FMI

Equity Markets and Valuation of Equity

Securities
Dr. Avinash Ghalke, CFA
Equity
 Equity instrument can be classified as
 Common Equity
 Ownership in a corporation
 Holders exercise control
 Elect Board of Directors
 Vote on corporate decisions
 Depository Receipts
 Hold shares listed in other countries
 Traded on a local stock exchange
 Represents a security issued by a foreign publicly listed
company

Dr Avinash Ghalke, CFA © 2022 2

Characteristics of Equity
 Shareholders receive dividends
 Returns for shareholders are made up of
 Capital Gains
 Dividends received
 Shareholders have residual claim
 Limited Liability
 Voting Rights
 Dual class shares

Dr Avinash Ghalke, CFA © 2022 3

Preferred Stock
 A hybrid security that has characteristics of both
bonds and common stock
 Pays fixed dividend
 No voting rights except in decisions pertaining to
preferred stocks
 Paid after bond holders but before common equity
holders are paid
 Corporations can miss preferred dividend payment
without fear of bankruptcy
 Firms have to pay clear arrears before common equity
holders can be paid
 Preferred dividend may be costlier than debt

Dr Avinash Ghalke, CFA © 2022 4

Stock Exchange
 Primary Markets – Issue of new financial securities
 Primary Issuance
 Initial Public Offering (IPO)
 Follow-on Public Offering (FPO)
 Offer for Sale (OFS)
 Secondary Markets – trading of financial securities
 Corporations benefit as stock prices serve as feedback
 Investors get liquidity to buy/sell the stock

Dr Avinash Ghalke, CFA © 2022 5

IPO Process

Dr Avinash Ghalke, CFA © 2022

IPO Process

Dr Avinash Ghalke, CFA © 2022

IPO Process

Dr Avinash Ghalke, CFA © 2022

IPO of loss making firms

Profit Making Loss Making

IPO Allocation
Firms Firms
Qualified Institutional Buyers (QIB) 50% 75%
High Networth Individuals (HNI) 15% 15%
Retail 35% 10%

Dr Avinash Ghalke, CFA © 2022

What is an Index ?
 Represents a given security market, market
segment, or asset class
 Value of an index is calculated on a regular basis
using either the actual or estimated market prices of
the individual securities, known as constituent
securities, within the index.
 Price return index, reflects only the prices of the
constituent securities within the index.
 Total return index, reflects the prices of the
constituent securities and the reinvestment of all
income received since inception.

Dr Avinash Ghalke, CFA © 2022

 Calculation of Price Return

VPRI 1 − VPRI 0 N N
 Pi1 − Pi 0 
PR I = =  w i PR i =  w i  
VPRI 0 i =1 i =1  Pi 0 
PRI = the price return of index portfolio I
PRi = the price return of constituent security i
wi = the weight of security i
Pi1= the price of constituent security i at the end of the
period
Pi0= the price of constituent security i at the beginning
of the period
 Calculation of Total Returns

VPRI 1 − VPRI 0 + Inc I

TR I =
VPRI 0
N
 P1i − P0i + Inci
N

TR I =  w i TR i =  w i  
i =1 i =1  P0i 

TRI = the total return of the index portfolio

IncI = the total income from all securities in the index
TRi = the total return of the constituent security i
Inci = the total income from security i
 Different Weighting Methods Used in Index
Construction

Price weighted

Equal weighted

Market capitalization weighted

Fundamentally weighted
 Weighting Schemes

Price weighted: Market capitalization weighted:

Pi Q i Pi
w =
P w M
i = N

Q P
i N

 Pi
i =1
j =1
j j

Equal weighted: Factor weighted:

Fi
1 w = F

w E
= i N
i
N F j =1
j
 Computing Index Values
Beginning Ending of Dividends
of Period Period Price per share Shares
Security Price (€) (€) (€) Outstanding
LMN 10.00 12.00 0.50 200
OPQ 25.00 24.00 1.00 100
RST 15.00 18.00 0.25 400
Free float capitalization
 Takes into consideration only the free-float market
capitalization of a company for the purpose of index
calculation and assigning weight to stocks in the
Index
 Only those shares issued by the company that are readily
available for trading in the market.
 Shareholdings of investors that would not, in the normal
course, come into the open market for trading are treated
as 'Controlling/ Strategic Holdings' and hence not
included in free-float.

Dr Avinash Ghalke, CFA © 2022

Advantages of Free-float Methodology
 Makes the index more broad-based by reducing the
concentration of top few companies in Index
 Aids active managers by enabling them to
benchmark their fund returns vis-à-vis an investible
index.
 Improves index flexibility in terms of inclusion of
stock.
 Under a full-market capitalization methodology,
companies with large market capitalization and low free-
float, when included in Index, tend to distort the index by
having an undue influence on the index movement.

Dr Avinash Ghalke, CFA © 2022

 Equity Indices
Wilshire 5000
Broad market Total Market
Index
MSCI
Multimarket Emerging
Markets
Equity indices
Sector BSE IT Index

BSE Small-
Style
Cap Index
Valuation of Assets in General
 The following applies to any financial asset:
V = Current value of the asset
Ct = Expected future cash flow in period (t)
k = Investor’s required rate of return
Note: When analyzing various assets (e.g., bonds,
stocks), the formula below is simply modified to fit the
particular kind of asset being evaluated.

nCt
V =
t = 1 (1 + k )
t

Dr Avinash Ghalke, CFA © 2022

Stock Valuation
 Like other assets in finance, the value of a stock is
the PV of its CF’s
 Stocks are typically valued as perpetual securities
 Corporations potentially have an infinite life
 Can pay dividends forever

20 Dr Avinash Ghalke, CFA © 2022

Common Stock Valuation : 1 year holding

D1 + P1 D1 P1
P0 = = +
(1 + i) (1 + i) (1 + i)

• P0 = Present value or price of stock today

• P1 = Price of stock next period
• D1 = Dividends received in first period
• i = discount rate

Dr Avinash Ghalke, CFA © 2022

Stock Value next year: Use same approach
D2 P2
P1 = +
(1 + i) (1 + i)

D2 + P2
D1 (1 + i) D1 D2 P2
P0 = + = + +
(1 + i) (1 + i) (1 + i) (1 + i) (1 + i) 2
2

Dr Avinash Ghalke, CFA © 2022

Valuation Fundamentals: Common Stock
 How was P1 determined?
 PV of expected stock price P2, plus dividends
 P2 is the PV of P3 plus dividends, etc...
 Repeating this logic over and over, you find that
today’s price equals PV of the entire dividend
stream the stock will pay in the future:
D1 D2 D3 D4 D5
P0 = + + + + + ....
(1 + i )1
(1 + i ) 2
(1 + i ) 3
(1 + i ) 4
(1 + i ) 5

Must be able to predict future dividends to use this model

Dr Avinash Ghalke, CFA © 2022

Zero Growth Valuation Model
 To value common stock, you must make
assumptions about future dividend growth.
Zero growth model assumes a constant,
non-growing dividend stream.

D1 = D2 = ... = D
• Plugging constant value D into the common stock
valuation formula reduces to simple equation for
the present value of a perpetuity:
D1
P0 =
i
Constant Growth Valuation Model
 Assumes dividends will grow at a constant rate (g)
that is less than the required return (r)
 If dividends grow at a constant rate forever, you
can value stock as a growing perpetuity, denoting
next year’s dividend as D1:

D1
P0 = Note:
Eq.4.6 D1 = D0(1+g)
r−g
Commonly called the Gordon growth model
Also called a DDM : Dividend Discount Model
Numerical
 PeopleTree Technologies paid a dividend of INR 6.2
last week. The dividends are expected to grow
indefinitely at 10%. Investors expect a return of 12%
from their investment in PeopleTree Technologies
stock. What should be value of the stock ?
 341

Dr Avinash Ghalke, CFA © 2022 26

Estimating the dividend growth rate
 Estimate from security analyst-experts
 Alternate method – using payout ratio

Plowback ratio = 1 – Dividend Payout Ratio

= 1 – DPS/EPS

RoE = EPS / Book Value per share

g = Plowback ratio * RoE

Dr Avinash Ghalke, CFA © 2022

PVGO
 A stock’s valuation can be heavily influenced by
future growth expectations
 Present Value of Growth Opportunities (PVGO)
 When a company sees no attractive growth
opportunities, it should payout all earnings as
dividends
 For the positive retained earnings to create wealth
for investors, the company’s return on equity must
exceed its cost of equity.
 PVGO = P(Growth) - P(No growth) = [D1/(r-g)] – E1/r

Dr Avinash Ghalke, CFA © 2022

Stock Price and Earnings Per Share
Our company forecasts to pay a $8.33 dividend
next year, which represents 100% of its earnings.
This will provide investors with a 15% expected
return. Instead, we decide to plowback 40% of the
earnings at the firm’s current return on equity of
25%. What is the value of the stock before and
after the plowback decision?
Before - $ 55.56
After - $ 100

Dr Avinash Ghalke, CFA © 2022

Terminal Value
 Firm is a going concern
 How to value the infinite cashflows
 Divide cashflows into near term and long term cashflows
 Near Term CFs
 Discount under discount rate
 Long Term CFs
 Valued life infinite perpetuity

Dr Avinash Ghalke, CFA © 2022

Terminal Value

The free cash flows (FCF) for a firm are given in

the following table. The required rate of return is
10% and g is 4%. Calculate the present value of
the FCF assuming firm as a going concern.

1 2 3 4
22.34 34.12 45.1 51.6

Dr Avinash Ghalke, CFA © 2022