VALUATION OF SECURITIES

OBJECTIVES OF THE SESSION

Free cash flow model Earning Multiplier Approach
Other comparative valuation ratios

Earning Multiplier Approach

Value of stock (P0) = E1* P0/E1

Determinants of P/E Ratio

P0= D1/r-g = E1(1-b) r-ROE*b Dividing both the sides by E1 P0 / E1 = (1-b) r-ROE*b The above formula indicates the following factors as the determinants of P/E Ratio. The dividend payout ratio, The required rate of return The expected growth rate

 P/E Ratio and Plough back ratio 1. ROE greater than r - an increase in b leads to an increase in P/E 2. ROE equal to r - an increase in b has no effect on P/E. 3. ROE less than r - an increase in b leads to decrease in P/E. P/E Ratio and interest rate 1. There is an inverse relationship between P/E Ratio and interest rate

 1. 2.

P/E Ratio and Risk Riskier stock have lower P/E Ratio P/E Ratio and Liquidity High liquid stock commands higher P/E Illiquid stock commands lower P/E Other Factors Size of the company Reputation of management


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Rules for establishing bench mark price-earning multiples

Thumb rule 1- PE multiples may be equated with the projected growth rate in earnings. Price earning to growth (PEG) ratio equal to 1 implies that the stock is fairly valued. PEG ratio greater than 1 implies that the stock is overvalued. PEG ratio less than 1 implies that the stock is undervalued. Thumb rule 2 a reasonable PE multiple could be the inverse of prime lending rate Thumb rule 3 a reasonable PE multiple would be the inverse of the real rate of return required by investors from equity stock. Growth and P/E Multiple The impact of growth on the PE multiple depends on whether the return on equity is greater than or less than the discount rate. When r<ROE, an increase in growth rate enhances the PE multiple. When r>ROE, an increase in the growth rate decreases the PE multiple. When r=ROE, growth rate does not influence the PE multiple.

2. 3.


1.

Other comparative valuation ratios:

Price to Book Value ratio
PBV ratio = market price per share at time t Book value per share at time t Determinants of PBV Ratio: P0 = D1 r -g

= E0 (1+g)(1-b) [as D1 = E1(1-b) and E1= E0 (1+g)] rg since E0 is the product of book value per share and return on equity P0 = BV0(ROE) (1+g)(1-b) rg P0 = (ROE) (1+g)(1-b) BV0 rg

 Price to Sales Ratio

Determinants of PS Ratio
P0 = E0(1+g)(1-b) [as D1 = E1(1-b) and E1= E0 (1+g)]

rg
As E0 is the product of sales per share and net profit margin P0 = S0(NPM)(1+g)(1-b) rg P0 = (NPM)(1+g)(1-b) S0 rg