BLOCK 2 – UNIT II

STRUCTURE

2.1 Introduction

2.2 Balance Sheet Valuation

2.2.1 Book Value

2.2.2 Liquidation Value

2.2.3 Replacement Cost

2.3 Dividend Valuation Model

2.3.1 Single Period Valuation Model

2.3.2 Multi period Valuation Model

2.3.3 Zero Growth Model

2.3.4 Constant Growth Model

2.3.5 Two Stage Growth

2.4 Price Earning Ratio approach to Equity Valuation

2.5 Summary
2.6 Keywords
2.7 Illustrated Problems
2.8 Review Questions

2.9 Further Readings

 OBJECTIVES

After reading this unit you will be able to understand

• The importance of equity valuation
• Different methods of equity valuation
• The calculations involved in appraising the price of equity

2.1 INTRODUCTION

Equity shares can be described more easily than fixed income securities. However, they are more
difficult to analyse. Fixed income securities typically have a limited life and a well defined cash
flow stream. Equity shares have neither. While the basic principles of valuation are the same for
fixed income securities as well as equity shares, the factors of growth and risk create greater
complexity in the case of equity shares. Equity analysts employ two kinds of analysis, viz.
fundamental analysis and technical analysis. Fundamental analysis assess the fair market value of
equity shares by examining the assets, earnings prospects, cash flow projections, and dividend
potential. Fundamental analysts differ from technical analysts who essentially rely on price and
volume trends and other market indicators to identify trading opportunities.

2.2 BALANCE SHEET VALUATION

Analysts often look at the balance sheet of the firm to get a handle on some valuation measures.
Three measures derived from the balance sheet are: book value, liquidation value and replacement
cost.
2.2.1 Book Value

The book value per share is simply the net worth of the company (which is equal to paid up equity
capital plus reserves and surplus) divided by the number of outstanding equity shares. For example,
if the net worth of Zenith Limited is Rs 37 million and the number of outstanding equity shares of
Zenith is 2 million, the book value per share works out to Rs 18.50 (Rs 37 million divided by 2
million). How relevant and useful is the book value per share as a measure of investment value?
The book value per share is firmly rooted in financial accounting and hence can be established
relatively easily. Due to this, its proponents argue that it represents an ‘objective’ measure of value.
An allied and a more powerful criticism against the book value measure, is that the historical
balance sheet figures on which it is based are often very divergent from current economic value.
Balance sheet figures rarely reflect earning power and hence the book value per share cannot be
regarded as a good proxy for true investment value.

2.2.2 Liquidation Value

The liquidation value per share is equal to:

𝑉𝑎𝑙𝑢𝑒 𝑟𝑒𝑎𝑙𝑖𝑠𝑒𝑑 𝑓𝑟𝑜𝑚 𝑙𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑛𝑔 𝑎𝑙𝑙 𝑡ℎ𝑒 𝑎𝑠𝑠𝑛𝑑 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠𝑒𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 − 𝐴𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 𝑏𝑒 𝑝𝑎𝑖𝑑 𝑡𝑜 𝑎𝑙𝑙 𝑡ℎ𝑒 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

To illustrate, assume that Pioneer Industries would realize Rs 45 million from the liquidation of
its assets and pay Rs 18 million to its creditors and preference shareholders in full settlement of
their claims. If the number of outstanding equity shares of Pioneer is 15 million, the liquidation
value per share works out to:

𝑅𝑠 45 𝑚𝑖𝑙𝑙𝑖𝑜𝑛−𝑅𝑠 18 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
= Rs 18
1.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
While the liquidation value appears more realistic than the book value, there are two serious
problems in applying it. First, it is very difficult to estimate what amounts would be realized from
the liquidation of various assets. Second, the liquidation value does not reflect earning capacity.
Given these problems, the measure of liquidation value seems to make sense only for firms which
are ‘better dead and alive’ – such firms are not viable and economic values cannot be established
for them.

2.2.3 Replacement Cost

Another balance sheet measure considered by analysis in valuing a firm is the replacement cost of
its assets less liabilities. The use of this measure is based on the premise that the market value of
a firm cannot deviate too much from its replacement cost. If it did so, competitive pressures will
tend to align the two. The major limitation of the replacement cost concept is that organizational
capital, a very valuable asset, is not shown on the balance sheet. Organisational capital is the value
created by bringing together employees, customers, suppliers, managers and others in mutually
beneficial and productive relationship. An important characteristic of organizational capital is that
it cannot be easily separated from the firm as a going entity.

Although balance sheet analysis may provide useful information about book value, liquidation
value, or replacement cost, the analyst must focus on expected future dividends, earnings and cash
flows to estimate the value of a firm as going entity. We examine the quantitative models used for
this purpose in the following sections.
 2.3 DIVIDEND VALUATION MODEL

A difficult problem in using the dividend valuation model is the timing of cash flows from
dividends. Since equity shares have no future measure, the investor must forecast all future
dividends. This might imply a forecast of intently long stream of dividends. Clearly, this would be
almost impossible. And therefore, in order to manage the problem, assumptions are made with
regard to the future growth of the dividend of order to manage the problem, assumptions are made
with regard to the future growth of the dividend of the immediately previous period available at
the time the investor wants to determine the intrinsic value of his/her equity shares. The
assumptions can be:

a) Dividends do not grow in future i.e., the constant or zero growth assumption.
b) Dividends grow at a constant rate in future, i.e., the constant assumption.
c) Dividends grow at varying rates in the future time period i.e., multiple growth assumption.

The dividend valuation model is now discussed with these assumptions.

2.3.1 Single Period Valuation Model

Let us begin with the case where the investor expects to hold the equity share for one year. The
price of the equity share will be:
 𝐷
1 𝑃1
P0 = (1+𝑟) + (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

Example : Prestige’s equity share is expected to provide a dividend of Rs 2.00 and fetch a price
of Rs 18.00 a year hence. What price would it sell for now if investor’s required rate of return is
12 per cent

2.0 18.00
Po = (1.12) + = Rs17.86
(1.1.2)

What happens if the price of the equity share is expected to grow at a rate of g percent annually?
If the current price, Po, becomes Po (1+g) a year hence, we get:

1𝐷 𝑃𝑜 (1+𝑔)
Po = (1+𝑟 )
+ (1+𝑟)
eq ( 1 )

Simplyfying Eq. (1) we get:

𝐷1
Po = (𝑟−𝑔)
eq (2)
Example: The expected dividend per share on the equity share of Rotamac limited is Rs 2.00. The
dividend per share has grown over the past five years at the rate of 5% per year. This growth rate
will continue in future. Further, the market price of the equity share of Rota mac too is expected
to grow at the same rate. What is the fair estimate of the intrinsic value of the equity share of
Rotamac if the required rate is 15 per cent?

Applying equation ( 2 ) we get the following estimate:

2.00
Po = 0.15−.05 = Rs 20.00

Expected Rate of Return

In the preceding discussion we calculated the intrinsic value of an equity share, given information
about (i) the forecast values of dividend and share price, and (ii) the required rate of return. Now
we look at a different question: What rate of return can the investor expect, given the current
market price and forecast values of dividend and share price? The Expected rate of return is equal
to:

r = D/Po + g Eq ( 3)

Example : The expected dividend per share of Utsav fashions is Rs 5.00. The dividend is expected
to grow at the rate of 6 per cent per year. If the price per share now is Rs 50.00, what is the expected
rate of return?

Applying equation (3) , the expected rate of return is:

R = 5/50 +0.06 = 16 percent

2.3.2 Multi period Valuation Model

Having learnt the basics of equity share valuation in a single period framework, we now discuss
the more realistic, and also the more complex, case of multi period valuation. Since equity shares
have no maturity period, they may be expected to bring a dividend stream of infinite duration.
Hence the value of an equity share may be put as:

𝐷 𝐷 𝐷 𝐷 𝐷
1
Po = (1+𝑟) 2
+ (1+𝑟) 3 ∞
2 + (1+𝑟)3 +…………+ (1+𝑟)∞ =
∑∞ 𝑡
𝑡=1 (1+𝑟)𝑡 eq (4)

Where Po = price of the equity share today

D1 = dividend expected a year hence

D2 = dividend expected two years hence

D∞ = dividend expected at the end of infinity

r = expected return

Equation (4) represents the valuation model for an infinite horizon. Is it applicable to a finite
horizon? Yes. To demonstrate this consider how an equity share would be valued by an investor
who plans to hold it for n years and sell it thereafter for a price of Pn. The value of the equity share
to him is:

𝐷1 𝐷2 𝐷3 𝐷𝑛 𝑃𝑛
Po = + + +…………+ + 𝑛
(1+𝑟) (1+𝑟)2 (1+𝑟)3 (1+𝑟)𝑛 (1+𝑟)
 𝐷 𝑃𝑛
= ∑𝑛𝑡=1 (1+𝑟)
𝑡
𝑡 + 𝑛 equation (5)
(1+𝑟)

2.3.3 Zero Growth Model

If we assume that the dividend per share remains constant year after at a value op D, eq 4 becomes

𝐷 𝐷 𝐷 𝐷
Po = (1+𝑟) + (1+𝑟)2 + (1+𝑟)3 +…………+ (1+𝑟)∞ equation (6)

Equation ( 6 ) on simplification becomes:

𝐷
P0 = 𝑟 equation (7)

2.3.4 Constant Growth Model

One of the most popular dividend discount models, called the Gordon model as it was originally
proposed by Myron J. Gordon, assumes that the dividend per share grows at a constant rat (g). The
value of a share, under this assumption, is :

𝐷
1 𝐷1 (1+𝑔) 𝐷1 (1+𝑔)𝑛
Po = (1+𝑟) + +……… equation (8)
(1+𝑟)2 (1+𝑟)𝑛+1
Applying the formula for the sum of a geometric progression, the above expression simplifies to:

1 𝐷
Po = 𝑟−𝑔 equation (10)

Example: Rathod engineering limited is expected to grow at the rate of 6 percent per annum. The
dividend expected on Rathod’s equity share a year hence is Rs 2.00. What price will you put on it
if your required rate of return for this share is 14 per cent?

The price of Rathod’s equity share would be:

2.00
Po = 0.14−0.06 = Rs 25.00

2.3.5 Two Stage Growth Model

The simplest extension of the constant growth model assumes that the extraordinary growth (good
or bad) will continue for a finite number of years and thereafter the normal growth rate will prevail
indefinitely. Assuming that the dividends move in lines with the growth rate, the price of the equity
share will be:

1𝐷 𝐷1 (1+𝑔1 ) 𝐷1 (1+𝑔1 )2 𝐷1 (1+𝑔1 )𝑛−1 𝑃 𝑛

Po = [ (1+𝑟) + + …+ ] + (1+𝑟) equation
(1+𝑟)2 (1+𝑟)3 (1+𝑟)𝑛 𝑛

(11)

Where Po = current price of the equity share

D1 = dividend expected a year hence

g 1 = extraordinary growth rate applicable for n years

Pn = price of the equity share at the end of year n

The first term on the right hand side of equation (11) is the present value of a growing annuity. Its
value is equal to:

1+𝑔1 𝑛
1−[ ]
1+𝑟
D1 = [ ]
𝑟−𝑔1

1+𝑔
1−[ 1+𝑟1 ]𝑛 𝑃𝑛
Hence P0 = D1 [ ] +
𝑟−𝑔1 (1+𝑟)𝑛

Since the two-stage growth model assumes that the growth rate after n years remains constant, P n
will be equal to:

𝐷𝑛+1
𝑟 − 𝑔2

Where Dn+1 = dividend for year n +1

g 2 = growth rate in the second period.

Dn+1, the dividend for year n+1 may be expressed in terms of the dividend in the first stage.

Dn+1 = D1 (1+g1)n-1 (1+g2)

Substituting the above expression, we have:

1+𝑔
1−[ 1+𝑟1 ]𝑛 𝐷1 (1+𝑔1 )𝑛−1 1
Po = D1 [ 𝑟−𝑔 ] + [ ] [ (1+𝑟)𝑛
1 𝑟−𝑔2
Example The current dividend on an equity share of Vimal Ltd is Rs2.00. It is expected to enjoy
an above normal growth rate of 20 per cent for a period of 6 years. Thereafter the growth rate will
fall and stabilize at 10 per cent. Equity investors require a return of 15 percent. What is the intrinsic
value of the equity share of Vimal?

The inputs required for applying the two stage model are:

g 1 = 20 percent

g 2 = 10 percent

n = 6 years

r = 15 years

D1 = Do (1+g1) = Rs 2 (1.20) = 2.40

Plugging these inputs in the two stage model, we get the intrinsic value estimate as follows:

1.20 6
1−[ ] 2.40 (1.20)5 (1.10) 1
1.15
Po = 2.40[ 0.15−0.20 + [ [(1.15)6]
0.15−0.10

1−1.291 2.40(2.488)(1.10)
= 2.40 [ ]+[ ] [0.497]
−0.05 0.15−0.10

= 13.968+65.289

=Rs 79.597
 2.4 Price Earning Ratio approach or Earnings Multiplier Approach to Equity Valuation

An approach to valuation, practiced widely by investment analysis, is the P/E ratio or the earnings
multiplier approach. The value of a stock, under this approach, is estimated as follows:

Po = E1 X Po / E1

Where Po = estimated price

E1 = estimated earnings per share

Po/E1 = justified price-earnings ratio

2.5 SUMMARY

The valuation task is relatively straightforward in case of bond and preference share, because
benefits are generally constant and reasonably certain. Equity valuation is different, because the
return on equity is uncertain and can change from time to time. It is the size of the return and the
degree of fluctuation (i.. risk), which together determine the value of a share to the investor. We
have also discussed equity valuation models. The purpose of these models is to identify whether a
stock is mispriced. Underpriced stocks need to be purchased, overpriced stocks should be shorted.
 2.6 KEYWORDS

1. Dividend Discount Model: A technique for estimating the value of a stock issue as the present
value of all future dividends.

2. Expected rate of return: the return that analysts calculations suggest a security should provide,
based on the market’s rate of return during the period and the security’s relationship to the market.

3. Price / Earning Ratio: The number by which expected earnings per share is multiplied to
estimate a stock’s value; also called earnings multiplier.

4. Required rate of return: The return that compensates investors for their time, the expected
rate of inflation, and the uncertainty of the return.

2.7 ILLUSTRATED PROBLEMS

1. The equity stock of Ren Ltd is currently selling for Rs 30 per share. The dividend expected next
year is Rs 2.00. The investors’ required rate of return on this stock is 15 percent. If the constant
growth model applies to Ren, what is the expected growth rate?

Solution:

According to the constant growth model

1𝐷
Po = 𝑟−𝑔

This means g = r-D1/Po

Hence, the expected growth rate (g) for Ren Ltd is:
 2.00
g = 0.15- 30.00 = 0.083 or 8.3%

2. Shyama Enterprise earnings and dividends have been growing at a rate of 18% per annum. This
growth rate is expected to continue for 4 years. After that the growth rate will fall to 12 % for the
next 4 years. Thereafter, the growth rate is expected to be 6 % forever. If the last dividend per
share was Rs 2.00 and the investors required rate of return on shyama equity is 15 per cent, what
is the intrinsic value per share?

Solution:

The intrinsic value per share of Shyama may be computed using a 3 step procedure.

Step 1: the dividend stream during the firt eight years when Shyama would enjoy a relatively high
rate of growth will be

D1 = 2.00 (1.18) = 2.36

D2 = 2.00 (1.18)2 = 2.78

D3 = 2.00 (1.18)3 = 3.29

D4 = 2.00 (1.18)4 =3.83

D5 = 2.00 (1.18)4 (1.12) = 4.34

D6 = 2.00 (1.18)4 (1.12) = 4.86

D7 = 2.00 (1.18)4 (1.12) = 5.45

D8 = 2.00 (1.18)4 (1.12) = 6.10

The present value of this dividend stream is ;

2.36 (PVIF15%,1yr) + 2.78 (PVIF15%,2yrs) +3.29 (PVIF15%,3yrs) +3.88 (PVIF15%, 4yrs) + 4.34
(PVIF15%,5yrs) + 4.86 (PVIF15%,6yrs) + 5.45 (PVIF15%, 7yrs) + 6.10 (PVIF15%,8yrs)
= 2.36 (0.870) + 2.78 (0.756) + 3.29 (0.658) + 3.88 (0.572) +4.34 (0.497) + 4.86 (0.432) +5.45
(0.376) + 6.10 (0.327)

= 2.05 + 2.10 + 2.16 + 2.22 + 2.16 + 2.10 + 2.05 + 1.99 = Rs 16.83

Step 2: The price of the share at the end of 8 years, apply71ing the constant growth model at that
point of time, will be:

𝐷 2.00(1.18)4 (1.12)4 (1.06)

P8 = 𝑟−𝑔9 = = Rs 71.84
𝑛 0.15−0.06

The present value of this price is:

71.84
= Rs 23.49
(1.15)8

Step 3: The sum of the above components is:

P0 = Rs 16.83 + Rs 23.49 = Rs 40.32.

3. The current dividend on an equity share of Pioneer Technology is Rs 3.00. Pioneer is expected
top enjoy an above normal growth rate of 40 per cent for 5 years. Thereafter, the growth rate will
fall and stabilize at 12 percent. Equity investors require a return of 15 % from Pioneer’s stock.
What is the intrinsic value of the equity share of Pioneer?

Solution:

The inputs required for applying the two-stage growth model are:

g 1 = 40%, g2 =12%, n=5 years, r = 15%

D1 = D0 (1+g1) = Rs 3 (1.40) = Rs 4.20

Plugging these inputs in the two-stage growth model, we get the intrinsic value estimate as follows:

1.40 5
1−[ ] 4.20 (1.40)4 (1.12) 1
1.15
P0 = 4.20 [0.15−0.40] + [(1.15)5]
0.15−0.12

= 28.12 +299.37 = Rs 327.49

______________________________________________________________________________

2.8 REVIEW QUESTIONS

SHORT ANSWER QUESTIONS

1. Write a note on the present value of expected stream of benefits from equity shares.

2. Write a short note with illustrations for the following:

( a ) Dividend valuation model
( b ) the Zero Growth Case

LONG ANSWER QUESTIONS

1. What do you mean by valuation? Explain briefly different equity evaluation modules.

2. Describe the following measures of value: book value, liquidation value and replacement
cost. How useful are they?

3. Explain the two stage growth model.

4. The share of a certain stock paid a dividend of Rs 2.00 last year (D 0 = Rs 2.00). The
dividend is expected to grow at a constant rate of 6 percent in the future. The required rate
of return on this stock is considered to be 12 per cent. How much should this stock sell for
 now? Assuming that the expected growth rate and required rate of return remain the same,
at what price should the stock sell 2 years hence?

5. The commonwealth corporation’s earnings and dividends have been growing at the rate of
12 percent per annum. This growth rate is expected to continue for 4 years. After that the
growth rate would fall to 8 per cent for the next four years. Beyond that the growth rate is
expected to be 5 percent forever. If the last dividend was Rs 1.50 and the investors required
rate of return on the stock of commonwealth is 14 percent, how much should be the market
value per share of commonwealth equity stock?

______________________________________________________________________________

2.9 FURTHER READINGS

1. Fisher, Donald E, and Jordan, Ronald J: Security Analysis and Portfolio management, ,
1967.Prentice Hall, 1987.

2. Coates, Robert C: Investment Strategy, Mc Graw Hill 1978.

3. Fisher, Philips A: Common Stock and uncommon Profit, N.Y. Harper, 1960.

4. Francis, Jack Clark: Investment Analysis and Management, New York: Mc Graw Hill,
1983

5. Fraser, William J: the Demand for Money, New York, World Publishing.

6. Gupta L.C: Rates of return on Equities: The Indian Experience, Bombay Oxford University
press, 1981.