VALUATION OF SHARES

 The valuation of common stock in terms of the future

earnings and dividends the firms will yield is known as
quantitative models.
QUANTITATIVE MODELS
 Expected HPR =E(D1) +[E(P1) –p0] /po
 E(D1)= expected dividend per share
 P0 = current price of a share
 E(P1) = expected price at the end of the year

Example :
 Expected dividend per share $4, current price a share $
48, expected price at the end of the year $52. one year
holding period.
Expected HPR =E(D1) +[E(P1) –p0] / po
4+( 52-48)/48 = 0.167 = 16.7%
REQUIRED RATE OF RETURN
EXAMPLE
 rf = 6%
 E(rm)-rf = 5%
 Βeta = 1.2
 Calculate required rate of return (k)

 k = rf+β[E(rm)-rf]

 = 6%+1.2x 5% = 12%
INTRINSIC VALUE
 Is defined as the present value of all cash payments to the
investor in the stock, including dividends as well as the
proceeds from the ultimate sale of stock, discounted at the
appropriate risk adjusted interest rate (k)

 Vo = E(D1) + E (P1) / 1+k

 Vo = intrinsic value
 E(D1) = expected dividend per share
 E (P1) = expected price of the share at the end of the year
 k = required rate of return
EXAMPLE :
 Expected dividend per share $4
 Expected price at the end of a year $52

Required rate of return 12%.

 Vo = E(D1) + E (P1) / 1+k = 4+52/1.12 =$50
MULTIPLE YEAR HOLDING PERIOD (FOR 3
YEARS)

 An investor may hold a share for a certain number of years

and sell it off at the end of his holding period.
 In this case, he would receive annual dividends each year
and the sale price of the share at the end of the holding
period.
 The present value of share may be expressed as

Vo = D1/1+k +D2 /(1+k)2 +D3/ (1+k)3+PH/(1+k)3

EXAMPLE
 An investor expects to get $3.50, $4 and $4.50 as
dividend from a share during the next three years and
hopes to sell it off $75 at the end of the third year. The
required rate of return is 25%.
 The present value(Vo)

(Vo)= D1/1+k +D2 /(1+k)2 +D3/ (1+k)3+PH/(1+k)3

= 3.50/(1.25) + 4.00/(1.25)2 +4.50/(1.25)3 + 75/(1.25)3

= 2.8+2.56+2.30+38.40
= $46.06
THE CONSTANT GROWTH MODEL
 In this model it is assumed that dividends will grow at the
same rate into the indefinite future.
 If dividend’s growth rate (g) is 0.05 and most recently paid
dividend was 3.81(Do) expected future dividends are
 D1 =Do (1+g) 3.81 x (1.05) = 4.00
 D2 = Do (1+g) 2 3.81 x (1.05)2 = 4.20
 D3 = Do (1+g) 3 3.81 x (1.05)3 = 4.41
And so on, we can solve the present value as
Vo = D0(1+g) /1+k +D0(1+g)2 /(1+k)2 / D0 (1+g)3/(1+k)3
OR Vo = D0 (1+g)/k-g OR D1/ k-g
 EXAMPLE
 A company has declared a dividend of $2.50 per share for the
current year. The company has been following policy of
enhancing its dividends by 10 percent every year and is
expected to continue this policy in the future also.
 An investor who is considering the purchase the shares of this
company has a required rate of return of 15 percent .
 The intrinsic value of the company’s share can be calculated
as
Vo = Do (1+g)/ k-g
= 2.50(1.10)/0.15-0.10
= 2.75/0.05 = $55
 The investor would be advisable to purchase the share if the
current market price is lower then $55.

Example
The prices of IBX stock to be $59.77 per share a year form now.
The current market price is $50. the expected dividend at the end
of one year is $2.15 per share.
1. What is the stock’s expected yield, capital gains and holding
period return.
2. If the stock has a beta of 1.5 risk-free rate is 6% per year and the
expected rate of return on the market portfolio is 14% per year,
what is required rate of return on IBX stock ?
3. What is the intrinsic value of IBX stock and how does it compare
to the current market share?
A.Expected dividend yield
E(D1) / P0 = 2.15/50 = 4.3%

Capital gains = E(P1) – P0) / P0 = 59.77-50/50

= 0.1954 = 19.54%
Total return = 4.3% +19.54% = 23.84%
B. Required Rate of Return

k= rf+β[E(rm)-rf]

6% + 1.15 x 14% -6%

= 6+1.15x8 =6+9.20
= 15.2%

C. Intrinsic value
v0 = E(D1) + E(P1)/ 1+k

= 2.15+59.77/1+15.2%
= 61.92/1.152 = $53.75
Which exceeds the market price. This would indicate to buy
opportunity.