > MP : Buy IV < MP : Sell IV = MP : Hold Return ER > RR : Buy ER < RR : Sell ER = RR : Hold
Dr Raju Indukoori

Dividend Discount Model

Holding period : 1 YEAR Holding Period > 1 year Holding Forever

Dividend Discount Model One Year Holding Period

D1 P IV !  1 1  k 1  k

Dr Raju Indukoori

Dividend Discount Model - One Year Holding Period

Example

An investor expects to get Rs 3.50 as dividend from a share next year and hopes to sell of off the share at Rs 45 after holding it for one year and if his required rate of return is 25% calculate intrinsic value of this share

3.50 45 I !   0.25   0.25 1 1

! 3.50 45  1.25 1.25

! Rs 2 . 80  Rs 36 . 00 ! Rs 38 . 80
Dr Raju Indukoori

Dividend Discount Model - More than one year Holding Period

D1 D2 D3 Dn Pn IV !    .............  1 2 3 n n 1  k 1  k 1  k 1  k 1  k
n

IV

t !1

Dt 1  k

Pn  1  k

Dr Raju Indukoori

Dividend Discount Model More than one year Holding Period

Example

If an investor expects to get Rs3.50, Rs 4, and Rs 4.50 as dividend from a share during the next three years and hopes to sell it off at Rs 75 at the end of the third year and if his required rate of return is 25 percent calculate the intrinsic value.

IV !

3.50 4.00 4.50 75    .....  1  0.25 1 1  0.25 2 1  0.25 3 1  0.25 3

! Rs2.80  Rs2.56  Rs2.30  Rs38.80 ! Rs46.06

Dr Raju Indukoori

Dividend Discount Model Holding for ever (Perpetual)

I !

1  k 1  k 1  k
2

 1

3 3

 ............. 

1  k

Dr Raju Indukoori

Dividend Discount Model - Holding for ever (Perpetual)

Example

If an investor expects to get Rs3.50 dividend for ever with a required rate of return of 25 percent calculate the intrinsic value.

3.50 IV ! 0.25

! Rs 14

Dr Raju Indukoori

Growth Model
Dividend Growth and price for 1 year Dividend Growth for ever Dividend Growth for n years Uneven Dividend and growth for ever

Dividend Growth and Price for One Year

D0   g P 1 IV !  1 1  k 1 1  k

D1 P !  1 1 1 k 1 1 k

Dr Raju Indukoori

Dividend Growth and Price for 1Year - An Example

Calculate intrinsic value of a stock which paid Rs 20 as dividend and expected to reach Rs 220 with a dividend growth rate of 30% and required rate of return is 20%.

20  0.30 1 220  I ! 1  0.20 1  0.20

26  220 ! 1.20

246 ! 1.20

! Rs 205

Dr Raju Indukoori

Dividend Growth Forever (Perpetual) - Gordons Share Valuation Model

I !

1  g 1  0 1  g 2  0 1  g 3  .....  0 1  g g 0 1  k 1 1  k 2 1  k 3 1  k g 1 g 1 0
kg
1

I !

I !

kg

Dr Raju Indukoori

Dividend Growth Forever (Perpetual) - Gordons Share Valuation Model: An Example

A company has declared a dividend of Rs 2.50 per share for the current year. The company has been following a policy of enhancing its dividends by 10 percent every year and is expected to continue this policy in the future also. An investor who is considering the purchase of the shares of this company has a required rate of return of 15 percent. Calculate intrinsic value of the companys share. Also advise the investor if CMP is Rs 40

2 . 50 1  0 . 10 IV ! 0 . 15  0 . 10

2 . 75 ! Rs 55 0 . 05

Dr Raju Indukoori

Dividend Growth for n Years

I !

1  g 1 1  g 2 1  g 1 n1   g  .....   1 2 3 1  k 1  k 1  k 1  k n
0

!
t !1

1  g 1  k t
t 1

IV !

D1

1  k 1 1  k 2 1  k 3

D2

D3

 ..... 

Dn

1  k n

!
t !1

1  k t

Dr Raju Indukoori

Dividend Growth for n Years - An Example

Calculate intrinsic value of a stock which paid a current dividend Rs 20 and expected to grow @ 30% for five years with a required rate of return is 20%.

20 .30 20 .30 20 .30 20 .30 20 .30 1 1 1 1 1 IV !      .20 1  .20 2  .20 3  .20 4  .20 5 1 1 1 1 1
1 2 3 4

20 .30 20 .69 202.197 202.8561 203.7129 1 1     1.20 1.44 1.728 2.0736 2.4883
26 33.80 43.94 57.12 74.26     1.20 1.44 1.728 2.0736 2.4883

! Rs 21 .67  Rs 23 .47  Rs 25 .43  Rs 27 .55  Rs 29 .84

I ! Rs127.96
Dr Raju Indukoori

Uneven Dividend and Growth Forever (Perpetual) - Two Stage Model

IV !

D 1

 k  k  k 1 1 1
IV
! V
n 1

 1

D2

 2

D3

.........  3

Dn

 k k  g  k n 1 1

 n

1 Dn   g

1   g t k  g   k n 1 1 t !1   k
n t

 V

Where V V
1

D t 1 1  k t t ! D n 1  g !  k  g 1  k

Dr Raju Indukoori

Uneven Dividend and Growth Forever (Perpetual) - Two Stage Model : An Example
A company paid a dividend of Rs 1.75 per share during the current year. It is expected to pay a dividend of Rs 2 per share during the next year. Investors forecast a dividend of Rs 3 per share and Rs 3.50 per share respectively during the two subsequent years. After that it is expected that annual dividends will grow at 10 percent per year into an indefinite future. If the investors required rate of return is 20 percent, what would be the intrinsic value of the stock

I !

2.00 3.00 3.50 3.50 .10 1    1.20 1 1.20 2 1.20 3 0.20  0.10 1.20 3

2.00 3.00 3.50 3.85 !    1.20 1.44 1.728 0.10 1.728

! Rs1.67  Rs2.08  Rs2.03  Rs22.28

Dr Raju Indukoori

! Rs 28.06

Terminal Value
Liquidation Approach Based on BV
[ Liqudation Value ! BookValue   InflationR ate 1
TernmialVa luePeriod

]  Vd

Discounted Earnings Power of the asset

CF3 CFn CF1 CF2 LiquidationValue !  Vd    .........  n 1 2 3 1  WACC 1 1 1   WACC   WACC   WACC Where n is the life the life of asset Vd is Debt value of the firm

Dr Raju Indukoori

Terminal Value
Earning Multiple Approach
iqudation alue ! ExpectedEa rning sin Ter min alPeriod * SalesMultiple

Dr Raju Indukoori

Terminal Value
Stable Growth Forever Approach

1 EPS n   g

1  k n k  g

Dr Raju Indukoori

Growth Rate
Estimating growth of equity return based on retention ratio

g ! ROE * b
1 n

Historic growth rate based on increase in dividends over a period of time

Dr Raju Indukoori

Dn CAGR! 1 D 0

Growth rate Vs Intrinsic Value

If IV =MV, growth rate is sustained, stock should sell at P ! D1
0

If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist) IV > MV If all earnings are retained, price should be higher IV < MV
Dr Raju Indukoori

Growth of Retained Earnings

Dr Raju Indukoori

Multiple Model

Price Multiples
Price to Earnings Per Share Price to Book Ratio Price to EBT Ratio Price to Sales

Dr Raju Indukoori

Price Earnings (P/E)

P/E is the function of three variables 1) Required rate of return 2) Expected growth in dividends 3) Firms retention ratio

Dr Raju Indukoori

P/E Valuation Approach

P0 !
1

k  g

E1 - expected earnings for next year E1 is equal to D1 under no growth

E 1 (1  b ) P0 ! k  ( b * ROE )
P0 (1  b ) ! E1 k  ( b * ROE )

k - required rate of return b = retention ratio ROE = Return on Equity

Dr Raju Indukoori

P/E Multiple Approach

P m! E

P ! mE

Dr Raju Indukoori

Price EPS Mismatch

Current Price Future EPS Current Price Historic EPS Current Price TTM EPS

Dr Raju Indukoori

Industry PEs - July 2011

Banking Private Sector Infrastructure Retail Entertainment Pharma IT Telecom Equipment utomobile Construction Consumer Durables Telecom Services Cement Shipping Iron & Steel Fertilizers Banking Pub Sector 6 6

9 9 8 9

Dr Raju Indukoori

PE Ratios of Important Industries in 2010 and 2011

ankin

ri a

or

In ra ru ur R ai n r ain n

ar a I o Industry ui n

uo o i on ru ion on u o r Dura ri n i in Iron r i iz r ankin u or PE Ratio

Dr Raju Indukoori

Price Earnings (P/E)

Importance
Relative Valuation Widely used

Drawbacks Use of accounting earnings Reported earnings fluctuate around the business cycle Inflation
Dr Raju Indukoori

Economy to Company - Macro to Micro

Fundamental Equity Analysis Company to Economy - Micro to Macro

Dr Raju Indukoori

Three-Step Valuation
1. General economic influences
Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash

2. Industry influences
Determine which industries will prosper and which industries will suffer on a global basis and within countries

3. Company analysis and Equity Valuation

Determine which companies in the selected industries will prosper and which stocks are undervalued

Dr Raju Indukoori

Does the Three-Step Process Work? - Evidence through research

Studies indicate that most changes in an individual firms earnings can be attributed to changes in aggregate corporate earnings and changes in the firms industry

Studies have found a relationship between aggregate stock prices and various economic series such as employment, income, or production

An analysis of the relationship between rates of return for the aggregate stock market, alternative industries, and individual stocks showed that most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stocks industry
Dr Raju Indukoori

Questions????

Thank You

Fundamental Vs Technical
Technical Analysis Doesnt consider value Based on History Meant for Trading Consumes less time and efforts Forecasts price based on price and volume Extensive use of charts Helpful in identifying best timing Fundamental Analysis Considers only value Based on future Meant for investment Tedious process and time consuming based on

Price forecasting fundamental factors

Use of financial variables Helps in identifying undervalued stock

Dr Raju Indukoori

Fundamental Vs Technical
Technical Analysis is useful for timing to pick the value stock TA is feasible in short run

Dr Raju Indukoori

Corporate Actions

Impact of Corporate Actions

Stock Split Bonus Issue Rights Issue FPO Spin Offs
Dr Raju Indukoori

Impact of Corporate Actions

Dividend Business Combinations Product price Management changes Legal Issues
Dr Raju Indukoori