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Stock Return & Valuation

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Techniques of Fundamental Equity Valuation Balance Sheet Techniques – Book Value – Liquidation Value – Replacement Cost Discounted Cash Flow Techniques – Dividend Discount Model – Free Cash Flow Model Relative Valuation Techniques – Price Earnings Ratio – Price to Book Value Ratio – Price to Sales Ratio 9/23/2010Srinivasa Rao C / Module32

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Dividend Discount Model (single period valuation) P 0 = D 1 /(1+r) + P 1 /(1+r) P 0 - Current price D 1 - Dividend Expected a year hence r – Required rate of return P 1 – Expected price of the share a year hence 9/23/20103Srinivasa Rao C / Module3

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Multi Period - Zero Growth model P 0 = D 1 /(1+r) + D 1 /(1+r) 2 + D 1 /(1+r) 3 +…. D 1 /(1+r) n P 0 = D 1 /r 9/23/20104Srinivasa Rao C / Module3

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Stock Price – Constant Growth Model Assumptions: Dividends will grow at the same rate(g) into an indefinite future. P 0 = D 1 /(1+r) + D 1 (1+g)/(1+r) 2 + D 1 (1+g) 2 /(1+r) 3 + D 1 (1+g) 3 /(1+r) p 0 = D 1 /(r-g) 9/23/20105Srinivasa Rao C / Module3

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What drives the growth of dividend? Year1 Beginning Equity100 Return on Equity20% Equity Earning20 Dividend Payout Ratio0.4 Dividend8 Ploughback Ratio0.6 Retained Earnings12 9/23/2010Srinivasa Rao C / Module36 Ploughback Ratio * ROE = growth; b*ROE=g

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What drives the growth of dividend? Year1Year2 Beginning Equity Return on Equity20% Equity Earning Dividend Payout Ratio0.4 Dividend88.96 Ploughback Ratio0.6 Retained Earnings /23/2010Srinivasa Rao C / Module37

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What drives the growth of dividend? Year1Year2Year3 Beginning Equity Return on Equity20% Equity Earning Dividend Payout Ratio0.4 Dividend Ploughback Ratio0.6 Retained Earnings /23/2010Srinivasa Rao C / Module38

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Two Stage growth model Let P 0 be the current price of the equity share Let D 1 be the Dividend expected a year hence Let g 1 be the high growth rate per annum for next n years Let P n be the equity price at the end of year n Hence the model would be P 0 = D 1 /1+r + D 1 (1+g 1 )/(1+r) 2 + D 1 (1+g 1 ) 2 /(1+g 1 ) 3 + D 1 (1+g 1 ) 3 /(1+r) 4 +….. P n /(1+r) n 9/23/2010Srinivasa Rao C / Module39

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Two Stage growth model P 0 = D 1 /1+r + D 1 (1+g 1 )/(1+r) 2 + D 1 (1+g 1 ) 2 /(1+g 1 ) 3 + D 1 (1+g 1 ) 3 /(1+r) 4 +….. P n /(1+r) n P 0 = D 1 {1 – [(1+g 1 )/(1+r)]}/(r-g 1 ) + P n /(1+r) n Since the two stage model assumes growth after n years remains constant, Hence P n = D n+1 /r-g 2 Here D n+1 is the dividend for year n+1 and g 2 is the growth rate in the second period P 0 = {D 1 {1 – [(1+g 1 )/(1+r)] n }/(r-g 1 )} + {D 1 [(1+g 1 ) n-1 (1+g 2 )]/(r-g 2 ) }* 1/(1+r) n 9/23/2010Srinivasa Rao C / Module310

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Problem The current dividend on an equity share of ABC is Rs ABC is expected to enjoy an above normal growth rate of 20% for a period of 6 years. Thereafter the growth rate will fall and stabilise at 10%. What is the intrinsic value of the share of the company if the expected return is 15%? – /23/2010Srinivasa Rao C / Module311

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Impact of Growth on Price, Returns and P/E Ratio Low growth Firm 5% Normal growth rate 10% High growth rate 15% Let the expected EPS = Rs3 Let the expected DPS = Rs2 Investors require a 20% return 9/23/2010Srinivasa Rao C / Module312

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Variation in stock parameters with change in Growth PriceDividend Yield Capital GainsPrice Earnings P 0 = D 1 /(r-g)D 1 /P 0 (p 1 – p 0 )/p 0 P/E Low Growth Firm2/( )15%5%4.44 9/23/2010Srinivasa Rao C / Module313

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Variation in stock parameters with change in Growth PriceDividend Yield Capital GainsPrice Earnings P 0 = D 1 /(r-g)D 1 /P 0 (p 1 – p 0 )/p 0 P/E Low Growth Firm2/( )15%5%4.44 Normal Growth Firm2010% 6.67 High Growth Firm405%15% /23/2010Srinivasa Rao C / Module314

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Earnings Multiplier Approach P 0 = D 1 /r-g P 0 = E 1 *(1-b)/{r-(ROE*b)} P 0 /E 1 = (1-b)/{r-(ROE*b)} 9/23/2010Srinivasa Rao C / Module315

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Home Work The earnings and dividends of ABC Ltd have been growing at the rate of 18% pa. The growth rate is expected to continue for 4 years. After that the growth rate will fall to 12% pa for the next 4 years. Thereafter the growth rate is expected to be 6% pa forever. If the current Dividend per share is Rs2 and the investor’s required rate of return on ABC Ltd is 15%, what is the intrinsic value of the share? 9/23/2010Srinivasa Rao C / Module316

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