Fundamentals of Finance

Anshul Jain
Valuation of Financial Securities
• First Principles:
• Value of financial securities = PV of expected future cash
flows
• To value bonds and stocks we need to:
• Estimate future cash flows:
• Size (how much) and
• Timing (when)
• Discount future cash flows at an appropriate rate:
• The rate should be appropriate to the risk presented by the
security.
Stocks
• Dividends versus Capital Gains
• Valuation of Different Types of Stocks
• Zero Growth
• Constant Growth
• Differential Growth
Stocks
• Case 1: Zero Growth
Div 1 Div 2 Div 3
P0    
(1  r ) (1  r ) (1  r )
1 2 3

Div
P0 
r

• Case 2: Constant Growth

Div 1  Div 0 (1  g )
Div 2  Div 1 (1  g )  Div 0 (1  g ) 2 Div 1
P0 
Div 3  Div 2 (1  g )  Div 0 (1  g ) 3 rg
Stocks
• Case 3: Differential Growth
• 2 Step Growth
 Div N 1 
 
Div0  (1  g1 )   r  g 2 
T
P 1  T 

r  g1  (1  r )  (1  r ) N

• g = Retention Ratio * RoE

Stocks
• Assumptions
• g – retained earnings generate RoE
• r – estimation error

• Dividends vs Earnings
Price – Earnings Ratio
• Many analysts frequently relate earnings per share to price.
• The price earnings ratio is a.k.a the multiple
• Calculated as current stock price divided by annual EPS
Price per share
P/E ratio 
EPS
• Firms whose shares are “in fashion” sell at high multiples.
Growth stocks for example.
• Firms whose shares are out of favour sell at low multiples.
Value stocks for example.
1 NPVGO
PE  
R EPS
Other Ratios
• The PE ratio focuses on equity, but what if we want the
value of the firm?

• Use Enterprise Value:

EV = market value of equity + market value of debt – cash

• Like PE, we compare the value to a measure of earnings.

From a firm level, this is EBITDA, or earnings before
interest, taxes, depreciation, and amortization.
• EBITDA represents a measure of total firm cash flow

• The Enterprise Value Ratio = EV / EBITDA