--.

Stock Return and Valuation

UNIT 10 STOCK RETURN AND

VALUATION
NOTES
Structure
10.0 Introduction
IO.I Unit Objectives
I0.2 Return
t,
I0.3 The Anticipated Return
,.
I0.4 Present Value of the Return
I0.5 Multiple Year Holding Period
10.6 Constant Growth ·Model
10.7 Two~stage Growth Model
J0.8 Three-phase Model
10.9 Valuation through P/E Ratio
JO.JO · Whitbeck Kisor Model
JO.I I Preferred Stock Valuation
10.12 Summary
10.13 Review Problems
10.14 Questions and Exer.cises

10.0 INTRODUCTION
The investor takes a number of decisions in the process of investment. The investor has to
decide about his risk tolerance level and whether the assets to be bought should be stocks
or bonds or real estate. Once he decides the nature of the asset, h~ has to select it from the
different alternatives. For example, if the common stock is to be chosen by the investor, he
has to decide which company's stock he has to buy. It may be Reliance Industries stock or
BHEL or Infosys or any other company's stock. Stocks are selected on the basis of their
return and risk. The investor analyse_s the risk and returns·of holding a particular stock for
say, five years or ten years. The risk and return analyses of the securi"ty are known as
security analyses. This chapter deals with stock return analysis.

10.1 UNIT OBJECTIVES

At the end of this unit you will have learnt about:
• Stock return analysis
• Returns from stocks
• The various methods of calculation of returns on stocks
• The two-stage growth model
• The three-phase model
• Price earnings per share

Se/f-Jns1ruc;1lonai Material 151

 Srock Rewm and Valuation 10.2 RETURN
from · Iudes both current income and capital gain caused by the
the stoc k rnc
1
The return
· · of the pnce. • Th . come 'and capital gain are expressed as a percer.tagc
e 111 . of
NOTES appreciation . 1 b . ning The historical returns or expos! returns are derived from
oney invested in I ,e eg111 . . . d f h Id'
m . · d as well as the price changes that occur dunng the perro o o mg
the cash now ,ece1ve ' . h Id.
. ""sset · The income now is the dividend he receives dunng the o mg
the stoc k 01. ,rny
period. Consider the following example.
Example I 0.1
Smithkline Health Care's share price on February 28, 1998 is Rs.40 I (P1) and the price on
October 26, 1998, is Rs.480 (P,+ 1) . Divid;~d received is Rs.35 (D). What is the rate of
return?
Solution:
Now the return (r) :

'(t+l) -'(t) +D 480-401+35 114

r = - - - - - = - - - - =- x 100
fli 401 401
= 28.43%

In simple terms

r = Price Change+ Cash dividend x

100
Purchase Price
To find out the ex post or historical average return of the stock, the common arithmetic
mean is used.

· r =1/n (r 1 + r2 + ,:3 ...... + rn)

r" r2 and r3 indicate the returns that occur in different periods of the stock. Now let us
consider the following exampie. The return of stock A for four quarters is as follows:
I (IO), JI (8), Ill (-4), IV (20). The average return for the year is

IO+ 8 - 4 + 20 = S.S
4

10.3 ... THE ANTICIPATED RETURN .

The historical return can be calculated by a direct method. The calculation of the anticipated
or expected return is different. The ex-ante or future returns are calculated with the help of
probability. Probability describes the likelihood occurrence of an event, i.e., the likelihood
of getting a certain rate of return. The value of the probability ranges from Oto +J. The
value never exceeds one.

The expected rate of return of any stock is the weighted average rate ofreturn. Probabilities
of the rate of returns are used as weights.

N
E(R) = L (Probability P,) (Return Rt)
t=l

This can be explained with the help of the following example:

ilf-ln.rlnlctional Material
 /
X
. / "mple I 0.2
------:-:-----------------...:_
Re/um (R 1) Probability(P1 )
Stock Return and Valuation

(P,) (R,)
10% 0.1 1.0
11% 0.2 2.2 NOTES
12% 0.4 4.8
13% 0.2 2.6
14% 0.1 1.4

S(P 1)(R 1) = 12.0

10.4 PRESENT VALUE OF THE RETURN

In ~he prev_ious section, we found the anticipated rate of return for a particular holding
period. An investor holds shares ofTVS Suzuki from 13 January 1997 to 23 far.uary 1998.
The beginning a~d end period prices are Rs 335 and Rs 42 I. The dividend paid is 35 per
cent. Now, the yield and return can be expressed easily. · ·

Dividend Yield =E._ = Rs 3. 5 x 100 =J%

P Rs 335

421 335
CapitalGainsYield = - xl00=25 .7%
335

Holding Period Return 421-335 + 3.5

-----x I00:, 26.7%
335
The return occurs at the end of the period. If it is to be expressed at the beginning of the
holding period, -;1 has to be given in terms ofthe present value.

p = _!3_+_!)__
o l+r I+r
PO = Present selling price
P 1 = Selling price at the end of orie year period
D 1 = The dividend received during the one year holding period
r = Investor's required rate of return
With the help of the above mentioned formula, the investor can find out whether the price
he has to offer is suitable to his required rate of return. Now, if the investor wants to get 20
per cent return by holding TVS Suzuki stock for a: year, he could find whether the purchase
price is high or low. Utilising the details given in the previous example the pres~nt value is
calculated.

3.5 421
P0 =--+--=2.92+350.83
I+ 0.20 I+ 0.20
= 353.75

The price or the value of the stock would have to be Rs 353.74. The present stock price
Rs 33$ is very low and the investor can buy it.
: The investor can also find out the anticipated selling price for the stock.with his expected
t'
rate of return from holding the stock. His expected return is _20 per cent.

St/f-lnstructiona/ Material 153

 Stock Re111rn and Va/uarion - D1 11
P,o --+-
1+r I +r

Rs 335 = + ___i_
I +.2 I+ .2
NOTES
Rs 335 = 2.92 + l
1.20
335 - 2.92 = 2
1.2
332.08 X J.2 = Pi
1; = 398.5

10.5 MULTIPLE YEAR HbLDING PERIOD

It is easy to calc ulat e th e prese nt va lue of the stock·for a year. If the holding period is more
than a yea r, a separa te formula is app lied to find ou t the preseni value of the share.

P = [±[(eo )d / c](l +g )"]+[(P/£) [(e0)(1+g/• 1]]

. o n= I I +r )" (l+,t'

g = annual expected growth in earni ngs, dividends and price.

e 0 = most recent earni ngs per share
di e = dividend pay ou t
r = required rate of return
PI I:.' =0 price-earnings ratio
N = ~1olding period in yea~s
Example I 0.3

A research study·has stated that the rate of return ofABC Company due to capital appreciation
and divid end after making adjustment for the outflow of income is 16.27 per cent for the
. period 1993-98. Let us assume that the ret urn would continue to grow at this rate for
another four years. The recent dividend paid by the company to its stockholders is 40 per
cent and th e EPS on I 0/98 is Rs 35 and PIE is 4.8. lf an inve·stor wants to buy and hold the
A BC stock for another four yea rs, what would be the ideal price if his required rate of
return is 20 per ce nt ? The price is Rs I 67 on 14 October 1998.
Solution:

Po -- [~[(e 0 )d/
L.....:_.c._ _(l+g)"]
_e] _ _ +[(PIE) [(eo)O+gt+
N ']] .
_n=I (l+rt (l +r)
The expected growth rate g = 16.27
The most recen t earnings per share e0 = 35

. . dividend per share _ Rs 4 _ ,

D1v1dend pay-out = - - - - ' - -- - - 11 .4J
EPS 35
Required rate of return = 20%
Price earnings rat_io P/E = 4.8
Holding period in years N = 4

,54 Seif-Instructional Material

 Sw .. 4 R,,~,n iJnJ l oluar,o,,

Sttp 2

[£
NOTES
((t-o)d l e ] (I + g)'']
(I + r)"

:::: 4 x( l.l 627) 1 + 4 x (l.1627)2 •l x( l. 1627) J + 4 x (l. 1627)J

2
(I+ 0.20) (I+ 0.20) (I + 0.20) J (I+ 0.20) 4
_ 4.6508 5.4074 6.2872 7.J I 02
- - + - + - ... -
1.2 1.44 1.728 2.07)6
= 3.8756 J . 7551 + J.6)8 + ) .5253
The present va!uc of rhe dividend stream = 14.792
Step J

= [<Pt£) ((t-0 )( 1 gl"· 1 JJ

n + n"
= 4.h 35(1-t- 0. 1627) 3
(I + 0.2) 4
356.9830
=
2.0736
= R.s . 1n . 1s6
S.rp 4

.p0 = [t
n• I
l(e~)d l e) (~+ g )"
(I +r )
]•[(PlE) l(ro)(I;
(J + r )
g).v., 11·

= Rs . 14 .7934 +1n . 1S6

= Rs . 186 .95

The expected present value of the ABC company stock is Rs 186.95 . Compared ro ir. lhe
pm-ailing price, Rs 167 is low. According 10 the prcscnl value approach 1he share can be
bought .

10.6 CONSTANT GROWTH MODEL

In lhis model. the basic assumplion is that di vidends will grow ar rhe same rare (g) inro an
indcfmite fUlure.

D(I + g) D(I + g) 2 D(I + g}3 D(I +

Po = - - - + - - - + - - ~1+ . + --"---
gl
1+ r (l+r)2 (l+r) (l + r )"

Whtn the pcr;oo approaches 10 infinity rhc cqua1ion rakes the form
q
p0 - -
r --
g
P O • Presenr value of 1hc stock
r • Required rale of rt'h.lm
 Stock Return and Valuation
NOTES
Check Your Progress
I. What do you understand by
stock return?
2. What is anticipated return?
3. Explain the Constant
Growth Model.
4. Mr A purchases a stock in
the stock market. His
holding period return
depends which,of the
following:
(a) Purchase price of the
stock
(b) Selling price of the
stock
(c) Dividend paid to the
stock
(d) All the above
156 Self-Instructional Material :
g = The growth rate
D1 = The next year dividend
This model is based on the assumption:
(a) The firm 's dividend policy will be stable.
(b) The linn will earn a stable return over the time.
This 111oclel is applicable when the analvst is able to predict all the three variables in the
equation namely (I) next year 's dividen~I , (2) the firm's long-term growth rate, a nd (3) th e
required rate of return of the investor. Once the three values are known to the analyst, the
theoretical value or the present value of the stock can be computed and compared with the
prevailing price.
If
Theoretical value > Actual price-> buy
Theoretical value < Actual price--'-> sell
Another advantage of this model is that with the present selling price, next year's dividend
and growth rate, the rate of return of the stock can be estimated.
Prese nt rate of return > Required rate of return -> buy
Present rate of return < Required rate of return - > sell
Exa mplc I 0.4
The company AI3C's next year dividend per share is expected to be Rs 3 .50. The
dividend in subsequent years is expected to grow at a rate of IO per cent per year. If the
required rate of return is 15 per cent per year, what should be its price? The prevailing
market price is Rs 75.
Sulution:
P0 = Di
--
r-g
D 1 = 3.50
r= 0.15
g = 0.10
3.5
Rs.70
= Rs 70
The investor would be willing to pay Rs 70 for the share. Since the theoretical price is less ·
than the market price, the investor is advised not to buy.
Example IO.S
Anil estimates that from investment on stock A he would get 15 per cent dividend next year.
It would continue to grow by IO per cent for the rest of the years. The selling price is
Rs 40. He needs a return of20 per cent per year for his son's educational expenses. Can he
invest on stock 'A'?
Sol_ution:
r=Di+g
p
 r= -+g
o, Stock Return and Valuation
p

( = .00375 + .I
r= .10375
NOTES
r= .]0375 X ]00
r = 10.37%
The rate of return from the investment on stock ' A' would be only 10.37 per cent. Since
Anil needs 20 per cent return, he should not invest in this stock. He should look for an
alternate investment.
/ ·

10.7 TWO-STAGE GROWTH MODEL

The constant growth model is extended to the two-stage growth model. Here, the growth
stages are divi-Oed into two, namely, a period of extraordinary growth (or decline) and a
constant growth period of infinite nature. The extraordinary growth period will continue
for some period followed by the constant growth rate. The information techn ology industry
is at present experiencing an extraordinary growth rate, it may continue for sometime and
afterwards it may maintain constant growth rate.

Present value of the dividend during

the above normal growth period
The present value of the stock or price =
Present value of stock price at the
end of the above normal growth period

N Do(l+g,)' DN+I I
P
- O. t=I
= I ~(l+r,)'
---+---x---
(r,-gn) (l+r;t·

D0 = Dividend of the previous period

g, = Above normal growth rate
gn = Normal growth rate
r, = Required rate of return
N = Period of above-normal growth
Example I0.6
According to the financial Express report, October 1998, the rate of return o~ Nagarjuna
Fertilizer stock for the past five years is 18.58 per cent. This is assumed to continue for the
next five years and after that rate of return is assumed to have a growth rate of _IO per cent
indefinitely. The dividend paid for the. year 1997-98 is 18 per cent._ The required rate_of
· return is 20 per cent. The price is Rs 14 on 14 October 1998. Estimate the stock pnce
according to the two-stage model.
Solution:

D0 = Rs 1.80
·· g$ = 18.58% or 0.1858
g 11 = 10% or 0.10
Seif-Jn,tructional Material 157
 Stock Return and Va/11ation rJ = 20% or 0.2
N'" 5 years
Step I
NOTES
L
N t

t =I (I + r,)'

3
= ~.:_8i_!J~:)~~+ ~ ~ ~ + 1.8(1.1858) + 1.8(1.1858) 4 + 1.8(1.1858) 5
1
(11 0.2) (I+ 0.2)2 (I+ 0.2) 3 (I+ 0.2) 4 (I+ 0.2) 5
2.1344 2.531 3,0013 3.5589 4.2201
= - - -··· ·I· - - - + - - + - - t .- -
1.2 1.44 I. 728 2.0736 2,- 488
= I. 779 + 1.758 + 1.737 + 1.716 + 1.696
= 8.686

Step 2

- ~"iJ_
(rs - gn)

DN. 1 is the fitth year' s dividend growing at I0% rate

D,1+ 1 = Rs 4.220l x l.l0
D N+ I = Rs 4.642

-- - =4.642
D N+ I
--
rs - g,, 0.2-0.1
= 46.42
Step 3 -

Dn+I
=---x-
.--
(rs - 8n) (1 +rs)N
46.42
· 2.488
= Rs .18.6575
Step 4

p,o -_ LDo(I + gs)' DN+I I

...,----+---x---
r=I (l+rsl (rs-gn) (l+r,)N
= Rs 8.686 + 18.6575
= Rs 27.34

The compult:u value, Rs 27.34 is higher than the market price, Rs 14.

10.8 THREE-PHASE MODEL

158 &lflnstrui:tlonal Material
Here, three phases of dividend growth pattern is assumed. Dividends are assumed to grow
at a constant rate ·g0 ' for a period of'A' years. After the phase 'A', the growth rate of
dividend declines for A + I years through out the phase B and the decline in the dividend
rate would be linear. Afterwards, there would be perpetual growth rate 'gn •. Sometimes the
'g0 ' would be less than 'gn' and in the second phase there would be linear growth rate. The
 , ,ual growth rate is known as the firms long run normal growth rate. The followin
. ,,gure illustrates the three-stage growth rates. g Stock Return and Valuation

NOTES

Phase II

Phase Ill
--l
I

Time

Figure JO.I: Three-phase Model a/Stock Return and Valuation

p
O
= ±
r=I
Do(l+ga)1 +
(l+r)
1
i
r=A+I
D1 - 1(l+gb) + Da(l+gn)
(l + r)1 r-g 11 (l+r) 8

D0 = Dividend forth coming year

g0 = Growth rate period 'A'
g b = Growth rate period ' B'
gn = Growth rate in the third phase
DB = Dividend at the beginr:-:ng of the third phase.
Example 10.7
For the first four years, XYZ firm is assumed to grow at a rate of 10 per cent. After four
years the growth rate of dividend is assumed to decline linearly to 6 per cent. After 7 years,
the finn is assumed to grow at a rate of 6 per cent infinitely. The next year dividend is
Rs 2 and the required rate of return is 14 per cent. Find out the value of the stock.
Solution:

D0 =2
r= 0.14

ga= 0.1
Db= declining rate of return from i0% to 6%, i.e., 0.09, 0.08, 0.07, 0.06
gn = 0.06
B = 7 years (the beginning of the Ill phase)

Self-instructional Material 159

 Su,c* Return and Valuation Step I

= t
l =I
Da(l+ g:,)'
(I +r)
3
NOTES 2 2(1.1) 2(1.1) 2 2(1. 1)
=--+--+-- +-- 4
(1.14) (1.14)] (1.14) 3 (1.14)
= 1.754 + 1.693 + 1.633 + 1.576
= Rs.6.656

Skp 2

= L Dt - 10+gb)
/J

l =A+ I (I+ r)t

3
2(11 ) (109) 2(1.1) 3 (1.09) (1.08) 2(1. 1) 3 (1.09) (1.08) (1.07)
= + - -- - - +
. (114) 5 (114) 6 · (1.14/
= Rs.4 .2746
Step 3

D8 (1 +g 11 )
(r-g 11 )(1+r)8

2(1. 1) 3 (I .09) {I .08) (1.07) (1.06)

(0. ]4 - 0.06) X 2.5023
3.554
2001
= Rs.17,7611
Step 4
Add all the components of the equation
P0 = Rs 6.656 + 4.2746 + 17.761 I
P0 = Rs 28.69
The presenl value of the stock is Rs 28.69.
The value of the stock can be compared wilh the actual price to take a decision on the
purchase, sale or hold the stock. The alternate way lo employ !his model is to find out the
return by equating P0 to the aclual price, without giving the required rate. By solving the
equation, the rale of return can be found. This rate can be compared with the investors
expected rate of return and proper decision can be made.
We have moved from the constant growth model to two-phase growth model and the
three-phase model; with each model the number of variables and complexity of compution
have increased. If growth models are over simplified, inadequate information would be
provided by !he forecasts. If they are too complex, the results or the forecasts made by the
computation are likely to be inaccurate. Hence, lhe analyst has to trade off between
manageabilily and accuracy. Estimating year by year growlh rate into an infinite future is
quite impossible. At the same time giving a single average growth rate for the future is not
fully dependable. The analyst has to strike a balance betwe~n the complexity and manageability
of;t~e known information for forecasting the value of the stock.

60 &/f-lmlrlll:lioaal Material
 -
-,;_.1 · ~ALUATION THROUGH l'/E RATIO Stock Return and Valuation

~' Price-earnings (PIE) ratios are used to estimate lhc I alue of 1he stocks bv the investors
ra1her than adopting the discounting models. Ever) financial magazine ;nd newspaper
publishes price earnings per share at regular intm al. The PIE ratio models have three NOTES
distinct advantages over the discounting models.

I. The PIE ratio indicates price per rupee of share earnings. This would help to compare
the prices of stocks, which have differcnl earnings per slme.
2. PIE ratios are helpful in analysing the stocks of 1hc companies that do not pay dividend
but have earnings. It should be noted that when !here is a loss, the PIE ratio analysis is
difficult to use.

J. The variables used in PIE ratio models arc easier 10 estimate than the vari~bles in the
discounting model.
With the PIE ratio models the investor can only find the relative positions of the different
stocks. It does not indicate what price is appropriate for a particular stock. For example
from the PIE ratio, the analyst can state that PIE ratio of Kinetic Honda 27.5 ( 14. l 0.98) is
higher than that of Bajaj Auto-( 17.2) and T.V.S. Suzuki Ltd.-{ 18. I).
Concept The conceptual framework of the l'/E ra1io arises from the constant growth
model. The constant growth model can be easily written in price-earnings model.

P=~
r-g

Dividing both the sides with E, PIE = .!!...!!...

r-g
die is the pay out ratio. Now the PIE ratio is the funclion of the payout ratio, the discount
rate and the growth rate. The (ac_tors involved in th~ formula indiq1te that higher the payout
ratio, higher is the price earning multiples keeping other things i.e. rand g constant. If the
growth rate is high, then also the PIE ratio would .. be h.igh. If the discount rate or the
required rate of return is high th~.1/lflu-e- of tne"PTE-ratitr wot1Tdile-l~~nd vice-versa.
.. ·__ ··----
If the growth rate is taken to be depending on the return on equity (ROE) then
g = ROE ( I - die); die - payout ratio then

P= -d can be written
. as
r-g

PIE= di e
r-ROE(l-d l c)

Thus, PIE ratio depends on the dividend payout, discount rate and return on equity. All
these factors affect the price earning multiples.

10.10 WHITBECK KISOR MODEL

The PIE ratio can be related to concerned variables by using multiple regression technique.
Whitbeck Kisor has developed the following model
PIE= f (growth rate of earnings g, dividend payment rate
DIE, risk in the growth rate s)
Self-Instructional Material 161
 Slod Rtturn and Valuation
They took 135 stocks and estimated the relationship between PIE and the above-me
variables. The results are given below.

PIE = 8.2 + 1.5 g + 0.067 DIE - .2 s

NOTES This equation indicates the impact of all the three variables on the PIE ratio and consistent
with the earlier model

die
PIE = -
r-g
All the three variables in the multiple regression arc associated with the above-mentioned
equation. The coefficients of the equation indicate the weights of the variables on the PIE
ratio. The signs show the direction of impact of the panicular variable on the PIE ratio. One
per cent increase in the standard deviation of gro111h rate would cause 0.2 unit decrease in
the PIE ratio. Funher, the equation indicates' that J per cent increase in earnings' gro111h
would cause 1.5 unit increase in the PIE ratio. I per cent increase in dividend payout ratio
would result in 1.5 unit increase in the PIE ratio. Thu~. the equation indicates higher growth,
higher dividends and lower risk would lead to high PIE ratio and vice versa. With the help
of the Whitbeck Kisor model, the analyst can calculate the theoretical value of the PIE ratio
and compare it with actual value. If,
Theoretical P/E > actual PIE Sell
Theoretical PIE < actual PIE Buy

The model is sample sensitive. The co-efficients of the panicular period and sample may
not give correct estimation of PIE for another period.
Example 10.8

Company 'A' ,s stock growth rate is 15 per cent, its dividends pay out ratio is 40 per cent
and its standard deviation in the groW1h rate is 5 per cent. The value of the PIE ratio is 22.5
per cent. On the basis of Whitbeck Kisor's model, what is your advice?
Solution:

PIE = 8.2 + 1.5g + .067 die - 2s

The values have to be substituted
PIE= 8.2 + 1.5 (15) + .067 (40) - .2 (5)
= 8.2 + 22.5 + 2.68 - I
C~ec:k Your Progress
= 33.38 - I
5. Explain the two-stage
Growth modd. = 32.38.
6. Whal is the three-phase
model? The actual value of the PIE ratio is below the theoretical value and the stock can be sold
short.
7. Explain the Whitbeck Kisor
nmcl.
8. ~ s c a prefmcd stock's
IIIIIUal dividend is of Rs 3 10.11 PREFERRED STOCK VALUATION
and the required rate of
ICIUm is 15 per cent, what
Preferred stocks provide a fixed income return; hence the equation adopted to find out the
is its worth today? value is given below:
(a) Rs 20
(b) Rs 25
(c) Rs 30 p = !}_
O r
(d) Rs u
D = The dividend paid
r = -Required rate of.return.
~2 Uat,r/a/ ,.
 Suppose a preferred stock's annua, dividend is Rs 4 and the required rate of return is IO per Siock Return and Valuation
cent 1• hat is it worth today?

D 4
P0 =- =- =Rs 40
r 0.10
NOTES
If the the market price is given, it is easier to lind out the rate of return of the preferred
stock. Suppose Rs 6dividend paying prcfenwl stock is se lling in the market for Rs 50, the
yield or return also can be found out.

I'0 -- -D
,.
50 =
/'

:. r = 0.12

Thus, with the given value of dividend and the market price. the return can be found.

10.12 SUMMARY
• The return from holding a stock consists of capital apµrecia:i on_and dividend.
• The discounted present value of al l future income from the stock decides its present
value or price.
• The present price of a single yea r holdi ng period stock could be estimated as follows

Di
Po=-+-
fi
l +r l+r
, If the investor wants to hold the stock for multiple years, the present price could be
estimated wiih c.'/e, F/E a11d EPS. The formula is

1
~[(e0)d /e](l+ g)"] [(P IE) [(e0 ) (l+gl'+ ]]
Po L, ::..:...:;.:__--'----'-- +, ,v
[ n=I {I tr)" (I tr)

, When dividends are assumed to grow constantly over the years for an indefinite future,
the formula is:
r,
VJ
Po= -
r- g
This is known as the constant growth model.
I
• An extension of the constant growth model is the two-stage growth model. It is assu med
A lo have a period of extraordinary growth and a period of normal gro111h.

Po= LNDo(l+g,) I
1-D_,v_+l_ x_l_
t=I (!+I~.)' (!J-g,,) (l +;~).N
An extension of the two-stage growth model is the three-phase growt h model where
three growth rates are used.
The present price of the stock is esti1rnted with ti1e help of P.'E ratio. Earnings. grow1h,
risk and dividend payout ratio decide the price of the share.
The Whitbeck Kisor model explains the relationship between the earnings' growth rate,
dividend payout, standard deviation in growth rate (risk) and the PIE ratio.
Setf.Jns1ruc1ionat Alallrial 163
Stock Re111m 011d Val11a tio11
10.13 REVIEW PROBLEMS
. • Hon da, LML , TVS with the
Problem I Vi nodh bought the stuck of Kinetic . expected .rate of
NOTES . an d tI1e en d perJO
return of 30% after a year. The purchase price · d price are given below. Find out
whether his expectations are fulfilled.

Price 011

._Stock 13.01.9 7 23.01.98 Dividend

Kinetic Honda IOI 125 10%
LML 45 104 15%
TVS. 335 42 1 35%
,.
Solution:

Holding Period Return = P(,+t)- P(,) + D x I00

Pi

125
I. Kinet ic Honda = - IOl+l xl00 = 24.75%
IOI
4 4
2. LM.L. = I0 - S+l.S xl00=134.4%
45

. 421 -335+ 3.5

3. T.V.S.Suzuk1 =----xl00=26.7%
335

Vinodh's expectmion was fulfilled in the purchase of LML stocks but not in other stocks.
Problem 2 Anup wants to purchase the stock of company A and B. He e_st imates the return and
probabilities of returns by analysing the past records. With the given details, find out the expected
return .

Return

A 8 Probability
8% - 2% 0. 15
10% 6% 0.20
12% 10% 0.30
13% 15% 0.2
14% 20% 0. 15
Solution :

The expected return E (r) = S (Probability P,) x Return (R,)

Return Etpecteil Return

Stock A Stock B P, Stock A Stock B

8 -2 0. 15 1.2 --0.30
10 6 0.20 2.0 1.2
12 10 0.30 3.6 3.0
13 15 . 0.2 2.6 3.0
14 20 0.15 2.1 3.0

16-' S: , . /;,,/,! ,( /Ir ,/! ii i\i(l,r!fial 11.5 9.9

 Probfem 3 Vigilenl company stock is currently selling at Rs 25 p.er share Th I k . d
R ·· . e s oc 1s expecle S1ock Re/urn and Valualion
10_ pay e 1_ as d1v1dend per share at the end of the next year. II is reliably estimated that the stock
will be available for as Rs 29 at the end of one year.

(a) If_1he forecasts _about the dividend and price are accurate, is ii advisable to buy al the present
price? His required rate of return is 20%.
NOTES
(b) If the investor requires 15'½0 1 11,1 1 - • .
• re urn ien I ie (1ividcnd remains constant what should be the
price at lhe end of the first yearry

Solution:

D1
(a) P0 = - + -
Pi
l +r l+r
I 29
= - + - =0.833 +24.16
1.2 1.2
P0 = Rs 25.0

Since the estimated price and the actu al price are eq ual, the_investor coul d buy ii.

D1 Pi
(b) Po=-+-
1+r I+r
. I 'Pi
2)=- +-
1.15 1.15

25 = .87 +...!L
!.15
25-0.87 = _i_
1.15
fi =24.13 xl.15
fi = 27.75

The vah:e of the s:ock at the e1;d of the period should be Rs 27.75, if the required rate of return is ·
15%.

Problem 4 Ashok wants to buy Watchful company's stock and hold on it for fi ve years. He
estimates that Rs 3.44 dividend would be paid by the company continuously for the next fi ve
years. He hopes to sell the shares at Rs 60 at lhe end of the fifth year, What is the present price?
His required rate of return is 10 per cent.
folution:

Di D2 Di D,1 D5 P,,
Po=--+1
- -, +--1 + - -i +- - . + -- .
(ltr) (l +r)" (l tr) (ltr) (l +r)" (l +rf
1 3.44 3.44 344 3.44 344 60
Po=--+--2 +--3 +-- +-- +- - -
(1.1)1 (1.1) (1.1 ) (LI/ (11 )5 (l +0 1)5
p, 3.44 3.44 3.44 3.44 3.44 60
o =(U)+(llit (1331) +(1.4641) +(1.6105) + (1.6105)
= 3.13 +2.84 + 2.58 + 2.35 +2. 14 +37.25
= Rs.50.29

roblem 5 Fashions Ltd, operates a large ready made garment system in lhe lextile industry.
ssume that its r.onunou slock can be purthased in lhe beginning or 1997 al Rs 40 . The diviJend
!r share would be Rs 2 for the nex1 1hree years. Ii is eslimated 1ha1 al lhe end or 2000 lhe stock
ill be sold for Rs 55. Whal is the rale or return Fashion 's stock?

Si!!f-!11Jtructional Morena/ 165

l
Stock Return and Valuation Solution:

D1 D2 D3 +_!1_
A=--+--,+--J J
o (l+r)I (l+r)" (l+r) (l+r)
NOTES 2 2 2 55
40 =--+--+--+--)
(l+r) (l+r)2 (l+r)3 (l+r)
This requires trial and error procedure. Lei us try 15% return al first.

2 2 2 55
=-+--+--+--
I.I 5 1.3225 1.5209 1.5209
= 1.739 +1.512 +1.3150 +36.162
= 40.728 /·

The rate of return is 15%.

Problem 6 An investor owns the share of Rise company whose current cash dividend is Rs 3.
I
The constant growth rate in.dividend is 16¾ per year and the required rate of return is 20 per cent.
I
What is the value of th~ Rise company's share?
Solution:

We have to use cash dividends expected one year hence.

I
Po = __j}J_ = Do(I +g)
(K -g) (K -g)
3.00(1 +.16)
0.20-0.16
P0 = Rs 87

Problem 7 Antique Arts compan_)'. would pay Rs 2.50 as dividen_d per share for the next year and
expected to grow indefinitely at 12%, What would be the equity value if the investor requires 20¾
return?

Solution:

D
p = - l-
o K- g

0 1 = 2.50 (next year dividend)

K =20%

g = 12%

2.5
.20- .12

Problem 8 Anil has bought the Everest company stock that has paid Rs 3.00 as dividend per
share during the last fiiiancial year. He anticipates two situations either a 5% decline in the
dividend or 5% growth in the dividend in the next year. His anticipated return is 20%. Fix the price
for both the situations.
Solution:
(a) 5% Growth:

Po =_!l_
K-g

= J(I.OS) =Rs .21

.20-.05

l
 Slock Re/urn and Va/11a1ion

Po=_E.!__
K-g
= 3(1- .05)
NOTES
.20 - (-.05)
= Rs.11.4

·oblem 9 The Grace & Company has

rnings ratio of 15. The annual . common s~ares outstanding in the market with a price-
. expected growth m · d' . . .
mmgs per share is Rs 2 the d' .d . earnings, 1v1dends and price 1s 7%. The
5
· ' IVI end payout 1s 60'1/i0 d h ·
,r 4 years. The required rate of t . an t e mvestor wants to hold the stock
. re urn 1s 1s pe r cen 1· '"h
" at would be the present value?
oluhon:

PoI(eodle) (l+g)" +[(P/ £) [(eo) (l+g)"'+ll

n=I (l+r)" (l+r)N

e 0 = 2.5

di e= 60% or .6

g =7%

r = IS¾or .15

N=4

2
= 2.Sx.6(1+.07) + 2.Sx6(1+0.07) + 2.Sx.6(1+.07)3
(l + 0.15)1 (I+ 0.15)2 (I+ 0. 15)3

2.5x .6(l+07)4 15 x2.5(1+ .07)'

+ + 4
(1+0.15)4 (1+0.15) .

l.5x L07 l.5x 1.1449 1.5 x 1.225 1.5 x 1.3108 15x2.5x l.4026
=---+----+---+----+-----
1.15 1.3225 1.5209 1.7490 1.749

= Rs .1.3956 + 1.2985 + 1.208 + 1.124 + 30.072

P6 = Rs .35.098
rroblem IO The return of ABC company at present is 2I%. This is assumed to continue for the
·next five years and after that it is assumed to have a growth rate of I0% indefinitely. The dividend
!paid for the year· 1997-98 is 32%. The required rate of return is 20% and the present price is Rs 57.
_What is the estimated price according to the two-stage model? '\ t+w_ f .:;,t.{ \/ i I1 {J 10 .
1solution :

A
•
• 0 0 =Rs 3.2

• g, =21%or0.21
g" = lOo/oor0.10
r, = 20%or0.20

N = 5 years
S,/f/nstructionol ,Material 167
'J

Stock Return ar.d Valuation Step I

N t
Po= L Do(I + g:)
t =I (l+r5 )
NOTES
_3.2(1+0.21) 3.2(1.21)2 3.2(1.21)5
- -----'- + - - - + ... _....:_____;__
1 2
(I+ 0.2) (I+ 0.2) (I+ 0.2)5
3.872 4.6851 5.669 6.8595 8.3
=--+--+--+--+--
1.2 1.44 1.728 2.0736 2.4883
= 3.2267 + 3.2535 + 3.2807 + 3.3080 + 3.3356
= 16.4045
Step 2
D N+ !
X ---

(,:S - 811) (1 + 's)N

_ 8.3 x (l.l0) . I
- x---
0.20- 0.10 (I+ 0.2j 5
91.3 x I
= - - = Rs .36.69
2.4883 .
Step 3
Po = 16.4045 + 36.69

Problem 11 The
. .
P0 =Rs53.09
k f
common st oc O Bulls corporation is currently selling for Rs 70 per share.
D~v•d~n_d per share has grown from Rs 2 to the current level of Rs 6 over the past ten years and
th
,s dividend growth is expected to continue in future. What is the required rate of return of the
I
Bulls corporation?
Solution :

Po= Do(I + g)
K-g
K and g are not given

g = [ future value ]" n _ 1

present ·value

g = [Rs 6]1110 - I
Rs 2
= l.116-1 = . li6
g=ll.6%
K=Do(l+g)
Po +g
6 (1.116)
=
70+.l 16
K = 9.5%
Problem 12 Case Study Smart Tyres and Brisk lyres companies' shares are presentiy sold at
Rs 60 and Rs I00 respectively. Annual dividends over the next year are.expected to be Rs 1.5 and
Rs 2.5 respectively. Smart's projected earnings per share is Rs 2.5 and Brisk's is Rs 4. Smart's
dividends are expected to grow at I 0% per annum in the future and Brisk's by 9%. Financial
analysts have estimated the likely prices forJhe year ahead on two stocks to be Rs 66, Rs 72,
168 Self-ln.structional Material Rs 75 for Smart, and Rs I 14, Rs 126, Rs 132 for Brisk.
 (a) You are asked to examine the I f
h re urn o each com '
pure ased for a holding period of o pany s stock. Choose one stock to be S1ock Re/urn and Va/ualion
. ne year. Support your choice
(b) If the mvestor's required rate f . .
. . o return 1s 15% d h
penod, which stock would you s ; an e wants lo hold the stock for a longer
uggest. Why?

Case Analysis NOTES

Th~ analysis can begin with the finding of the ex

penod. Smee the probabil't f peeled average return at the end of 1he holding
. ' y o occurrence of expe t d . . .
be assumed, 1.e., 33 33 f · c e pnce is not given, equal probabilities rnn
. o occurrence for each price.
Expected Price = R p +R p +R P
I I 2· 2 J· J
Smart's expected pnce
· ,=66 xOJ33+72 xOJ33 +75 xO.J33
·p

=ils 71
Brisk'·' exp
. ected pnce
· P, = 114 x0.333 + 126 x0.333 +132 x0.333

=Rs 124
One year holding period return is

P. -P. + D
£(r) = ' -0 -xl00
po

71-60+1.5
Smart's £(,) = - - - xI00 = 20.833%
60

. 124-100+2.5
Bnsk's £(,) = - - - - x 100 = 26.5%
100
The capital apprecia1ion of the Brisk's share in the holding period is higher than lhe Smart's share.
(-'i) The growth·is assumed for the foreseeable fu!ure; hme the ccnstant growth ,n0del ran ~e
adopted for finding out whether the share is overvalued or undervalued.

D
p =-
0 r-g

1.5
$mart's P0 = - - - = Rs 75
r, ·· 0.12-0.10
S, 25
Bns. k's PO= - - - = Rs 83.33
012-.09
The Smart's presenl price in lower than the theoretical price and the stock is undervalued, i.e., 60
< 75 . It is heller to buy Smarts share than the Brisks share in which lhe theoretical price is lower
11
than the prevailing price Rs 100 > 83.33.

At
10.14 QUESTIONS AND EXERCISES
I. How are multiple-year holding stock prices estimated with two-stage and three-phase growth
model?
2. Ex plain the importance of earnings, dividend payout and required rate of return in estimating
the theoretical value of the stock.
J. Explain the Whitebeck Kisor model.
4. AB<. company's stock is currently selling at Rs 45 per share. The company has paid Re I per
share as dividend in the last year. It has been estimated that the stock's dividend would grow
at a rate of 10% per annum. It is anticipated to sell at Rs 50 in the end of the next year. Assume Stlflrutructionol Materioi I69
 Stock Return and Vi1/11atio11 the dividend and price forecasts are accurate. Would you pay Rs 45 to buy and bold the
stock for a year for a 13 per cent required rate of return?
5. Arun has made some forecast regarding Jasmine Company's divide~d and price. According
to him, the company will pay a dividend of Rs 3 per share in the future and al lhe end of five
NOTES years holding period the stock could be sold at Rs 80. His required rate of return is l2"/o per
annum . What should be the price of the Jasmine stock?
6. Joan wa nts lo buy Morning Star Company, shares that have paid a dividend of Rs l.50
during the last financial year. Joan traditionally requires 18% return from his investmenl An
analyst sugges ts that camin ~s and dividends on the stock will grow at a rate of 15 % for lhe
next li ve years and there atier at a rate of I0%. Whal is the fair price expected by Joan?
7. fvlodern Foods, a manufacturer of fast food is ex pected to earn Rs 4 per share next year and
pay a di vidend of Re I per share. Earnings and dividends are _expected lo grow into lhe
foreseeable future al 9% per annum on the'company's stock. If the required rate of return is
12%, what wo uld be the theoretical value of the stock?
8. The Sun corporation recentl y paid a dividend o.f Rs 3 per share. Dividends have been
growing at an annual rate of 9% and this growth rate is expected to continue in the foreseeable
future. If the required rate of return for Sun Corp. is 13 %, what is the value of the stock?
9. The 8ig Brother corp has a req uired rate of return of'! 5% and its current dividend is Rs 2.50
per share. If the current price of the Big Br~ther Corp. stock is Rs 53 per share. is the
growth rate of di vidend?
10. The share of ABC company is currently selling for Rs 65 .per share, dividend per share has
grown from Rs 2 to the current level of Rs 5 over the past IO years, and this dividend growth
is expected to continue in the future . What is the required ~te of return of ABC company?
11. The Visual Computer Corp. has been experiencing and above normal dividend growth rate of
25 per cent per yea r for the past 5 years The above normal growth rate is expected lo
co ntinue for another 5 years before it leve ls off at a normal rate of 7%. The last dividend paid
by the company is Re I per share. Determine the current value ofth_e stock if its required rate
of return is 20%.
12. Mr Vijay fs trying to determine the value of River Valley Corporation's common stock. He
wants to hold the stock for fi ve years and the estimated earnings growth rate is I0%. The
dividend pay out ratio is 50%. The ending PIE ratio is expected to be 20 and the current
earnings per share is Rs 5. If the required rate of return is 16%, what should be the price of the
River Va lley Corp. sto,k?
13. An investor plans to purchase some common stock from XY Corp. The COi]) has not paid
cash di vidend since it start ed its business 5 years ago. The investor expects to hold the
stock for four years. In vestor has been told by several financial analysts that XY Col]). will
start paying the cash di vidend in 3 years that will be 20 per cent of its earnings. The required
rate of return is 18%. The ending PIE ratio is 19. If the investor expects earnings which is
currently Rs 2 per share to continue to grnw at a rate of 15% per year, what is the present
value of the stock?
14. Kayal is considering the In stant Starch Company for possible investment. The holding
period of her inves tment is 5 years. Instant company's earnings per share is Rs 4 and
ex pected to grow at a rate of I0% per year. The present cash dividend payout ratio is to
remain at 50%. If Instant company's current stork price is Rs 50, what is the ending P/E ratio
with 15% required rate of return?

It
170 Self-ln1tructionol .1/armal