Equity Valuation

Dr. Satish Kumar

Why share valuation is different?
• Claims of investors

• Dividends vs interests

• Redemption

• Conversion

• Why is share valuation difficult compared to bond

valuation?
 Assumptions of DDM

• Investors know the future value of dividends

• Dividends are paid at the end of every year

• Dividends are the only way of cash flows

• Investor is expected to hold the shares till infinity

Dividend discount model
Valuation with constant dividends

Valuation with constant growth in dividends

ABC Ltd. is expected to offer a dividend of Rs. 2.0 per share. The
investor’s required rate of return is 14%. If the dividends are expected to
grow at 14%, what is the price of the share?
Constant growth DDM
 Two-stage DDM

Supersonic Ltd recently paid a dividend of Rs. 4.0 per share a dividends. It is
expected to grow by 15% every year for the next three years, thereafter it will
continue a normal growth rate of 6% per annum. If the required rate of return is
16%, what is the intrinsic value of the share?
A firm presently pays a dividend of Rs. 6. The company
expects the dividend to increase at 20% per annum for the first
4 years, 13% for the next 4 years and the grow at 7% thereafter.
If the required rate of return is 24%, what is the present value of
the share?
= 5.8065 + 5.6191 + 5.4379 + 5.2625 + 4.7956 + 4.3702 + 3.9825 + 3.6292 + 22.8429
= Rs. 61.75
How to calculate growth rate?
 Earnings capitalization
1. When the firm pays out 100% of its earnings as dividends

2. When the return on equity is equal to cost of equity

 Relative Valuation
• P/E Ratio What is the relation between P/E and b?

Retention Ratio
0 0.25 0.5 0.75
ROE A. Growth Rate
10% 0 2.5% 5.0% 7.5%
12% 0 3.0% 6.0% 9.0%
14% 0 3.5% 7.0% 10.5%

B. P/E Ratio
10% 8.33 7.89 7.14 5.56
12% 8.33 8.33 8.33 8.33
14% 8.33 8.82 10.00 16.67

Higher the retention ratio, higher the growth rate, but it does not necessarily mean a higher P/E ratio