3.company analysis and equity valuation

8/3/2019 3.Company Analysis and Equity Valuation

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Company AnalysisTable 1 Ad Hoc Scoring Models

Points

Character

* Average past payment On time

Up to 30 days late

Up to 60 days late ________

Capacity

* Profit margin 05% 610% >10% ________

* Quick Ratio 1.25 ________

* Cash Flow Low Average High ________

Capital

* Current Ratio < 1 1

1.5 >1.5 ________* Debt-Equity Ratio 2

* Interest Earned 3x ________

Collaterall

* Net Worth Low Average High ________

* Per cent assets Low Average High ________

free

* Market value Low Average High ________to net worth

Conditions

Recession Average Prosperity ________

________

Total ________


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Company AnalysisTable.2 Indicators to Judge Corporate Excellence

Peters and Waterman : In Search of Excellence Compound Asset Growth

Compound Equity Growth

Market Value To Book Value Ratio

Return On Total Capital

Return On Equity Return On Sales

Industrial Development Bank of India Study

Growth Rate Of Sales

Growth Rate of Assets Profit Before Tax To Capital Employed

Working Capital To Gross Sales

Dividend Coverage

Debt-Equity Ratio


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Company Analysis &Equity Valuation

1.One approach to firm valuation is to focus on the firms book value, either as itappears on the balance sheet or as adjusted to reflect current replacement cost of assets or

liquidation value. Another approach is to focus on the present value of expected futuredividends.

2. The Dividend Discount model holds that the price of a share of stock should equal the present

value of all future dividends per share, discounted at an interest rate commensurate with the

risk of the stock.

3. The constant-growth version of the DDM asserts that if dividends are expected to grow at aconstant rate forever, the intrinsic value of the stock is determined by the formula:

This version of the DDM is simplistic in its assumption of a constant value of g. There are moresophisticated multistage versions of the model for more complex environments. When the

constant-growth assumption is reasonably satisfied and the stock is selling for its intrinsic

value, the formula can be inverted to infer the market capitalization rate for the stock:


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4. Stock market analysis devote considerable attention to a companys price-to-earnings ratio. The P/E ratio is auseful measure of the markets assessment of the firms growth opportunities. Firms with no growth

opportunities should have a P/E ratio that is just the reciprocal of the capitalization rate. K. As growth

opportunities become a progressively more important component of the total value of the firm, the P/E ratio

will increase.

5. The expected growth rate of earnings is related both to the firms expected profitability and to its dividend

policy. The relationship can be expressed asg= (ROE on new investment) x (1 Dividend Payout Ratio)

6. You can related any DDM to a simple capitalized earnings model by comparing the expected ROE on future

investments to the market capitalization rate, k. If the two rates are equal, then the stocks intrinsic value

reduces to expected earnings per share (EPS) divided by k.

7. Many analysts form their estimate of a stocks value by multiplying their forecast of next years EPS by a P/E

multiple derived from some empirical rule. This rule can be consistent with some version of the DDM,although often it is not.

8. The free cash flow approach is the one used most often in corporate finance. The analyst first estimates the

value of the entire firm as the present value of expected future free cash flows, assuming all equity financing,

then adds the value of tax shields arising from debt financing and finally subtracts the value of all claims

other than equity. This approach will be consistent with the DDM and capitalized earnings approaches as

long as the capitalization rate is adjusted to reflect financial leverage.

Company Analysis &

Equity Valuation (Contd..)


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Company Analysis &Equity Valuation (Contd..)

9. We explored the effects of inflation on stock prices in the context of the constant growth DDM. Although

traditional theory has been that inflation should have a neutra effect on real stock returns, historical

evidence shows a striking negative correlation between inflation and real stock market returns. There arefour different explanations that may account for this negative correlation:

a. Economic shocks that simultaneously produce high inflation and lower real earnings.

b. Increased riskiness of stocks in a more inflationary environment

c. Lower real after-tax earnings and dividends attributable to inflation-induced distortions in the tax system.

d. Money, illusion.

10. The models presented in this chapter can be used to explain and forecast the behavior of the aggregate stock

market. The key macroeconomic variables that determine the level of stock prices in the aggregate are

interest rates and corporate profits.


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The H model of equity valuation is based on the following assumptions:

(a) If the current dividend growth rate gais greater than gnthe normal long-run growthrate, the growth rate begins to decline.

(b) After 2H years the growth rate becomes gn(c) At H years the growth rate is exactly halfway between gaand gn

The graphical representation of the dividend growth rate pattern for the H model is shown inFigure 6B.1.

Dividend Growth Rate Pattern of H Model


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Secondary Market Selected Indicators

(Amount in Rs.Crore)At the

Capital Market Segment Of Stock Exchanges Turnover of Govt TurnoverEnd of Securities ofFincl No. of No. of S&P Sensex Market Market Turnover Turnover On WDM On SGL DerivativesYear Brokers Listed CNX Capitali- Capitali- Ratio Segment Segment

Cos. Nifty sation sation (%) of NSE ofExchanges

1990-91 -- 6229 366.45 1167.97 110279 20.6 -- -- -- -- --1991-92 -- 6480 1261.65 4285.00 354106 57.4 -- -- -- -- --1992-93 -- 6925 660.51 2280.52 228780 32.4 -- -- -- -- --1993-94 -- 7811 1177.11 3778.99 400077 45.6 203,703 50.9 -- -- --1994-95 6711 9077 990.24 3260.96 473349 45.6 162,905 34.4 5660 50,569 --1995-96 8476 9100 985.30 3366.61 572257 47.0 227,368 39.7 9988 127,179 --1996-97 8867 9890 968.85 3360.89 488332 34.6 646,116 132.3 38308 122,941 --1997-98 9005 9833 1116.65 3892.75 589816 37.7 908,681 154.1 103585 185,708 --1998-99 9069 9877 1078.05 3739.96 574064 34.1 1,023,382 178.3 95280 227,228 --1999-00 9192 9871 1528.45 5001.28 1192630 84.7 2,067,031 173.3 293887 539,232 --2000-01 9782 9954 1148.20 3604.38 768863 54.5 2,880,990 374.7 414096 698,121 4,0182001-02 9687 9644 1129.55 3469.35 749248 36.4 895,826 119.6 927604 1,573,893 103,848

Note: Turnover Figures For The Respective Year.-- Not Available Cos: CompaniesSource: Report on Currency and Finance, 1998-99 for data in respect of Capital Market Segment


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Equity Stock Valuation Models

1. The intrinsic value of a stock is equal to the present value of thecash inflows discounted at the capitalization rate.

2. Dividend Discount Model: This assumes a constant growth ratein the dividends and the price of stock is given by formula

Po = D1 Ke g, where D1 is the dividend for the nextyear and K

eis the required rate of return and g is the growth rate

in dividends

3. The above equation can also be expressed as Po = bE1/Kg gwhere b is the dividend pay-out ratio and E1 is the expectedearnings at the end of first year.

4. The P/E ratio approach states that the intrinsic value of a stockwill be equal to the earnings per share times the price-earningsmultiple prevailing in the market for the similar stocks.

Po = E x P/E multiple


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Equity Stock Valuation Models (Contd..)

5. It is required to estimate the P/E multiple in the equation given above. One modeldeveloped by whitbeck and Kisor to estimate the P/E ratio is given as

P/E = a+b. EG + c DP d SD where

a = P/E ratio when it is assumed to be unaffected by growth in equity, dividendpayment and variability of earnings growth

b = Price Earning Ratio

EG = Growth Rate in Earnings (in Percentage)

DP = Dividend Payout (In percentage)

SD = Standard deviation of growth rate in earnings (in %)

6. There is another model called 11 model wherein it is assumed that the growth ratedeclines from gato gn in a period of 211 years and the growth rate continues at gn forever.

It should be noted that value of H in the formula is equal to half the number of years duringwhich the growth rate has declined from gato gn .


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3.company analysis and equity valuation

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