EQUITY VALUATION

Outline

• Dividend Discount Model

• Free Cash Flow Model

• Earnings Multiplier Approach

• Earnings – Price Ratio, Expected Return, and Growth
• Other Comparative Valuation Ratios
Techniques of Fundamental Equity Valuation
Balance Sheet Techniques
• Book Value
• Liquidation value
• Replacement Cost

Discounted
• Cash Flow Techniques
• Dividend discount
model
• Free cash flow model

Relative Valuation Techniques

• Price earnings ratio

• Price-book value ratio
• Price-sales ratio
 Balance Sheet Valuation
• Book Value

• Liquidation Value

• Replacement Cost
 Dividend Discount Model
• Single Period Valuation Model
D1 P1
P0 = +
(1+r) (1+r)
• Zero Growth Model
D
P0 =
r
• Constant Growth Model
D1
P0 =
r-g

© 2017 by Prasanna Chandra

The more commonly used
assumptions
The dividend per share remains constant forever, implying that the
growth rate is nil (the zero growth model).
The dividend per share grows at a constant rate per year forever (the
constant growth model).
The dividend per share grows at a constant extraordinary rate for a
finite period, followed by a constant normal rate of growth forever
thereafter (the two-stage model).
The dividend per share, currently growing at an above-normal rate,
experiences a gradually declining rate of growth for a while. Thereafter,
it grows at a constant normal rate (the H model).

© 2017 by Prasanna Chandra

Single-period valuation model

the case where the investor expects to hold the equity

share for one year. The price of the equity share will
be:
Where, P0 = current price of the equity share; D1 =
dividend expected a year hence; P1 = price of the share
expected a year hence; and r =rate of return required
on the equity share.

© 2017 by Prasanna Chandra

 Prestige’s equity share is expected to provide a dividend of
Rs. 2.00 and fetch a price of Rs. 18.00 a year hence. What
Illustration
price would it sell for now if the investors’ required rate of
return is 12 per cent?
what happens if dividend grows at the rate of g
percentage?
Given: D1 = Rs.2, P1 =18, r=12. find Po?
= 2/(1.12) + 18/(1.12) = 17.85

© 2017 by Prasanna Chandra

P0 =

P0 = D1/r-g

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 2.0 18.00
P0 = (1.12) + (1.12) = Rs. 17.86

P0 = D1/r-g

© 2017 by Prasanna Chandra

 Illustration 2
The expected dividend per share on the equity share of Roadking
Limited is Rs. 2.00. The dividend per share of Roadking Limited
has grown over the past five years at the rate of 5 per cent per
year. This growth rate will continue in future. Further, the market
price of the equity share of Roadking Limited, too, is expected to
grow at the same rate. What is a fair estimate of the intrinsic
value of the equity share of Roadking Limited if the required rate
is 15 per cent?
Given: D1=Rs.2, g=5%, r=15%. Model? Constant growth rate

© 2017 by Prasanna Chandra

 2.00
c = 0.15 – 0.05 = Rs. 20.00

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 Two-Stage Growth Model

n
1 - 1+g1
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
Where P0 = current price of equity share
D1 = dividend expected a year hence
g1= extraordinary growth rate applicable for n years
g2= growth rate in the second period
Pn= price of equity share at the end of year n

© 2017 by Prasanna Chandra

The Current Dividend On An Equity Share Of Vista Limited Is Rs.2.00.
Vista 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 Vista ?

© 2017 by Prasanna Chandra

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
Solution : 13.97 +56.79 = 70.76

© 2017 by Prasanna Chandra

Asynch…
1. The current dividend on equity share of Infy Tech. Ltd., is Rs.3. The
firm is expected to enjoy above normal growth rate of 40 percent for 5
years. Thereafter the growth rate will fall and stabilise at 12 percent.
Equity investors' require a return of 15 percent from Infy Tech’s stock.
What is the intrinsic value of the equity share of the firm?
2. the equity stock of Max limited is currently selling at Rs.32 per share.
The dividend expected next is Rs. 2. The investors required return on
stock is 12 percent. Assume that the constant growth model applies to
Max limited. What is the expected growth rate of Max limited

© 2017 by Prasanna Chandra

Multi stage model
Vedhanth Limited’s earnings and dividends have been growing at the
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 percent for the next
four years. Thereafter the growth rate is expected to be 6 percent
forever. If the last dividend per share was Rs.2 and the investor’s
required rate of return is 15%, what is the intrinsic value per share.
Stage 1- 18% Div, 4 years
Stage 2 -12 percent div, 4 years
Stage 3 , g=6% forever.
R=15, Do =Rs,2, Po=?

© 2017 by Prasanna Chandra

© 2017 by Prasanna Chandra
Do=Rs Div PVIF @15% PVCF
.2
D1 2.00(1.18)=2.36 1/(1.15)=0.86 2.02 Σ PVCF(8yrs@15%)
D2 2.36(1.18)=2.78 1/(1.15)^2=0.75 2.08 = 16.602
Po=D1/(r-g)
D3 2.78(1.18)=3.28 1/(1.15)^3=0.65 2.132 P8= D9/(0.15-0.06)
D4 3.28(1.18)=3.87 1/(1.15)^4=0.57 2.205 D9 =6.08(1.06)
D5 3.87(1.12)= 4.34 1/(1.15)^5=0.49 2.126 =6.44
P8 =
D6 4.34(1.12)=4.85 1/(1.15)^6=0.43 2.085 6.44/(0.15-0/06)
D7 4.85(1.12)=5.43 1/(1.15)^7=0.37 2.009 =71.55
D8 5.43(1.12)=6.08 1/(1.15)^8=0.32 1.945 71.55x(0.32)=23.
Po =16.602+23
=39.60

© 2017 by Prasanna Chandra

Do=Rs.2 Div PVIF @14% PVCF
D1 1.50(1.12)=1.68 0.88 1.48 Σ PVCF = Rs.
D2 1.68(1.12)= 1.88 1/(1.14)^2 1.45 10.64
=0.77 P8=
D9/0.14-0.05
D3 1.88(1.12)= 2.1 1/(1.14)^3 1.41
=0.67 D9 =
3.21(1.05)
D4 2.1(1.12)= 2.36 0.59 1.39 = 3.37
P8 =3.37/0.09
D5 2.36(1.08) =2.55 0.52 1.33 = 37.44
Po =37.44
D6 2.55(1.08)= 2.75 0.46 1.27 x0.35
D7 2.75(1.08)=2.97 0. 4 1.19 = 13.104
D8 2.97(1.08)=3.21 0. 35 1.12 Po =
10.64+13.104
= 23.74

© 2017 by Prasanna Chandra

Eg.2
The commonwealth corporation’s earnings and dividends have been
growing at a rate of 12 percent per annum. This growth rate is expected
to continue for 4 years. After that the growth rate would fall to 8
percent for the next four years. Beyond that the growth rate is expected
to be 5 percent forever. If the last dividend was Rs.1.50 and the investors
required rate of return is 14 % how much should be the market value
per share of CW corporation’s equity share?
Stage 1= 12% for 4 years
Stage 2 = 8 % for 4 years
Stage 3 = 5 % constant growth
Do=1.50
D1 = 1.50(1.12) =1.68

© 2017 by Prasanna Chandra

Asyn…
For the first four years, XYZ firm is assumed to grow at 10 percent. After
4 years the growth rate of dividend is assumed to decline linearly to 6
percent. After 7 years the firm is assumed to grow at the rate of 6
percent indefinitely. The next year dividend is Rs.2 and the required
rate of return is 14 percent. Find out the value of the stock.
Stage 1: 10% for 4 years
Stage 2: linear decline in growth – 3 years ( 5th to 7th year)
5th year= 9%, 6th= 8%, 7th 7%
Stage 3: 8th year onwards the growth rate is 6 percent indefinite
D1: 2
R=14%

© 2017 by Prasanna Chandra

Dividend: Rs.2 (D1) PVIF@14% PVCF

D1 = Rs.2 1/1.14 = 0.88 1.754 Σ PVCF = 10.9027

D2 = 2(1.10)= 2.2 1/(1.14)^2= 1.691 Po= D1/r-g

0.77 P7= D8/0.14 -0.06
D3 = 2.2(1.10)=2.42 0.67 1.621 D8 =3.35(1.06)
=3.551
D4= 2.42(1.10) = 2.66 0.59 1.569 P7= 3.551/(0.14-0.06)
D5= 2.66(1.09)=2.9 0.519 1.505 = 44.388
D6=2.9(1.08) =3.13 0.455 1.424 PV = 44.388(0.399)
= 17.71
D7=3.13(1.07) = 3.35 0.399 1.337 Po =10.9027+17.71 =
28.61

© 2017 by Prasanna Chandra

© 2017 by Prasanna Chandra
 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 growth rate abnormal growth rate
H model assumptions
The dividend per share, currently growing at an
above-normal rate,
experiences a gradually declining rate of growth for a while.
Thereafter, it grows at a constant normal rate (the H
model).
Note : while the current dividend growth rate ‘ga’ is greater
than gn, the normal long run growth rate, the growth rate
declines linearly for 2H years
After 2H years the growth rate becomes gn.
At H years the growth rate is exactly halfway between ga
and gn.
© 2017 by Prasanna Chandra
Illustration
The current dividend on an equity share of ITC is rs.3. The
present growth rate is 50 percent. However this will decline
linearly over a period of ten years and then stabilise to 12
percent. What is the intrinsic value per share of ITC if the
investors require a return of 16 percent ?

© 2017 by Prasanna Chandra

Do = Rs.3
ga = 50 percent gn = 12percent
H = 5 years
R= 16

According to H model, Po = Rs.226.5

© 2017 by Prasanna Chandra

The current dividend on equity share of a firm is Rs.5.00.
the present growth rate is 50 percent which will decline
linearly over a period of 8 years and stabilise to 10 percent.
What is the intrinsic value per share of the firm if the
investors require a return of 18 percentage from its stock?

Ans.Rs.168.75

© 2017 by Prasanna Chandra

© 2017 by Prasanna Chandra
Example
You have decided to buy 500 shares of an IT company with the
intention of selling out at the end of five years. You estimate that the
company will pay Rs.3.50 per share as dividends for the first two years
and rs. 4.50 per share for the next three years. You further estimate
that , at the end of five year holding period, the shares can be sold for
Rs.85. what would you be willing to pay or these shares of the required
rate of return is 12 percent?
D1 =3.50, D2=3.50, D3= 4.50, D4= 4.50, D5 = 4.50, P5= 85
R=12%
Po = 3.50/(1.12) + 3.50/(1.12)^2 +4.50/(1.12)^3+ 4.50/(1.12)^4+
4.50/(1.12)^5 +85/(1.12)^5= 62.762

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Rs. 62.76 per share.

© 2017 by Prasanna Chandra

Impact of growth on Price, Returns
and P/E ratio
Growth rates of companies differ widely
Low, Normal. Super normal
Assuming a constant required return, the different growth rates lead to
Differing stock prices, dividend yield and capital gains yield and price
earning ratio.

© 2017 by Prasanna Chandra

Example
Given the following information, calculate the stock price, dividend
yield and PE ratio for the following cases and analyse the impact of
growth on the same for the constant growth dividend model.
Growth rate:
Low growth firm g = 5 %
Normal growth firm g = 10 %
Supernormal growth firm g = 15 %
Expected earning per share = Rs3.00 and dividend per share is Rs. 2 for
all three firms. The investor’s required return remains constant at 20
percent.

© 2017 by Prasanna Chandra

 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)

2 = Rs.13.33 15% 5% 13.33/3=4.44

Low Growth Firm PO =
(0.20-0.05)

2 =Rs.20 10% 10% 6.66

Normal Growth PO =
Firm (10%) (0.20-0.10)

2 5% 15% 13.33
Supernormal PO = Rs.40
Growth Firm (0.20-.15)
 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
Normal Growth 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
Interpretation
1. As the expected growth in dividend increases, other
things being equal, expected return depends more on
capital gain yield and less on dividend yield
2. As the expected growth rate in dividend increases, other
things being equal, the price earning ratio increases.
3. High dividend yield and low price earning ratio imply
limited growth prospects
4.low dividend yield and high price earning ratio imply
considerable growth prospects.

© 2017 by Prasanna Chandra

Case 2
Consider the following growth rates
Growth rate in percentage:
Low growth firm g = 4 %
Normal growth firm g = 8 %
Supernormal growth firm g = 12%
The expected earning per share and dividend per share next year for
each of the three firms are Rs.4.00 and Rs. 2.00 respectively. The
investor’s required return remains constant at 16 percent.
Calculate the stock price, dividend yield and PE ratio for the above cases
and analyse the impact of growth on the same for all the three firms.

© 2017 by Prasanna Chandra

Discounted cash flow valuation
DCF analysis is an intrinsic valuation method used to estimate the
value of an investment based on its forecasted cash flows.
Discounted cash flow valuation is based upon the notion that the value of
an asset is the present value of the expected cash flows on that asset,
discounted at a rate that reflects the riskiness of those cash flows.
It establishes a rate of return or discount rate by looking at
dividends, earnings, operating cash flow or free cash flow that is
then used to establish the value of the business outside of other
market considerations
Cash flow is normally defined as earnings before depreciation, interest,
taxes, and other amortisation expenses (EBDIT)
EBDIT is relevant since interest income and expense, as well as taxes, are
all ignored because cash flow is designed to focus on the operating
business and not secondary costs or profits.

© 2017 by Prasanna Chandra

 ed
Cash
flows
(Rs. In
Illustration Year crore) PVIF@12%
1 the discounted
Calculate the intrinsic value of a share using 200 200/(1.12)=178.5
cash flow
method with a discount rate of 12% 254/(1.12)^2 =
And 100 crores as outstanding shares. 2 254 202.48
236/(1.12)^3=168.0
3 236 9
4 280 177.95
5 310 175.9
6 324 164.15
PV of CFs=
7 356 161.04
1647.16 crores
8 368 148.63
Price per share 9 375 135.23
(intrinsic value of a 10 420 135.22
share) =
1647.16/100= Rs.
16.47
© 2017 by Prasanna Chandra
© 2017 by Prasanna Chandra