Valuation by Comparables

Fundamental analysis attempts to identify

stocks that are mispriced to some measure of
true value that can be derived from observable
financial data. Law of price is enforced by the
process of arbiterage – simultaneously buying
an under priced asset and selling its
overpriced equivalent to achieve a positive
profit with no net outlay of cost.
Other Approaches to Stock Valuation
Book Value
• Book value per share is the amount per share that
would be received if all the firm’s assets were sold for
their exact book value and if the proceeds remaining
after paying all liabilities were divided among common
stockholders.
• This method lacks sophistication and its reliance on
historical balance sheet data ignores the firm’s
earnings potential and lacks any true relationship to
the firm’s value in the marketplace.
Other Approaches to Stock Valuation
Liquidation Value
• Liquidation value per share is the actual amount per
share of common stock to be received if al of the firm’s
assets were sold for their market values, liabilities
were paid, and any remaining funds were divided
among common stockholders.
• This measure is more realistic than book value
because it is based on current market values of the
firm’s assets.
• However, it still fails to consider the earning power of
those assets.
Other Approaches to Stock Valuation
Valuation Using P/E Ratios
• Some stocks pay no dividends. Using P/E ratios are
one way to evaluate a stock under these
circumstances.
• The model may be written as:
– P = (m)(EPS)
– where m = the estimated P/E multiple.
For example, if the estimated P/E is 15, and a
stock’s earnings are $5.00/share, the estimated
value of the stock would be P = 15*5 =
$75/share.
Other Approaches to Stock Valuation
Weaknesses of Using P/E Ratios

• Determining the appropriate P/E ratio.

– Possible Solution: use the industry average P/E
ratio
• Determining the appropriate definition of earnings.
– Possible Solution: adjust EPS for extraordinary
items
• Determining estimated future earnings
– forecasting future earnings is extremely difficult
 Financial Highlights of Tata Steel Ltd.
NSE BSE
Date 11/3/05 11/3/05
Market 24410.18 Open Price 433.00 432.00
Capitalization Rs
Cr High Price 443.00 442.20
Book Value 122.79 Low Price 433.00 432.00
Debt/Equity 0.74 Close Price 441.15 440.80
P/E 9.28 No. of 38564 17567
Dividend yield % 2.00 Trades
Traded Qtyt. 5205571 2383129
EPS 47.48
Return on Net worth 43.76 Trade Value 2282602815 104527604
1
Current Ratio 0.68 52 Weeks H 443.00 442.20
Quick Ratio 0.39
52 Weeks L 155.44 154.90
Interest cover 15.98
FUNDAMENTALS
PRICE HISTORY
• Tata Steel PE Ratio is 9.28
• Price to book value Ratio is 3.59
• Price to Sales Ratio is 5.97
• Compare this data with other steel companies (Essar, Jindal, SAIL) to
assess the valuation of Tata Steel
• PE Ratio of Tata can be compared to average for industry being 6.43.
Tata Steel appear to be overvalued
• Market price of Tata Steel stock on March 11,2005 was 3.6 times its
book value at the end of 31st March 2004, as against for the average
firm in the steel industry being 4.08. This implies Tata Steel is
undervalued.

Valuation Ratios for Steel Industry

Tata Essar Jindal Jindal SAIL Industr

Steel Steel Iron Steel y

P/E 9.28 5.88 4.15 7.51 5.33 6.43

ratio
P/BV 3.59 4.87 1.77 4.29 5.90 4.08
Ratio
 Limitations of Book Value
• Book value of a firm is the result of
applying a set of arbitrary accounting rules
to spread the acquisition cost of assets
over a specified number of years whereas
market price of a stock takes account of
the firm’s value as a going concern
• Market price reflects a PV of its expected
future cash flows.
 Common Stock Valuation

• Stockholders expect to be compensated for their

investment in a firm’s shares through periodic
dividends and capital gains.

• Investors purchase shares when they feel they are

undervalued and sell them when they believe they are
overvalued.
 Common Stock Valuation
Market Efficiency
• Investors base their investment decisions on their
perceptions of an asset’s risk.

• In competitive markets, the interaction of many buyers

and sellers result’s in an equilibrium price – the market
value – for each security.

• This price is reflective of all information available to

market participants in making buy or sell investment
decisions.
 Common Stock Valuation
Market Adjustment to New Information
• The process of market adjustment to new information
can be viewed in terms of rates of return.
• Whenever investors find that the expected return is
not equal to the required return, price adjustment will
occur.
• If expected return is greater than required return,
investors will buy and bid up price until new
equilibrium price is reached.
• The opposite would occur if required return is greater
than expected return.
 Common Stock Valuation
The Efficient Market Hypothesis
• The efficient market hypothesis, which is the basic
theory describing the behavior of a “perfect” market
specifically states:
– Securities are typically in equilibrium, meaning they are
fairly priced and their expected returns equal their
required returns.
– At any point in time, security prices full reflect all public
information available about a firm and its securities and
these prices react quickly to new information.
– Because stocks are fairly priced, investors need not
waste time trying to find and capitalize on mis-priced
securities.
 Common Stock Valuation
Stock Returns are derived from both dividends and
capital gains, where the capital gain results from the
appreciation of the stock’s market price.due to the
growth in the firm’s earnings. Mathematically, the
expected return may be expressed as follows:

E(r) = D/P + g

For example, if the firm’s $1 dividend on a $25

stock is expected to grow at 7%, the expected
return is:

E(r) = 1/25 + .07 = 11%

 Stock Valuation Models
The Basic Stock Valuation Equation
 Stock Valuation Models
The Zero Growth Model

• The zero dividend growth model assumes that the

stock will pay the same dividend each year, year after
year.
 Stock Valuation Models
The Constant Growth Model

• The constant dividend growth model assumes that the

stock will pay dividends that grow at a constant rate
each year -- year after year.
 Stock Valuation Models
Variable Growth Model
• The non-constant
dividend or variable
growth model
assumes that the
stock will pay
dividends that grow
at one rate during
one period, and at
another rate in
another year or
thereafter.
 Stock Valuation Models
Variable Growth Model
What would an investor be willing to pay for a stock if she just received a
dividend of $2.50, her required return is 15%, and she expected dividneds
to grow at a rate of 10% per year for the first two years, and then at a rate of
5% thereafter.

Step 1: Compute the expected dividends during the first growth period.

g 10.0%
D0 $ 2.50
D1 $ 2.75
D2 $ 3.03
 Stock Valuation Models
Variable Growth Model
What would an investor be willing to pay for a stock if she just received a
dividend of $2.50, her required return is 15%, and she expected dividneds
to grow at a rate of 10% per year for the first two years, and then at a rate of
5% thereafter.
Step 2: Compute the Estimated Value of the stock at the end of year 2
using the Constant Growth Model

D2 $ 3.03
k 15.00%
g 5.00%
V2? $ 31.76
 Stock Valuation Models
Variable Growth Model
What would an investor be willing to pay for a stock if she just received a
dividend of $2.50, her required return is 15%, and she expected dividneds
to grow at a rate of 10% per year for the first two years, and then at a rate of
5% thereafter.
Step 3: Compute the Present Value of all expected cash flows
to find the price of the stock today.

Cash PV at
Flow 15%
1 D1 $ 2.75 $ 2.39
2 D2 $ 3.03 $ 2.29
3 V2? $ 31.76 $ 20.88
V0 ? $ 25.56
 Stock Valuation Models
Free Cash Flow Model
• The free cash flow model is based on the same
premise as the dividend valuation models except that
we value the firm’s free cash flows rather than
dividends.
 Stock Valuation Models
Free Cash Flow Model
• The free cash flow valuation model estimates the
value of the entire company and uses the cost of
capital as the discount rate.
• As a result, the value of the firm’s debt and preferred
stock must be subtracted from the value of the
company to estimate the value of equity.
Decision Making and Common Stock Value
• Valuation equations measure the stock value at a
point in time based on expected return and risk.
• Any decisions of the financial manager that affect
these variables can cause the value of the firm to
change as shown in the Figure below.
Decision Making and Common Stock Value
Changes in Dividends or Dividend Growth
• Changes in expected dividends or dividend growth
can have a profound impact on the value of a stock.

Price Sensitivity to Changes in Dividends and Dividend Growth

(Using the Constant Growth Model)

D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.00 $ 2.00

g 3.0% 3.0% 3.0% 3.0% 6.0% 9.0%
D1 $ 2.06 $ 2.58 $ 3.09 $ 2.06 $ 2.12 $ 2.18
kS 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
P $ 29.43 $ 36.79 $ 44.14 $ 29.43 $ 53.00 $ 218.00
Decision Making and Common Stock Value
Changes in Risk and Required Return
• Changes in expected dividends or dividend growth
can have a profound impact on the value of a stock.

Price Sensitivity to Changes Risk (Required Return)

(Using the Constant Growth Model)

D0 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00

g 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
D1 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06
kS 5.0% 7.5% 10.0% 12.5% 15.0% 17.5%
P $ 103.00 $ 45.78 $ 29.43 $ 21.68 $ 17.17 $ 14.21
Decision Making and Common Stock Value
Changes in Risk and Required Return
• Changes in expected dividends or dividend growth
can have a profound impact on the value of a stock.

Price Sensitivity to Changes in Both Dividends and Required Return

(Using the Constant Growth Model)

D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.50 $ 3.00

g 3.0% 6.0% 9.0% 3.0% 6.0% 9.0%
D1 $ 2.06 $ 2.65 $ 3.27 $ 2.06 $ 2.65 $ 3.27
kS 5.0% 7.5% 10.0% 12.5% 15.0% 17.5%
P $ 103.00 $ 176.67 $ 327.00 $ 21.68 $ 29.44 $ 38.47
 DIVIDEND DISCOUNT MODEL
• SINGLE PERIOD VALUATION MODEL
D1 P1
P0 = +
(1+r) (1+r)
• MULTI - PERIOD VALUATION MODEL
 Dt
P0 = 
t=1 (1+r)t
• ZERO GROWTH MODEL
D
P0 =
r
• CONSTANT GROWTH MODEL
D1
P0 =
r-g
 Centre for Financial Management , Bangalore
 TWO - STAGE GROWTH MODEL

1 - 1+g1 n

1+r Pn
P0 = D1 +
r - g1 (1+r)n
WHERE
Pn D1 (1+g1)n-1 (1+g2) 1
=
(1+r)n r - g2 (1+r)n

 Centre for Financial Management , Bangalore

TWO - STAGE GROWTH MODEL : EXAMPLE
EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OF
VERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY AN
ABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6
YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISE
AT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15
PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OF
VERTIGO ?
THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE :
g1 = 20 PERCENT
g2 = 10 PERCENT
n = 6 YEARS
r = 15 YEARS
D1 = D0 (1+g1) = RS.2(1.20) = 2.40

PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THE

INTRINSIC VALUE ESTIMATE AS FOLLOWS :

1.20 6
1 -
1.15 2.40 (1.20)5 (1.10) 1
P0 = 2.40 +
.15 - .20 .15 - .10 (1.15)6

1 - 1.291 2.40 (2.488)(1.10)

= 2.40 + [0.497]
-0.05 .05

= 13.968 + 65.289
= RS.79.597
 Centre for Financial Management , Bangalore
 H MODEL

ga
gn

H 2H

D0
PO = [(1+gn) + H (ga + gn)]
r - gn
D0 (1+gn) D0 H (ga + gn)
= +
r - gn r - gn

VALUE BASED PREMIUM DUE TO

ON NORMAL ABNORMAL GROWH
GROWTH RATE RATE
 ILLUSTRATION: H LTD

D0 = 1 ga = 25% H=5
gn = 15% r = 18%
1 (1.15) 1 x 5(.25 - .15)
P0 = +
0.18 - 0.15 0.18 - 0.15
= 38.33 + 16.67 = 55.00
IF E = 2 P/E = 27.5
 IMPACT OF GROWTH ON PRICE, RETURNS,
AND P/E RATIO

PRICE DIVIDEND CAPITAL PRICE

D1 YIELD GAINS EARNINGS
PO = YIELD RATIO
r-g (D1 / PO) (P1 - PO) / PO (P / E)

RS. 2.00
LOW GROWTH FIRM PO = = RS.13.33 15.0% 5.0% 4.44
0.20 - 0.05

RS. 2.00
NORMALGROWTH PO = = RS.20.00 10.0% 10.0% 6.67
FIRM 0.20 - 0.10

RS. 2.00
SUPERNORMAL PO = = RS.40.00 5.0% 15.0% 13.33
GROWTH FIRM 0.20 - 0.15
 EARNINGS MULTIPLIER
APPROACH

P0 = m E1

DETERMINANTS OF m (P / E)
D1
P0 =
r-g
E1 (1 - b)
=
r - ROE x b
(1 - b)
P0 / E1 =
r - ROE x b
 E / P, EXPECTED RETURN, AND GROWTH
1 2
……...
E1 = D1 E2 = D2
= 15 = 15
15
r = 15% P0 = = 100
0.15
INVESTMENT .. RS. 15 PER SHARE IN YEAR 1 … EARNS 15%
2.25
NPV PER SHARE = - 15 + = 0
0.15

RATE OF INCREMENTAL PROJECT'S IMPACT ON SHARE PRICE E1/P0 r

RETURN CASH FLOW NPV IN SHARE PRICE IN YEAR 0,
YEAR 1 IN YEAR 0 P0

0.05 0.75 -10 -8.70 91.30 0.164 0.15

0.10 1.50 -5 -4.35 95.65 0.157 0.15
0.15 2.25 0 0 0 0.15 0.15
0.20 3.00 5 4.35 104.35 0.144 0.15
0.25 3.75 10 8.70 108.70 0.138 0.15
IN GENERAL, WE CAN THINK OF THE STOCK PRICE AS THE
CAPITALISED VALUE OF THE EARNINGS UNDER THE ASSUMPTION OF
NO GROWTH PLUS THE PRESENT VALUE OF GROWTH OPPORTUNITIES
(PVGO).

E1
P0 = + PVGO
r

MANIPULATING THIS A BIT, WE GET

E1 PVGO
= r 1 -
P0 P0

FROM THIS EQUATION, IT IS CLEAR THAT :

 EARNINGS-PRICE RATIO IS EQUAL TO R WHEN PVGO IS ZERO.
 EARNINGS-PRICE RATIO IS LESS THAN R WHEN PVGO IS
POSITIVE.
 EARNINGS-PRICE RATIO IS MORE THAN R WHEN PVGO IS
NEGATIVE.
 STOCK MARKET

 Principal Exchanges

• The National Stock Exchange

• The Bombay Stock Exchange

 Veritable Transformation

• Screen-based Trading

• Electronic Delivery

• Rolling Settlement
 STOCK MARKET INDICES

• Bombay Stock Exchange Sensitive Index (Sensex)

• Base year 1978-79  100
• 30 shares
• Value-weighted index of the free float

• S & P CNX Nifty

• Base period ; November 3, 1995  1,000
• 50 shares
• Value-weighted index
 SUMMING UP
 The value of any asset, real or financial, is equal to the present value of the cash
flows expected from it
 The value of a bond is:
n I F
V= +
t =1 (1+k d )t (1+k d)n

 The yield to maturity (YTM) on a bond is the rate of return the investor earns
when he buys the bond and holds it till maturity. It is the value of k d in the bond
valuation model. For estimating the YTM readily, the following approximation
may be used:

I + (F – P) / n
YTM ~
0.4 F + 0.6P

 According to the dividend capitalisation approach, the value of an equity share

is equal to the present value of dividends expected from its ownership plus the
present value of the resale price expected when the equity share is sold.
 Most share valuation models are based on the assumption that dividends tend to
increase over time.
 If dividends are expected to grow at a constant rate, the following equity
valuation model, a very popular model, is obtained:
D1
P0 =
ks–g
 Conceptually, the dividend capitalisation approach is unassailable.
practitioners, however, seem to prefer the earnings capitalisation approach,
mainly because of its simplicity. The procedure typically employed while using
this approach consists of the following steps: (i) Estimate the earnings per share.
(ii) Establish the price-earnings multiple. (iii) Develop a value anchor and a
value range.
 Sometimes analysts look at the book value per share and the liquidation value
per share as proxies for intrinsic value. However, these measures have serious
flaws.