Valuation of Stocks

Raise funds – Equities

• Companies borrow money by selling the new shares to the investors.

• Sale of shares to raise the new capital is called primary market

• Most trades happens in the stock exchange

• Stock exchange is the place where the investors buy and sell the
existing shares. It is called secondary markets
• There are two Important exchanges in India : BSE and NSE
How does the common stocks are valued?
• Each Quarter company publishes the balance sheet.

• Book value of equity = Book value of Assets – Book value of Liabilities

• Book values are basically historical cost

• Book value do not capture the going concern value.
Valuation by Comparable
• P/E ratio : Price Earning Ratio

• How much investor is willing to pay for Rs. 1 of the earnings of the company

• P/B Ratio : Price to book Ratio

𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
• P/B ratio =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
• Lower P/B ratio indicates the stock are undervalued
Valuation of Comparable
Company Name Mkt Cap Revenue % Change P/E P/B

Alphabet Inc 742.80B 104.60B 40.26% 35.75 4.75

Microsoft Corp 663.07B 98.63B 40.15% 29.08 7.4

Amazon.com Inc 572.95B 161.15B 10.36% 300.12 23.24

Facebook Inc 527.17B 36.49B 65.66% 33.72 7.4

Baidu Inc 84.06B 11.74B 24.86% 34.48 5.01

eBay Inc 39.76B 9.35B 36.28% 5.62 3.54

Criteo SA 1.72B 889.14M 30.76% 22.54 2.15

Sometimes the P/E and P/B ratios vary widely even with the same industry. We need into
look into what determines the stock market value.
Stock Price and Dividend

• PV of stock = PV (Expected future cash flows)

• Two cash flows associated with stock

• Dividend
• Capital gain ( Sale of the share)
Various Approaches for stock valuation

• Dividend Discount Model

Mature
• Dividend discount with constant growth
Companies
• Two stage growth model

Growth
• EPS and PV of Growth Opportunities
Companies
Stock Price and Dividend

• PV of stock = PV (Expected future cash flows)

• Two cash flows associated with stock

• Dividend
• Capital gain ( Sale of the share)
• Return = Dividend + Capital gains

𝐷𝑖𝑣1+𝑝1−𝑝0
•r =
𝑝0

• This r is basically the rate of return, discount rate or cost of equity.

• For eg: Investor expects Rs. 5 dividend, expects to sell at Rs. 110 and
bought the share for Rs. 100
• R = 5 +10/100
• = 15%
Example
• Infosys paid a dividend of Rs 8 in 2016. Infosys price began at Rs.
1800 and stock price at the end of the year is 2100. Calculate the
stock return.
 𝐷𝑖𝑣+ 𝑃1
• 𝑃𝑜 =
1+𝑟

Here R is basically the cost of equity

Po =100 then the price is correct
P0>100 then the stock is overvalued
P0<100 then the stock is undervalued
Applying stock valuation
Expected future values Present values
Horizon Dividend Price Cumulative Future Price Total
Dividends
0 - 100 100
1 5 110 4.35 95.65 100
2 5.50 121 8.51 91.49 100
3 6.05 133 12.48 87.52 100
4 6.66 146 16.29 83.71 100
10 11.79 259 35.89 64.11 100
20 30.58 672.75 58.89 41.11 100
50 533.5 11739.09 89.17 10.83 100
100 62639.15 1378061.23 98.83 1.17 100
Dividend discount model
• Po = Present value of the dividends
• Assumptions
• They ignore capital gains

Drawback
1) Growth companies do not pay dividends
Dividend Discount Model : Cost of Equity
• Under Dividend discount Model,

𝐷𝑖𝑣1
• 𝑝𝑜 =
𝑟
• If there exist a constant growth in the payment of dividend

𝐷𝑖𝑣1
• 𝑝𝑜 =
𝑟−𝑔

𝐷𝑖𝑣1
• Cost of Equity r = +g
𝑝𝑜
Examples
• Stock A is expected to provide Dividend of Rs. 10 a share forever

• Stock B is expected to pay a dividend of Rs. 5 next year. Thereafter,

dividend growth is expected to grow 4% every year

• If market capitalization rate is 10%. Which is more valuable?

How to get the growth rate
• Analyst reports
• Payout Ratio
Payout Ratio
• Payout ratio is the ratio of dividends to earnings per share.

• How much Dividend is been paid out of earnings

• How much is been put to business?

• 1- payout ratio
𝐷𝑖𝑣
• 1- = Plowback ratio
𝐸𝑃𝑆
• Growth Rate g= plowback ratio x ROE
𝐸𝑃𝑆
• ROE =
𝐵𝑜𝑜𝑘 𝑒𝑞𝑢𝑖𝑡𝑦 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Problem
• Company Q current ROE is 14% , It pays out one half of the earnings ad
dividend.
• Current book value of share is Rs. 50
• Assume ROE and Payout ratio stays constant for next four years.
• After that, competition forces ROE down to 11.5%. And payout ratio
increases to 0.8
• Cost of capital is 11.5%
• What is the Q earnings?
• What are Q dividend next year and how does dividend grows in the year 2,
3, 4, 5.
• What is Q stock worth per share?
Link between Stock Price and Earnings per
share.
• Investor separate
• Growth stocks ( Expectations of capital gains)
• Income stocks ( Primarily for cash dividends)
• Growth stocks

• Expected Return = Dividend Yield = earnings price ratio

𝐷𝐼𝑉1 𝐸𝑃𝑆1
• =
𝑃0 𝑃0

𝐷𝐼𝑉1 𝐸𝑃𝑆1
• 𝑝𝑜 = =
𝑟 𝑟
How do you calculate G for growth firms
• G : Net present value of its future investments

• Share price = Present value of earnings stream + PV of growth

opportunities.