Shares and Their Valuation

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 value
of equity shares
Source: Financial Management-Rajiv
Srivastava Prof. IIFT, Anil Misra, Asso.Prof.
MDI & Brealey Myers
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 market
hypothesis on the fundamental valuation,
technical analysis, and for portfolio management
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Features of equity
Equity shares are characterized bya) Ownership and management
b) Entitlement to residual cash flows
c) 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 valuation Dividend

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 valuation dividend

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 of
12%. The current performance of the firm leads to a
belief 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 a
year?
c) What maximum price do you think that the investor
should pay today for a share of ABC Ltd?
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The current price of the share using Eq:1 that would
provide a return of 12% is Rs. 22.32.
(a) The current price of the share is Rs.22 and buying at
this price would provide a return in excess of desired
rate 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 than
compensates the loss in value.
(c) The maximum price that can be paid for the share is
Rs. 22.32. any price above Rs. 22.32 would result in
lesser 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 have
the dividend of D1 and the capital gain of P1-P0.
the following equation gives the return
r=
+
Eq:2
Dividend 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 Reliance
shares?
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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 incorporate
the growth.
we can estimate the share price with the help
of:
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+
=
+
=
+
( + ) ( + ) ( + )
( + )
By rearranging we get,
=
()
Eq:3
and
=

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Eq:4

CASE:
The earnings of Indian Jet Airlines have been
growing at 10% for the last 3 years and the same
growth is expected to continue in future. The
dividends and the share price too have been
consistent with the growth in earnings. Last year
the firm paid a dividend of Rs.10. if investors
expectation from the firm is a return of 20% what
do you think is the worth of the share of Indian Jet
Airlines?
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The last years dividend 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) the
current price of the equity share is equal to the
present value of the infinite stream of dividend
expected.
To calculate the price of the share if the holding
period extends beyond one, Eq:1 may be
reproduced 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 dividend
in Period 2 and price at the end of Period 2.
Mathematically this can be expressed as:
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=
+
+ +
Substituting the value of P1 in Eq:1

+
+ +
+
+
+ Source:Financial
+ Management-Rajiv +
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Similarly the price at the end of Period 2, P2 can be
expressed as:
=
+
+ +
Again substituting the value of P2 and continuing in
this fashion for indefinite period of time, the
dividend discount model for equity share price is as
given 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 may

be abbreviated as:
=

Financial Management-Rajiv
+ Source:
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Eq:6

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 the
investor 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 share
we need to estimate the dividend that would
be 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 DIVIDEND NO GROWTH
Value of equity needs projection of dividend for infinite
period a requirement difficult to fulfill.
Shareholders would see business grow and, therefore,
the dividends grow with time.
We make an extremely simplifying assumption of
constant amount of dividend in each period, i.e.,
dividends are constant in each period and do not vary
or grow with time.
If the dividend for all times to come is assumed
constant, then the current price of the share is simply
the current dividend divided by the capitalization rate.
Eq: 5 can be rewritten as :
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VARIANTS OF DDM
=
+ +
Eq: 7
This is further simplified as

=
0 =
1+
Eq: 8
1+ 2
1+ 3
+ +
1+
(a)
Multiplying the above Equation (a) by (1+r), we get

1 + 0 = +
1+
1+ 2
1+ 3
1+ 4
1+ 5
++
Subtracting (a) from (b) and rearranging, we get

0 =
1+

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(b)
VARIANTS OF DDM
The simplest of valuation model as given in Eq: 8
states that the value of equity is given by the
expected dividend divided by the expected discount
rate.
For example, if the expected dividend on a share is
Rs. 5 and the expectation of the returns on the
investor is 10%, then the expected price would be
Rs. 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 the
valuation of equity and leads to a belief that it
ignores the capital appreciation on the prices.
It is a misconception because the formulation
has been done for infinite life and it merely
replaces the future price in terms of dividend.
The price of the equity at any point of time
shall be driven by the dividends subsequent to
investment, 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 equity
after 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 expressed
as:
=
++
Eq:8 (b)
Replacing the value of P4 in Eq: 8 (a) would lead to Eq:7 i.e.,
=
+
+
+ +
+
+
Financial Management-Rajiv
+
+
Source:
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VARIANTS OF DDM
CONSTANT DIVIDEND CONSTANT GROWTH
It is difficult to assume that the dividend of
the firm would remain constant.
Investors choose to invest in equity because of
the growth anticipated in the earnings and the
dividends
Recognizing the growth and again making a
simplifying assumption that dividend grow at
a continuous rate of g, Eq: 5 can be restated
as:
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VARIANTS OF DDM
+
+
+
+
+
+
+
+
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+
+
Eq:9
VARIANTS OF DDM
Here dividend in next period is D. for convenience, we
may denote it by D1, the dividend period in period 1.
The dividend in subsequent period 2 is D1*(1+g), and
in period thereafter is D1*(1+g)*(1+g) = + ,
and so on.
Upon simplification Eq:9 reduces to:
=
: 3
Eq: 10
The expected rate of return would be:

=
Eq: 11
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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 DDM expectations

cannot be less than growth
Constant dividend growth model, known as Gordon
Model, is the same as discounted cash flow approach.
This applies only when g<r.
In other words, the expected return must exceed
growth.
The minimum what the investors expect must be
somewhat higher than the potential growth of the firm
else the capital markets would be extremely inefficient.
The firm must strive to fulfill this extra expectation at
all times.
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Implications of DDM the 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 be
Rs.400. (Eq: 10)
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Implications of DDM the 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 1.15
= . 460
0.20 0.15
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Implications of DDM different

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 DDM different

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 of
the value with respect to estimated growth is
very high, any small revision in the growth
potential explains the wild movements in the
stock price.
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Implications of DDM stock pays no

dividend too has value
According to DDM the price of non-dividend
paying stock must be Zero.
In fact, all stock, irrespective of whether the
dividend is paid or not, have some market
value.
One plausible explanation for non-zero price
of share that does not pay dividend is the
assumption that it is the expectation of
dividend that drives the price .
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Dividend and growth

Under constant growth model we assumed a
constant growth in dividend without bothering
about the source of dividend growth.
Another convenient assumption was the
distribution of all the earnings in the form of
dividend.
To propel growth a firm needs funds, which, it
must get by retaining a part of the earnings and
deploying them into assets that provide growth in
earnings.
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Dividend and growth would a cut in dividend

result in decline in the price of the share?
To fund growth, the firm must necessarily
curtail dividend.
A mere look at the DDM would lead to an
inference that cut in dividend leads to decline
in price of the share.
However, it is not necessarily so.
Impact on share price would depend on the
successful deployment of retained earnings by
the 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 returns
by the shareholders is 20% and , therefore the
price of the share is Rs.100., as constant flow of
Rs. 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 opportunities
available for providing growth to the earnings
and hence add to the shareholders wealth.
Consider three options A, B and C.
Option A is an opportunity to make product
called Square that provides a return of 25%.
Option B is an expansion of the project for
existing products and would give return 20%
Option C is to produce low technology product
called Round that would generate a return of
15%.
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For simplicity of understanding, we assume
that all the projects are scalable, mutually
exclusive 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 curtailed
from existing Rs.20 per share to Rs.10 per
share.
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The retained part of the dividend would be
used to fund the selected projects and provide
growth 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 shareholders
expectations and proportions of earnings
retained 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 growth
provided 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.) = 20
Expected return = 20%
Return on Equity = 20%
Current price, P0 = D/r = 20/0.2 = Rs.100
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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
1
0 =
1
0 =
Rs.133.33Source: Financial Management-Rajiv

Rs.100

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1
0 =
Rs.80

The value of the share would rise if the firm
accepted the Square project, remain the same if
the Expansion of the existing selected and fall if
the 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 project
was exactly equal to expected rate of return
In case of Round, the price declined because the
return offered by the project was less than the
expected return
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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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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 of
the growth opportunities.
Value of the share = No growth value + PV of growth
opportunities
= +
Eq: 12
in case of Round, the value of the share would decline since
the present value of the project is negative (the project
offers 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

MODELS
Value based on the constant growth of dividend is a
greatly simplifying assumption that helps explain some
of 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, as
opportunities for extraordinary growth are available
only for limited time.
Slowly there opportunities dry up and firms start
registering a rather normal growth consistent with rest
of 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 phases high growth phase lasting for
n years and normal growth phase continuing
thereafter.
The cash flows of the firm can be represented
as:
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MODELS TWO STAGE
=
+
[
+
+
+
+
+
+
]+
+
High Growth Phase of n years
Normal Growth
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MODELS TWO 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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MODELS TWO STAGE
CASE:
ABC limited, an IT firm, is having a current level of
earnings of Rs.10 per share. Due to extremely good
prospects and opportunities in this field, the firm is
experiencing a high growth phase and therefore, pays
only 25% of its earnings as dividend and retained the
balance. ABC limited is expected to register a high growth
of 20% over the next 5 years. Thereafter the growth in
earnings is expected to settle down at 6%-- the rate at
which the economy is growing. Investors of ABC Ltd
expect a return of 15%. To find the current value of the
share, by applying the dividend discount model.
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MODELS TWO 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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MODELS TWO STAGE
Assuming 20% growth for 5 years, the value of the share can be
estimated as:
0 =
3.00
3.00 1+0.20
+
1+0.15
1+0.15 2
=3.00
+
1.15
3.00 1+0.20 2 3.00 1+0.20 3 3.00 1+0.20 4
+
+
+
+
1+0.15 3
1+0.15 4
1+0.15 5
1+0.15
3.60
4.32
5.18
6.22
+
+
+
+
1.15 2 1.15 3 1.15 4 1.15 5 1.15
=2.61+2.72+2.84+2.96+3.09+ 1.15
This value is equal to the present value of all dividend streams for
next five years growing at 20% and discounted at 15% PLUS the
price 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 obtained
from constant growth model with the assumption of
normal growth at 6%.
With dividend expected in period 6 at Rs. 6.22 (1+0.06)
the price expected is:
6
6.22 1+0.06
0.150.06
P5 =
=
= . 73.27
This price must be discounted back in todays terms at
15% discount rate, which gives the price of ABC as Rs.
50.65.
P0 = 2.61 + 2.72 + 2.84 + 2.96 + 3.09 + (
50.65
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73.27
)=
1.15 5

MODELS THREE STAGE
A number of valuation models are based on the
premise that the growth rate will taper off
eventually.
The transition might be from a present above
normal growth rate one that is considered normal.
If the dividends per share expected to grow at
normal growth rate to one that is considered
normal.
If the dividends per share were expected to grow at
a 14% compound rate for 10 years and then grow at
a 7% rate. The equation would become
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MODELS THREE STAGE
10
0 =
=1
0 1.14
+
1+
10(1.07)10
1+
=11
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 it
is period 1, in period 12 it is 2, and so forth.
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MODELS THREE STAGE
The transition from an above normal to a normal
rate of growth could be specified as more
gradual.
For example, we might expect dividends to grow
at a 14% rate for 5 years for 5 years, followed by
an 11% rate for the next 5 years and a 7% growth
rate thereafter.
Share price, then, is the summation of the
present values of expected future dividends in
each of the growth phases.
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MODELS THREE 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 =
5 2 1.14
=1
1+
10 1.11
=6 1+

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10 1.07 10
=11
1+

MODELS THREE STAGE
In multiphase growth situation like this, solving for the
rate of return that equates the stream of expected
future dividends with the current market price is
arduous.
Start by employing the middle growth rate in a
perpetual growth model to approximate the actual r.
With an initial growth of 14%, the expected dividend at
the end of year 1 is Rs.2.00(1+1.14)^1 = 2.28.
Using perpetual growth rate (Eq:11 ) r=
2.28
40
r=
+ 11% = 16.7%
Employ 16 % as a starting discount rate:
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MODELS THREE 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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MODELS THREE STAGE
Process for finding the value of a supernormal growth
stock:
(a) Estimate the expected dividends for each year during
the period of non-constant growth
(b) Find the expected price of the stock at the end of the
non-constant growth period, at which point it has
become a constant growth stock
(c) Find the present values of the expected dividends
during the non-constant growth period and the
present value of the expected stock price at the end
of the non-constant growth period. Their sum is the
intrinsic value of the stock, P0
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MODELS THREE 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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MODELS THREE 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 phases
growth.
They call their formula the H model.
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MODELS THREE STAGE
RusselJ. Fuller and Chi-Cheng Hsia
suggested the following model to calculate intrinsic value of
the share
0
0 =
1 + +

ga beginning growth rate
gn-long-run growth rate
H halfway point for the period of above normal growth rate
0 =
2.00
0.150.07
1 + 0.07 + 5 0.14 0.07 =40.57

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MODELS THREE 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
=
1 + + +
0
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MODELS THREE STAGE
D0= Present dividend per share
P0=Present Market price per share
gn= Long-run growth rate in final phase
H = halfway point for the period of above normal growth rate
ga= Growth rate in phase 1
For our previous example, the formula is expressed as:
0
=
1 + + +
0
2
=
40
1 + 0.07 + 5 0.14 0.07

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+ 0.07 = 14.97%
Other approaches to value the sharesBook 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 number
of outstanding equity shares.
Alternatively, the BVPS is the amount per
share on the sale of the assets of the company
at their exact book value minus all liabilities
including preference shares.
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Other approaches to value the sharesBook value approach

CASE:
Total assets of Alert Company is Rs. 60 crore, total
liabilities including preference shares of Rs. 45 crore and
10,00,000 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 of
the firm
MDI & Brealey Myers
Other approaches to value the sharesLiquidation value approach

This approach to valuation of shares is based on the liquidation value
per share
LVPS=(value realized from liquidating all assets)(amount to be paid to all creditors and preference
shareholders)/number of outstanding shares
LVPS is more realistic measure than book value. But it ignores the
earnings power of the assets of the firm
It is difficult to estimate the liquidation value of going concern

MDI & Brealey Myers
Other approaches to value the sharesPrice/Earnings (P/E) Multiples Ratio

The price earnings based approach is extremely popular
among other valuation techniques.
=

0
=( )
0
Some analysts believe that the current market price

discounts not the present earnings but future earnings
too, rely more on another ratio called leading P/E ratio.
It is calculated on the basis of expected earnings in the
next period
=

0
=( )
1

MDI & Brealey Myers

P/E multiple and growth:
The P/E ratio of the firm is said to represent its
growth prospects.
1
1 1
0 =
=
Or
0
1
=
1
MDI & Brealey Myers
Other approaches to value the sharesPrice/Earnings (P/E) Multiples

CASE:
Multi-products limited has been following a
dividend payout of only 20% so that the funds
needed for the growth of the firm targeted at 10%
is retained., the market expectations of return are
12%.
a) At what rate the market is discounting the
current and future earnings of company?
b) If the current level of earnings are Rs.10 per
share at what price the shares of the firm are
being traded?
MDI & Brealey Myers
Retention ratio, b = 80%

Required return, r = 12%
Growth rate, g = 10%
P/E ratio based on current earnings
1
10.80
0.120.10
= Rs. 10 (E0)
P/E ratio based on expected earnings (E1)

10(1+0.10) = Rs.11
MDI & Brealey Myers

Current earnings, E0 = 10.00
Growth rate, g = 10%
Required return, r = 12%
Expected Earnings, E1 = Rs. 11.00
Retention ratio, b = 80%
1 1
Price =
11 10.80
=
0.120.10
= Rs. 110

MDI & Brealey Myers

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%
MDI & Brealey Myers

Slow growth
Fast growth
Earnings (Rs. per share)
10
10
Dividend (Rs. per share)
Market Capitalization (%)
20
20
Growth Potential (%)
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
15
P/E ratio
33.33/10 =3.33
100/10 = 10.00

MDI & Brealey Myers
Other approaches to value the sharesPrice/Earnings (P/E) Multiple

P/E reflects a composite measure of dividend
policy, retention ratio, b; re-investment rate, k;
and market expectations r
The P/E would increase if k and b increase 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 by
themselves and this value would be higher if the
retention ratio is increased.
MDI & Brealey Myers

A higher value of r translates into a lower
value 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.
MDI & Brealey Myers

Riskier firms have low P/E multiple while firms
with stable cash flows have higher P/E multiple.
Valuation based on P/E ratio is extremely popular
and often provides a basis of comparison of firms
within the same industry. The management and
investors confidence can be measured by the P/E
multiple.
All other things remaining constant, a higher P/E
multiple means greater confidence reposed by
the market in the management of the firm.
MDI & Brealey Myers

The 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 broad
class 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 as
reflected in the data obtained from the market is 5.25.
Therefore value of the share = 10*5.25 = 52.50
MDI & Brealey Myers
Application
Analyze the dividend of a public limited company
for the last 10 years. Project the growth in
dividend and then apply dividend discount model
with constant growth to project its price for the
next year.
Collect the 10-year earnings, dividends and other
financial data for any five companies. Use
alternative approaches to value the shares of
these companies. How have these companies
performed in terms of market values and P/E
ratios?
MDI & Brealey Myers

Shares and Their Valuation

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Shares and Their Valuation

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Shares and their valuation

Explaining the features of equity

Shares and their valuation

Source: Financial Management-Rajiv

Issues in valuation of equity

Issues in valuation of equity

Methods of valuation Dividend

Methods of valuation dividend

Methods of valuation dividend

Source: Financial Management-Rajiv

Methods of valuation dividend

Here the current price is a function of :

the dividend expected in next period

Methods of valuation dividend

Methods of valuation dividend

Dividend yield and capital gain

Required rate of return

Required rate of return

Source: Financial Management-Rajiv

Share price and Growth

Share price and Growth

Source: Financial Management-Rajiv

Share price and Growth

Share price and Growth

Methods of valuation dividend

Methods of valuation dividend

Methods of valuation dividend

Methods of valuation dividend

Alternatively, for indefinite period of time this may

Methods of valuation dividend

Methods of valuation dividend

Source: Financial Management-Rajiv

This is further simplified as

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

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

Source: Financial Management-Rajiv

The price P0 then can be stated as:

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

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

The expected rate of return would be:

Implications of DDM expectations

Implications of DDM the price grows

Implications of DDM the price grows

Implications of DDM different

Implications of DDM different

Implications of DDM stock pays no

Dividend and growth

Dividend and growth would a cut in dividend

Dividend and growth would a cut in dividend

Dividend and growth would a cut in dividend

Dividend and growth would a cut in dividend

Dividend and growth would a cut in dividend

Dividend and growth would a cut in dividend

Source: Financial Management-Rajiv

Dividend and growth would a cut in dividend

Dividend and growth would a cut in dividend

New share price

Rs.133.33Source: Financial Management-Rajiv

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

Dividend and growth would a cut in dividend

Present value of growth opportunities

Present value of growth opportunities

DDM MULTI-STAGE GROWTH

DDM MULTI-STAGE GROWTH