Financial Markets and Investments: Valuation of Securities

Financial Markets and Investments
Module Valuation of Securities
Session No. III
Version 1.0
Material from the published or unpublished work of others which is referred to in the Class
Notes is credited to the author in question in the text. The Class Notes prepared is of 5,903
words in length. Research ethics issues have been considered and handled appropriately
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FM&I/M4SIII/v1.0/181119 Valuation of Stocks | Session No.: III

Table of Contents
List of Figures ............................................................................................................... 5
1. Share Valuation ......................................................................................................... 6
1.1. Valuation of Preference Stocks ............................................................................. 6
2. Concept of Present value ......................................................................................... 7
2.1. Use of Present Value to Share Valuation .............................................................. 8
3. Intrinsic Value of Stock ........................................................................................... 10
3.1. Market Price and Comparison of such price with Intrinsic Value ......................... 10
4. Skills of a Successful Investors ............................................................................. 11
4.1. Stock Selection Abilities ...................................................................................... 11
4.1.1. Strong Knowledge of Sectors ...................................................................................11
4.1.2. Reading Between the Lines .....................................................................................11
4.1.3. Strong Analytical and Forecasting Skills ...................................................................11
4.1.4. Finding Bargains ......................................................................................................12
4.2. Market Timing Abilities ........................................................................................ 12
4.2.1. Identifying Trends and Trends Reversal ...................................................................12
4.2.2. Feeling the Pulse of the Market ................................................................................13
4.2.3. Contrary Thinking .....................................................................................................13
5. Importance of Beta for Portfolio Performance...................................................... 13
6. Equity Valuation Method ........................................................................................ 14

6.1. Balance Sheet Method ........................................................................................ 15
6.1.1. Book Value Method ..................................................................................................15
6.1.2. Liquidation Value Method .........................................................................................15
6.1.3. Replacement Cost Method .......................................................................................15
6.2. Dividend Discount Model .................................................................................... 15
6.2.1. Single-Period Valuation Model .................................................................................16
6.2.2. Multi Period Valuation Model ....................................................................................16
6.2.3. Zero Growth Model ..................................................................................................17
6.2.4. Constant Growth Model............................................................................................17
6.2.5. Two Stage Growth Model .........................................................................................19
6.2.6. No Dividend Firm .....................................................................................................20
6.3. Price Earnings Ratio Approach ........................................................................... 20
6.4. Dividend Pay-out Ratio ....................................................................................... 21
6.4.1. Earnings Yield ..........................................................................................................21
6.4.2. Mixing of Dividend Yield and Earnings Yield ............................................................22
6.5. Required Rate of Return and Expected Growth Rate ......................................... 22
6.6. Relationship between P/E Ratio, Expected Return and Expected Growth .......... 23
7. Whitbeck-Kisor Model............................................................................................. 24
7.1. Limitations ........................................................................................................... 25
References ................................................................................................................... 26

List of Figures
Figure 4.1: Formula of Information Coefficient ..........................................................................12
Figure 5.1: Performance of two categories of Beta ....................................................................14
Figure 6.1: Formula – Multi Period Valuation Model ..................................................................17
Figure 6.2: Constant Growth Model...........................................................................................18
Figure 6.3: Simplification of Constant Growth Model .................................................................18
Figure 6.4: Formula of Two Stage Growth Model ......................................................................19

1. Share Valuation
According to the premise of fundamental analysis every share carries an intrinsic value. The
investment is made to the share inthe hope that the holder will receive adequate returns from
such investment in the form of dividend or capital appreciation. Dividend can be possessed from
the part of the profit earned by the firm. The firm may also disburse the whole profit by way of
dividend which is decided by the appropriate body of a firm. Capital appreciation is a process
when a firm retains its income without declaring its profits to the shareholders by way of
dividend. Anyhow, when a firm seeks to buy or sale its shares it makes a comparison between
the intrinsic value and market value of the shares. If the market price of the share is lower than
the intrinsic value, the firm will buy such shares with a comprehension that such share is
underpriced. On the other hand, when the intrinsic value of a share is lower than its market price
the firm should try to release the shares with a comprehension that such share is overpriced in
the market. When a share is issued in the market generally the market price and the intrinsic
price remains same. However, deviation between these two prices start to occur during the
passage of time. In particular, in the long run deviation between intrinsic value and market price
can be observed actively. The investment decision of the fundamental analyst is based on the
belief that there exist certain relationship between the market price and intrinsic value of the
share. The two basic inputs in the investment decision are the intrinsic value and market value.
The source of intrinsic value of a share can be obtained through the valuation process of this
share and the source of market price of the share is the quoted price published by the stock
exchanges from time to time. Shares are of two types (Clear Tax, 2019). These are preferred
stocks and common stocks. Valuation of these stocks are described below:
1.1. Valuation of Preference Stocks

The nature of preferred stock is dual. On one hand, it acts as a debt instrument. It is issued with
an objective to distribute fixed rate of dividend to the holders over its term. On the other hand, it
also acts a common stock as it carries the feature of perpetual existence. The value of
preference shares is calculated by considering the discounted future payments over its life. It
means the value of preferred share is equal with the payments accrued in the future discounted
by a certain rate called required rate of return of the stock (Tutor on net, 2019). This required
rate of return is also termed as cost of capital (preferred capital).
The following formula is used in valuing the preferred stock.
P0 = D * PVIFA(r%,n) + M * PVIF(r%,n)

Where,
P0 = Current price of the Preference Stock
D = Annual Dividend
n = Life of the preference stock
r% = Required rate of return
M = Maturity Value
Since the future payments are accrued at a certain interval of time so present value
annuity factor is used here. The principal sum can be realized at the end of the life of
preferred stock hence the present value factor is used here. Although the preferred stock
follows the path of perpetuity. Due to the perpetual nature of the preferred stock, the
fixed period dividends form a perpetuity. The required rate of return reflects the market
assessment of the risk inherent in the preferred stock.
Example:
Determine the value of a share of Rs. 1000 par value preferred stock that pays 8%
dividend at the end of each year assuming the cost of preferred capital is 8.5%
P0 = D * PVIFA(r%,n)
P0 = 1000 × 8% PVIFA (8.5, 1y)
80
=
8.5%
= Rs. 941.18
2. Concept of Present value

In the share valuation process a major technical method is required to be used which is known
as present value technique. It is a fundamental process where time value of money is applied in
knowing the present value of any future amount. The concept of time value implies that rupee
received now is worth more than rupee to be received in the future. The worth of Rs. 100 is
more than the worth Rs. 100 after one year. It is because if Rs. 100 is invested for one year
having interest rate 10% the receivable amount after one year would be Rs. 110 which is more
than Rs. 100 of this future period of time. The amount of money increases over the period which

creates an erosion on the power of money. It means over the period of time the worth of money
decreases that can be technically shown through present value method (My Accounting Course,
2019).
𝐹
P=
(1+𝐾)ⁿ
Where,
P = Present of the sum to be received in the future
F = Amount to be received after n years
K = discount rate
n = Number of years to maturity
2.1. Use of Present Value to Share Valuation

The value of any asset is the present value of its expected future cash flows. The discount rate
used in the present value models is the investor’s required rate of return. Discount rate is
measured through the application of time value of money as well as the risk of the asset in
which investment is proposed to be made. Discount rate possesses two components. One is
risk free rate i.e. interest rate on Government security and another component is risk premium.
The term risk premium refers to price of risk obtained by the investors for taking up the risk
associated with the invested shares. The riskier the investment, the greater the risk premium the
investor will require (Clear Tax, 2019).
The value of any asset is the present value of its expected future cash flows. Present value
refers to current value of stream of cash flows to be received in the future where an appropriate
discount rate is applied. Higher such discount rate brings lower present value of the future cash
flows. The shareholder obtains two types of appreciation by virtue of holding the stocks of the
company. The future cash flows may arise by way of dividend if any firm declares it from its
profits. The present value technique is applied to know the current value of these future
dividends. Else, any firm, instead of declaring dividend may retain the profits and create capital
appreciation. Capital appreciation is made with the objective of using the appreciated money for
the future purpose of the firm. Therefore, it is necessary to know the current value of such
capital appreciation.
By using a simple formula, the present value of the stock price can be obtained where dividend
to be paid during the period. The formula is:

𝐸
Present value of stock price = D+
(1+𝑅)ⁿ
Where,
D = Dividend
E = Expected stock price
R = discount rate
n = number of years down the line
Example:
Expected stock price is Rs 58 and dividend is paid Rs 2 per share during a certain period.
Discount rate is 5%. Find out present value of stock
𝐸
Present value of stock = D+
(1+𝑅)ⁿ
58
=2+
(1+.05)¹
58
= 2+
(1.05)
= 57.24
It means the value of stock is equal to dividend plus discounted present value of the sum of next
period’s stock price. In case of dividend earnings on the later period the present value of stock
should be summation of present value of dividend earnings of the later period plus present
value of later period’s stock price.
A purchased share can be sold later at a higher price or on profit cannot be distributed among
the shareholders by way of dividend. Both the two ways are considered as a means of capital
appreciation of the share price. It is required to measure the appreciation price. The present
value is used in determining the current price of capital appreciation. The required rate of return
is used to find out the current value of the cash flows. The formula is described earlier under
heading 2.

3. Intrinsic Value of Stock

The intrinsic value of a share is the present value of all future amounts to be received in respect
of the ownership of that share, computed at a certain discount rate. Intrinsic value is the actual
value of a security compared to its market price or book value. The currently traded amount is
regarded as price of a particular item whereas value implies true worth of something. It is
required to determine the value of a security and compare such value with the market price to
find out whether the value of the security is underpriced or overpriced in comparison with
prevailing prices of such share in the market. Intrinsic value is the real worth of the business. It
is the summation of future cash flows where an appropriate discount rate is applied to find out
the present value of such cash flows. In a business umpteen number of cash flows can be held.
Generally, these cash flows are obtained after making the adjustment of taxes; interest cost,
working capital requirements, expansion costs. Such types of adjusted cash flows are termed as
free cash flows of the firm. There are several techniques are applied in finding out the intrinsic
value of a share. Whichever be the formula for its findings it is important to determine whether
the right price is paid or not. Such right price is nothing but the intrinsic value of the share. While
determining the intrinsic value of a share it is also required to consider other important variables.
These variables are not found out in the market price (Walsh, 2019). Therefore, when we
compare market price with the intrinsic value of a share we have to check whether the variables
are inserted in the intrinsic price or not. These variables are brand name; trademarks; and
copyrights.
3.1. Market Price and Comparison of such price with Intrinsic Value
The market price is referred as a trading price of the securities which is being traded in the
market currently. It is an interaction between trader, dealer and investor currently present in the
market. The movement of the price in the market catches the signal of the stock exchanges and
accordingly the price of a share gets changed. It is a proven fact about the performance of the
share price that sometimes a bad price of worst business may land up to huge gain in the
business or sometimes the best business can be proved as an unsuccessful investment on the
part of the investors. The relationship between market price and intrinsic value of share is often
compared to know the status of the share in the market. Whether the market price is overpriced
or underpriced can be gauged with such comparison. When the market price is overpriced it
indicates that intrinsic value of a share is lower than the market price of such share. When
market price is underpriced it signals that the intrinsic value of a share is greater than the
market price of such share. In the perspective of market price when such price is overpriced the

investors attempt to sell the shares in the market. Conversely under underpriced condition
investors intend to buy the shares from the market. Another state can be formed between these
two prices (Walsh, 2019). When both such prices are same the investors hold the shares and
do not move to exercise the process of buying or selling of such shares.
4. Skills of a Successful Investors

The highly successful investors should possess the following skills for the purpose of their
investment. These are:
4.1. Stock Selection Abilities

The investor should possess the following skills while dealing with stocks in the capital market.
These are:
4.1.1. Strong Knowledge of Sectors

In order to know the condition of the economy the top down investment strategy is a useful
component. Identification of the strength of different sectors and picking the best stocks within
those sectors are one of the most important skill of an investor. In the stock market it is
observed that the performance of certain sector outperforms others therefore, it should be the
object of the investors to identify such potential top performing sectors and invest therein. For
this purpose, it is required to acquire the knowledge about sector analysis. By doing so the
investors should look at multiple frames to make sure about the performance of the stock of the
selected sectors. In this connection, examination of charts containing the lists of top performers
are required to be checked to draw a conclusion of the potential stocks (Chen, 2019).
4.1.2. Reading Between the Lines

In a stock chart two or more price points are connected through some certain lines. These lines
are called trend lines. Also it is called as bounding lines. The previous data of these trend lines
and the contemporary data can help in identifying the projected stock price that might do better
in the coming years.
4.1.3. Strong Analytical and Forecasting Skills

It should be an important qualification for an investor to judge an investment analyst who
continuously monitoring the stock market, its movement related to different shares enlisted in
the respective stock exchange. The investor should possess an essential skill like measurement
of information coefficient(IC) of the stock market analyst. This measurement enables the

investor to understand the performance of an analyst regarding financial forecast of the

movement of stock with its actual result (Mashvisor, 2019).
Figure 4.1: Formula of Information Coefficient
(Analyst Notes, 2015)
4.1.4. Finding Bargains

An important skills of the investor is to employ value investing investment strategy which is a
process of picking up stocks in the market the market price of which are less than their intrinsic
value. The value investors actively search those shares whose price are low in the stock
market. One of such searching process includes waiting for overreaction related to good or bad
news of the market that does not depend upon company’s long term fundamentals.
Overreaction opens the opportunity in buying the stocks at discounted prices – on sale. In case
of capital market, it is observed that company’s value might be unchanged but still there exists
movement of price of stock of this company. It is held due to the existence of overreaction about
the price of such stock in the market (Mashvisor, 2019).
4.2. Market Timing Abilities

Prediction of future market price movements is a base for making a strategy relating to buying
or selling of stocks in the market. Market timing refers to future prediction of the market price
movement considering the outlook of the aggregate market. There are three elements
considered under market timing abilities and these are:
4.2.1. Identifying Trends and Trends Reversal

It is required to identify the direction of movement of share prices in the market. The rising trend
is called uptrend of the share price and when the price declines it is called downtrend of the
share prices. Capturing such trend in the movement of share prices seems to be lucrative but
this trend alignment may face interruption in the stock market for which the direction of the price
movement can be changed. The change in the direction of trend is referred to as trend reversal.
A share having uprising trend may fall after some time. This falling trend of prices is termed as

trend reversal. An investment analyst tries to identify the trend reversals at an early stage and
experience the benefit in the market (Trading with Rayner, 2019).
4.2.2. Feeling the Pulse of the Market

It is important to perceive the condition of the market. The market may have lost its direction or
volatility and sharp swings seem to be predominant modes of the market movement. These
conditions lead to create confusion among the investors. However, understanding these
situations may lead to develop some alternative mode of operations in dealing at stock market.
Some stocks still exist those are reasonably quoted in the stock market. It is important for an
investor to check the following criteria about these stocks. These are earnings visibility;
consumption demand and large caps. The investment advisors advocate to follow these three
pillars while making an attempt in dealing with stocks.
4.2.3. Contrary Thinking

If loss happens substantially to the general market over a long period of time it is required to
take up a contrary course of action which may bring some relief to the investors. It is advisable
for the investors to achieve a net gain from stock dealing by converting the mode of operation
from loss making trend to contrary course of conduct. The bad performance of a market is
required to study. Afterwards turn around and do the opposite things which are contrary to the
current trend of the market (Mashvisor, 2019).
5. Importance of Beta for Portfolio Performance

Systematic risk is the variability in security returns caused by changes in the economy or the
market. All the securities are affected by such changes to some extent. A portfolio consists of
numerous number of shares. Therefore, such portfolio also carries systematic risk. The
systematic risk cannot be removed through diversification. However, such risk can be
minimized. The systematic risk is measured by a statistical measure called beta. Portfolio can
be classified into concentrated portfolio and diversified portfolio. Concentrated portfolio refers to
the portfolio consisting fewer stocks to achieve a level of diversification. This kind of portfolio
does not aim to reach the level of higher diversification level. Therefore, risk taking capacity of
this portfolio is not so high comparing to diversified portfolio. Therefore, portfolio concentration
doesn’t lead to a significant difference in returns. As already stated, beta is a component which
measures the systematic risk involved in the portfolio. The individual share under a portfolio
have some beta exposure and it does not exist in the form of fixed value over a given period of
time. This translates to systematic risk of the portfolio having different values at different

occasions. By dividing the beta component an investor can keep a controlled set of amount of
beta exposure in terms of the investor’s risk tolerance capability. In case of portfolio which is
made up of concentrated funds exhibited lower volatility than the least concentrated ones. The
performance of the latter portfolio is better to the former. It is comprehensible that the least
volatile portfolio bears managed beta in its portfolio structure. On the other hand, the
concentrated portfolio is made up with certain categories of stocks maintaining constant beta
exposure (Educba, 2019). It can be shown through a suitable chart.
Figure 5.1: Performance of two categories of Beta
(Research Gate, 2002)
6. Equity Valuation Method

Valuing a firm or its equity and estimation of fair market value of an asset can be done through
the application of several techniques designed under equity valuation method. This method
represents an attempt to value cash flows which are uncertain and unpredictable. Stock market
always depends upon equity valuation. The market price of shares changes very quickly as per
the perceived information rotating in the market and the market receives such information on
real time basis (Finance train, 2019).

Equity valuation can be classified into three categories:
6.1. Balance Sheet Method

It is a process which follows the estimation of value of the assets lies at the balance sheet. The
date of balance sheet is made up with a school of thoughts which does not consider possible
future evolution of the company. It also overlooks industry’s current position, organizational
problems and other related factors of the company. Some of these methods are laid down
below:
6.1.1. Book Value Method

Under balance sheet method all the information depicted in the balance sheet are followed.
Whatever accounting information is used into the accounting process all such data are used as
an input for processing this technique. Book value as per balance sheet is considered as the
value of equity which is denoted by net worth.
Net Worth = Equity Share Capital + Preferred Capital + Reserve & Surplus – Miscellaneous Expenses – Accumulated Losses
6.1.2. Liquidation Value Method

If a company is liquidated the amount emerged from the liquidation is recognized as the value of
the company. This value is calculated by deducting the business liquidation expenses from the
adjusted net profit. Or,
Liquidation Value = Net realizable value of all assets – Amount paid to all Creditors (including Preference Shareholders)
6.1.3. Replacement Cost Method

This concept envisages that the cost which is incurred to create an alternative firm is the value
of the present firm. This concept confers that value of equity is assumed as the replacement
value and the newly formed company should be identical with the existing company in terms of
conditions maintained by the present company.
6.2. Dividend Discount Model

The profit of the firm is distributed by means of dividend. This model utters to show the current
value of the stream of dividends to be earned over the future period of time by applying
appropriate discount rate in these stream of cash flows. There are various approaches found
related to this model which are built up under multiple assumptions.

These models are given below:
6.2.1. Single-Period Valuation Model

Here the investor expects to hold the equity share for one year. The price of the equity share
will be:
P0 =D1/(1 + r) + P1/(1 + r)
Where,
P0 = current price of the equity share
D1 = dividend expected a year hence
P1 = price of the share expected a year hence
r = rate of return required on the equity share
Here the assumption is built up by taking up the stream of cash flows which are adjusted into
present value through the application of appropriate discount rate so that such discounted price
will be equal with the intrinsic value of the share (Finance train, 2019).
6.2.2. Multi Period Valuation Model

Since equity shares have no maturity period, they may be expected to bring a dividend stream
of infinite duration. When an investor intends to hold the stock for long duration of time or finite
periods and sell it at the end of the holding period such multi period valuation model is used.
Here also it is assumed that an appropriate discount rate is applied on the stream of cash flows
and the adjusted amount will be equal with the intrinsic value of the share (Laitenberger &
Loffler, 2005).

Formula of this model is laid down below:
Figure 6.1: Formula – Multi Period Valuation Model
(CFI, 2019)
6.2.3. Zero Growth Model

This model is based on the assumption that dividend has a zero growth rate. All stocks yield
same amount of dividend. The formula used for assessing value of such stocks is the same
formula which is used for valuing the perpetuity (CFI, 2019).
D
The formula of this model is: V=
K
Where,
V = Intrinsic value of the stock
D = Annual Dividends
K = Required rate of return
6.2.4. Constant Growth Model

This model is based on certain assumptions. The principal assumptions are the dividends will
grow at a constant rate over the years and the discount rate must be greater than growth rate.
Here Discount Rate is taken as k; Growth Rate as g. Current Dividend as D0 and Dividend to be
received after one year as D1.
D1 = D0(1+g)1

Dividend can be received for infinite times until the shares are held by the investor. When the
shares are held for n periods as per present value model the value of share S0 would be:
Figure 6.2: Constant Growth Model
(Wall Street Mojo, 2019)
However, this model can be simplified and is expressed in the following manner:
Figure 6.3: Simplification of Constant Growth Model
(Wall Street Mojo, 2019)
The intrinsic value of a share is equal to next year’s expected dividend divided by the difference
between the appropriate discount rate for the stock and its expected dividend growth rate (Wall
Street Mojo, 2019).
Example:
A company paid a cash dividend of Rs. 4 per share on its stock during the current year. The
earnings and dividends of the company are expected to grow at an annual rate of 8%
indefinitely. Investors expect a rate of return of 14% on the company’s shares. What is a fair
price for this company’s shares?
Given,
D0 = Rs. 4; g = 8%; k = 14%
D₀(1+g)
S0 =
k−g
4(1+.08)
=
0.14−0.08

4.32
=
0.06
= Rs. 72
6.2.5. Two Stage Growth Model

This is an extension of the constant growth model. This model assumes that the extraordinary
growth which may be good or bad will continue for a finite number of years and thereafter there
will be normal growth rate which will prevail indefinitely.
In this model we get to know that the dividend will go through two stages of growth. Accordingly,
this model is based on the following assumptions (Dividend.com, 2019). These are:
• Rapid growth occurred at the first phase
• Constant growth at the latter stage.
The growth rate at the first stage will grow at a higher speed afterwards pace declines and the
earnings eventually meet the long term stable growth rate of economy. Here the value of stock
is equal to PV of dividends during the initial stage + PV of terminal price.
Figure 6.4: Formula of Two Stage Growth Model
(CFI, 2019)
Explanation of the formula:

Step 1 – Anticipated dividend per year is required to be known from the current time.
Step 2 – The appropriate discount rate is required
Step 3 – Anticipated dividend growth rate is also required.
At the first phase when growth increases rapidly all the anticipated dividend cash flows are
denoted like D1, D2, D3 so on. Similarly, at stage two all the expected growth is denoted by G2. r
denotes expected rate of return. N is the number of years covered by first dividend growth rate.

Example:
ABC Ltd. will use 7% dividend growth rate during the period of 2014 – 2017. Later this growth
rate declines to 3%. The required rate of return is 10%. The projected dividend amount for the
consecutive 3 years is Rs. 2.10; Rs 2.25; Rs. 2.41
Solution:
Dividend increased per year @ 7%
D1 = 2.10 × 1.07 = 2.25
D2 = 2.25 × 1.07 = 2.41
D3 = 2.41 × 1.07 = 2.58
2.58(1+.03)
2.25 2.41 2.58 .1−.03
Value of Stock = (1+.1)ᶺ 1 + (1+.1)ᶺ2 + (1+.1)ᶺ3
+ (1+.1)ᶺ3
2.66
2.25 2.41 2.58 .07
= 1.10 + 1.21 + 1.331
+ 1.331
= 2.05 + 1.99 + 1.94 + 28.55
= Rs. 34.53
6.2.6. No Dividend Firm

Sometimes, for the purpose of improving the standard of the firm or for any expansion purpose
any firm may retain the whole profit without distributing anything to its shareholders. It doesn’t
mean that the shareholders are being deprived by such decision. When a profit is retained it
means capital is appreciated and the shareholders are entitled to the appreciated amount. The
retained money is generally reinvested by the firm for its future growth. The return on share is
obtained by two ways – either it is through dividend or capital appreciation.The shareholders are
benefitted as the share price is appreciated by way of retention. Forgoing dividends enables the
investors to earn greater dividends in the future (Finance train, 2019).
6.3. Price Earnings Ratio Approach

This approach is used to make an effective valuation of share prices. It is a certain kind of
multiplier which is used for share valuation. It is expressed as:
Price per share

P/E Ratio =
Earnings per share

The current share price of a firm is determined relative to its per share earnings. This ratio is
also termed as price multiples or earnings multiples. This ratio evaluates the state of a stock
price. Whether the current price is overvalued or undervalued is measured from this ratio. This
ratio is also used to persuade that the investors are expecting high growth rates in the future.
When the earnings of a firm are very low this formula is inapplicable as there is nothing left to
express as its denominator. When P/E ratio is analyzed on relative basis then it becomes more
worth full (Moneycontrol, 2019). The relative parameters are:
• Sector P/E – It is a comparison of stock’s P/E between the firms’ own stock P/E versus
the P/E of stocks related to peer firms.
• Relative P/E – Comparing P/E of a stock with P/E range of the same stock over a period
of time provides clear signal of the investors’ perception.
• P/E to Earnings Growth – It is a comparison between the growth rates of various future
P/E to P/E (forward) or making a comparison of various past P/E growth rates to P/E
(trailing) Suppose P/E is 10 and growth rates of future P/E is 10 then P/E to earnings
growth is 1.
6.4. Dividend Pay-out Ratio
Before finding out dividend pay-out ratio one should know about dividend yield. Dividend yield is
the ratio between the dividend per share and price per share. That is:
Dividend per Share
Dividend Yield =
Price per Share
This ratio is used to evaluate the potential of stocks. It indicates the ability of the firm to
generate dividend income over the price of a share. It can fulfil the expectation of the investors
as the investors understand that a firm has the ability to fulfil the interest of the investors. This
ratio can segregate the potential firm from other firms with a higher dividend yield that attracts
probable investors in the market. In order to make out dividend pay-out ratio it is required to
know earnings yield (Moneycontrol, 2019).
6.4.1. Earnings Yield

Earnings yield is the reverse formula of price earnings ratio. When earnings per share (EPS) are
divided by the price of a share earnings yield can be obtained.
EPS
Earnings Yield =
Price per Share

1
Earnings Yield =
P/E Ratio
6.4.2. Mixing of Dividend Yield and Earnings Yield

When the earlier two formulas are connected it yields another formula, known as Dividend Pay-
out Ratio.
DPS
Dividend Pay-out Ratio =
EPS
DPS/P
Or, Dividend Pay-out Ratio = i.e. Dividend Yield divided by Earnings Yield
EPS/P
6.5. Required Rate of Return and Expected Growth Rate

Unlike bond whose cash flows end with redemption the cash flows of stock last for indefinite
period of time. Further, in case of bond all the cash flows are predetermined but in case of share
cash flows are not certain these are expected. Hence the required rate of return for bond over
future stream of cash flows is certain. However, the required rate of return over expected cash
flows from shares is dissimilar with bond’s required rate of return. In case of share, instead of
specific discount rate, expected discount rate is applied. Assuming that an investor holds the
share for one-year period (Wall Street Mojo, 2019). Assume the current price of equity is P0
which is equal to expected dividend and the price of the share at the end of the period i.e. P1
D₁ P₁
P0 = +
(1+r) (1+r)
D₁ P₁−P₀
Or, r = +
P₀ 𝑃₀
Therefore, it is observed that the expected discount rate is totally dissimilar with bond’s discount
rate.
Example:
The share of Reliance Industries Ltd 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?
Solution:
P1 is Rs. 800; P0 is Rs. 700. Expected dividend is Rs. 25

D₁ P₁−P₀
r= +
P₀ 𝑃₀
25 800−700
= +
700 700
= 0.357 + 0.1428
= 0.1785
= 17.85%
The return consists of 3.57% of dividend yield and 14.28% of capital gains
Therefore, from the above the expected return can be assumed as the summation of dividend
yield and capital gains related to share returns.
Expected Growth Rate
However, sometimes it is required to project the rate with a certain growth. It is because the
investors require growth on returns. For them return should have growth prospects otherwise, it
looks dull. Given the growth in share price g:
D₁ P₀(1+g)
P0 = +
(1+r) (1+r)
D₁
P0 =
(r−g)
D₁
r= +g
P₀
6.6. Relationship between P/E Ratio, Expected Return and Expected Growth
The growth prospect of a firm is perceived from the P/E Ratio. The value of share i.e. P0 can be
divided into two components. First is the value of assets already in place that offer current level
of earnings E1 (no growth) and the value of the potential assets having growth opportunities.
The market makes an assessment of both the components to arrive at the price. When these
two values are added the aggregate of share can be determined. It also explains that two firms
are valued differently by the market despite same level of earnings and dividends. Two new
things are brought into the valuation of price of the share. These are “b” and “k”. b refers to
Retention Ratio and k denotes Reinvestment Rate. k is used for deploying funds for future

growth opportunities (Moneycontrol, 2019). The revised formula after bringing these two
elements is laid down below:
D₁ E₁(1−b)
P0 = =
(r−g) (r−g)
P₀ (1−b)
Or, =
𝐸₁ (r−bk)
Where,
E1 = Expected earnings per share equivalent with earnings per share. The term expected is
mentioned because there exists some thinkers who believe that market price is based on not
P0 is the price of the share
Growth on share price depends on how much earnings have been retained, i.e. b, and the
return on equity here it is reinvested rate i.e. k
Therefore, the dividend growth i.e. g = b×k
7. Whitbeck-Kisor Model
Statistical approach can be employed to determine an appropriate P/E Ratio. In this approach
several independent variables are required. These are earnings, growth, risk and dividend
policy. The Price of Share – Dependent Variable is measured by applying the statistical
approach where these variable components are utilized. The relationship between the
Independent Variables and Dependent Variables can be measured by Multiple Regression
Analysis. This Regression Analysis measures the simultaneous impact of the determining
variables on the price-earnings ratio. An appropriate P/E Ratio is obtained this regression
analysis. The application of multiple regression analysis in explaining P/E Ratios is found
through a renowned model known as Whitbeck-Kisor model. This model is developed to
measure the P/E of stock price by using all the independent variables afterwards it employs
multiple regression analysis to define the average relationship between each of these variables
and P/E Ratios (Majumdar, 2019).
As of June, 1962 P/E Ratio = 8.2 + 1.5 (earnings growth rate) + 0.067 (dividend pay-out rate) –
0.2 (standard deviation in growth rate)
Where,
8.2 is the constant term

Other numbers are used as weightage of the respective independent variables. To understand
the appropriate P/E Ratio it is required to analyze the fact with a suitable example.
Suppose a share having growth prospect 7%, dividend pay-out is 40% and σ in growth is 12%.
The P/E Ratio would be:
= 8.2 + 1.5 × (7) + 0.067 × (40) – 0.2 (12)
= 18.98
This equation covers all the three variables dividend payout, growth and required rate of return.
This model helps an analyst to compute the theoretical P/E ratio, compare with the actual and
take the following view:
If theoretical P/E Ratio > Actual P/E = Buy
If theoretical P/E Ratio < Actual P/E = Sell
7.1. Limitations
In this model the coefficients are effective for one year. Since this model is sample sensitive
therefore, these coefficients are not usable for other years. Besides, this model was used over
US based stock prices and there it performed successfully. However, in Indian context its
effectiveness is quite doubtful(Finance train, 2019).

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Financial Markets and Investments: Valuation of Securities

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Financial Markets and Investments

Module Valuation of Securities

Session No. III

FM&I/M4SIII/v1.0/181119 Valuation of Stocks | Session No.: III

List of Figures ............................................................................................................... 5

1. Share Valuation ......................................................................................................... 6

1.1. Valuation of Preference Stocks ............................................................................. 6

2. Concept of Present value ......................................................................................... 7

2.1. Use of Present Value to Share Valuation .............................................................. 8

3. Intrinsic Value of Stock ........................................................................................... 10

4. Skills of a Successful Investors ............................................................................. 11

4.1. Stock Selection Abilities ...................................................................................... 11

4.1.1. Strong Knowledge of Sectors ...................................................................................11

4.1.2. Reading Between the Lines .....................................................................................11

4.1.3. Strong Analytical and Forecasting Skills ...................................................................11

4.1.4. Finding Bargains ......................................................................................................12

4.2. Market Timing Abilities ........................................................................................ 12

4.2.1. Identifying Trends and Trends Reversal ...................................................................12

4.2.2. Feeling the Pulse of the Market ................................................................................13

4.2.3. Contrary Thinking .....................................................................................................13

5. Importance of Beta for Portfolio Performance...................................................... 13

6. Equity Valuation Method ........................................................................................ 14

FM&I/M4SIII/v1.0/181119 Valuation of Stocks | Session No.: III

6.1. Balance Sheet Method ........................................................................................ 15

6.1.1. Book Value Method ..................................................................................................15

6.1.2. Liquidation Value Method .........................................................................................15

6.1.3. Replacement Cost Method .......................................................................................15

6.2. Dividend Discount Model .................................................................................... 15

6.2.1. Single-Period Valuation Model .................................................................................16

6.2.2. Multi Period Valuation Model ....................................................................................16

6.2.3. Zero Growth Model ..................................................................................................17

6.2.4. Constant Growth Model............................................................................................17

6.2.5. Two Stage Growth Model .........................................................................................19

6.2.6. No Dividend Firm .....................................................................................................20

6.3. Price Earnings Ratio Approach ........................................................................... 20

6.4. Dividend Pay-out Ratio ....................................................................................... 21

6.4.1. Earnings Yield ..........................................................................................................21

6.4.2. Mixing of Dividend Yield and Earnings Yield ............................................................22

6.5. Required Rate of Return and Expected Growth Rate ......................................... 22

7.1. Limitations ........................................................................................................... 25

FM&I/M4SIII/v1.0/181119 Valuation of Stocks | Session No.: III

Figure 5.1: Performance of two categories of Beta ....................................................................14

Figure 6.1: Formula – Multi Period Valuation Model ..................................................................17

Figure 6.2: Constant Growth Model...........................................................................................18

Figure 6.3: Simplification of Constant Growth Model .................................................................18

Figure 6.4: Formula of Two Stage Growth Model ......................................................................19

FM&I/M4SIII/v1.0/181119 Valuation of Stocks | Session No.: III

1.1. Valuation of Preference Stocks

The following formula is used in valuing the preferred stock.

FM&I/M4SIII/v1.0/181119 Valuation of Stocks | Session No.: III

n = Life of the preference stock

r% = Required rate of return

P0 = 1000 × 8% PVIFA (8.5, 1y)

2. Concept of Present value

FM&I/M4SIII/v1.0/181119 Valuation of Stocks | Session No.: III

F = Amount to be received after n years

n = Number of years to maturity

2.1. Use of Present Value to Share Valuation

FM&I/M4SIII/v1.0/181119 Valuation of Stocks | Session No.: III

E = Expected stock price

n = number of years down the line

FM&I/M4SIII/v1.0/181119 Valuation of Stocks | Session No.: III

3. Intrinsic Value of Stock