Unit 2

Stock Valuation

What is the need for Stock Valuation?

Rs 25000

Mr Sharma

Market price Rs 110 per share

IS it worth to buy this share @ Rs 110 ?

How Mr Sharma will see the value of his investment in ITC Ltd?
Expected Return

Dividend Discount Model Free Cash Flow Method

Relative Valuation

Determining the value of stock based on Expected Return

Let us understand how to calculate expected return.

Hold for 1 year

One share for Rs 110

Dividend = Rs 5 Expected sale price = Rs 120

Expected return = (Income/Investment) * 100 = ( 5 + (120 -110)/110)*100 = 13.63 %

Calculation of Expected Return

One share for Rs 110

Dividend = Rs 5 Expected sale price = Rs 120 Income Purchase price x 100

Expected return

= (Dividend +Capital gain)/Purchase price x 100 = 5 + (120 -110 ) 110 = 13.63 % Expected return = D1 + (P1 P0) P0 x 100

Determining the value of stock based on Expected Return

1 Year

10 %

Rs 110

FV = P(1+K)n

Rs 110

Rs 100

P = FV/(1+K)n

Rs 110

Determining the value of stock based on Expected Return

1 year K = 15 %
Dividend = Rs 10 Expected sale price = Rs 135

Price = ?

P = FV/(1+K)n

P = (10 + 135)/(1.15)1 = Rs 126

The maximum price that can be paid is equal to the present value of future cash flows

Dividend Discount Models

Dividend Discount Models

Case 1 : One year investment in stock

Dividend discount model

What is the need for dividend discount model? Investors are always interested in knowing the intrinsic value or the fair value of a share The dividend discount model helps to identify overvalued and under valued stocks

What is Dividend discount model?

Dividend discount model discounts the dividend receivable in future to arrive at the present value of the stream of dividends The value so arrived is the fair value or intrinsic value of the stock
1 year K = 20 %

P = 125

P = FV/(1+K)n

D = Rs 10 P1 = Rs 140

P = 150/(1.20)1

DDM
Case 2: Investing in stock for more than 1 year

Po

D1

D2

D3

D4

Dn + Pn

Constant Growth Dividend Discount Model

Growth in dividend = 10 % 0 1 2 3 4 n

Do = 5

5.5

6.05

6.65
5(1.10)3

7.32
5(1.10)4 5(1.10) n

D1 =5(1.10)1 5(1.10)2

Constant growth dividend discount model

Higgins Sustainable Growth Rate

Let us suppose Mr. Prince had invested Rs 50,000 in a small coffee Shop. Last year he earned a net income of Rs 5000. Assume that he is the only shareholder in his business and the whole Investment is made out of his pocket.

He always maintain 10 % return on his investments

Out of Rs 5000 net income he took back Rs 2000 as dividend income and re-invested Rs 3000 into the business. Note: Prince bought one micro wave oven for Rs 3000 What will be the NI for the current year?

6%

6%

Invested Capital Rs 50,000

Invested Capital Rs 53,000

Invested Capital Rs 56,180

Income Rs 5000 ROE OF 10 %

Income Rs 5300 ROE OF 10 %

Income Rs 5618 ROEOF 10 %

Rs 2120 Rs 3180 Rs 2000 Rs 3000 Pay out ratio 40 % Re-investment Pay out ratio 40 % Re-investment ratio 60 % ratio 60 %

Free cash flow method (FCFF)

Relative Valuation Method

It is the process of finding the value of an asset based on how similar assets are priced in the market. Price earning ratio Price to book value.

Thank You

For any clarifications, please write to me at visu_prof@rediffmail.com