The Investment Decision Process

• Determine Objective
• Choose value
• Security Analysis
• Portfolio Construction
• Evaluation
• Revision
Key Firm Characteristics for Investment

• Size
• P-E Ratio
• B-M ratio
• Momentum
 Firm Size
• Measured as market value (market cap) of  
common stock outstanding
-Market value of the firms stock
-Small firm: bottom 10%of the market value
-Large firms: top 10 % of the market value
 Firm Size
• How do firms of different sizes weather
economic downturns? Who suffer more in
recsssion? big or small
• How else do stocks of small-cap and large-cap
stocks differ?
 Firm size

• Historical Returns:
• Effect of recession on Smaller firms and large
firms
• Beta market sensitivity
• Small firms are more sensitive to the state of
the economy than large firms that are less
sensitiev
 Firm Size
• How else do stocks of small- cap and large-
cap stock differ?
– Issue of liquidity: how it is easy to buy and sell a
stock.
– Owneship: Individual ownership for small firms,
institutional ownership for large firms
 B/M or M/B

• Measured by book value of firm equity (from

balance sheet) relative to market value of
equity
 QUESTION

• How do you interpret differences in book­to-

market ratios across firms?
• Why do some firms have high book­to-
market ratios and others have low book­to­
market ratios?
• Firms that have lot of tangible assets, lot of
property, plant, equipment have high book
value so B/M value going to be high.
• The growth company have low B/M value,
these company may have great idea that
worth a lot, so people pay a lot for the
company.
• In the world of finance the book to market
ratio and Market to book ratio predicts a lot of
stuff
– It predicts stock returns
– It predicts invetsments by firms
– What it represents
• High B/M high level of tangible Assets
• It can be proxy for undervaluation, Historically
this value strategy has been very profitable.
• Market value going lower if firms perofrms
poorly, so it can predicts bad past returns.
• High B/M ratio or low M/B ratio have low
return on investments
 MOMENTUM

• Performance of a firm over the past year

seems to predict the firm’s stock return
over the next month (both positively and
negatively).
 Price Earning Ratio

• P/E is a measuring parameter or a benchmark tool used to

decide whether any stock is investment worthy

• The Price to Earnings multiple (popularly termed as the ‘P/E’)

is academically read as ‘market price per share divided by the
EPS (i.e. the Earnings Per Share)

• It indicates the value that the market is willing to pay for the
potential of growth embedded in a stock with respect to the
company’s earnings and denotes the premium offered by the
market to value the company
What are the benefits of P/E ratio?
 What are the benefits of P/E ratio?
• Primarily, the P/E helps you to understand if a
particular company is over-priced or under-priced vis-
à-vis its peers

• A stock with a lower P/E vis-à-vis its industry P/E is

considered ‘undervalued’

• A stock with a higher P/E vis-à-vis its industry P/E

indicates that it is more popular and has better and
sustainable earnings growth potential vis-à-vis the
others
How do you calculate P/E?
 How do you calculate P/E?

• Trailing Twelve Month (TTM) EPS

• Future Twelve Month EPS

• For example :if the current market price of Company X is Rs

150 and its TTM EPS is Rs 6, its P/E will be 25 (Rs 150/ Rs 6).
For the same company, if the future twelve month EPS is Rs 8,
the forward P/E will be 18.75
 What is the difference between
TTM EPS and Future12 month EPS?
 What is the difference between
TTM EPS and 12 month EPS?

• TTM EPS provides more certainty against using the future 12

month EPS since it just provides earnings visibility

• However, in case the company is an emerging company

positioned in a high growth industry and having robust
expansion plans over the future years, using the future twelve
month EPS is more advisable
Remember: It is not necessary that stocks with a
lower P/E is always undervalued and stocks
commanding higher P/E are the best stocks
 Valuation Fundamentals
• Valuation is the process that links risk and
return to determine the worth of an asset.
• The emphasis is on the expected streams of
benefits from bonds, stocks, income
properties, oil wells, and so on.
• Concept of timevalue-of-money is important
here.
 Key Inputs
• Returns
• Timing of Returns
• Required Return
 Valuation of Common Stock
• Value of Common stockdiscounted value of a
series of uncertain future dividends
 One year holding
• P0= $25
• Hold stock for one year
• D= $1
• P1= $26.5
• Rate of Return = Dividen yiled + Capital gain
yield
 D $1
Dividen yield    .04
P0 $25
P1  P0 $26.5  25
Capital gain yield    .06
P0 $25
Total Return  .04  .06  .10or10%
• If expressed in terms of present value

D1 P1
P0  
1 r 1 r
D1 Dividend to be received at the end of the year one
r Investor required rate of return or discount rate

P1 Selling price at the end of the year

P0 Selling price today

If investor required rate of return change from 10% to 15 %,
what will be effect on current price

D1 P1
P0  
1  r 1  r
$1 $ 26
P0  
1  . 15 1  . 15
P0  $. 87  $ 23 . 04
P 0  $ 23 . 91
At what price must we be able to sell the stock at the end of the one
Year , if the purchase price is $25And dividend is $1) in order to attain a
rate of return of 15 %,

D1 P1
P0  
1  r 1  r
 Multiyear holding
• Constant growth
• Zero Growth
• Variable Growth
• Price Earning Multiplier
 Dividend Growth Model:
Stock Value = PV of Dividends

D1 D 2 D 3 D 
P0     ...... 
(1  r s ) 1 (1  r s ) 2
(1  r s ) 3
(1  r s ) 

where
P0 is value of the stock, D = dividend, and rs is the
required return on common stock.

What is a constant growth stock?

One whose dividends are expected to
grow forever at a constant rate, g.
 For a constant growth stock:
D1 = D0(1+g)1
D2 = D0(1+g)2 If g is constant and less than rs, then:

Dt = Dt(1+g)t
D1 D2 D3 D
P0     ...... 
(1  rs ) 1 (1  rs ) 2 (1  rs ) 3 (1  rs ) 
D 0 (1  g ) 1 D 0 (1  g ) 2 D 0 (1  g ) 3 D 0 (1  g ) 
P0     ..... 
(1  rs ) 1
(1  rs ) 2
(1  rs ) 3
(1  rs ) 
simplyfyin g ;
D1
P0 
( rs  g )
Required rate of return: beta = 1.2, rRF = 7%, and
RPM = 5%.

Use the SML to calculate rs:

rs = rRF + (RPM)bFirm
= 7% + (5%) (1.2)
= 13%.
 Projected Dividends
• D0 = current,most recent dividend =2 and
constant g = 6%
• D1 = next dividend, expected dividend,
dividend one period from now
– D1 = D0(1+g) = 2(1.06) = 2.12
– D2 = D1(1+g) = 2.12(1.06) = 2.2472
– D3 = D2(1+g) = 2.2472(1.06) = 2.3820
 Intrinsic/Present Stock Value:
D0 = 2.00, rs = 13%, g = 6%.

Constant growth model:

D0(1+g) D1
P0 = =
rs - g rs - g

$2.12 $2.12
= = = $30.29.
0.13 - 0.06 0.07
 Expected Dividends and PVs (rs = 13%)

0 g=6% 1 2 3 4

D0=2.00 2.12 2.2472 2.3820

13
1.8761 %
1.7599
1.6508
 Expected Return on Stock:
Rearrange model

D1 D1
P0 = to rs = + g.
rs - g P0

Then, rs = $2.12/$30.29 + 0.06

= 0.07 + 0.06 = 13%.
 For Zero Growth Stock:
If g = 0, the dividend stream is a perpetuity.

0 r =13% 1 2 3
s

2.00 2.00 2.00

PMT $2.00
P0 = = = $15.38.
rs 0.13
 Variable Growth Followed By Constant Growth:

Step 1: Find the value of the dividend at the end of each year
during the initial growth Period Year 1 through N,
0 rs=13% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.60 3.38 4.394
D0(1+g) D1(1+g) D2(1+g)
 Variable Growth Followed By Constant Growth:

Step 2: Find the present value of the dividends expected

during the initial growth Period.
0 rs=13% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.60 3.38 4.394
2.3009
2.6470
3.0453
 Variable growth followed by constant growth:
Step 3: Find the value of the stock at the end of the initial growth
period , which is the present value of the All dividends expected from
year N+1 to infinity, assuming a constant dividend growth rate g2.
0 rs=13% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
46.1135 $4.6576
P3 = = $66.5371
0.13 – 0.06
 Variable Growth Followed By Constant Growth:

Step 4: Add the present value components found in step 2,3

to find the present value of the stock.
0 rs=13% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
46.1135 $4.6576
P3 = = $66.5371
0.13 – 0.06
54.1067 = P0
Bond Valuation
 Bond Valuation

 n 1   1 
VB  I   t 
 M  n
 t 1 (1  rb )   (1  rb ) 

VB  I  ( PVIFA rb ,n )  M  ( PVIFrb ,n )
 What is the value of a 10-year, 10%
annual coupon bond, if kd = 10%?

0 1 2 n
r
...
VB = ? 100 100 100 + 1,000

$100 $100 $1,000

VB  1
 ...  10

(1.10) (1.10) (1.10)10
VB  $90.91  ...  $38.55  $385.54
VB  $1,000
 Required Returns and Value of the Bond

• What if , if the Interst rate increase?

• What if , if the interest rate decrease?
 What is the YTM on a 10-year, 9% annual
coupon, $1,000 par value bond, selling for
$887?

• Must find the kd that solves this model.

I I M
VB   ...  
(1  rd )1
(1  rd ) N
(1  rd ) N
90 90 1,000
$887   ...  
(1  rd )1
(1  rd )10
(1  rd )10
 The Price Path Of A Bond
• What would happen to the value of this bond if its
required rate of return remained at 10%, or at 13%,
or at 7% until maturity?
VB

1,372 rd = 7%.
1,211
rd = 10%.
1,000
837
775 rd = 13%.
Years
to Maturity
30 25 20 15 10 5 0
 Bond Values Over Time

• At maturity, the value of any bond must equal its

par value.
• If rd remains constant:
– The value of a premium bond would decrease
over time, until it reached $1,000.
– The value of a discount bond would increase
over time, until it reached $1,000.
– A value of a par bond stays at $1,000.