FM- ELECT: MODULE 3 & MODULE 4
MODULE 3
Securities Regulation Code
Republic Act No. 8799
Generally, securities should not be sold or offered for
sale or distribution within the Philippines, without a
registration statement duly filed with and approved by
the Securities and Exchange Commission (except
however for the classes of securities enumerated in
Section 9.1 of the code and the exempt transactions
enumerated in Section 10.1 of the code, as amended).
As a regulation, the code sets out reportorial
requirements (including financial statements) for issuers
of securities listed in Section 17.2 of the code, as
amended.
The Securities Regulation Code of the Philippines or
Republic Act No. 8799 is a landmark legislation that
aims to regulate the issuance and trading of equity
securities and debt securities in the Philippines.
These are measures to:
• protect investors,
• prohibit fraud,
• regulate securities professionals,
• and to ensure that the Philippine securities
market system is effective and in order.
There are several actors that engage in the issuance
and trading of securities.
For instance, issuers create the securities. They are
composed of corporations, domestic governments,
foreign governments, and investment trusts.
Brokers are agents who buy and sell securities for
others, while dealers buy and sell securities for
themselves.
For securities to be legitimate, they must indicate that
they are securities with a written or electronic certificate
or contract. Without proper registration, securities are
not allowed to be sold or distributed in the Philippines.
What is the nature of the Securities Regulation Code
(SRC)?
The SRC is enacted to protect the public from
unscrupulous promoters, who stake (risk) business or
venture claims which have really no basis, and sell
shares or interests therein to investors
What is a security?
Securities are shares, participation or interests in a
corporation or in a commercial enterprise or profit-
making venture and evidence by a certificate, contract,
instruments, whether written or electronic character.
These securities typically come in the form of the
following:
• shares of stocks, bonds, debentures
• investment contracts
• options and warrants
• certificates (assignment, participation, trust, etc.)
• proprietary and non-proprietary membership
certificates
What are the kinds of securities?
(NO NEED TO DISCUSS, just present)
1. Shares of stocks, bonds, debentures, notes,
evidence of indebtedness, asset-backed
securities
2. investment contracts, certificates of interest or
participation in a profit-sharing agreement,
certificates of deposit for a future subscription
3. fractional undivided interests in oil gas, or other
mineral rights
4. Derivatives, options and warrants
5. Certificates of assignments and participation,
trust certificates, voting trust certificates, similar
instruments
6. Proprietary or non-proprietary membership
certificates in corporation
7. Other instruments as may be in the future
determined by the SEC.
Definition of Terms
1. Securities are shares, participation or interests
in a corporation or in a commercial enterprise or
profit-making venture and evidenced by a
certificate, contract, instruments, whether written
or electronic in character
2. Issuer is the originator, maker, obligor, or
creator of the security.
3. Broker is a person engaged in the business of
buying and selling securities for the account of
others.
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4. Dealer means any person who buys, sells
securities for his/her own account in the ordinary
course of business.
5. Associated person of a broker or dealer is an
employee therefor whom, directly exercises
control of supervisory authority, but does not
include a salesman, or an agent or a person
whose functions are solely clerical or ministerial.
6. Clearing Agency is any person who acts as
intermediary in making deliveries upon payment
effect settlement in securities transactions.
7. Exchange is an organized market place or
facility that brings together buyers and sellers
and executes trade of securities and/or
commodities.
8. Insider means
(a)the issuer;
(b) a director or officer (or any person performing
similar functions) of, or a person controlling the
issuer; gives or gave him access to material
information about the issuer or the security that is
not generally available to the public;
(c) A government employee, director, or officer of an
exchange, clearing agency and/or self-regulatory
organization who has access to material information
about an issuer or a security that is not generally
available to the public; or
(d) a person who learns such information by a
communication from any foregoing insiders.
9. Pre-need plans are contracts which provide for
the performance of future services of or the
payment of future monetary considerations at
the time actual need, for which plan holders pay
in cash or installment at stated prices, with or
without interest or insurance coverage and
includes life, pension, education, interment, and
other plans which the Commission may from
time to time approve.
10. Promoter is a person who, acting alone or with
others, takes initiative in founding and
organizing the business or enterprise of the
issuer and receives consideration therefor.
11. Prospectus is the document made by or on
behalf of an issuer, underwriter or dealer to sell
or offer securities for sale to the public through
registration statement filed with the Commission
12. Registration statement is the application for
the registration of securities required to be filed
with the Commission.
13. Salesman is a natural person, employed as
such as an agent, by a dealer, issuer or broker
to buy and sell securities.
14. Uncertificated security is a security evidenced
by electronic or similar records.
15. Underwriter is a person who guarantees on a
firm commitment and/or declared best effort
basis the distribution and sale of securities of
any kind by another company.
16. Material Information
*Material information may include, but not limited to:
 Financial results
 Projections of future earnings or losses
 News of pending or proposed merger
 Change in the corporate structure (e.g.
reorganization)
 Acquisition / Divestiture / Joint Venture
 Dividend declaration and changes in dividend
policy
 Stock splits
 New significant equity investment or debt
offering
 Significant litigation exposure
 Major change in key senior management
position
How are securities traded?
Securities are traded in the primary and secondary
markets.
Primary Market
When a company issues stock or bonds for the first time
and sells those securities directly to investors
Examples are IPOs, or Initial Public Offerings which
occurs between the purchasing investor and the
investment bank underwriting the IPO. Any proceeds
from the sale of shares of stock on the primary market
go to the company that issued the stock
Secondary Market
If these initial investors later decide to sell their stake in
the company, they can do so on the secondary market.
Any transactions on the secondary market occur
between investors, and the proceeds of each sale go to
 FM- ELECT: MODULE 3 & MODULE 4
the selling investor, not to the company that issued the
stock nor to the underwriting  bank.
What is the state policy or purpose of Securities
Regulation Code (SRC)?
1. socially-conscious, free market that regulates
itself.
2. encourages widest participation.
3. democratization of wealth
4. development of the capital market
5. protect investors
6. ensure full and fair disclosure about securities
7. minimize if not totally eliminate insider trading
and other fraudulent manipulative devices.
Socially conscious, free market that regulates itself
Socially conscious investing positively impacts the
environment by reducing emissions or investing in
sustainable or clean energy sources, contributing to
causes such as women's rights, civil rights, and the anti-
war movement (why does gov’t focus on socially
conscious investing?)
A self-regulatory market has the power to create and
enforce stand-alone industry and professional
regulations and standards on its own. In the case of
financial SRO*s, such as a stock exchange, the priority
is to protect investors by establishing rules, regulations,
and set standards of procedures which promote ethics,
equality, and professionalism.
*SRO- Self-Regulatory Organization
Encourage the widest participation.
 Encourage investments and more active public
participation in the affairs of private corporations and
enterprises (why?)
Democratization of wealth
 One of the major limitations on our ability to do for
ourselves is the concentration of wealth in the hands
of a few.
 The democratization of wealth is intended to address
that limitation by making wealth democratically
available, so that it can be used in the interest of the
people
Development of the capital market
 Development of local capital markets can improve
the availability of long-term financing, allowing
households and firms to better manage interest rate
and maturity risk associated with long-term
investments (such as investments in equipment,
machinery, land and buildings) by allowing for a
better match
Protect investors
 The PSE and Securities and Exchange Commission
(SEC) have put in place several safeguards that
promote transparent, fair, and organized buying and
selling of stocks where every investor, big or small
alike, are protected from fraud, manipulative trading
practices, and erring stockbrokers
 For instance, a whistleblower is rewarded for
reporting financial fraud.
Ensure full and fair disclosure about securities
 To prevent selective disclosure by public companies
to market professionals and certain shareholders.
 A publicly-traded company or issuer of stock
discloses any material nonpublic information
regarding that issuer or its securities to a limited
group of individuals, the issuer must also make
public disclosure of that information. Such
disclosures (factual and truthful information only)
must be made simultaneously if it is an intentional
release of information. Non-intentional sharing of
such information must be promptly followed with
public disclosures.
Minimize if not totally eliminate insider trading and other
fraudulent manipulative devices
 The provisions of the Securities Regulations Code
are focused on preventing unfairness as a result of
fraudulent devices and insider trading. In an insider
trading, the main perpetrator called the “insider”
profits from the material information that are not
available to the public. These pieces of information
are called “Material Non-Public Information”
 “Insider Trading” - purchasing or selling a security
while in possession of material information not
generally available to the public,
Is the list of securities stated in Section 3 exclusive?
 “Securities” flexible rather than static (fixed)
principle, one that is capable of adaptation to meet
the countless and variable schemes.
(Exclusive? yes? or no?)
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What is an investment contract?
 Contract, transaction or scheme person invests his
money in a common enterprise led to expect profits
primarily from the efforts of others
Must securities be registered with the SEC?
 Yes! Shall not be sold or offered for sale or
distribution within the Philippines, without a
registration statement duly filed with and approved
by the Commission. Prior to such sale, information
on security made available to each prospective
purchaser.
Why is it required to register securities before they can
be sold or traded with the public?
 A primary means of protecting the investing public is
the disclosure of the important financial information
(timely, factual and accurate) through the registration
of securities enables investors to make informed
judgments.
Registration of Securities
What are the exempt securities?
The requirement of registration under Subsection 8.1
shall not as a general rule apply to any of the following
classes of securities:
1. Security issued or guaranteed by the
Government of the Philippines or by any political
subdivision or agency thereof, any person
controlled by and acting as an instrumentality of
said government. (what are some examples?)
2. Any security issued or guaranteed by the
government of any country within which the
Philippines maintains diplomatic relations,
reciprocity.
3. A receiver or by a trustee in bankruptcy duly
approved by the proper adjudicatory body.
4. Any security or its derivatives the sale or transfer
of which, by law, is under the supervision and
regulation of the Office of the Insurance
Commission (OIC), Housing and Land Use
Regulatory Board (HLURB) , Bureau of Internal
Revenue (BIR).
5. Issued by a bank except own shares of stock.
6. Added by the SEC by rule or regulation after
public hearing
What are exempt transactions?
The requirement of registration under Subsection
8.1 shall not apply to the sale of any security in any
of the following transactions:
1. Judicial sale by executor, administrator,
guardian/receiver in insolvency or bankruptcy.
2. Pledged or mortgaged security liquidated a
bonafide debt.
Mortgage  is a term that is used for fixed assets like
land, buildings, apartments etc. However, when
you  mortgage  your apartment, the documents
would remain with the lender
Pledge is used for movable assets (shares,
certificate of deposit). When you pledge  your
shares, they would still remain with you and you
would be entitled to dividends etc.
3. Isolated transactions by owner
(any security sold, offered for sale, subscription
or delivery by the owner thereof, or by his
representative for the owner’s account)
4. Distribution of stock dividends.
5. Sale of capital stock exclusively to stockholders,
no commission.
6. Issuance of bonds or notes secured by
mortgage upon real estate, tangible personal
property, entire mortgage is sold to a single
purchaser at a single sale.
7. security in exchange of any security, right of
conversion
8. Broker’s transactions
9. Pre-incorporation subscription, subscription to
an increase of the ACS.
10. Exchange of securities with existing security
holders less than 20 persons during any 12-
month period
 FM- ELECT: MODULE 3 & MODULE 4
11. banks registered investment house, insurance
companies, pension fund or retirement plan
maintained by the government.
What are the manipulative practices that are
prohibited?
1. A false or misleading appearance of active
trading in any listed security
a. by effecting any transaction in such
security which involves no change in the
beneficial ownership thereof;
b. by entering an order or orders for the
purchase or sale of such security, the
knowledge, a simultaneous order or
orders of substantially the same size,
time and price, for the sale or purchase
of any such security.
2. A series of transactions
a) Raises their price to induce the purchase of
a security
b) Depresses their price to induce the sale of a
security
c) Creates active trading to induce such a
purchase or sale marking the close, painting
the tape, squeezing the float, hype and
dump, boiler room operations.
3. Circulate or disseminate information price of
any security listed in an Exchange will or is likely
to rise or fall.
4. False or misleading statement with respect
to any material fact, knew or had reasonable
ground to believe was so false or misleading.
5. any series of transactions for the purpose of
pegging, fixing or stabilizing the price.
6. Any manipulative or deceptive device or
contrivance.
Prohibited conduct and/or acts.
- “painting the tape “: engaging in a series of
transactions in securities that are reported publicly to
give the impression of activity or price movement in
a security.
- “marking the close.”: buying or selling securities
at the close of the market in an effort to alter the
closing price of the security.
- “improper matched orders.”: both the buy and
sell orders are entered at the same time with the
same price and quantity by different colluding
parties.
- “hype and dump.”: buying at increasingly higher
prices and selling in the market at the higher prices
and vice versa such as selling at lower prices and
then buying at such lower prices.
- “wash sales.”: transactions in which there is no
genuine change in actual ownership
- “squeezing the float.”: taking advantage of a
shortage of securities in the market by controlling the
demand side and exploiting market congestion
during such shortages in a way as to create artificial
prices
What are short sales?
A short sale is the sale of an asset or stock the seller
does not own. 
It is generally a transaction in which:
• an investor sells borrowed securities in
anticipation of a price decline;
• the seller is then required to return an equal
number of shares at some point in the future.
In contrast, a seller owns the security or stock in a
long position.
Is Short Sale Prohibited?
General Rule: There is no absolute prohibition on short
sale
Exception:
1. Short sales in securities of the corporation made by
directors, officers of principal shareholder of such
corporation;
2. Whenever the SEC, motu proprio* or upon
recommendation of the Exchange, prohibits short selling.
*Latin for: "on his own impulse “; describes an
official act taken without a formal request from another
party
What is the limitation on short sales with respect to
directors, officers or principal stockholders?
No director, officer or principal stockholder of a
corporation shall make a short sale in securities of the
corporation in which he is a director, officer or principal
stockholder.
 FM- ELECT: MODULE 3 & MODULE 4

Example: Short Selling for a Profit
Imagine a trader who believes that XYZ stock—
currently trading at $50—will decline in price in the
next three months. They borrow 100 shares and sell
them to another investor. The trader is now “short”
100 shares since they sold something that they did
not own but had borrowed. The short sale was only
made possible by borrowing the shares, which may
not always be available if the stock is already heavily
shorted by other traders.
A week later, the company whose shares were
shorted reports dismal financial results for the
quarter, and the stock falls to $40. The trader
decides to close the short position and buys 100
shares for $40 on the open market to replace the
borrowed shares. The trader’s profit on the short
sale, excluding commissions and interest on the
margin account, is $1,000: ($50 - $40 = $10 x 100
shares = $1,000).
All companies, listed or applying for listing, are required
to divulge truthfully and accurately, all material
information about themselves and the securities they sell
for protection of the investing public in pain of
administrative, criminal and civil sanctions.
Under the SRC, when do civil liabilities arise?
1. False registration statement
2. In violation of registration requirements
3. by means of prospectus or communication with
untrue statement
4. Fraud in connection with securities transaction
5. Manipulation of security prices
6. Commodity futures contracts and pre-need
plans
7. Insider trading

Example: Short-Selling for a Loss Under the SRC, is mere presence of negligence
sufficient to hold a person accountable for civil liabilities?
Using the scenario above, let's now suppose the
trader did not close out the short position at $40 Fraud or deceit, not negligence, on the
but decided to leave it open to capitalize on a part of the offender must be established.
further price decline. However, a competitor
swoops in to acquire the company with a
takeover offer of $65 per share, and the stock
soars. If the trader decides to close the short
position at $65, the loss on the short sale would
be $1,500: ($50 - $65 = negative $15 x 100
shares = $1,500 loss). Here, the trader had to
buy back the shares at a significantly higher
price to cover his position.

Manipulation of Security Prices; Devices and Practices

Insider’s Duty to Disclose When Trading
-it shall be unlawful for an insider to sell or buy a security
of the issuer while in possession of material information
with respect to the issuer or the security that is not
generally available to the public.
MODULE 4
EQUITY VALUATION ANALYSIS
Equity valuation is a blanket term and is used to refer
to all tools and techniques used by investors to find out
the true value of a company's equity.

-it shall be unlawful for an insider to disclose “insider What is the main purpose of Equity Valuation?
information” to other parties.
The main purpose of equity valuation is to
Can Insider Trading be legal? estimate a value for a firm or its security.

YES! What is Equity Valuation Analysis?

Insider trading can be legal if the trading occurs on
the basis of information which is available to the Valuation analysis is a process to estimate the
public. approximate value or worth of an equity

What is the disclosure rule? Valuation: Fundamental Analysis

 FM- ELECT: MODULE 3 & MODULE 4

Fundamental analysis models a company’s I. Book value

value by assessing its current and future
II. Liquidation value
profitability.
III. Replacement cost
The purpose of fundamental analysis is to
identify mispriced stocks relative to some Book value is the net value of a firm's assets found on
measure of “true” value derived from financial its balance sheet, and it is roughly equal to the total
data. amount all shareholders would get if they liquidated the
company.
Models of Equity Valuation

I. Balance Sheet Models ⮚ Book values are based on historical cost, not
actual market values.
I. Book value
⮚ It is possible, but uncommon, for market value to
II. Liquidation value be less than book value.
III. Replacement cost ⮚ “Floor” or minimum value is the liquidation value
II. Intrinsic Value Model per share.

a. Dividend Valuation Methods ⮚ Tobin’s q is the ratio of market price to

replacement cost.
1. Dividend Discount Model
The values of both assets and liabilities recognized in
2. Constant Perpetual Growth Model financial statements are based on historical—not current
values.
3. Two-Stage Growth Model
a. Historical cost
4. Non-constant Growth in the First
Stage
On March 14, 2020,
b. Price-Earnings Ratio ABC company bought
machinery for P 1M.
c. Free Cashflow Models b. Current Market price for
the machine
Valuation by Comparable
is for P 1.5 M.
Compare valuation ratios of firm to industry
For example, the book value of an asset equals the
averages.
original cost of acquisition less some adjustment for
Ratios like price/sales are useful for valuing depreciation, even if the market price of that asset has
start-ups that have yet to generate positive changed over time.
earnings.

Book value = Original cost - depreciation

Moreover, depreciation allowances are used to allocate

the original cost of the asset over several years, but do
not reflect loss of actual value.

The market value of the shareholders’ equity investment

equals the difference between the current values of all
assets and liabilities.

Market value = Current Value of assets - Current

Value of liabilities

Remember: current values generally will not match

historical ones.

I. Balance Sheet Models Liquidation Value

 FM- ELECT: MODULE 3 & MODULE 4
A better measure of a floor for the stock price is the
firm’s liquidation value per share.
Liquidation value is the amount of money that could
be realized by breaking up the firm, selling its
assets, repaying its debt, and distributing the
remainder to the shareholders.
If the market price of equity drops below liquidation
value, the firm becomes attractive as a takeover target.
A corporate raider would find it profitable to buy enough
shares to gain control and then actually to liquidate
Liquidation is the difference between some value
of tangible assets and liabilities.
Liquidation value = Assets
Liabilities
As an example, assume liabilities for company A are
$550,000. Also, assume the book value of assets found
on the balance sheet is $1 million, the salvage value is
$50,000, and the estimated value of selling all assets at
auction is $750,000, or 75 cents on the dollar. The
liquidation value is calculated by subtracting the liabilities
from the auction value, which is $750,000 minus
$550,000, or $200,000.
Replacement cost is the price that an entity would pay
to replace an existing asset at current market prices with
a similar asset.
If the asset in question has been damaged, then the
replacement cost relates to the pre-damaged condition
of the asset.
The replacement cost of an asset may vary from the
market value of that specific asset, since the asset that
would actually replace it may have a different cost; the
replacement asset only has to perform the same
functions as the original asset - it does not have to be an
exact copy of the original asset.
Let’s look at a replacement costs example. If a company
bought a machine for $1,000 five years ago, and the
value of the asset today, less depreciation, is $300
dollars, then the book value of the asset is $300.
However, the cost to replace that machine at current
market prices may be $1,500. Therefore, the
replacement cost would be significantly higher than the
book value.
-
Similarly, if the company bought a quantity of steel for
$10,000 a year ago, and the price of steel subsequently
sky-rocketed, then the replacement cost for that same
amount of steel could be $15,000, or whatever the
current market price of steel dictates for the given
quantity.
Market vs. Book vs. Liquidation vs. Salvage Value
Market value typically provides the highest valuation
of assets although the measure could be lower than
book value if the value of the assets has decreased due
to market demand rather than business use.
The book value is the value of the asset as listed on the
balance sheet. The balance sheet lists assets at the
historical cost, so the value of assets may be higher or
lower than market prices. In an economic environment
with rising prices, the book value of assets is lower than
the market value.
The liquidation value is the expected value of the asset
once it has been liquidated or sold, presumably at a loss
to historical cost.
Finally, the salvage value is the value given to an asset
at the end of its useful life; in other words, this is the
scrap value.
Liquidation value is usually lower than book value but
greater than salvage value. The assets continue to have
value, but they are sold at a loss because they must be
sold quickly.
Intrinsic Value Model
a. Dividend Valuation Methods
1. Dividend Discount Model
 FM- ELECT: MODULE 3 & MODULE 4

2. Constant Perpetual Growth Model Is the stock attractively priced today given your
forecast of next year’s price?
3. Two-Stage Growth Model
The return on a stock is composed of dividends
4. Non-constant Growth in the First
and capital gains or losses.
Stage
E( D1 ) = expected dividend per share,
b. Price-Earnings Ratio
P0 = current price of a share,
c. Free Cashflow Models E( P1 ) = expected price at the end of a
year,
Intrinsic* value is an estimate of the actual true value
of a company, regardless of market value.

*basic/inherent

Intrinsic Value vs. Market Price

There is a significant difference between intrinsic value

and market value, though both are ways of valuing a
company.
Intrinsic value is an estimate of the actual true value
of a company, regardless of market value.
Market value is the current value of a company as
reflected by the company's stock price. Therefore,
market value may be significantly higher or lower than
the intrinsic value. Market value is also commonly used
to refer to the market capitalization of a publicly-traded
company and is obtained by multiplying the number of its
outstanding shares by the current share price.
The intrinsic value (IV) is the “true” value,
according to a model.
The market value (MV) is the consensus value
of all market participants
The expected Holding Period Return* may be more or
less than the required rate of return, based on the
stock’s risk.
*Holding Period Return (HPR) is the return on an asset
or portfolio over the whole period during which it was
held. It is one of the simplest and most important
measures of investment performance
The expected holding-period return is E(D1) plus the
expected price appreciation, E (P 1)- P0, all divided by the
current price, P0:
Given:
expected dividend per share, E( D1 ) = $4
current price of a share, P0 = $48
expected price at the end of a year, E( P1 ) = $52

Thus, the stock’s expected holding-period return is the

sum of the expected dividend yield, E (D 1 )/P0 , and the
expected rate of price appreciation, the capital gains
The most popular model for assessing the value of a firm yield, [ E (P1 ) - P0 ]/P0 .
as a going concern starts from the observation that an
Investor in stock expects a return consisting of cash
dividends and capital gains or losses.

Assuming a 1-year holding period and supposing that

But what is the required rate of return for ABC stock?
ABC stock has an expected dividend per share, E (D1),
The Capital Asset Pricing Model (CAPM) states that
of $4; the current price of a share, P0, is $48; and the
when stock market prices are at equilibrium levels, the
expected price at the end of a year, E (P1), is $52.
rate of return that investors can expect to earn on a
security is:
 FM- ELECT: MODULE 3 & MODULE 4

rf + β [ E ( rM ) -rf ] Naturally, the investor will want to include more of

ABC stock in the portfolio than a passive strategy
would indicate.
Where: Another way to see this is to compare the intrinsic value
rf = risk-free rate of a share of stock to its market price. The intrinsic
β = beta of the investment value, denoted V0, is defined as the present value of all
E = expected return cash payments to the investor in the stock, including
rm = market risk dividends as well as the proceeds from the ultimate sale
of the stock, discounted at the appropriate risk-adjusted
Thus, the CAPM* may be viewed as providing an interest rate, k.
estimate of the rate of return an investor can reasonably If the intrinsic value, or the investor’s own estimate of
expect to earn on a security given its risk as measured what the stock is really worth, exceeds the market price,
by beta. the stock is considered undervalued and a good
The *Capital Asset Pricing Model (CAPM) describes the investment.
relationship between systematic risk and  expected Why is this so?
return  for assets, particularly stocks. CAPM is widely
used throughout finance for pricing risky securities and In the stock market, the equivalent of a stock being
generating expected returns for assets given the risk of cheap or discounted is when its shares
those assets and cost of capital. are undervalued(mispriced). Value investors hope to
profit from shares they perceive to be deeply discounted.
Required Return = k
For ABC, using a 1-year investment horizon and a
CAPM gives the required return, k: forecast that the stock can be sold at the end of the year
at price P1 = $52, the intrinsic value is:

expected dividend per share, E (D1) = $4;

current price of a share, P0 = $48;
If the stock is priced correctly, k should equal
expected price at the end of a year, E (P1) = $52.
expected return.

k is the market capitalization rate.

This is the return that investors will require of any other

investment with equivalent risk. We will denote this
required rate of return as k. Equivalently, at a price of $50, the investor would derive
If a stock is priced “correctly,” it will offer investors a “fair” a 12% rate of return—just equal to the required rate of
return, that is, it’s expected return will equal its required return—on an investment in the stock. However, at the
return. current price of $48, the stock is underpriced compared
to intrinsic value ($50).
Of course, the goal of a security analyst is to find stocks
that are mispriced. At this price, it provides better than a fair rate of return
relative to its risk. Using the terminology of the CAPM, it
For example, an underpriced stock will provide an is a positive-alpha stock, (a positive alpha of 5 (+5)
expected return greater than the required return. means that the portfolio's return exceeded the
benchmark index's performance by 5%) and investors
Suppose that: will want to buy more of it than they would following a
rf =  6% passive strategy.
  E( rM )- rf = 5%, Remember: If the intrinsic value turns out to be lower
beta of ABC = 1.2. than the current market price, investors should buy
less of it than under the passive strategy.
Then the value of k is: k = 6% + 1.2 x 5% = 12%
Another example of CAPM.
The expected holding-period return, 16.7%, therefore
exceeds the required rate of return based on ABC’s risk An investor is contemplating a stock worth $100 per
by a margin of 4.7% (16.7% -12%) share today that pays a 3% annual dividend. The stock
 FM- ELECT: MODULE 3 & MODULE 4

has a beta compared to the market of 1.3, which means

it is riskier than a market portfolio. Also, assume that the
risk-free rate is 3% and this investor expects the market
to rise in value by 8% per year.

Given:

 Stock is worth $100 per share

 Beta = 1.3
 risk-free rate = 3%
 market to rise in value by 8%
The expected return of the stock based on the CAPM
formula is 9.5%:

Estimating Dividends

Trying to forecast future dividend payouts can

9.5% = 3% + 1.3 × (8%−3%) be a cumbersome task. It involves making
assumptions or trying to identify and calculate
Mr. Gua Po is considering a stock worth $10 per share
trends based on past dividend payments.
today that pays a 2.5% annual dividend. The stock has a
beta compared to the market of 1.4, which means it is Analysts usually assume the company will have
riskier than a market portfolio. Assuming that the risk- a fixed growth rate and treat it as perpetuity (a
free rate is 2% and Mr. Gua Po expects the market to regular stream of equal cash flows with no end).
rise in value by 9% per year.
We typically calculate the growth rate based on
What is the expected return of the stock based on the historical data.
CAPM formula?
Discount factor
Solution:
Shareholders bear the risk of a decline in the
Given: value of their purchased stock in companies.
• Stock is worth $10 per share Therefore, they expect a return on their
• Beta = 1.25 investment (compensation). A company’s cost of
• risk-free rate = 4% equity represents the expected remuneration
• market to rise in value by 9% investors demand in exchange for bearing the
The expected return of the stock based on the CAPM risk of ownership.
formula is: Analysts can estimate the discount factor via
the Capital Asset Pricing Model (CAPM) or the
Dividend Growth Model. We consider the rate of
return less the expected annual growth to be the
effective discounting factor for a company’s
dividends.

DDM shows us how much the stock should cost

if we expect it to generate our desired return.

Growth Rate

We can calculate the growth rate as Return on

Equity multiplied by the retention rate (the
opposite of the dividend payout ratio). The
dividend is paid out of the profit of the company,
so it cannot exceed it.
 FM- ELECT: MODULE 3 & MODULE 4

This means that the rate of return of the stock D1 – The dividend payment in one period from
has to be larger than the expected dividend now
growth rate for future cash flows. Otherwise, we
will get an unsustainable model with negative k – required return
stock prices, which is not possible in real-life
scenarios.

We can easily illustrate how growth increases

the nominal value of the dividend payout while
the time value of money concept decreases its
purchasing power. Consider Mang Inasar Corp. is expected to pay
Remember this! dividends of $10/share, $12/share, $14/share,
$17/share and $20/share in the following 5
V0 = The current fair value of a stock years. What is the present value of the stock?
Discount rate is 15%
D1 = Expected annual dividend per
share

k = Investor’s discount rate, or

required rate of return

g = Growth rate of dividend

T = date when the dividend growth

rate changes from g1 to g 2

The Dividend Discount Model for valuation uses the time

value of money concept to calculate the Net Present
Value (NPV) of the cash flows a company will generate
in the future in the form of dividends to shareholders. Where:

V0 = The current fair value of a stock

D1 = The dividend payment in one period

from now

k = required return

GROWTH RARE < DISCOUNT RATE

Where:
Mekeni Rogers Corporation recently paid a dividend of
V0 – The current fair value of a stock $8/share, and it is expected to grow at a constant rate of
 FM- ELECT: MODULE 3 & MODULE 4

10%. What is the value of the stock? Discount rate is
20%
Kisame Street Corporation was paying a dividend of $
0.72/share, and analysts forecasted a five-year growth
rates of 11% for Kisame Street Corporation and 11.25%
for the industry. Assume that after 5 years, the growth
rate for Kisame Street Corporation’s dividend will revert
to the industry projection. What is the value of the stock?
Discount rate is 14%

Suppose Café Pindot Inc. is expected to pay a dividend

of $ 1/share, and $ 2.5/share for the next three years.
After the 3rd year, it will grow at a constant rate of 5% for
Café Pindot Inc. and 11.25% for the industry. Discount
rate is 10%. What is the stock worth today?

Where:

g1 = growth rate for first stage

g2 = growth rate for second stage

k = discount rate

T = date when the dividend growth

rate changes from g1 to g 2
What Is Price-to-Earnings Ratio – P/E Ratio?
g2 < k
The price-to-earnings ratio (P/E ratio) is the ratio for
valuing a company that measures its current share price
relative to its per-share earnings (EPS). The price-to-
 FM- ELECT: MODULE 3 & MODULE 4
earnings ratio is also sometimes known as the price
multiple or the earnings multiple.
Significance of P/E Ratio
• P/E ratios are used by investors and analysts to
determine the relative value of a company's
shares in an apples-to-apples comparison.
• It can also be used to compare a company
against its own historical record or to compare
aggregate markets against one another or over
time.
• It shows whether a company's stock price is
overvalued or undervalued, the P/E can reveal
how a stock's valuation compares to its industry
group or a benchmark like the S&P 500 Index.
What is a good PE ratio for stocks?
The average P/E for the S&P 500 has historically ranged
from 13 to 15.
For example, a company with a current P/E of 25, above
the S&P average, trades at 25 times earnings. The high
multiple indicates that investors expect higher growth
from the company compared to the overall market.
Is it better to have a higher or lower P/E ratio?
Many investors will say that it is better to buy shares in
companies with a lower P/E, because this means they
are paying less for every dollar of earnings that they
receive. In that sense, a lower P/E is like a lower price
tag, making it attractive to investors looking for a
bargain.
It is important to understand the reasons behind a
company's P/E. If a company has a low P/E because
their business model is fundamentally in decline, then
the apparent bargain might be an illusion.
P/E Ratio Formula and Calculation
Analysts and investors review a company's P/E ratio
when they determine if the share price accurately
represents the projected earnings per share. The
formula and calculation is:
P/E as the Price Multiple
The price-to-earnings ratio indicates the dollar amount
an investor can expect to invest in a company in order to
receive one dollar of that company’s earnings. This is
why the P/E is sometimes referred to as the price
multiple because it shows how much investors are
willing to pay per dollar of earnings.
If a company was currently trading at a P/E multiple of
20x, the interpretation is that an investor is willing to pay
$20 for $1 of current earnings.
Remember:
• The P/E ratio helps investors determine the
market value of a stock as compared to the
company's earnings.
• The P/E ratio shows what the market is willing to
pay today for a stock based on its past or future
earnings.
• A high P/E could mean that a stock's price is
high relative to earnings and possibly
overvalued. Conversely, a low P/E might
indicate that the current stock price is low
relative to earnings.
Example of the P/E Ratio
The P/E ratio for Walmart Stores Inc. (WMT) as of
November 14, 2017, when the company's stock price
closed was at $91.09. The company's profit for the fiscal
year ending January 31, 2017, was US$13.64 billion,
and its number of shares outstanding was 3.1 billion. Its
EPS can be calculated as $13.64 billion / 3.1 billion =
$4.40.
Walmart's P/E ratio is, therefore:
$91.09 / $4.40 = 20.70x.
c. Free Cash Flow Valuation Model
In free cash flow valuation, intrinsic value of a company
equals the present value of its free cash flow, the net
cash flow left over for distribution to stockholders and
debt-holders in each period.
There are two approaches to valuation using free cash
flow.
• The first involves discounting projected free
cash flow to firm (FCFF) at the weighted
average cost of the capital (WACC) to find a
company's total value (i.e. sum of its equity and
debt).
 FM- ELECT: MODULE 3 & MODULE 4

• The second involves discounting the free cash

flow to equity (FCFE) at the cost of equity to find
the value of the company's shareholders equity.

The most basic single-stage free cash flow valuation

models are similar to the dividend discount model.
When we are interested in finding total value of a
company, we need to discount the free cash flow to firm
at the company's cost of capital:
The model applied here essentially calculates
the present value of a growing perpetuity. The
relevant FCFF is calculated by projecting current year
FCFF at the growth rate for one year.
Solution:

1. If market value of debt is $3,000 million, value of

equity is $2,200 million

Ve  = Vf − Vd 

Where:
= $5,200 M − $3,000 M
FCFF1 is the free cash flow to firm expected next year,
= $2,200 M
WACC is the weighted-average cost of capital
2. Per share intrinsic value for FC is
g is the growth rate of FCFF.
Vo = Ve ÷ shares outstanding
We can determine the company's equity value from its
$11 = [$2,200 M ÷ $200 M].
total firm value by subtracting the market value of debt:

Equity Value = Total Business Value − Market Value

of Debt

If we have to work with free cash flow to equity (FCFE)

which is expected to grow at rate g, we need to use the
cost of equity (ke) in the denominator:

Example 1: FCFF Valuation Model

Free cash flow to firm for Frontier Ceramics is currently

$300 million but is expected to grow by 4% each year
forever.
1.If the company's cost of capital is 10%, how much is it
worth?

2. If market value of debt is $3,000 million and FC has

200 million shares outstanding, find per share value of
FC.

Solution: