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Introduction
Equity shares can be described more easily than fixed income securities, however they are more difficult to analyse. Fixed income having a limited life and a well defined cash flow stream, equity share have neither. Fundamental analysis assess the fair market value of equity shares by examining the assets, earning prospects, cash flow projections and dividend potential.
Fundamental valuation
Balance sheet valuation Book value Liquidation value Replacement value Discounted cash flow models
Dividend discount model
Single period valuation, Multiple period valuation.
Assumptions 1. Dividends are paid annually. 2. The first dividend is received one year after the equity share is bought.
A equity share is expected t provide a dividend of Rs 2 and fetch a price of Rs 18 a year hence. What price would it sell for now if investors required rate of return is 12%.
SINGLE+ GROWTH
What happens if the price of the equity share is expected to grow at a rate of g percent annually. D1 P0 = r g
The expected dividend per share on the equity share of a company is Rs 2. the dividend per share has grown over the past five years @ 5%. This growth will continue in future. Further the market price of the equity share is expected to grow at the same rate. What is the fair value of the equity share if the required rate is 15%.
Prepared by Sumit Goyal- LPU
P0
(1+r)t
D
P0 = r CONSTANT GROWTH MODEL assumes that dividend per year grows at a constant rate g. D1 P0 = r-g
P0 =
D1
r - g1
D1 (1+g1)n-1 (1+g2)
r - g2
1
(1+r)n
1 (1.15)6
H Model
Assumptions While the current dividend growth rate, ga is greater than gn, the normal long-run growth rate declines linearly for 2H years. After 2H years the growth rate becomes gn. At H years the growth rate is exactly halfway between ga and gn. Where Po is the IV of the share, Do is the current dividend per share, r is the rate of return expected by investor, gn is the normal long-run growth rate, ga is the current above-normal growth rate, H is the one half of the period during which ga will level off to gn.
Prepared by Sumit Goyal- LPU
H MODEL
ga gn
H D0 PO = r - gn D0 (1+gn)
2H
=
r - gn
+
r - gn PREMIUM DUE TO ABNORMAL GROWH RATE VALUE BASED ON NORMAL GROWTH RATE
Example
Current dividend on an equity share of international computers limited is Rs 3. The present growth rate is 50%. However this will decline linearly over a period of 10 Years and then stabilise at 12 %. What is the intrinsic value per share, if investor requires a return of 16%.
Steps 1
1. divide the future into two parts, the explicit forecast period and the balance period. Explicit period- represents the period during which the firm is expected to evolve. balance period- a state in which the return on invested capital, growth rate and cost of capital stabilise.
Step 2
Forecast the free cash flow, year by year, during the explicit forecast period. FCF is the cash flow available for distribution to capital providers(Shareholders and debt holders) after providing for the investment in fixed assets and net working capital required to support the growth of the firm. FCF= NOPAT- Net Investment NOPAT is net operating profit adjusted for taxes. It is profit before interest and taxes(1- Tax rate). Net Investment: Change in net fixed assets + Change in net working capital.
Prepared by Sumit Goyal- LPU
Step 3
Calculate the weighted average cost of capital WACC= WeRe + WpRp + WdRd (1-t)
Step 4
Establish the horizon value of the firm Horizon value is the value placed on the firm at the end of the explicit forecast period(H years) Since the FCF is expected to grow at a constant rate of g beyond h, horizon value is equal to
Step 5
Estimate the enterprise value
The EV or value of the firm is the present value of the FCF during the explicit forecast period plus the present value of the horizon value.
Example
The balance sheet of Cosmos Limited at the end of year 0 (the present point of time) is as follows.
Rs. in crore
Liabilities
Shareholders funds Equity capital (20 crore shares of Rs. 10 each) Reserves and surplus Loan funds( rate 10 percent)
Assets
500 Net fixed assets 200 Net working capital 550 200
300
250 750
Prepared by Sumit Goyal- LPU
750
Additional information
The return on assets( NOPAT) is expected to be 18 percent of the asset value at the beginning of each year. The growth rate in assets and revenues will be 30 percent for the first three years, 18 percent for the next two years, and 10 percent thereafter. The effective tax rate of the firm is 34 percent, the pre-tax cost of debt is 10 percent and the cost of equity is 24 percent. The debt-equity ratio of the firm will be maintained at 1:2. Calculate the intrinsic value of the equity share.
Solution
Rs. In crore Year Asset value (Beginning) NOPAT Net investment FCF Growth rate (%) 1 750.0 2 3 4 5 6
975.0 1267.50 1647.75 1944.35 2294.33 228.15 380.25 (152.1) 30 296.60 296.60 20 349.98 349.98 20 412.98 229.43 183.55 10
The weighted average cost of capital is: WACC = (2/3) x 24 + (1/3) x 10 (1-0.34) = 18.2 percent The horizon value of the firm = (183.55 x 1.10) /(0.182-0.10) = 2462.26 crores
A high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. Compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E.