Measures for monitoring corporate environmental impact - Why market often value firms at many times of their book

value Valuing the firms: y Using the dividend growth model y Using the dividend valuation model Measure the performance of the firms: y The concept of value management and shareholder value added Book Value VS Market value Weights You should always use the market value weights to calculate WACC. In practice, firms do use the book value weights. Generally, there will be difference between the book value and market value weights, and therefore, WACC will be different. WACC, calculate using the book value weights, will be understand if the market value of the share is higher than the book value and vice versa. Why do managers prefer the book value weights for calculating WACC? Beside the simplicity of the use, managers claim following advantages for the book value weights: y Firms in practice set their target capital structure in terms of book values. y The book value information can be easily derived from the published sources. y The book value debt equity ratios are analyzed by the investors to evaluate the risk of the firms practice. The use of the book value weights can be seriously questioned on theoretical grounds. 1. The component costs are opportunity rates and are determined in the capital markets. Te weights should also be market determined. 2. The book value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus they are not reflecting economic values. It is very difficult to justify the use of the book value weights in theory. Market value weights are theoretically superior to book value weights. They reflect economic values and are not influenced by accounting policies. They are also consistent with the market determined component costs. The difficulty in using market value weights is that the market prices securities fluctuate widely and frequently. A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm charges.

The growth rate has to be less than or equal to the growth rate of the economy in which the firm operates. This does not, however, imply that analysts will always agree about what this rate should be even if they agree that a firm is a stable growth firm for 3 reasons. y Given the uncertainty associated with estimates of expected inflation and real growth in the economy, there can be differences in the benchmark growth rate used by different analysts, i.e., analysts with higher expectations of inflation in the long term may project a nominal growth rate in the economy that is higher. y The growth rate of a company may not be greater than that of the economy but it can be less. Firms can becomes smaller over time relative to the economy. y There is another instance in which an analyst may be stray from a strict limit imposed on the 'stable growth rate'. If a firm is likely to maintain a few years of 'above-stable' growth rates, an approximate value for the firm can be obtained by adding a premium to the stable growth rate, to reflect the above-average growth in the initial years. Even in this case, the flexibility that the analyst has is limited. The sensitivity of the model to growth implies that the stable growth rate cannot be more than 1% or 2% above the growth rate in the economy. If the deviation becomes larger, the analyst will be better served using a two-stage or a three-stage model to capture the 'super-normal' or 'above-average' growth and restricting the Gordon growth model to when the firm becomes truly stable. Does a stable growth rate have to be constant over time? The assumption that the growth rate in dividends has to be constant over time is a difficult assumption to meet, especially given the volatility of earnings. If a firm has an average growth rate that is close to a stable growth rate, the model can be used with little real effect on value. Thus, a cyclical firm that can be expected to have year-to-year swings in growth rates, but has an average growth rate that is 5%, can be valued using the Gordon growth model, without a significant loss of generality. There are two reasons for this result. First, since dividends are smoothed even when earnings are volatile, they are less likely to be affected by year-to-year changes in earnings growth. Second, the mathematical effects of using an average growth rate rather than a constant growth rate are small. Dividend Growth Model y Purpose: - A valuation model used to determine the intrinsic value of a share price - Assumes valuation of a share is based on: Forecast dividend, Growth rate of dividend, Required rate of return y Investors should have a dividend growth model as a part of their asset allocation investment management. Every investment portfolio should include dividend growth stocks of companies who have the ability to pay and grow their dividends. In general these stocks with dividends will be more mature companies with stable business models. y There are important advantages to dividend growth investing. Substantial long term gains can be reaped from re-investment of growing dividends. The exponential power of dividend growth compounding can provide competitive returns regardless of whether the price of the stock increases in value or not. In addition the dividend payout of dividend growth stocks provides a cushion against bear market declines. y There are two key principles to successful dividend growth investing. Dividends should always be re-invested and investors should continue to hold dividend growth stocks when prices are low. Dividend growth shares should only be sold at cyclical highs or when something has fundamentally changed in the individual company or industry to make it unable to grow or pay the dividend. y Dividend paying stocks characterized by companies with strong management, competitive advantages, and rising cash flow provide an advantage unavailable in other asset allocation categories. Investors savvy enough to re-invest dividends during bear markets purchase more shares with the dividend while prices are low than when the prices are high. Later when prices recover, the return is actually enhanced by the temporary fall in the stock price. Re-investing dividends and accumulating more shares during bear markets greatly boosts dividend growth stock returns. 2

Advantages and Disadvantages of Dividend Growth Model: y Advantage easy to understand and use y Disadvantages - Only applicable to companies currently paying dividends - Not applicable if dividends arent growing at a reasonably constant rate - Extremely sensitive to the estimated growth rate an increase in g of 1% increases the cost of equity by 1% - Does not explicitly consider risk How does an investor determine if a stock is undervalued, overvalued, or trading at fair market value? With fundamental analysis, this may be done by applying the concept of intrinsic value. If all the information regarding a corporation's future anticipated growth, sales figures, cost of operations, and industry structure, among other things, are available and examined, then the resulting analysis is said to provide the intrinsic value of the stock. To a fundamentalist, the market price of a stock tends to move towards its intrinsic value. If the intrinsic value of a stock is above the current market price, the investor would purchase the stock. However, if the investor found through analysis that the intrinsic value if a stock was below the market price for the stock, the investor would sell the stock from their portfolio or take a short position in the stock. There are several steps associated with fundamental analysis. The investor must make an examination of the current and future overall health of the economy as a whole. Attempt to determine the short-, mediumand long-term direction and level of interest rates. This may done through interest rate forecasting. An understanding of the industry sector involved, including the maturity of the sector and any cyclical effects that the overall economy have on it, is also necessary. Once these steps have been undertaken, then the individual firm must be analyzed. This analysis must include the factors which give the firm a competitive advantage in its sector (low cost producer, technological superiority, distribution channels, etc.). As well, an in-depth look at the firm must be undertaken. Such factors as management experience and competence, history of performance, accuracy of forecasting revenues and costs, growth potential, etc., must be examined. All the steps above give a qualitative overview of the firm's position within its sector and the economy as a whole. This is necessary in order to understand whether a quantitative analysis should be undertaken. If numbers must come into play, there are two relatively simple models which can be helpful for the investor willing to better understand the firm being investigated for investment. The two most commonly used methods for determining the intrinsic value of a firm are the dividend discount model, and the price/earnings model. Both methods if employed properly should produce similar intrinsic values. When using the dividend discount model, the type of industry involved and the dividend policy of the industry is important in choosing which of the dividend discount models to employ. As mentioned earlier, the intrinsic value of a share is the future value of all dividend cash flows discounted at the appropriate discount factor. For those familiar with the calculation of yield in fixed income analysis, the concepts are similar.

Stock valuation and market efficiency The theories of stock valuation are an expression of the belief that what rational investors will pay for a stock is related to what they expect to get from the stock in the future, in terms of cash flows, and the uncertainty related to these cash flows. Does this really work? Is the stock price really related to what we view to be a stocks intrinsic value? Basically, yes. But in reality, stock valuation is not as simple as it looks from the models weve discussed: How do you deal with dividends that do not grow at a constant rate? What if the firm does not pay dividends now? The DVM doesnt apply in the case when dividends do not grow at a constant rate (or at least in stages) or in the case when the company does not pay dividends. In those cases, we need to resort to other models, such as the valuing free cash flows or valuing residual income. Valuation is the process of determining what something is worth at a point in time. When we value investments, we want to estimate the future cash flows from these investments and then discount these to the present. This process is based on the reasoning that no one will pay more today for an investment than what they could expect to get from that investment on a time and risk adjusted basis. If a market is efficient, this means that the price today reflects all available information. This information concerns future cash flows and their risk. The price that is determined at any point in time is affected by the marginal investor the one willing to pay the most for that stock. As information reaches the market that affects future cash flows or the discount rate that applies to these cash flows, the price of a stock will change. Will it change immediately to the correct valuation? For the most part, the more complex the information and valuation of the information, the more time it takes for the market to digest the information and the stock to be properly valued. For well-known companies, a given piece of material information will be reflected in the stocks price within fifteen minutes too late for the individual investor to react to it. The implication of efficient markets is that technical analysis will not be profitable. It also means that fundamental analysis, while valuable in terms of evaluating future cash flows, assessing risk, and assisting in the proper selection of investments for a portfolio, will not produce abnormal returns it will simply produce returns commensurate with the risk assumed. We can see this with mutual funds. We assume that the fund managers have adequate access to all publicly available fundamental information. However, these fund managers cannot outperform random stock picks. Even the most sophisticated fundamental analysis cannot generate abnormal returns. Summary The dividend valuation model is a useful model when valuing a company that pays a dividend and for which the dividend pattern is estimable. The basic premise behind the dividend valuation model is that the value of a stock today is the present value of all future dividends. This model can be applied whether or not the company currently pays a dividend, but if the company does not currently pay a dividend the analyst should be able to estimate the future dividends in amount and timing. The dividend valuation model can be modified for patterns including a constant dividend, a constantly growing dividend, and a dividend that grows at different rate depending on the period in the future. The dividend valuation model can be related to fundamental factors that drive the value of a companys equity, including the return on equity and the dividend payout.

Nature of Dividend Decision y The dividend decision of the firm is crucial for the finance manager because it determines: 1. the amount of profit to be distributed among the shareholders, and 2. the amount of profit to be retained in the firm. y There is a reciprocal relationship between cash dividends and retained earnings. y While taking the dividend decision the management take into account the effect of the decision on the maximization of shareholders' wealth. - Maximizing the market value of shares is the objective. - Dividend payout or retention is guided by this objective. Dividend Policy y Factors Affecting Dividend Policy: 1. External Factors 2. Internal Factors External Factors Affecting Dividend Policy 1. General State of Economy: - In case of uncertain economic and business conditions, the management may like to retain whole or large part of earnings to build up reserves to absorb future shocks. - In the period of depression the management may also retain a large part of its earnings to preserve the firm's liquidity position. - In periods of prosperity the management may not be liberal in dividend payments because of availability of larger profitable investment opportunities. - In periods of inflation, the management may retain large portion of earnings to finance replacement of obsolete machines. 2. State of Capital Market: - Favourable Market: liberal dividend policy. - Unfavourable market: Conservative dividend policy. 3. Legal Restrictions: Companies Act has laid down various restrictions regarding the declaration of dividend: - Dividends can only be paid out of: - ** Current or past profits of the company. Money provided by the State/ Central Government in pursuance of the guarantee given by the Government. - Payment of dividend out of capital is illegal. - A company cannot declare dividends unless: - ** It has provided for present as well as all arrears of depreciation. Certain percentage of net profits has been transferred to the reserve of the company. - Past accumulated profits can be used for declaration of dividends only as per the rules framed by the Central Government 4. Contractual Restrictions: - Lenders sometimes may put restrictions on the dividend payments to protect their interests (especially when the firm is experiencing liquidity problems) - Example: A loan agreement that the firm shall not declare any dividend so long as the liquidity ratio is less than 1:1. The firm will not pay dividend more than 20% so long as it does not clear the loan.

Internal Factors affecting dividend decisions 1. Desire of the Shareholders: - Though the directors decide the rate of dividend, it is always at the interest of the shareholders. - Shareholders expect two types of returns: a) Capital Gains: i.e., an increase in the market value of shares. b) Dividends: regular return on their investment. - Cautious investors look for dividends because, a) It reduces uncertainty (capital gains are uncertain). b) Indication of financial strength of the company. c) Need for income: Some invest in shares so as to get regular income to meet their living expenses. 2. Financial Needs of the Company: - If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings. 3. Nature of earnings: - A company which has stable earnings can afford to have an higher divided payout ratio 4. Desire to retain the control of management: - Additional public issue of share will dilute the control of management. 5. Liquidity position: - Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends Stability of Dividends - The term stability of dividends means consistency in the payment of dividends. It refers to regular payment of a certain minimum amount as dividend year after year. - Even if the company's earnings fluctuate from year to year, its dividend should not. This is because the shareholders generally value stable dividends more than fluctuating ones. - Stable dividend can be in the form of: a) Constant dividend per share b) Constant percentage c) Stable rupee dividend plus extra dividend Significance of Stability of Dividend 1. Desire for current income 2. Sign of financial stability of the company 3. Requirement of institutional investors 4. Investors confidence in the company Danger of Stable Dividend Policy - Stable dividend policy may sometimes prove dangerous. Once a stable dividend policy is adopted by a company, any adverse change in it may result in serious damage regarding the financial standing of the company in the mind of the investors.

Forms of Dividend 1. Cash Dividend: - The normal practice is to pay dividends in cash. - The payment of dividends in cash results in cash outflow from the firm. Therefore the firm should have adequate cash resources at its disposal before declaring cash dividend. 2. Stock Dividend: - The company issues additional shares to the existing shareholders in proportion to their holdings of equity share capital of the company. - Stock dividend is popularly termed as 'issue of bonus shares.' - This is next to cash dividend in respect of its popularity. 3. Bond Dividend: - In case the company does not have sufficient funds to pay dividends in cash it may issue bonds for the amount due to shareholders. - The main purpose of bond dividend is postponement of payment of immediate dividend in cash. The bond holders get regular interest on their bonds besides payment of the bond money on the due date. [Bond dividend is not popular in India] 4. Property Dividend: - This is a case when the company pays dividend in the form of assets other than cash. This may be in the form of certain assets which are not required by the company or in the form of company's products. [This type of dividend is not popular in India]

y Impact of external environment on Business* For success in the present world, one need to consider not only the internal environment of the company consisting of its resources and employees, but also needs to consider the external factors. These aspects cannot be stopped but one can adjust accordingly as per the changes in the economical, social or political pressures. These are the external factors which consist of: Opponents or competitors The changing economic structure Impact of the society Financial arrangement Legal or political system The impact of the environment Opponent's procedures influence the capability of work in earning profits, as the basic aim of the opponent is to get advantage over the other which is obtained by either diversifying the existing products and services or by finding means to offer better options for the same worth of money. There are three stages of opposition existing in the present world organizations which can be either having a straight competition when the associations are challenging for the similar customers with the analogous products for example grocery or bakery items. Or when there is a rivalry existing between goods that can be replaced with one another for example butter for margarine. Similarly when consumer's purchasing power is the main attraction for the producers it results in competition between organizations for example the entertainment sector. The allocation of the scarce resources is handled by the organization comprising the economic system. Economy is part of a nation which is expected to undergo phases of progress by leaps and bounds. When the economy is in a flourishing stage lifting the standards of living resulting in the growth of the business. On the other hand the society is a foundation of inspirations, outlook and activities which are a part of the human affairs. However the business is subjective to change by the actions of customer because of their approach and activities which alter depending on various factors such as maturity level, populace, type of vocation, and spare time activities. Alternatively fiscal classification smoothes the progress of trade alternates. Activities dealing with money basically move around producing, having a loan, expenses and banking. For the lubrication of the wheels of commerce, capital is considered to be the main oil. Monetary doings engross production in a network of contacts linking fiscal bodies which consists of banks, people or companies who grant loans or to whom money is given as advance, clients and contractors. A main factor affecting the business is the interest rate because it is directly proportional with the cost of the company. The elevated the rate, more will be the expenditure to act as a stop on payments in the economy. The rules and regulations created by the legal system provide the framework on which the organization runs. Administration policy of any nation shores up by promoting activities like ventures while puts off others which result in polluting the natural environment. In contrast the environment is made up of all the nature's gifts bestowed upon us ranging from land to water and to air which has any sort of life in it. Progressively more productions have turned out to be alert of the affiliation between their cost-effective movements that is composing produces and providing assistance for earnings making sure the environment is not at stake at any cost.

Inflation and Gross Domestic Product (GDP): Inflation and GDP growth are probably the two most important macroeconomic variables. The Gross Domestic Product (GDP) is the key indicator used to measure the health of a country's economy. The GDP of a country is defined as the market value of all final goods and services produced within a country in a given period of time. Usually, GDP is expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP was up by 3%, it means that the economy has grown by 3% over the last year. A significant change in GDP, whether increase or decrease, usually reflects on the stock market. The reason behind this is that, a bad economy usually means lower profits for companies, which in turn means lower stock prices. Investors really worry about negative GDP growth. Therefore growth in GDP reflects both on growth in the economy and price changes (inflation). GDP deflator is based on calculations of the GDP: it is based on the ratio of the total amount of money spent on GDP (nominal GDP) to the inflation corrected measure of GDP (constant price or real GDP). It is the broadest measure of the price level. Deflators are calculated by using the following formula:

Current price figures measure value of transactions in the prices relating to the period being measured. On the other hand, Constant price figures express value using the average prices of a selected year, this year is known as the base year. Constant price series can be used to show how the quantity or volume of goods has changed, and are often referred to as volume measures. The ratio of the current and constant price series is therefore a measure of price movements, and this forms the basis for the GDP deflator. The GDP deflator shows how much a change in the base year's GDP relies upon changes in the price level. It is also known as the "GDP implicit price deflator".