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Submitted To Ms.Thenmozhi.M
Submitted by Sindhu Penugonda MBA-NIT WARANGAL.
The capital of the company can be divided into different units with definite values called shares. Thus a share is the shared capital in the firm giving ownership right to the shareholder.
Types of Shares
There are two types of shares that a company may issue-
A Preference share has following two features-
A right to receive dividend at a given rate or amount before any dividend is paid.
(ii) Aright to repayment of capital in the event of winding-up of company.
2. Equity Shares:
An Equity share has following features(i) It gets dividend and repayment after payment to preference shareholders. (ii) Rate of dividend is not fixed and is determined by Directors. (iii) Such shareholders may go without any dividend if no profit is made. (iv) They also have voting rights proportionate to one’s share in the paid-up equity capital
Par value of shares:
An amount is noted on each share of a company. This is known as the par value of the share. It is also known as the face value of the share.
Market value of Share:
It is the value at which the share is sold or purchased in the market. Market value may be more or less than the face value of the share
VALUATION OF SHARES
The shares which are included in the list of stock exchange are quoted but the shares which are not quoted are valued by various methods.
Need for Valuation:(i) When two or more companies amalgamate. (ii) When absorption of a company takes place. When some shareholders do not give their consent for reconstruction of the
company, there shares are valued for the purpose of acquisition. company, there shares are valued for the purpose of acquisition. (iv) When shares are held by the partners jointly in a company and dissolution takes place., it becomes necessary to value the shares for proper distribution of partnership property among the partners. (v) When a loan is advanced on the security of shares. (vi) When shares of one type are converted into shares of another type (vii) When some company is taken over by the government, compensation is paid to the shareholders of such company and on this occasion, valuation of shares is made. (viii) When a portion of shares is to be given by a member of proprietary company to another member, fair price of these shares has to be made by an auditor or accountant
VALUATION METHODS 1.Earnings-Based Valuations 2.Revenue-Based Valuations 3. Cash-Flow Based Valuations 4. Equity-Based Valuations 5. Member-Based Valuations 1. EARNINGS-BASED VALUATIONS The most common way to value a company is to use its earnings. Earnings(net income or n et profit) is the money let after a company meets all its expenditures. To allow for comparisons across companies and time, the measure of earnings is stated as earnings per share(EPS). You arrive at the earnings per share by simply dividing the dollar amount of the earnings a company reports by the number of shares it currently has outstanding. Thus, if XYZ Corp. has 1 million shares outstanding, and it's earned $1 million in the past 12 months, it has a trailing EPS of $1. (It's called "trailing" because it looks at the numbers reported in the previous four completed quarters.) $1 million in earnings / 1 million shares = $1 earnings per share (EPS) The earnings per share figure alone means absolutely nothing, though. To look at a company's earnings relative to its price, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings.
For instance, if, in our example above, XYZ Corp. was currently trading at $15 a share, it would have a P/E of 15. $15 share price / $1 in EPS = 15 P/E Many individual investors stop their entire analysis of a company after they figure out the trailing P/E ratio. Also called a "multiple," the P/E ratio is most often compared against the current rate of growth in earnings per share. Some argue that that for a fairly valued growth company, the P/E ratio should roughly equal the rate of EPS growth. The P/E ratio or multiplier has been used most often to make an investment decision. A high P/E multiplier implies that the market has overvalued the security and a low P/E multiplier gives the impression that the market has undervalued the security. When the P/E multiple is low, it implies the earnings per share is comparatively higher than the prevailing market price. Hence ,the conclusion that the company has been undervalued by the market. Assume a P/E multiplier of 1.0 .The implication is that the earnings per share is equal to the prevalent market price. While market price is an expectation of the future worth of the firm ,the earnings per share is the current results of the firm. Hence, the notion that the firm has been undervalued by the market. On the other hand, a high P/E ratio would imply that the market is overvaluing the security for a given level of earnings. The forward P/E valuation is another technique that is based on the assumption that prices adjust to future P/E multipliers . The assumption is that shares typically trade at a constant P/E and therefore the ‘future’ value of a share can be calculated by comparing the current P/E with the future (as predicted using analysts’ estimated earnings for that year). The forecasted market price is calculated as [price*(P/E, current)(P/E, future)]. This valuation technique cannot be applied to shares with negative current or future earnings. This is based on the assumption that for a growth company, in a fairly valued situation, the price/earnings ratio ought to be equal to the rate of EPS growth.
The PEG considers the annualized rate of growth and compares this with the current share price .Since it is future growth that makes a company valuable to the investors in the market, the earnings growth is expected to depict the valuation of a company better than the historical earnings per share. If a company is expected to grow at 10 % a year over the next two years and has a current P/E multiple of 15,the PEG will be computed as 15/10 = 1.5. The interpretation of PEG is that the market price is worth 0.5 times more than what it really is worth, since the assumption is that the P/E multiplier to be equal to the earnings growth rate. A PEG of 1.0 suggests that a company is fairly valued .That is, in the previous example, if the P is 15 and the earnings growth rate is also 15, then PEG is equal to (15/15)1.0. Here is company is evaluated a priced correctly by the market. If the company in the above example had a P/E of 15 but expected to grow at 20% a year, it would have a PEG of (15/20),0.75. This means the shares are selling for 75% of their real value. This leads to the conclusion that the shares are “underpriced” in the market. The forward P/E and growth ratio (FPEG) can be used for valuing companies with an expected long-term performance. Rather than looking at the current historical price earning multiplier, the measure considers the price earnings multiplier forecast by analysts. This is compared with the expected earnings growth rate to evaluate the fair price of the shares. Assuming the analysts’ expectation of the P/E multiplier of a company is 20 and the earnings growth is expected to be 25 % over the next five years, the FPEG is computed as (20/25)=0.8. The interpretation of this number is similar to the interpretation of PEG, that is, the company is evaluated in the market at only 80% of its realistic price This will be indicator of “under pricing” of shares in the market. Similarly , a company that has an expected P/E multiplier of 20 and the growth in earnings in the next five years of 10 % will have a FPEG of (20/20)2.0. This indicates an “overpricing” of the share by the market by double its fair value.
2.REVENUE -BASED VALUATION:
Every time a company sells a customer something, it produces revenue. Revenue is the income generated by a company for peddling goods or services. Whether or not a company has made money in the previous year, there is always revenue -even companies that may be losing money temporarily and have earnings depressed due to shortterm circumstances, such as product development or higher taxes. Companies that are relatively new in a high-growth industry are often valued off of their revenue and not their earnings. Revenue-based valuations are assessed using the price/sales ratio, or PSR. The price/sales ratio takes the current market capitalization of a company and divides it by the past 12 months trailing revenue. The market capitalization is the current market value of a company, arrived at by multiplying the current share price times the shares outstanding. This is the current price at which the market is valuing the company. For instance, if our example company, XYZ Corp., has 10 million shares outstanding priced at $10 a share, then the market capitalization is $100 million. Some investors are even more conservative and add the current long-term debt of the company to the total current market value of its stock to get the market capitalization. The logic here is that if you were to acquire the company, you would acquire its debt as well, effectively paying that much more. This avoids comparing PSRs between two companies when one has taken out enormous debt to use to boost sales, and the other has lower sales but no additional nasty debt. Market Capitalization = (Shares Outstanding x Current Share Price) +current long term debt.
The next step in calculating the PSR is to add the revenue from the last four quarters and divide this number into the market capitalization. If XYZ Corp. had $200 million in sales over the past four quarters and currently has no long-term debt, the PSR would be: (10 million shares x $10/share + $0 debt) / $200 million in revenue = 0.5 PSR Companies often consider the PSR when making an acquisition. If you have ever heard of a deal being done based on a certain "multiple of sales," you have seen the PSR in use. As a legitimate way for a company to value an acquisition, many investors simply expropriate it for the stock market and use it to value a company as an ongoing concern.
uses of PSR:
As with the PEG and the YPEG, the lower the PSR, the better. Ken Fisher, who is most famous for using the PSR to value stocks, looks for companies with PSRs below 1.0 to find value stocks that the market might be overlooking. This is the most common application of the PSR and is a pretty good indicator of value, according to the work that James O'Shaughnessey has done with S&P's CompUSA database. The PSR is also a valuable tool to use when a company has not made money in the past year. Unless the corporation is going out of business, the PSR can tell you whether or not the concern's sales are being valued at a discount to its peers. If XYZ Corp. lost money in the past year, but has a PSR of 0.50 when many companies in the same industry have PSRs of 2.0 or higher, you can assume that, if it can turn itself around and start making money again, it will have a substantial upside as it increases that PSR to be more in line with its peers'.There are some years during recessions, for example, when none of the auto companies make money. Does this mean they are all worthless, and there is no way to compare them? Nope, not at all. You just need to use the PSR instead of the P/E to measure how much you are paying for a dollar of sales instead of a dollar of earnings.
Another common use of the PSR is with the P/E to confirm value and compare companies in the same line of business. If a company has a low P/E but a high PSR, it can be a signal that there were some one-time gains in the past four quarters that were pumping up earnings per share. Finally, new companies in hot industries are often priced based on multiples of revenues and not multiples of earnings
CASH FLOW-BASED VALUATIONS Despite the fact that most individual investors are ignorant of cash flow, it is probably the most common measurement used by investment bankers for valuing public and private companies. Cash flow is literally the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation, and amortization (EBITDA). Why look at earnings before interest, taxes, depreciation, and amortization? Interest income and expense, as well as taxes, are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the vagaries of the laws in a given year and actually can cause dramatic fluctuations in earnings power. For instance, early in a company's life, it usually loses money. When the company starts to turn a profit, it can often use those losses from previous years to cut its taxes. That can overstate current earnings and understate its forward earnings, masking the company's real operating situation. Thus, a canny analyst would use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company's growth. EBIT is also adjusted for any one-time charges or benefits. As for depreciation and amortization, these are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting convention for tax purposes that allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful.
Amortization normally comes in when a company acquires another company at a premium to its shareholder equity -- a number that it accounts for on its balance sheet as goodwill and is forced to amortize over a set period of time, according to generally accepted accounting principles (GAAP). When looking at a company's operating cash flow, it makes sense to toss aside accounting conventions that might mask cash strength.
when and how to use cash flow:
Cash flow is most commonly used to value industries that involve tremendous up-front capital expenditures and companies that have large amortization burdens. Cable TV companies, for instance, reported negative earnings for years as they made huge capital expenditures to build their cable networks. However, their cash flow actually grew; huge depreciation and amortization charges masked the companies' ability to generate cash. Sophisticated buyers of these properties use cash flow as one way of pricing an acquisition, thus it makes sense for investors to use it as well. The most common valuation application of EBITDA, the discounted cash flow, is a rather complicated spreadsheet exercise that defies simple explanation. Economic value added (EVA) is another sophisticated modification of cash flow that looks at the cost of capital and the incremental return above that cost as a way of separating businesses that truly generate cash from ones that just eat it up. A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
Calculation: Discounted cash flow model
There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is just to estimate the money you'd receive from an investment and to adjust for the time value of money Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on. Terminal value in year n = cash flow in year (n+1)/(d-g) Where, d is the discount rate of the cash flows, g is the stable growth rate. This approach alos requires the assumption taht growth is constant forever, and that cost of capital (discount rate ) will not change over time. Price to cash flow ratio can also be used as evaluation model.Cash flow multiplier is compared as: market price/ cash flow per share. For example, if the current market price is Rs.60 and cash flow per share is Rs.20, the cash flow multiplier would be 3. If the forecasted cash flow per share is Rs.23,then the market value can be estimated as (23*3)Rs.69.
Economic value added (EVA) is another modification of cash flow that considers the cost of capital and the incremental return above that cost. Assuming the after tax return from operations is 8% and the cost of capital is 10% ,the incremental return for the company would be 8%(18-10). If the face value of the investment in the company is Rs.100 per share ,the economic value added per share will be Rs.8.If the current market price of teh share is Rs.200, then the EVA multiplier will be(200/8)25.EVA multiple can then be used to identify the under pricing or over pricing of a share in the market. The most straightforward way for an individual investor to use cash flow is to understand how cash flow multiples work. By looking at recent mergers and acquisitions, you can divide the price that the acquirer pays for a company by its cash flow, producing a price-to-cash flow multiple. Then you can compare that ratio to the multiple of the company you're looking at. .4. ASSET VALUATION Asset valuation is an accounting convention that includes a company’s liquid assets such as cash, immovable assets such as real estate, as well as intangible assets. This is an overall measure of how much liquidation value a company has if all of its assets were sold off. Asset valuation gives the exact book value of the company. Book value is the value of a company that can be found on the Balance sheet .A company’s total asset value is divided by the current number of shares outstanding to calculate the book value per share. This can also be found through the following method –the value of the total assets of a company less the longterm debt obligations divided by the current number of shares outstanding.
The formulas for computing the book value of the share are given below: Book value = Equity worth( capital including reserves belonging to shareholders )/Number of outstanding shares. Book value = (Toatl assets-Long term debt)/Number of outstanding shares. Book value is a relatively straightforward concept. The closer to book value you can buy something at, the better it is. Book value, however, has a lot of skeptics these days. Depending on what tax consequences are being avoided, most companies can exercise some latitude in valuing their inventory and in reporting inflation or deflation on their real estate. But with financial companies such as banks, consumer-loan concerns, brokerages and credit card companies, the book value remains extremely relevant. For instance, in the banking industry, takeovers are often priced based on book value. Another useful measure of asset valuation is the price to book ratio. This ratio is arrived at by relating the current market price of the share to the book value per share. The intention is to compare the prevailing market price with the book value per share and identify if teh shares are undervalued or overvalued in the market. The computation of price to book ratio is computed as follows: Price to book value ratio = market price/ book value per share. The undervaluation of shares will be established when the price to book ratio is relatively low. A high price to book ratio ,on the other hand, implies that the shares are sold at a price not supported by its asset value in the market. Another use of shareholder equity is to determine return on equity. ROE is a measure of how much in earnings a company generates in four quarters in comparison with its shareholder equity. It is measured as a percentage. For instance, if XYZ Corp. made $1 million in the past year and has shareholder equity of $10 million, then the ROE is 10%. Some use ROE as a screen to find
companies that can generate large profits with little in the way of capital investment. HighROE companies are so attractive to some investors that they'll take the ROE and average it with the expected earnings growth to figure out a fair multiple. This is why mature companies in industries that require little capital can have relatively low growth rates compared to their priceto-earnings multiple.
YIELD VALUATION: A dividend yield is the percentage of a company’s share price that it pays out as dividends over the course of a year. For example ,if a company pays Rs.4.00 in dividends during a year and its shares are trading at Rs.100,it has dividend yield of 4%. DIVIDEND DISCOUNT MODELS: Cash Flows: Imagine that you are considering buying a share of stock today. You plan to sell the stock in one year. You somehow know that the stock will be worth $70 at that time. You predict that the stock will also pay a $10 per share dividend at the end of the year. If you require a 25 percent return on your investment, what is the most you would pay for the stock? In other words, what is the present value of the $10 dividend along with the $70 ending value at 25 percent? If you buy the stock today and sell it at the end of the year, you will have a total of $80 in cash. At 25 percent: Therefore, $64 is the value you would assign to the stock today. More generally, let P0 be the current price of the stock, and assign P1 to be the price in one period. If D1 is the cash dividend paid at the end of the period, then: P0 = (D1 +P1)/(1 +R) where R is the required return in the market on this investment.
Notice that we really haven’t said much so far. If we wanted to determine the value of a share of stock today (P0), we would first have to come up with the value in one year (P1 ). This is even harder to do, so we’ve only made the problem more complicated. What is the price in one period, P1? We don’t know in general. Instead, suppose we somehow knew the price in two periods, P2. Given a predicted dividend in two periods, D2, the stock price in one period would be:
You should start to notice that we can push the problem of coming up with the stock price off into the future forever. It is important to note that no matter what the stock price is, the present value is essentially zero if we push the sale of the stock far enough away. What we are eventually left with is the result that the current price of the stock can be written as the present value of the dividends beginning in one period and ex tending out forever:
We have illustrated here that the price of the stock today is equal to the present value of all of the future dividends. How many future dividends are there? In principle, there can be an infinite number. This means that we still can’t compute a value for the stock because we would have to forecast an infinite number of dividends and then discount them all. In the next section, we consider some special cases in which we can get around this problem.
EXAMPLE : You might be wondering about shares of stock in companies such as Yahoo! that currently pay no dividends. Small, growing companies frequently plow back everything and thus pay no dividends. Are such shares worth nothing? It depends. When we say that the value of the stock is equal to the present value of the future dividends, we don’t rule out the possibility that some number of those dividends are zero. They just can’t all be zero. Imagine a company that has a provision in its corporate charter that prohibits the paying of dividends now or ever. The corporation never borrows any money, never pays out any money to stockholders in any form whatsoever, and never sells any assets. Such a corporation couldn’t really exist because the IRS wouldn’t like it; and the stockholders could always vote to amend the charter if they wanted to. If it did exist, however, what would the stock be worth? The stock is worth absolutely nothing. Such a company is a financial “black hole.” Money goes in, but nothing valuable ever comes out. Because nobody would ever get any return on his investment, the that when we speak of companies that don’t pay dividends, what we really mean is that they are not currently paying dividends.
Some Special Cases
There are a few very useful special circumstances under which we can come up with a value for the stock. What we have to do is make some simplifying assumptions about the pattern of future dividends. The three cases we consider are the following: (1) the dividend has a zero growth rate, (2) the dividend grows at a constant rate, and (3) the dividend grows at a constant rate after some length of time. We consider each of these separately. Zero Growth The case of zero growth is one we’ve already seen. A share of common stock in a company with a constant dividend is much like a share of preferred stock..
we know that the dividend on a share of preferred stock has zero growth and thus is constant through time. For a zero growth share of common stock, this implies that:
Because the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period. The per-share value is thus given by:
where R is the required return.
For example, suppose the Paradise Prototyping Company has a policy of paying a $10 per share dividend every year. If this policy is to be continued indefinitely, what is the value of a share of stock if the required return is 20 percent? The stock in this case amounts to an ordinary perpetuity, so the stock is worth $10/.20 $50 per share. Constant Growth Suppose we know that the dividend for some company always grows at a steady rate. Call this growth rate g. If we let D0 be the dividend just paid, then the next dividend, D1, is:
The dividend in t years into the future i.e Dt is given by
We could repeat this process to come up with the dividend at any point in the future. An asset with cash flows that grow at a constant rate forever is called a growing perpetuity. As we will see momentarily, there is a simple expression for determining the value of such an asset. The assumption of steady dividend growth might strike you as peculiar. Why would the dividend grow at a constant rate? The reason is that, for many companies, steady growth in dividends is an explicit goal. For example, in 2000, Procter and Gamble, the Cincinnati-based
maker of personal care and household products, increased its dividend by 12 percent to $1.28 per share; this increase was notable because it was the 44th in a row.
EXAMPLE : The Hedless Corporation has just paid a dividend of $3 per share. The dividend of this company grows at a steady rate of 8 percent per year. Based on this information, what will the dividend be in five years? Here we have a $3 current amount that grows at 8 percent per year for five years. The future amount is thus: $3 ×1.085= $3 ×1.4693= $4.41 The dividend will therefore increase by $1.41 over the coming five years. If the dividend grows at a steady rate, then we have replaced the problem of forecasting an infinite number of future dividends with the problem of coming up with a single growth rate, a considerable simplification. In this case, if we take D0 to be the dividend just paid and g to be the constant growth rate, the value of a share of stock can be written as:
As long as the growth rate, g, is less than the discount rate, r, the present value of this series of cash flows can be written very simply as:
This elegant result goes by a lot of different names. We will call it the dividend growth model. By any name, it is very easy to use. To illustrate, suppose D0 is $2.30, R is 13 percent, and g is 5 percent. The price per share in this case is:
In our example, suppose we are interested in the price of the stock in five years, P5. We first need the dividend at Time 5, D5 . Because the dividend just paid is $2.30 and the growth rate is 5 percent per year, D5 is:
From the dividend growth model, we get the price of the stock in five years:
Gordon Growth Company
EXAMPLE The next dividend for the Gordon Growth Company will be $4 per share. Investors require a16 percent return on companies such as Gordon. Gordon’s dividend increases by 6 percent every year. Based on the dividend growth model, what is the value of Gordon’s stock today? What is the value in four years? The only tricky thing here is that the next dividend, D1, is given as $4, so we won’t multiply this by (1 + g ). With this in mind, the price per share is given by:
Because we already have the dividend in one year, we know that the dividend in four years is equal to The price in four years is therefore:
To see why this is so, notice first that:
However, D5 is just equal to D1 *(1 + g )4 ,we can write P4 as:
This last example illustrates that the dividend growth model makes the implicit assumption that the stock price will grow at the same constant rate as the dividend. This really isn’t too surprising. What it tells us is that if the cash flows on an investment grow at a constant rate through time, so does the value of that investment. You might wonder what would happen with the dividend growth model if the growth rate, g, were greater than the discount rate, R. It looks like we would get a negative stock price because R- g would be less than zero. This is not what would happen. Instead, if the constant growth rate exceeds the discount rate, then the stock price is infinitely large. Why? If the growth rate is bigger than the discount rate, then the present value of the dividends keeps on getting bigger and bigger. Essentially, the same is true if the growth rate and the discount rate are equal. In both cases, the simplification that allows us to replace the infinite stream of dividends with the dividend growth model is “illegal,” so the answers we get from the dividend growth model are nonsense unless the growth rate is less than the discount rate. Finally, the expression we came up with for the constant growth case will work for any growing perpetuity, not just dividends on common stock. If C1 is the next cash flow on a growing perpetuity, then the present value of the cash flows is given by:
Notice that this expression looks like the result for an ordinary perpetuity except that we have R g on the bottom instead of just R.
Non constant Growth
The last case we consider is non constant growth. The main reason to consider this case is to allow for “supernormal” growth rates over some finite length of time. As we discussed earlier, the growth rate cannot exceed the required return indefinitely, but it certainly could do so for some number of years. To avoid the problem of having to forecast and discount an infinite number of dividends, we will require that the dividends start growing at a constant rate sometime in the future. For a simple example of non constant growth, consider the case of a company that is currently not paying dividends. You predict that, in five years, the company will pay a dividend for the first time. The dividend will be $.50 per share. You expect that this dividend will then grow at a rate of 10 percent per year indefinitely. The required return on companies such as this one is 20 percent. What is the price of the stock today? To see what the stock is worth today, we first find out what it will be worth once dividends are paid. We can then calculate the present value of that future price to get today’s price. The first dividend will be paid in five years, and the dividend will grow steadily from then on. Using the dividend growth model, we can say that the price in four years will be:
If the stock will be worth $5 in four years, then we can get the current value by discounting this price back four years at 20 percent:
The stock is therefore worth $2.41 today.The problem of nonconstant growth is only slightly more complicated if the dividends are not zero for the first several years. For example, suppose that you have come up with the following dividend forecasts for the next three years:
After the third year, the dividend will grow at a constant rate of 5 percent per year. The required return is 10 percent. What is the value of the stock today? In dealing with non constant growth, a time line can be very helpful. Figure 8.1 illustrates one for this problem. The important thing to notice is when constant growth starts. As we’ve shown, for this problem, constant growth starts at Time 3. This means that we can use our constant growth model to determine the stock price at Time 3, P3. By far the most common mistake in this situation is to incorrectly identify the start of the constant growth phase and, as a result, calculate the future stock price at the wrong time. As always, the value of the stock is the present value of all the future dividends. To calculate this present value, we first have to compute the present value of the stock price three years down
the road, just as we did before. We then have to add in the present value of the dividends that will be paid between now and then. So, the price in three years is:
We can now calculate the total value of the stock as the present value of the first three dividends plus the present value of the price at Time 3, P3:
The value of the stock today is thus $43.88.
EXAMPLE : Chain Reaction, Inc., has been growing at a phenomenal rate of 30 percent per year because of its rapid expansion and explosive sales. You believe that this growth rate will last for three more years and that the rate will then drop to 10 percent per year. If the growth rate then remains at 10 percent indefinitely, what is the total value of the stock? Total dividends just paid were $5 million, and the required return is 20 percent. Chain Reaction’s situation is an example of supernormal growth. It is unlikely that a 30 percent growth rate can be sustained for any extended length of time. To value the equity in this company, we first need to calculate the total dividends over the supernormal growth period:
The price at Time 3 can be calculated as:
where g is the long-run growth rate. So we have:
To determine the value today, we need the present value of this amount plus the present value of the total dividends:
The total value of the stock today is thus $87.58 million. If there were, for example, 20 million shares, then the stock would be worth $87.58/20 $4.38 per share.
Components of the Required Return
Thus far, we have taken the required return, or discount rate, R, as given. For now, we want to examine the implications of the dividend growth model for this required return. Earlier, we calculated P0 as:
If we rearrange this to solve for R, we get:
This tells us that the total return, R, has two components. The first of these, D1/P0 , is called the dividend yield. Because this is calculated as the expected cash dividend by the current price, it is conceptually similar to the current yield on a bond. The second part of the total return is the growth rate, g. We know that the dividend growth rate is also the rate at which the stock price grows .Thus, this growth rate can be interpreted as the capital gains yield, that is, the rate at which the value of the investment grows. To illustrate the components of the required return, suppose we observe a stock selling for $20 per share. The next dividend will be $1 per share. You think that the dividend will grow by 10 percent per year more or less indefinitely. What return does this stock offer you if this is correct?
The dividend growth model calculates total return as:
In this case, total return works out to be:
This stock, therefore, has an expected return of 15 percent. We can verify this answer by calculating the price in one year, P1, using 15 percent as the required return. Based on the dividend growth model, this price is:
Notice that this $22 is $20 × 1.1, so the stock price has grown by 10 percent as it should. If you pay $20 for the stock today, you will get a $1 dividend at the end of the year, and you will have a $22 - 20 = $2 gain. Your dividend yield is thus $1/20= 5%. Your capital gains yield is $2/20 10%, so your total return would be 5% +10% =15%. To get a feel for actual numbers in this context, consider that, according to the 2001Value Line Investment Survey, Procter and Gamble’s dividends were expected to grow by 8 percent over the next 5 or so years, compared to a historical growth rate of 13 percent over the
preceding 5 years and 11.5 percent over the preceding 10 years. In 2001,the projected dividend for the coming year was given as $1.34. The stock price at that time was about $75 per share. What is the return investors require on P&G? Here, the dividend yield is 1.8 percent and the capital gains yield is 8 percent, giving a total required return of 9.8 percent on P&G stock.
Sometimes a company can be valued based on its subscribers or its customer accounts. Such subscriber-based valuations are most common in media and communication companies that generate regular, monthly income -- like cellular, cable TV, and online companies. Often, in a subscriber-based valuation, analysts will calculate the average revenue per subscriber over their lifetime and then figure the value for the entire company based on this approach. For instance, say a cable company has 4 million members, each of whom spends an average of $100 per month. Each member, on average, sticks around for five years. Using a subscriber-based valuation, you could say that the company is worth: 4 million * $100/month * 60 months = $24 billion This sort of valuation is also commonly used for Internet service providers and cellular phone companies. Another form of subscriber-based valuations is based on accounts. In the health-care informatics industry, companies are routinely acquired based on the value of their existing accounts. These acquisitions often completely ignore the past earnings or revenue of the company, instead focusing on what additional revenue could conceivably be generated from these new accounts. The exact mechanics of member-based valuations are unique to each industry. Although this type of valuation may seem rather confusing, studying the history of the last few major acquisitions can tell an inquisitive investor how the member model has worked in past mergers and can suggest how it might work in the future.
The above five models are used for valuation of shares based on the respective needs. Hence,Valuation is the first step toward intelligent investing. When an investor attempts to determine the worth of her shares based on the fundamentals, it helps her make informed decisions about what stocks to buy or sell.
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 Security analysis and portfolio management ,authors Madumathi
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