ACFN 3201

Investment and Portfolio Management

Kebede A.(MSc)
Ambo University,
Ethiopia
 Introduction

• A share or stock means a share of ownership in a corporation (company).

• stocks is often used as a synonym for shares especially in the United States, but it
is less commonly used that way outside of North America.
• In the United Kingdom, South Africa, and Australia,
• stock are different financial instruments such as
• government bonds or, less commonly,
• to all kinds of marketable securities
• Definition:
• Stock means
 a share in the ownership of a company.
 a claim on the company’s assets and earnings.
 a shares, equity, or stock
 Dividends
• company may distribute its surplus profits as returns to investors which termed as dividends.
• Types of dividend:
 Cash dividends-------Dividends are paid in the form of cash
 bonus shares (stock dividend)--------- When shares are issued additionally to the existing
investors
• Cash dividend payments reduce --------the cash balance of the company
• bonus share payments reduce ----------the reserve position of the company.
• Payment of dividend --------- influences the stock price of the company
 Cash dividend------- the book value of the company reduced and lower the market price of the
share
 Bonus shares(stock dividend)--------- increases the number of existing shares.
• Bonus shares are different from stock splits
• Bonus shares
 increase the value of equity capital to the company.
Stock split
 reduction in the face value and increase in the quantity of stock
 does not increase the value of current equity capital
 Basic characteristics of common stock
and
Share valuation
Basic characteristics of common stock
• Each share of common stock represents -----------equity (ownership) in a company
• Every share holder entitled ---------an equal ownership position and equal vote, and equal
voice in management.
• Common stock has no maturity date---- unless the holder decides to sell it to another
investor.

• Share valuation(share estimation)

Share valuation is the process of assigning a Birr value to a specific share

Valuation models or approaches

 1. Earning multiplier approach
 2. Free cash flow model
 3. Balance sheet valuation
 4. Dividend-discount model
 1. Earning multiplier approach

 Earnings means net income or net profit

 Earnings are the money left after a company meets all its expenditure.
 the measure of earnings is stated as earnings per share (EPS)
1. EPS= Earnings / No. of share
• E.g.; if a company has 10 million shares outstanding and has earned 20 million Birr
• EPS= Birr. 20,000,000/10,000,000 shares = 2.00 Birr
• But EPS alone would not be able to measure if a company’s share in the market is undervalued or overvalued.
• Another measure used to arrive at investment valuation is the Price/Earnings (P/E) ratio
2. P/E Ratio = market price of a share /earnings per share.
• E.g.; if a company is currently trading at 150 Birr per share with an EPS of 5 Birr per share.
• P/E Ratio= 150/5 = 30 Birr.
•   The P/E ratio or multiplier used to make an investment decision
• A high P/E multiplier implies
 the market has overvalued the security i.e; EPS<MP
A low P/E multiplier implies
 the market has undervalued the security i.e; EPS>MP
If P/E multiplier of 1.0. means ---------EPS= MP
3. Forward P/E ratio is another techniques -------often used in comparison with
the current rate of growth in earnings per share.(used in comparison with in
EPS)

• After knowing Forward P/E ratio------- ‘future’ value of a share can be

calculated by comparing the current P/E with the future P/E
•Forecasted market price is calculated as
• ((market Price X (current P/E,))
• (future P/E,).
•E. g; if current market price is Birr. 20, current P/E is 4 and forecasted P/E is
2.5,
•The forecast price is [(20x(4/2.5)]= . Birr 32.

4. A modification to the P/E multiplier approach is to determine the relationship

between the company’s P/E and the average P/E of the stock index. This is called as the
price-earnings relative
•NB earnings multipliers is not applicable when the earnings are negative.
 2. Free Cash flows model:
• Cash flows means ----(net of inflows less outflows from operations)
• Cash flows differ from book profits or accounting profit
• Cash flow=EBDIT( Earnings Before Depreciation, interest and Taxes)
• Book profits or accounting profit means=EBDIT- Depreciation
• Depreciation is a non cash expenditure.
• The most common valuation method is discounted cash flow (EBDIT) method
• The formula for computing the value of the firm will be;
•
n
Ci
• V= i 1 1  d i
• Where Ci = cash flows forecast for year I
• d = expected rate of return
• n = number of years for which forecasts have been made.
• Cash forecasts are made for a limited time duration but the shares are valued for their ability
to produce an indefinite stream of cash flows. Which is called the terminal value of shares.
 2. Free Cash flows model……cont’d

1. Terminal value method

Terminal value in year n = Cash flow in year (n + 1)/(d – g)
• Where,
•  ‘d’ is the discount rate of the cash flows
•  ‘g’ is the stable growth rate

• Assumption of the approach;

 1.growth is constant forever, and
 2. The cost of capital (discount rate) will not change over time.

• No company in the long term, can grow faster than the economy that it
operates. This means that the discount rate has to be fixed after considering
the inflation rate, economic growth rate, time value, and so on.
 
 2. Free Cash flows model…Cont’d
2. Price to cash flow ratio
• Price to cash flow ratio can also be used as a valuation model.
• Cash flow multiplier is computed as: market price/cash flow per share.
• For example, if the current market price is 60 Birr and cash flow per share is 20 Birr,
• the cash flow multiplier =60/20= 3.
3.Economic value added (EVA) is another modification of cash flow that considers;
 1.the cost of capital and
 2.the incremental return above that cost.
EVD = Increment return - cost of capital
• Example; if after tax return from operations is 18% and the cost of capital is 10%,
• Then the incremental return for the company would be (18 – 10)= 8%..
• EVA multiple can be used to identify the under pricing or over pricing of a share in
the market. 
 3. Asset valuation or Balance sheet valuation:
• Expectation of earnings, and cash flows alone may not be able to identify the
correct value of a company.
• investors started valuation of equity through the company’s assets.
• Asset valuation includes a company’s liquid assets such as;
 cash, immovable assets such as real estate, as well as intangible assets.
– Simply knowing the liquidation value a company if all of its assets were
sold off.
Asset valuation or Balance sheet valuation Methods:
1.book value method : Asset valuation gives the exact book value of the
company.
– Book value = Equity worth (capital including reserves belonging to
shareholders) / Number of outstanding shares
– Or
• Book value = (Total assets – Long-term debt)/Number of outstanding shares
 3. Asset valuation or Balance sheet
valuation…..cont’d
2. Price to book ratio : Another useful measure of asset valuation is the price to book ratio.
Price to book value ratio = Market price/Book value per share.
 A low price to book ratio --- means undervaluation of shares
 A high price to book ratio-------means overvaluation of shares
• For example,;
• if a company has total assets less long-term liabilities as 43950 million Birr and
• the number of outstanding shares at 2,000 million Birr,
• the book value per share will be (43950/2000) =21.975 Birr.
• If the market price is quoted at 84 Birr, then;
• Price to Book ratio or multiplier will be (84/21.975) =3.82 Birr.
3. Return on Equity(ROE): Another useful measure of asset valuation is ROE
• Return on equity is a measure of how much earnings a company generates to its shareholder’s equity.

• ROE = Earning on equity of company generate

share holders equity
• For example; if a company earned 2 million Birr and shareholder’s equity of 10 million Birr,
• then the ROE= 2 million Birr/10 million = 0.20 or 20 percent. .

 
 4.Dividend discount Model
• The value of an equity share = the present value of expected dividends +
the present value of the expected sale price.
• Assumptions of the Dividend discount model:
 (i) dividends are paid annually- this seems to be a common practice for
business firms; and
 (ii) the first dividend is received one year after the equity share is
bought.
– Dividend valuation Models:
 Single-period valuation model
 Multi-period valuation Model:
 i)The zero growth model:
 ii) The constant growth model:
 iii) Two stage growth model
 iv) H model:
 Single-period valuation model
• where the investor expects to hold the equity share for one year.
• The current price of the equity share will be:
D1 P1
current price of the equity share (P0 ) = --------------- + -------------
(1 + r) (1 + r)
D1 = dividend expected a year
P1 = price of the share expected a year and
r = rate of return required on the equity share.
For example; expected dividend on equity share is 2.00 Birr and expected price is
18.00 Birr , required rate of return is 12 %
2 18
current price of the equity share (P0 ) = --------------- + ------------- = 17.86
(1 + 0.12) (1 + 0.12)
 Multi-period valuation Model:
• Concept: Since equity shares have no maturity period
dividends generates continuously(infinite period)

I) .Zero growth model

• Assumptions of the model are;
• The growth rate is Nil. So dividend per share remains constant
forever
D
• Current price of the share P0= ------
r
ii).constant growth model
• Assumptions of the model are;
• The dividend per share grows at a constant rate per year
forever
D1
• Current price of the share P0 = ------
r-g
 
 Multi-period valuation Model……cont’d
iii).Two stage growth model
Assumptions of the model are;
extraordinary growth will continue for a limited number of years
and there after constant normal growth rate will exist
indefinitely (forever).

iv) H model:
Assumptions of the model are;

 The dividend per share, currently growing at an above-

normal rate,
 A gradually declining rate of growth for a while.
 Thereafter, it grows at a constant normal rate.
End of the Chapter