EQUITY VALUATION

• Equity shares are more difficult to anlayse

• The basic principles of valuation are the same for
fixed income securities as well as equity shares.
• The factors of growth and risk create greater
complexity in the case of equity shares.
• Equity analysts employ two kinds of analysis.
 Balance sheet valuation
• Analysts often look at the balance sheet of the
firm to get a handle on some valuation measures.
• 3 measures derived from the b/s are book value,
liquidation value and replacement value.
BOOK VALUE
Book value per share is the net worth of the
company (paidup share capital plus reserves and
surplus) divided by the number of outstanding
equity shares.
• Book value per share is firmly rooted in financial
accounting and hence can be established easily.
• Book value is based on accounting conventions
and polices which is characterized by a great
deal of subjectivity and arbitrariness.
LIQUIDATION VALUE
The liquidation value per share is equal to:
(value realized from liquidating all the assets of the
firm – amount to be paid to all the creditors and
preference shareholders)/ no. of outstanding
equity shares.
Replacement cost: replacement cost of its assets
less liabilities.
The use of this measure is based on the premise
that the market value of the firm cannot deviate
too much from its replacement cost.
 Share valuation model
• One year holding period
• If an investor expects to get Rs.3.50 as divided
from a share next year and hopes to sell off
the share at Rs.45 after holding if for one year.
And if his required rate of return is 25% the PV
of share is?
 Multiple year holding period
• If an investor expects to get Rs.3.50, Rs.4 and
Rs.4.50 as divided from a share during the
next three years and hopes to sell it off at
Rs.75 at the end of the 3rd year, and if his ROR
is 25% the PV of share is?
 Constant growth model
• Gordons share valuation model
• A company has declared a divided of Rs.2.50
per share for the current year. The company
has been folowing a policy of enhancing its
divdends by 10 per cent every year and is
expected to continue this policy in the future
also. An investor who is considering the
purchase of the shares of this company has a
ROR of 15%
 problems
• The equity stock of Rax Ltd. Is currently selling
for Rs.30 per share. The dividend expected
next year is Rs.2. the investors required rate of
return on this stock is 15 percent. If the
constant growth model applies to Rax Ltd.
What is the expected growth rate?
• Vardhman Ltd. Earnings and dividends have been
growing at a rate of 18 percent per annum. This
growth rate is expected to continue for 4 years.
After that the growth rate will fall to 12% for the
next 4 years. Thereafter the growth rate is
expected to be 6 percent forever. If the last
dividend per share was Rs.2. and the investors
ROR is 15%, what is the intrinsic value per share.
 P/E Ratio
Analysts value shares by estimating an appropriate
multiplier for the share.
Price earnings ratio = share price/EPS
Investment decisions to buy or sell the share
would be taken after comparing this intrinsic
value with the current market price.
High P/E
• Companies with a high Price Earnings Ratio are
often considered to be growth stocks.
• This indicates a positive future performance,
and investors have higher expectations for
future earnings growth and are willing to pay
more for them.
• The downside to this is that growth stocks are
often higher in volatility and this puts a lot of
pressure on companies to do more to justify
their higher valuation.
Low P/E
• Companies with a low Price Earnings Ratio are
often considered to be value stocks.
• It means they are undervalued because their
stock price trade lower relative to its
fundamentals.
• This mispricing will be a great bargain and will
prompt investors to buy the stock before the
market corrects it. And when it does, investors
make a profit as a result of a higher stock price.
P/E Ratio Example
• If Stock A is trading at $30 and Stock B at $20, Stock A
is not necessarily more expensive. The P/E ratio can
help us determine from a valuation perspective which
of the two is cheaper.
• If the sector’s average P/E is 15, Stock A has a P/E = 15
and Stock B has a P/E = 30, stock A is cheaper despite
having a higher absolute price than Stock B, because
you pay less for every $1 of current earnings. However,
Stock B has a higher ratio than both its competitor and
the sector. This might mean that investors will expect
higher earnings growth in the future relative to the
market
 Price to book value ratio
• The book value per share is the net worth of
the company (total assets minus total
liabilities) divided by the number of equity
shares issued.
• The book value is determined by economic
events as well as accounting conventions.
• PBV = market price per share at time t/book
value per share at time t
Price to sales ratio
PSR has received a lot of attention as a valuation
tool. The PSR is calculated by dividing a
company's current stock price by its revenue
per share for the most recent 12 months.
Alternatively it is calculated by
Current market value of equity capital/annual
sales of the firm.
Popular rule of thumb is PSR of 1 may be used as
a norm for all companies.
 ECONOMIC VALUE ADDED
• It’s a measure of economic profit
• It is a tool of performance measurement
• EVA = NOPAT – (WACC*Operating capital
employed)
• NOPAT = EBIT- income from non trade investment
– tax
• Operating capital = long term capital (equity+
reserve surplus + long term debt) – Non trade
investment
• WACC = Ke.We+Kp.Wp +Kd.Wd
• EVA is based on the idea that real value is
created when additional return are generated
for share holders above their required rate of
return
• Projects should earn rate of return above their
cost of capital
 2015 2016
2014
Capital invested (beginning of $54,236 $50,323 $55,979
year)
WACC 8.22% 8.28% 8.37%

Finance Charge $4,460 $4,167 $4,682

NOPAT $7,265 $5,356 $4,336