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Valuation Techniques

Using fundamental analysis, there are two

techniques

1. Discounted cash flow techniques

1. Dividend Discounted Model (Income Method)

2. Free Cash flow to equity (Cash Flow Analysis)

3. Free Cash flow to firm (Cash Flow Analysis)

2. Relative Valuation technique [these techniques measure the

stocks while comparing with some bench mark (such as the

market, industry) or stocks own history over time]

Tobins q (Asset-based Approach)

Price/Earning Ratio (Market-based Technique)

Fundamental analysis

Fundamental analysis is a term for studying a

companys accounting statements and other

financial and economic information to estimate

the economic value of a companys stock.

The fundamental analysis was formally used to

analyze and evaluate the balance sheets, annual

reports, trend analysis, profitability ratios and

profit & loss figures in order to beat the market.

The basic idea is to identify undervalued stocks to

buy and overvalued stocks to sell.

Intrinsic Value Vs Market Value

Intrinsic Value (IV) is the estimated value of

the stock today derived from discounting the

future cash flows for a stock

Market value (MV) is the current share price.

If IV > MV = the assets is undervalued and

should be purchased.

If IV < MV = the assets are overvalued and

should be sold

If IV = MV, the assets are correctly valued.

Dividend Discounted Model (DDM)

The basic idea behind the discounting model

is:

Present Value = Future Value

1+ Interest Rate

OR

Intrinsic Value of security = Cash flow

1+RRR

Intrinsic Value

As already mentioned that Intrinsic value of a share

is the present value of all cash payments to the

investor in the stock

To calculate intrinsic value we need,

All cash flows (dividend + closing price)

Discount rate (required rate of return)

6-7

The Dividend Discount Model

The Dividend Discount Model (DDM) is a method to

estimate the value of a share of stock by discounting all

expected future dividend payments. The DDM equation is:

In the DDM equation:

IV (Intrinsic Value) = the present value of all future

dividends

D(t) = the dividend to be paid t years from now

k = the appropriate risk-adjusted discount rate

T 3 2

k 1

D(T)

k 1

D(3)

k 1

D(2)

k 1

D(1)

IV

Three Foms of DDM

1. Zero Growth Model

2. Constant Growth Model

3. Multi-growth rate model

Zero Growth Model of DDM

If share produces same dividend over an

infinite period of time; then its become

perpetuity.

IV = D

K

Where IV = Intrinsic Value; D is the series of

equal dividend; K is the discounting rate

Constant Growth Model of DDM

If there is constant forever growth in the

dividend; then the dividend will increase on

the basis of compound rate;

Hence, the dividend next period (t + 1) is:

6-11

Constant Growth Model of DDM

If there is constant forever growth in the

dividend; then the dividend will increase on

the basis of compound rate;

Hence, the dividend next period (t + 1) is:

As

g 1 t D 1 D or 1 t D

T 3 2

k 1

D(T)

k 1

D(3)

k 1

D(2)

k 1

D(1)

IV

6-12

Constant Growth Model of DDM

Or it can be calculated like:

Using limit Theorem, the DDM formula for

constant growth becomes:

Or

Where, K g is the growth factor

g k

g D

IV

o

) 1 (

T

T

0

3

3

o

2

2

o o

k 1

g) (1 D

k 1

g) (1 D

k 1

g) (1 D

k 1

g) (1 D

IV

g k

D

IV

1

6-13

Estimating the Growth Rate

The growth rate in dividends (g) can be

estimated in a number of ways.

Using the companys historical average growth

rate.

Using an industry median or average growth rate.

The Multi growth rate model

Or

Two-Stage Dividend Growth Model

The firm grow at the faster rate in the

beginning years and then slow down to

normal growth (constant growth)

The two-stage dividend growth model

assumes that a firm will initially grow at a rate

g

1

for T years, and thereafter grow at a rate g

2

< k during a perpetual second stage of growth.

The intrinsic value is calculated while

calculating the PV of different growth stages

and sum up both PV.

The Multi growth rate model

Where P is calculated using the constant growth

model of DDM

t

k

P Dt

k

D

k

D

k

D

IV

) 1 (

...

) 1 (

3

) 1 (

2

1

1

3 2

) (

) 1 (

g k

G Dt

P

Example...

Suppose a firm current dividend is Rs. 8 per

share, the dividend increases at 7% in the first

stage for 5 years and grows at a constant

growth of 4% thereafter, required rate of

return (discount rate) is 9%, calculate the

intrinsic value of the firm?

Relative Valuation Methods

Tobins Q:

Tobins q is the ratio of the market value of a firm to the

replacement cost of its assets

The replacement cost of an asset is the cost of acquiring

an asset of identical characteristics, such as the

production capacity of a plant:

For example the market value of a firm is Rs. 500 and the

replacement cost of its assets is Rs. 250, its q is 2

Tobins q =

Market value of firm

Replacement cost of its assets

or Total Assets Value

Relative Valuation Methods

Tobins Q (cont):

Tobins q has been used in investment context to spot

undervalued companies

For example, a low Q (between 0 and 1) means that the cost

to replace a firm's assets is greater than the value of its stock.

This implies that the stock is undervalued.

Conversely, a high Q (greater than 1) implies that a firm's

stock is more expensive than the replacement cost of its

assets, which implies that the stock is overvalued.

This measure of stock valuation is the driving factor behind

investment decisions in Tobin's model.

Relative Valuation Methods

Price/Earning Ratio:

Price/Earning Ratio (PER) also known as the earnings

multiplier, expresses the relationship between a firms

earnings for equity market capitalization

P/E ratio means how much price investors are willing to

pay for one rupee of earning

In practice, equity value is proxied by the market value of

companies equity:

PER =

Market value of equity

Earnings for equity

PER =

Share price

Earnings per share (EPS)

or

For Example

OGDCL P/E ratio is = 500/50 = 10

It means for one rupee earnings investors are willing

to pay Rs.10 for buying one share of OGDCL

High P/E ratio refers that investors are paying for

money for shares for the same one rupee of

earnings. Similarly;

Low P/E shares are cheap, investors have to pay

lesser price for the same one rupee of earnings,

So it will be feasible for bidder to target the low P/E

ratio firm.

Relative Valuation Methods

There are two decision criteria

On the basis of firm own earnings estimates

On the basis of industry P/E

Relative Valuation Methods

Suppose OGDCL current earnings is Rs. 50

Million and current market price is Rs. 500

Million. It is expected that coming year

earnings will be Rs. 100 million. On the basis

of P/E ratio, whether OGDCL is suitable for

investment or not.

OGDCL P/E ratio is = 500/50 = 10x

On the basis of firm own earnings estimates

Current P/E is 10x

Price = (P/E)x future Earnings

= 10x 100 = 10,00

Current price is 500, so buyer should invest in

OGDCL.

On the basis of industry P/E

Analysts usually calculate P/E ratio for an

industry or whole market

An individual stocks P/E is compared with

others in the industry

If it is traded at discount in relations to others,

then the stock is recommended for buying

Example on P/E ratio

Firm OGDCL P/E ratio Vs Industry P/E ratio

10 = 10 (Correctly Valued)

10 Vs 15 (Under-Valued)

10 Vs 7 (Over-Valued)

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