EQUITY VALUATION AND

INVESTMENT DECISIONS
(PART 1& 2)
Chapter 5 & 6

Required rate of return on Equity

Capital Asset pricing Model (CAPM) can be used to determine the

return required by equity shareholders

According to the CAPM the return required will be commensurate with
the risk involved
Two types of risk can be identified
Non-systematic risks these risks are specific to the company and can be

diversified by investing in a large number of companies

Systematic risks these risks cannot be diversified away and they are
unique to equity investing
CAPM says that the return required by equity shareholders should be

in line with the systematic risk of the stock; the non-systematic risk is
not important because it can be diversified away
According to the CAPM
Required return = Risk-free return + Beta*Equity market risk premium

Examples of Non-systematic risk

1. Company workers declare a strike
2. An accident occurs in the production facility
3. A formidable competitor enters the market
4. Loses a big contract
5. Makes a break-through in new product/delivery/services
6. Key personnel leaves the organization
7. Customs duty increases/decreases

Examples of Systematic risk

1. Interest rate changes
2. Corporate taxes change
3. Government resorts to massive deficit financing
4. RBI changes to a restrictive credit policy
5. Full convertibility
6. Withdraws/imposes dividend tax
7. Increases/decreases capital gain taxes

Measuring systematic risk

Systematic risk of a security measured by its beta
Beta of a security explains how sensitive is the

security return to the market return

The market return can be proxied by a stock market
index like the Sensex or Nifty
Beta of the stock market index is always 1
Beta of a risk-free security like a Treasury Bill is zero
why?
Beta of a risky security may be < 1 or > 1

Interpreting the beta

Beta > 1 implies that security is highly sensitive to

changes in market return

Known as aggressive security
Companies in sectors like metal, capital goods, banks, automobiles

etc

Beta < 1 implies that security is less sensitive to changes

in market return
Known as a defensive security
Companies in sectors like pharma, FMCG

Calculating security beta

Periodic

return
Mont Shar Nifty Share Nifty
h
e
price
price
(Rs.)
1

120 8000

125 8120

4.2%

1.5%

132 8200

5.6%

1.0%

139 8380

5.3%

2.2%

138 8208 -0.7%

-2.1%

134 8076 -2.9%

-1.6%

131 7980 -2.2%

-1.2%

125 7800 -4.6%

-2.3%

119 7715 -4.8%

-1.1%

10

123 7988

3.4%

3.5%

Beta can be computed using the

Excel function SLOPE
The periodic return of the stock is
regressed against the periodic
return of the Nifty and the slope
of the regression line is beta
A beta of 1.48 implies that when
the Nifty changes by 1%, the
stock price changes by 1.48%
Hence the stock is more volatile
than the Nifty

Reliability of the beta estimate

Periodic

return
Month Share Nifty Share Nifty
price
price
(Rs.)
1
120 8000

2
125 8120 4.2% 1.5%
3
132 8200 5.6% 1.0%
4
139 8380 5.3% 2.2%
5
138 8208 -0.7% -2.1%
6
134 8076 -2.9% -1.6%
7
131 7980 -2.2% -1.2%
8
125 7800 -4.6% -2.3%
9
119 7715 -4.8% -1.1%
10
123 7988 3.4% 3.5%
11
127 8267 3.3% 3.5%
12
131 8455 3.1% 2.3%

Correlation

0.83

R-squared

0.68

Check the correlation between the periodic

returns of the XYZ Ltd stock and the Nifty
using the Excel function CORREL
Correlation works out to 0.83
The square of the correlation coefficient is
known as R-squared
R-squared can be interpreted as the
proportion of change in the stock returns
which is explained by Nifty returns
Here 68% of the change in the stock price of
XYZ Ltd is explained by changes in Nifty
Our beta estimate is therefore reliable

The CAPM equation

Required return = Risk-free return + Beta*Equity market

Risk premium
Risk-free return is the return on risk-free debt securities such
as treasury bills
If the one-year treasury bill yields 8%, the risk-free return can
be considered to be 8%
Equity market risk premium is simply the difference between
the historical returns from the equity market and the risk-free
return
Thus if the historical return on equity is taken as 14%, the risk
premium becomes 6%
Hence required return on XYZ Ltd stock = 8% + 1.48*6%
which works out to 16.88%

Weighted Average Cost of Capital (WACC)

The return required by equity shareholders to compensate for the

riskiness of XYZ Ltd shares is 16.88%

Hence the cost of equity for the company is 16.88%
If the company employs debt we need to compute the cost of debt as
well
Suppose the following data about XYZ Ltd is available
Rs.
(Lakh)
Interest for the year

36

Debt funds
(12% debentures)

300

Net worth

600

Marginal tax rate

40%

The average interest cost of debt

is 12%
However because interest is a
tax-deductible expense, the
actual cost of debt is 12%*(10.4), i.e. 7.20% only

Weighted Average Cost of Capital (WACC)

Suppose the equity shares of XYZ Ltd are currently

traded at Rs.135
If the number of equity shares issued is 5 lakhs then the
market capitalization of XYZ Ltd is Rs.675 lakhs
If the debentures of XYZ Ltd are traded at Rs.110 the
market value of the companys debt is Rs.330 lakhs
Hence the total market value of debt and equity for XYZ
Ltd is Rs.675+330 = Rs.1005 lakh
Thus the WACC works out to 13.7%

Fundamental valuation
Approaches:
Dividend Discounting
Free Cash flow
Earnings multiple
Models aim at arriving at intrinsic value of an asset

Intrinsic Value and Market Price

Intrinsic Value
Self assigned Value
Variety of models are used for estimation
Market Price
Consensus value of all potential traders
Trading Signal
IV > MP Buy
IV < MP Sell or Short Sell
IV = MP Hold or Fairly Priced

Dividend discounting approach

Value of the security is PV of expected cash flows

discounted at rate that reflects riskiness of the cash flows

The discounting rate is the cost of equity
Required inputs
Discount rates
Expected cash flows
Expected growth rate

Dividend Discount Model (contd)

Intrinsic value of a stock is V0
Year-end price P1 can be estimated as
Substituting the above in V0
In general for a holding period of H years, intrinsic value of a

stock is the present value of dividends over the H years plus the
terminal sale price PH

No Growth Model
D
Vo
k
Stocks that have earnings and dividends that
are expected to remain constant
For instance Preferred Stock

Example Constant Dividends

XYZ Ltd has paid a dividend of Rs.10 per share for the

year 2014
Management has promised to keep dividends constant at
Rs.10 till infinity
Cost of equity is 16.88%
What is the value of equity shares of XYZ Ltd?
D1 = D0 =Rs.10
K = 0.1688
Hence share value = D1/k = Rs.59.24

Constant Growth Model

Assuming constant dividend for each year is not practical
We assume that dividend grows at a constant rate g

every year
Hence intrinsic value can be computed as

Simplified to
g is the constant perpetual growth rate
This is known as the Gordon Growth Model

Example Gordon Growth Model

XYZ Ltd has paid a dividend of Rs,10 per share for the

year 2014
Dividends are expected to grow @ 10% p.a. each year
What is the value of equity shares of XYZ Ltd using the
GG Model?
Cost of equity = 16.88%
Constant growth rate g = 10%
Next years dividend D1 = D0*(1+g)
Hence value of shares = D1/(k-g) = Rs.159.88
If XYZ Ltd shares are trading at Rs.175, what can you
conclude?

Multistage Growth Model

(1 g1 )t
DT (1 g 2 )
P0 D0

t
T
(k g 2 )(1 k )
t 1 (1 k )
T

g1 = first growth rate

g2 = second growth rate
T = number of periods of growth at g1

Example Multi-stage Growth Model

ABC Ltd is a fast-growing company in the online retailing

space
Dividends expected over the next three years are as
follows
Year 1: Rs.12
Year 2: Rs.15
Year 3: Rs.19
Dividends are expected to grow at a stable rate of 8% p.a.
after the next 3 years

Valuation using Multi-stage Growth Model

Cost of equity for ABC Ltd is 18%
Present value of dividends for next 3 years
Year

Dividen
d
Df

PV

12

0.8475

10.17

15

0.7182

10.77

19

0.6086

11.56

32.51

At the end of 3 years dividend growth rate

is assumed to be constant at 8%
Hence at end of year 3,
Terminal value = D4/(k-g)
Hence P3 = 20.52/(0.18-0.08) = 205.20

Value of equity share today = PV of dividends + PV of terminal value

= 32.51 + 124.89
= Rs.157.40

DCF valuation limitations

Faulty application may yield values far from the intrinsic value
Requires more data
May not recommend any stock if markets are overvalued

Free Cash flow approach

This approach is based on the free cash flow of the

company to value its equity shares

Free cash flow to the firm (FCFF)
Free cash flow to Equity (FCFE)

Valuation using the FCFF

Year 1 Year 2
EBIDTA
641
888
Interest
30
50
Depreciation
55
60
Amortization
10
10
PBT
546
768
Tax
218
307
PAT
328
461
Dividend
250
400
Retained earnings
78
61
Increase in working capital
50
60
Increase in Fixed cap
100
125

What is the value of equity

shares of XYZ Ltd based on
FCFF?
WACC is 13.7%
Assume that FCFF will grow at a
constant rate of 6% after year 2

Calculations
Year

FCFF

Df

PV

261 0.879507

229.55

376 0.773533

290.85

Proj FCFF year 3

FCFF of year 1 = 328+55+10+30*(1-0.4)-50-100

= 261

520.40

398.56

Terminal val end year 2

5176.10

PV of terinal val

4003.89

Value of share

4524.29

Projected FCFF for year 3 = 376*1.06

Terminal value = Proj FCFF year 3/(WACC-growth rate)

Calculation of FCFE
Suppose XYZ Ltd is scheduled to repay loan of Rs. 10

and Rs.15 in year 1 and year 2

FCFE = FCFF Interest*(1-tax rate)-loan repayment
Year 1: 261-18-10 = 233
Year 2: 376-30-15 = 331
These will be discounted at the cost of equity 16.88%
Assume that FCFE is expected to grow at a constant rate
of 7% after year 2
Projected FCFE for year 3 = 331*1.07
Terminal value is worked out assuming cost of equity
16.88% and growth rate 7%

Calculation
Year

FCFE

Df

PV

233 0.855578

199.35

331 0.732014

242.30

Proj FCFE year 3

Computation of FCFE for year 1

and 2

441.65

354.17

Terminal val end year 2

3584.72

PV of terinal val

2624.06

Value of share

3065.71

Computation of terminal value

Enterprise Value
Current share price
Number of shares
Current price of
debentures

189
10
105

Number of debentures

Cash and investments

60

EV = 189*10+105*5 60 =2355

EV = Market value of equity

shares + market value of debt
less cash and investments

Earnings Multiple
Market price

189

Current PAT

195

Number of shares

10

EPS

19.5

Trailing P/E

9.69

Projected PAT

Year 1 Year 2
328

461

10

10

Projected EPS

32.8

46.1

Forward P/E

5.76

4.10

Number of shares

Trailing P/E is computed on

earnings of past 12 months
May not reflect expected
earnings

Forward P/E takes into account

projected growth in earnings and
compares them with current
share price

Price- Book value Ratio

Net worth

400

Number of shares

10

Book value per share

40

Current share price

110

Price to book ratio

2.75

The book value or intrinsic

value per share is used
instead of earnings per share

Used for evaluating companies in

banking and finance space

Margin of safety
Valuation-based price

157.40

Market price

135.60

Margin of safety = (Valuationbased price Market price)/

(Valuation-based price)

MS = (157.40-135.60)/157.40
= 13.85%

Economy Industry & Company Analysis

Economy Analysis
Economic cycles boom, peak, recession, trough
Sectoral performance during each economic cycle
Stock markets are leading indicators of the economic cycle
Decline in stock markets may affect the real economy because of
wealth effect
Stock markets track economic fundamentals over a longer period
but not necessarily on a daily basis
Important indicators of economic performance are: inflation data
(WPI and CPI), industrial production data (IIP), purchasing
mangers index, Current account deficit data, exports data etc
The US markets track a host of economic indicators such as
unemployment numbers, new housing starts etc

Industry Analysis
Based on Porters Five Forces Model which states that

attractiveness and profitability of any industry depends on

the interaction of five forces
Industry competitors
Bargaining power of buyers
Bargaining power of suppliers
Threat of substitutes
Threat of new entrants

Strategies to combat the problems

Cost leadership
Differentiation
Focus

Investment Approaches
Top-down approach
Allocation for different regions such as US, Europe, MENA, Asia-Pacific
Allocation to countries within each region country allocations are
based on an index (e.g.MSCI Emerging Markets) and revised
periodically
Sectoral allocation within each country
Allocation to specific companies within each sector
This approach leads to diversification of risks
Bottom-up approach
Select the best companies to be included in the portfolio regardless of

the sector
No fixed sectoral allocation

Top-down approach said to be suitable for mature markets

and bottom-up approach for emerging markets