09 - Chapters - 2

Chapter Second
Equity Share Valuation Models: Theoretical Background
2.1 Introduction:
2.2 Conceptual Framework:
2.2.1 Meaning and definition of Investment & Investment Management
2.2.2 Concept of Investment & Investment Management
2.2.3 Evolution and origin of Investment Management
2.2.4 Features of Investment Management
2.2.5 Scope of Investment Management
2.2.6 Functions of Investment Management
2.2.7 Objectives of Investment Management
2.3 Equity share valuation Models
2.3.1 Concept and nature of valuation models
2.3.2 Features of Share Valuation models
2.3.3. Need and importance of valuation Models
2.3.4 Types and Scope of valuation models
2.3.5. Critical evaluation
2.4 Conclusion
Chapter Second
Equity Share Valuation Models: Theoretical Background
2.1 Introduction:
Equity share valuation models were given by researcher’s time to time by
analysing the impact of different factors on movement of share price of companies.
The market price of shares cannot move isolated and suddenly, without any changes
in market condition or some associated phenomena affecting the company. It is
affected with factors like demand and supply of shares, prevailing market sentiments,
liquidity, the future prospects of the company, market condition, company
performance are just a few name. It is difficult and unreasonable to predict the
expected market price of share without giving importance to these associated factors.
For a layman it is difficult to judge and establish a suitable linkage between the
occurring event and its impact on changing price of shares. In this case equity share
valuation models help them. It provides compact methodology for calculation of
expected price of shares through the associated factors of price movements of shares.
2.2 Conceptual Framework:

2.2.1 Meaning and Definition of Investment & Investment Management
Investment Management basically related with the management of investment
in such a way that can generate high return on the invested amount. It provides the
necessary guidance and analysis for effective investment. Everyone invest their
money with the intention of high return. But it is not possible to generate high return
if one has not been invested money wisely. On the same time, it is also not advisable
to keep huge hard cash as the value of money decreases with the passage of time due
to inflation which decreases the purchasing power of money in future. Even to keep
same worth of money, in terms of purchasing power, it requires to invest somewhere
which can at least generate the inflationary return. But the confusion arises at the time
of selection of investment options, as the multiple financial instruments are available
in market for investment and the associated risk & return also varies with each
instrument. Here investment management comes into picture and play a major role in
evaluation and analysis of available investment options. The basic concept of
investment is based on the theme of balance between income, expenses and saving of
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the person. An investment is “the current commitment of money for a period of time
in order to derive future payments”. It compensates the investor in term of refund of
surplus money as return compare to amount invested for bearing the risk of
uncertainty of the future payments and the expected rate of inflation.
2.2.2 Concept of Investment & Investment Management

Investment means deployment of funds with the expectation of deriving future
benefits. It generally referred as the current sacrifice of money with the hope of
making more money or benefits in future. In finance, investment means “purchase of
financial instruments or other valuable item with the hope of generating favourable
future return. It is basically the present commitment of funds, saved from current
consumption, with the expectation of future return. Thus, it is reward for deferred
consumption and current sacrifice of money.
Investment management represents the professional management of various
securities (bonds, shares etc.) and other assets (i.e. real assets). It aims to meet the
particular investment goals of investors as the preference of every investor varies in
terms of time, risk and return. In relation to this, the investor’s money is
professionally managed by group of people by keeping into consideration of
individual priority and desire. In present scenario, everybody is running for money,
day or night and it is considered as a root of happiness. Investment provides the
monetary return in future and it is useful for bright future and secure life. But it
requires the rightful selection of investment option as day to day investment options
are increasing with variation in their risk and return capacity. So, even if researcher
focuses on past, present or future, investment is such a topic which requires the
versatile knowledge and constant up gradation of scope of investment reflecting the
changing scenario of the market.
2.2.3 Evolution and Origin of Investment Management

As the investment opportunities are increasing day by day, the area and scope
of investment are widening, new innovative financial instruments are coming into
market, the need and importance of proper investment management is felt all around
the world. It gained moment and developed as the core of effective investment in past
few years due to increased wide variety of investment options in this global market.
With this, investors can choose their investment instrument by analysing and
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balancing their risk and return appetite. Now it involves professionally management
of fund for the future benefits by considering the different factors like importance of
time, low expenses, proper diversification, asset allocation, margin of safety and so
on.
2.2.4 Features of Investment Management

As various investment options are available in market and they are offering
different risk-reward trade-offs, it requires to have an understanding of core concepts
and a thorough analysis of the available options to create a portfolio which maximizes
returns while minimizing the risk exposure. It can be highlighted with the following
features:
1) Safety of Principal: The investor should carefully assess the economic and
industry trends before choosing the investment option. It protects against the
sudden uncertain loss in the changing environment though no one can predict
future accurately and certainly. Safety of principal can be achieved through the
diversification of assets. It reduces the risk and provides safeguard against
certain errors.
2) Liquidity: Liquid investment helps the investors to convert their investment
into cash immediately without any monetary loss to meet sudden emergencies.
In share market, those stocks are easily marketable which provides regular
return in terms of dividends and capital appreciation. So investors should
carefully choose their stock for investment.
3) Stability in Income: Regular and stable return is basic requirement of every
investors. It requires to properly analyze the pattern of past return for selection
of target companies.
4) Stability of Purchasing Power: Investors should link the expected rate of
inflation with the projected future return to maintain balance between
portfolios and stability of purchasing power.
5) Legality: Investors must invest their money only in those assets which is
approved by law. Invested amount in different financial instruments should be
properly managed by investors in terms of legality to protect self from any
trouble in future.
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2.2.5 Scope of Investment Management
The overall scope of investment management is quite wide as the investors are
represented by different groups i.e. an individual, firm, corporation, trust, or a
government. Everybody wants to grow their money. The main purpose behind an
investment is to generate good return. But to generate good return from the invested
amount, one’s requires having proper analysis and management of fund which can be
done with the help of investment management. So, the investment management
covers all investors group as stated above. In this present study, the researcher tried to
focus on retail investors of equity share.
2.2.6 Functions of Investment Management

The basic function of the investment management is to analyse and invest the
individual money in such as manner which can generate high return within the
defined scope of investors. It tries to establish balance between market and individual
requirement. It focuses on enhancement of money worth with the effective
management of investment. It includes analysis of financial statement, assets
selection and proper implementation of plan along with ongoing monitoring for the
fruitful results.
2.2.7 Objectives of Investment Management

Investment is a wide spread practice with the basic objectives of high rate of
return. The starting point in this process is to determine the characteristics of the
various investments and then matching them with the individuals need and
preferences that may be financial or personal. The financial objectives focus on
monetary consideration of investment i.e. profitability, safety and liquidity while the
personal objectives dealt with individuals personal priority such as commitments for
family requirement related to education, day to day consumption, status in society,
dependents and provision for retirement etc. The overall objectives of investment
management are outlined as follows:
i. To select best possible portfolio as per the risk capacity of the
individual.
ii. To get high return in short term by putting lum sum amount.
iii. To generate regular but stable return
iv. To get increase the worth of capital in long term through capital
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appreciation
v. To save tax in short term or in long term
vi. To select an option which can meet their financial needs over their
lifetime
vii. To minimize the cost of management of assets and financial needs.
viii. To get peace of mind through having the financial security.
2.3 Equity share valuation Models:

2.3.1 Concept and nature of valuation models
Investment is all about the deployment of funds with an objective of
earning reasonable return. It requires proper analysis and effective
management of investment. Valuation is the heart of effective investment
management. It helps in finding out the actual worth of assets. It is a work out
where the worth of a company is determines to check out the market price of
assets.
The share valuation provides the basic guidelines for calculation of
theoretical value of companies and their stocks. It is used for effective trading
strategy of shares through the prediction of expected future market price. It
helps in earning of profit from the price movement of shares as it provides
idea about the evaluation of undervalued or overvalued shares. It can be done
with the help of available share valuation models which provides the expected
price of shares traded in stock exchange. The share valuation models are based
on different factors which is combined together to provide a compact figure of
expected price of shares traded in stock exchange. So, share valuation models
are basically the concept, system or a formula based calculation for finding out
the expected price of share.
A definition of share valuation given by Shri John Maynard Keynes
is highlighted here to clarify the concept of share valuation as follows:
“Stock valuation is not a prediction but a convention, which serves to
facilitate investment and ensure that stocks are liquid, despite being
underpinned by an illiquid business and its illiquid investments, such as
factories”.
Therefore, it can be said that the share valuation models is a useful tool
for the determination of expected price of share.
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2.3.2 Features of Share Valuation Models
Share valuation models calculate the projected price of companies share.
As the valuation models gives the base price of company share and the market
price of share is fluctuated with multiple factors, it is expected that a share
valuation model has incorporated all these important factors which can rightly
predict the market price of share. A good share valuation models should have
the following important features:
 It should have incorporated all the necessary factors of price changes.
 It should rightly predict the expected price of share.
 It should be user friendly in terms of calculation of price.
 It should not create the ambiguity at the time of actual implementation.
 It should not provide different figure to different users.
 It should not be time consuming.
 It should be economical and cost effective.
2.3.3. Need and Importance of Valuation Models

A wide variety of stocks are traded in the stock markets day today and
their market price is also get fluctuated by multiple factors frequently. In
which, One of the important factor is due to the change in real time
information received by market. It influences the perceived value of investors
as the public information provides the necessary base and justification for the
expected price of shares.
The share valuation is treated as the backbone of the modern financial
system. It establishes the premium price of share to those companies which
has sound business models while reflects the price drop of fundamentally
weak companies by providing the expected price of share, calculated with the
help of models. Therefore it enables the efficient allocation of scare resources
in the market.
The overall importance of share valuation models are increasing day
by day in this rapidly changing business environment. In this global market,
large numbers of companies are traded in stock exchanges which provide the
exposure of choice for investment in particular company. At the same time it
creates doubt, in terms of selection of a particular company for investment.
This can be deal appropriately with the help of share valuation models as it
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provides the calculated expected price of share which can be compare with the
actual price for decision making. In this way the valuation models play a
major role in deciding the target company for investment.
The key importance of share valuation models is highlighted as follows:
 It helps in calculating the expected share price of company.
 It helps in finding out the overpriced or under priced shares traded in
market.
 It enables the efficient allocation of scare resources.
 It helps in generating high return from investment of share.
 It boosts confidence of investors in share market.
 It provides moral assurance to investors for their invested money.
2.3.4 Types and Scope of Valuation Models

Nothing is perfect in its own. In the same way, a particular valuation
model is not perfect for every situation. But as per requirement and
characteristics of a particular company, a model should appropriately predict
the expected price of share and should also best suit the situation for decision
making.
In addition, investors should not get stuck with a particular model.
Often, investors should use the several valuations models to find out a range of
possible values or average price of company’s shares. In respect of stock
analysis it is not all about the right or wrong tool of analysis, but it is more
important to reach the final destination of good return though the investors has
analysed the market with different insights and models. Therefore, the
researcher has taken the following models for this study to review the results
of available models and their scope of implementation:
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Investment Models
Walter's
Model
Discounted Gordon's
Cash Flow Model
Model
Investment
Models M &M
(Modigilani
H Model
and Miller
Model
Dividend
Traditional Discount
(Graham & Model( John
Dodd) Model Burr
Williams)
All the above stated models are furnished in details one by one by the researcher to
reflect the core concept of each model. They are as follows:
1. Walter’s Model
1. Walter’s Dividend Model (1963)
Walter's Model was developed by Prof. James E. Walter in 1963 to
determine the value of firm. Through the model Prof. Walter tried to reflect the
importance of dividend on overall valuation of firm. As per him the price of the share
usually influenced by two major factors that is:
i. Company’s dividend payout ratio
ii. Relationship between the Company’s cost of capital and
the internal rate of return.
He explained the impact of changes in dividend payout on the overall value of the
firm in connection to “Cost of Capital (k)” and “Internal Rate of Return (r)”:
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Table No. 2.1 Walter Model: Dividend Payout and firm value
Criteria r>k r<k r=k
Impact on the overall value of the firm

Increase in
Decreases increases No change
Dividend Payout
Decrease in
Increases Decreases No change
Dividend Payout
The above table clearly shows the impact of dividend payout on firm valuation with
respect of firm’s internal rate of return (r) and its cost of capital (k). If the firm’s “r” is
greater than “k” and it increases the dividend payment, then the overall value of the
firm will decrease and vice versa. It means that there is a negative relationship
between firm value and dividend payout in case of (r > k). While it has positive
relationship in case of (r < k) and neutral in case of (r = k).
The developed valuation model of Walter is furnished as follows:

Formula: Walter's model
D + r/k (E – D)
P=
k
Where,
P = Current Market price per Share
D = Dividend per Share
E = Earnings per Share
r = Internal rate of return
k = Cost of Capital
It can be seen with dummy data as
Let assume the D = Rs. 5/ share
E = Rs. 20/ Share
r = 8%
k = 6%
then, P = (5 + .08/.06(20-5))/.06
= Rs. 416.67
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RESEARCHER OBSERVATION:
Though the Walter model included the dividend, earning, cost of capital and internal
rate of return for the calculation of market price of a share, but still it has following
issues and problems:
i. Source of finance: It was assumed that the retained earnings are the
only source of finance, but it is not realistic and feasible in this global
market as the firm uses debt also for their funding purpose for taking
advantage of trading on equity.
ii. Firm's business risk: its assumption of business risk does not change
with additional investments by stating constant r and k is not possible
as r and k changes with additional fund and change in other
circumstances which influenced the market price of share.
iii. No change in the key variables: Model assumption for constant
earnings per share (E) and dividends per share (D) is not possible as
the EPS and DPS varies time to time.
iv. Tax Impact: Impact of tax in movement of share price is overlooked
by this model.
v. Zero DPS: the calculated market price per share will come zero in case
of dividend per share is zero. It means, it is not applicable to non
dividend paying firm.
vi. External factors: it ignored following external factors
 impact of government policy
 change in interest rate,
 flow of FDI and FII,
 condition of foreign market,
 GDP and National Income database,
 Performance of sector in which company share belongs.
 Price sensitive news relating to company either positive or
negative
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2. Gordon’s Model
2. Gordon’s Model:
Gordon’s Model was developed by Myron J. Gordon to determine the value
of firm. Through this model Gordon tried to reflect the importance of dividend
on overall valuation of firm. As per him the price of a share is usually
influenced by dividend policy of the firm. He indicated that the dividend of a
company is expected to grow at constant rate in future, therefore the value of
company’s share, is the present value of future dividends. The developed
valuation model of Gordon is furnished as follows:
Formula: Gordon’s Model
P= E (1-b) D0 (1+ g)
or
ke – br ke - g
Where,
b = Retention ratio
r = Rate of return on investment of an all equity firm.
br = g = Growth rate of earnings and dividends
Ke = Cost of equity capital / Rate of return expected by the
shareholders
P = Price of share
E = Earnings per share
1-b = Dividend payout ratio
D0 = Dividend per share
Though the Gordon model included the dividend, growth rate and cost of capital for
the calculation of market price of a share, but still it has following issues and
problems:
i. Source of finance: It was assumed that the firm is purely financed by
equity share or retained earning only and it not uses any external
financing. so there is no any debt capital, but it is not realistic and feasible
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in this global market as the firm uses debt also for their funding purpose
for taking advantage of trading on equity.
ii. Firm's business risk: its assumption of business risk does not change
with additional investments by stating constant r and k is not possible as r
and k changes with additional fund and change in other circumstances
which influenced the market price of share.
iii. Perpetual Earning: the model assumed the perpetual earning of the firm
based on its perpetual life. But in reality many firms also incurs losses in
its life many time due to market scenario and other factors.
iv. Tax Impact: Model assumed that there is no corporate tax but it is in real
life.
v. Zero DPS: the calculated market price per share will come zero in case of
dividend per share is zero. It means, it is not applicable to non dividend
paying firm.
vi. Risk Factor: It ignored the effect of risk on the overall value of the firm.
vii. External Factors: The following external factors have been ignored in this
model:
 Impact of government policy
 Change in interest rate,
 Flow of FDI and FII,
 Condition of foreign market,
 Price sensitive news relating to company either positive or
negative
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3. Traditional (Graham & Dodd)Model
3. Graham & Dodd Model (Traditional Model) :
Traditional Model is given by B Graham and DL Dodd to determine the

value of a firm. Through this model Graham and Dodd tried to reflect the
importance of dividend and earning on the overall valuation of a firm. They
believe that the price of a share is majorly influenced by dividend policy of the
firm as the model places considerably more weightage to dividends against
retained earnings.
According to them:
“… the stock market is overwhelmingly in favour of liberal dividends
as against niggardly dividends.”
The developed valuation model of Graham & Dodd is furnished as follows:
Formula: Traditional Model
P = m (D + E/3)
Where,
P = Market price of share
D = dividend per share
E = earnings per share
m = a multiplier
Though the Traditional model included the dividend and earnings for the calculation
of market price of a share, but still it has following issues and problems:
i. Assigned Weights: The weights provided by the Graham and Dodd in
this model are based on their subjective judgments.
ii. Deciding multiplier factor: There are no any set norms for assigning
the value of multiplier factor (m).
iii. Favourable dividend and market price: It is not always possible to
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have the favourable impact of company’s liberal dividend payout
policy on their market price of share.
iv. Key variables: The model has only incorporated the importance of
dividend and earning.
v. Tax Impact: Impact of tax in movement of share price is overlooked
by this model.
vi. External Factors: The following external factors have been ignored in
this model.
 change in interest rate and fed rate
 Changes in flow of FDI and FII,
 condition of International market,
 Price sensitive news relating to company either positive
or negative
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4. M &M (Modigilani and Miller) Model
4. Modigliani and Miller Model:

M & M Model is given by Franco Modigliani and Merton H. Miller
to determine the value of a firm. Through this model Modigliani and Miller tried to
reflect the irrelevance of dividend on the overall valuation of a firm. They believe that
the dividend policy of a firm doesn’t affect the wealth of shareholders. It depends on
the firm’s earnings & their investment policy.
The developed valuation model of Modigilani and Miller is furnished as follows:
Formula: M & M Model
P +D
P0 = 1 1
1 + Ke
Where,
P0 = Current Market price of per Share
D1 = Dividend to be received at the year end
P1 = Market value of the share at the year end
Ke = Cost of equity Capital or rate of capitalisation
Though the M & M model included the cost of equity and expected dividend for the
calculation of market price of a share, but still it has following issues and problems:
i. Expected Price and Expected Dividend: As the Model is based on
expected price and expected dividend at year end for the calculation of
present price, it becomes fully forecasted data which itself changes and
based on individual perception and judgment.
ii. Irrelevance of dividend: Dividend is a kind of return on investment
and investment is done for the return. Investors prefer and get attracted
towards the regular dividend paying companies which influence the
market price of a share. The Ezra Solomon also highlighted the
importance of present dividend in these words:
“In an uncertain world in which verbal statements can be
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ignored or misinterpreted, dividend action does provide a clear-cut
means of ‘making a statement’ that speaks louder than a thousand
words”.
iii. Fixed Investment Policy: As the model assumed fixed investment
policy, it is not possible in this competitive business environment.
Organizations adopt and draft new policy for investment as per their
requirement time to time.
iv. No change in the key variables: Model assumption for Constant rate
of return (r), cost of capital (ke) and risk is not realistic as they changes
with market and business conditions.
v. Tax Impact: Non existence of taxes or same rate of tax for capital gain
and dividend payment is not right as presently tax is existed for both
and at different rate.
vi. Individual influence: In reality, Even an individual investor can
change the market sentiment of a particular share as against the model
assumption of no investor is large enough to influence the market price
of shares.
vii. External Factors: The following external factors have been ignored in
this model.
or negative
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5. Dividend Discount Model (John Burr Williams)
5. Dividend Discount Model (John Burr Williams)

Dividend Discount Model (DDM) is given by John Burr Williams to
determine the value of a firm. Through this model Williams tried to reflect the
importance of dividend on the overall valuation of a firm. They believe that the
dividend policy of a firm affect the wealth of shareholders. They stated that the
market price of a share is equals to the sum of the discounted present value of all its
future dividend payments. Different approaches were given for the valuation of a firm
due to differences in dividend policy. As all the DDM’s are based on dividend growth
rate, it is also important to realize and consider the importance of dividend growth
rate, since the small variations in growth of dividend will make a large impact on the
calculated value of the firm.
Following different approaches were also highlighted for the calculation
of market price of a share based on different dividend policy:
 Constant Dividend/Zero Growth Dividend Model
 Constant Growth/ Stable Growth Dividend Model
 2- stage Dividend Growth Model
It is discussed one by one as follows:
5.1 Constant Dividend/Zero Growth Dividend Model
Zero growth Model based on the assumption that the dividends always remain the
same. So the share price of company is equal to the annual dividends divided by the
Rate of Return (ROR). Therefore, the stockholders can expect that their future
earnings will be flat as there will not be any further increase in the dividends payout.
The stated valuation model is furnished as follows:
Formula: Zero Growth Dividend Model
D
P = 1
Ke
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Where,
P0 = Current Market price per Share
Though the Zero Growth Dividend model included the cost of equity and expected
dividend for the calculation of market price of a share, but still it has following issues
and problems:
i. Expected Dividend: As the Model is based on expected dividend at
year end for the calculation of present price, it becomes fully
forecasted data which itself changes and based on individual
perception and judgment.
ii. No change in the key variables: Model assumption of Constant
dividend is not realistic as they changes with market and business
conditions.
iii. Tax Impact: Impact of tax in movement of share price is overlooked
by this model.
iv. External Factors: The following external factors have been ignored in
this model.
or negative
5.2 Constant growth/ Stable Growth Dividend model
It is considered in this model that company's future dividends will grow at a

constant rate. It means, the dividend amount will change at a constant rate. This
model is best suitable for calculation of market price of those companies who have
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increased the dividend steadily over the years.
Share Valuation Formula
D
P = 1
Ke - g
Where,
g = dividend growth rate
Though the Constant Growth Dividend model included the cost of equity, dividend
growth rate and expected dividend for the calculation of market price of a share, but
still it has following issues and problems:
i. Expected Dividend: Calculation of expected dividend is based on
dividend growth rate of the company. The calculated value of growth
rate may differ person to person due to their individual perception and
judgment for the selection of time duration.
ii. Growth Rate: if the firm has not declared dividend in a particular year
the calculation of growth rate in next year not possible as the base
amount becomes nil.
iii. No change in the key variables: Model assumption of Constant rate of
growth in dividend is not realistic as they changes with market and
business conditions along with the management policies.
by this model.
v. External Factors: The following external factors have been ignored in
this model.
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or negative
5.3 Two Stage Dividend Growth Model

It is not possible that the companies will grow always at a constant rate. The
growth and profitability tends to change during its life cycle. Some companies may
grow rapidly in its initial period and thereafter may get stable or decline while others
may not. This model is useful for calculation of share price of those companies, who
tend to initially grow very rapidly in its first few years and thereafter settled down to a
constant growth rate. However it is difficult to calculate the value of those companies
who has non-constant growth in their dividends. To short out this issue we may take
appropriate growth rate based on the past trend of company. Under this model the
price of share is calculated as follows:
Value of the Stock = PV of Dividends during extraordinary phase + PV of terminal

price
D (1+ g ) t
P= 0 1 + D0 (1+ g2)
t
(1 + Ke ) k e– g 2
Extraordinary growth rate: Stable growth: gn

g% each year for n years forever
Where,
g
1 = Market value of the share at the year end
g
2= Stable growth rate

t = time duration of extraordinary growth rate
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Though the two stage Dividend Growth model included the cost of equity,
extraordinary and stable dividend growth rate for the calculation of market price of a
share, but still it has following issues and problems:
i. Extraordinary and Stable growth rate: It is not confirms that
company will grow at stable rate after a certain period. Fluctuation
always arises during its life cycle.
amount becomes nil.
iii. Time Period: Time period of extraordinary growth is also not fixed
and it may vary person to person based on their prediction and
estimation.
iv. No change in the key variables: Model assumption of Constant rate of
growth in dividend after a certain time is not realistic as they changes
with market and business conditions along with the management
policies.
v. Tax Impact: Impact of tax in movement of share price is overlooked
by this model.
vi. External Factors: The following external factors have been ignored in
this model.
or negative
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6. H Model
6. H Model
The H-model is used to value a stock when it is assumed that the dividend growth
will change from one growth rate to another in a linear manner. This model basically
incorporated the impact of dividend along with its expected change of growth rate, on
the company’s share price. The model is based on the theme of company’s growth or
decline trends, over the time, but the growth rate not remains constant. It assumes the
two phases of growth rate. At the one phase the growth rate is normal and in other it
seems abnormal growth. The abnormal rate of growth represents the gradual change
in dividend rates over the time. It is the increase or decrease in regular manner each
year. For example, a company’s dividend growth rate may decline by 2% each year
for three years to transition from 15% to 9%. The rate of change remains consistent
but the growth rate itself gradually decreases.
The H-model is represented as follows:

P0 = DPS0 ( 1 + gn) + DPS * H (ga – gn )
r - gn r - gn
Value from normal Added Value from

growth abnormal Growth
Where,
DPS0 = Dividend Per Share
r = required rate of return to equity investor
ga=growth rate initially (abnormal growth rate)
gn=growth rate at the end of 2H years applied for ever after that
(normal growth rate)
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Though the “H” Model included the cost of equity, extraordinary and stable dividend
growth rate for the calculation of market price of a share, but still it has following
i. Decline in growth rate: The assumption of linear decline in growth
rate not reasonable in this global market scenario. Fluctuation may
arise at different rate.
amount becomes nil.
iii. Time Period: Time period of normal growth is also not fixed and it
may vary person to person based on their prediction and estimation.
by this model.
v. External Factors: The following external factors have been ignored in
this model.
or negative
48 | P a g e
7. Discounted Cash Flow Model
7. Discounted Cash Flow Model
A discounted cash flow (DCF) is given to determine the value of a firm which can
be used for deciding the attractiveness of an investment opportunity. It is based on
discounted future free cash flow. The present value of a share is estimated through the
discounting the estimated future free cash flow of the organisation. Through this
model, it is tried to reflect the importance of free cash flow on the overall valuation of
a firm. If the calculated value is higher than the market price of a share, then it is a
good opportunity and time for the purchase of company’s share.
The discounted cash flow model is furnished as follows:
Formula: Discounted Cash Flow Model
DCF = CF1 + CF2 + …………….+ CFn
(1 + r)1 (1 + r)2 (1 + r)n
Where,
CF = Cash Flow
r = discount rate
Though the “Discounted Cash Flow” Model included the cost of equity and projected
future cash flow for the calculation of market price of a share, but still it has following
i. Projected Cash Flow: It is projection based and the calculated value of
projected future cash flow differs from person to person.
ii. No change in the key variables: The assumption of constant discount
rate for finding out the present value of a share, is also not realistic in
this rapidly changing business environment.
iii. Tax Impact: Impact of tax in movement of share price is overlooked
by this model.
49 | P a g e
iv. External Factors: The following external factors have been ignored in
this model.
 Impact of government policy
 Change in interest rate and fed rate
 Condition of International market,
or negative
1.3.5. Critical evaluation
Table No. 2.2 Critical Evaluation of Models
Models Walter’s Gordon’s Traditional M &M Dividend H Discounted
Model Model Model Model Discount Model Cash Flow
Details
Model
Company’s
Financial No No No No No No No
Condition
Past record of
Dividend and No No No No No No No
Bonus declaration
Industry/ Sector
Performance No No No No No No No
Tax Impact No No No No No No Yes
Global market
scenario No No No No No No No
Political stability
No No No No No No No
Government
policy and No No No No No No No
decision making
Flow of FII/ FDI
No No No No No No No
Economic
condition of the No No No No No No No
country
Other investment
option and their No No No No No No No
return
Source: Researcher observation
50 | P a g e
2.4 Conclusion:
The present chapter deals with the conceptual framework of investment management.
It provides information about the available share valuation models, methods of
calculation of expected market price of shares along with attached problems and
shortcoming.
This chapter broadly covers concepts, features, scope, functions, and
objectives of investment management. It also throws light on the share valuation
models which is the crux of this study. Hence, this chapter helped in creating
theoretical foundation for the present research study.
***
51 | P a g e

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Chapter Second

Equity Share Valuation Models: Theoretical Background

2.2 Conceptual Framework:

2.2.2 Concept of Investment & Investment Management

2.2.3 Evolution and Origin of Investment Management

2.2.4 Features of Investment Management

2.2.6 Functions of Investment Management

2.2.7 Objectives of Investment Management

2.3 Equity share valuation Models:

2.3.3. Need and Importance of Valuation Models

2.3.4 Types and Scope of Valuation Models

Criteria r>k r<k r=k

Impact on the overall value of the firm

The developed valuation model of Walter is furnished as follows:

Formula: Gordon’s Model

3. Graham & Dodd Model (Traditional Model) :

Traditional Model is given by B Graham and DL Dodd to determine the

The developed valuation model of Graham & Dodd is furnished as follows:

Formula: Traditional Model

4. Modigliani and Miller Model:

5. Dividend Discount Model (John Burr Williams)

5.1 Constant Dividend/Zero Growth Dividend Model

The stated valuation model is furnished as follows:

Formula: Zero Growth Dividend Model

5.2 Constant growth/ Stable Growth Dividend model

It is considered in this model that company's future dividends will grow at a

Share Valuation Formula

5.3 Two Stage Dividend Growth Model

Value of the Stock = PV of Dividends during extraordinary phase + PV of terminal

Share Valuation Formula

Extraordinary growth rate: Stable growth: gn

Ke = Cost of equity Capital or rate of capitalisation

The H-model is represented as follows:

P0 = DPS0 ( 1 + gn) + DPS * H (ga – gn )

Value from normal Added Value from

The discounted cash flow model is furnished as follows:

Formula: Discounted Cash Flow Model

DCF = CF1 + CF2 + …………….+ CFn

(1 + r)1 (1 + r)2 (1 + r)n

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