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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.

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Balance sheet valuation
Book value
Liquidation value
Replacement value
Discounted cash flow models
Dividend discount model
Single period valuation, Multiple period valuation.
Free cash flow model
Relative valuation techniques
Price-earning ratio
Price book value ratio
Price sales ratio
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Book value:- Book value per share is simply the
net worth of the company(which is equal to paid up
equity capital plus reserves and surplus) divided by
no. of shares outstanding.

Liquidation value:- Value realised from liquidating
all the assets of the firm amount to be paid to all
the creditors and preference shareholders divided
by no. of outstanding equity shares.
Replacement cost:- this measure considered by
analysts in valuing firm is the replacement cost of
its assets less liabilities.
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The value of an equity share is equal to the present
value of dividends expected from its ownership
plus the present value of the sale price expected
when the equity share is sold.


Assumptions
1. Dividends are paid annually.
2. The first dividend is received one year after the
equity share is bought.
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DIVIDEND DISCOUNT MODEL

SINGLE PERIOD VALUATION MODEL
D
1
P
1

P
0
= +
(1+r) (1+r)

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%.


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What happens if the price of the equity share
is expected to grow at a rate of g percent
annually.
D
1

P
0
= 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%.
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DIVIDEND DISCOUNT MODEL

More realistic



MULTI - PERIOD VALUATION MODEL

D
t

P
0
=
t=1 (1+r)
t


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DIVIDEND DISCOUNT MODEL
ZERO GROWTH MODEL
If the dividend per year remain constant.

D
P
0
=
r

CONSTANT GROWTH MODEL
assumes that dividend per year grows at a constant rate g.
D
1

P
0
=
r - g
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The extension of the constant growth model
assumes that the extraordinary growth will
continue for a finite period of years and thereafter
the normal growth rate will prevail forever.

Po = Current market price
D1= expected dividend a year hence
G1= extraordinary growth rate applicable for n
years.
G2= constant growth rate
r= required rate of return


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TWO - STAGE GROWTH MODEL

1 - 1+g
1
n

1+r
P
0
= D
1
+
r - g
1


D
1
(1+g
1
)
n-1
(1+g
2
) 1



r - g
2
(1+r)
n


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TWO - STAGE GROWTH MODEL : EXAMPLE











EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OF
VERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY AN
ABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6
YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISE
AT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15
PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OF
VERTIGO ?
THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE :
g
1
= 20 PERCENT
g
2
= 10 PERCENT
n = 6 YEARS
r = 15 YEARS
D
1
= D
0
(1+g
1
) = RS.2(1.20) = 2.40

PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THE
INTRINSIC VALUE ESTIMATE AS FOLLOWS :


1.20
6

1 -
1.15 2.40 (1.20)
5
(1.10) 1
P
0
= 2.40 +
.15 - .20 .15 - .10 (1.15)
6


1 - 1.291 2.40 (2.488)(1.10)
= 2.40 + [0.497]
-0.05 .05

= 13.968 + 65.289
= RS.79.597
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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 instrinsic value 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.
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H MODEL

g
a
g
n



H 2H

D
0

P
O
= [(1+g
n
)

+ H

(g
a
- g
n
)]


r - g
n

D
0
(1+g
n
) +H

(g
a
- g
n
)
= r-gn


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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%.
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The share of a certain stock paid a dividend of
Rs.3.00 last year. The dividend is expected to
grow at a constant rate of 8 percent in the
future. The required rate of return on this stock
is considered to be 15 percent. How much
should this stock sell for now? Assuming that
the expected growth rate and required rate of
return remain the same, at what price should
the stock sell 3 years hence?

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Do = Rs.3.00, g = 0.08, r = 0.15

Po = D1 / (r g)
= Do (1 + g) / (r g)
= Rs.3.00 (1.08) / (0.15 - 0.08)
= Rs.46.29

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The equity stock of Max Limited is currently
selling for Rs.280 per share. The dividend
expected next is Rs.10.00. The investors'
required rate of return on this stock is 14
percent. Assume that the constant growth
model applies to Max Limited. What is the
expected growth rate of Max Limited?

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The current dividend on an equity share of
Omega Limited is Rs.8.00 on an earnings per
share of Rs. 30.00.
(i) Assume that the dividend per share will
grow at the rate of 20 percent per year for the
next 5 years. Thereafter, the growth rate is
expected to fall and stabilise at 12 percent.
Investors require a return of 15 percent from
Omegas equity shares. What is the intrinsic
value of Omegas equity share?

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Assume that the growth rate of 20 percent
will decline linearly over a five year period
and then stabilise at 12 percent. What is the
intrinsic value of Omegas share if the
investors required rate of return is 15
percent?
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It involves determining the value of the firm as a
whole(the value is called enterprise value) by
discounting the free cash flow to investors and
then subtracting the value of preference and debt
to obtain the value of equity.

It involves following steps.
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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.
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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.
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Calculate the weighted average cost of capital
WACC= WeRe + WpRp + WdRd (1-t)
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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
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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.
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Step 6: Derive the equity value=
Enterprise value Preference value- Debt value


Step 7: Compute the value per share
The value per share is simply the equity value
divided by the no of outstanding equity shares.
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The balance sheet of Cosmos Limited at the end of
year 0 (the present point of time) is as follows.

Rs. in crore
Liabilities Assets
Shareholders funds 500 Net fixed assets 550
Equity capital
(20 crore shares of
Rs. 10 each)
200 Net working capital 200
Reserves and surplus 300
Loan funds( rate
10 percent)

250

750 750
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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.

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Rs. In crore
Year 1 2 3 4 5 6
Asset value
(Beginning)
750.0 975.0
1267.
50
1647.
75
1944.
35
2294.
33
NOPAT 135.0
175.5
0
228.1
5
296.6
0
349.9
8
412.9
8
Net investment 225.00
292.5
0
380.2
5
296.6
0
349.9
8
229.4
3
FCF (90.0)
(117.
0)
(152.1
)
- -
183.5
5
Growth rate (%) 30 30 30 20 20 10
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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

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A valuation ratio of a company's current share
price compared to its per-share earnings.
Calculated as:
Market Value per Share/ Earnings per Share (EPS)

For example, if a company is currently trading at 43 a
share and earnings over the last 12 months were 1.95
per share, the P/E ratio for the stock would be 22.05
(43/1.95).
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The P/E is sometimes referred to as the "multiple",
because it shows how much investors are willing to
pay per dollar of earnings. If a company were
currently trading at a multiple (P/E) of 20, the
interpretation is that an investor is willing to pay
20 for 1 of current earnings.
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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.

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A ratio used to compare a stock's market value to
its book value. It is calculated by dividing the
current closing price of the stock by the latest
quarter's book value per share.

A lower P/B ratio could mean that the stock is
undervalued.
However, it could also mean that something is
fundamentally wrong with the company.
As with most ratios, be aware that this varies by
industry.

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A ratio for valuing a stock relative to its own past
performance, other companies or the market itself.
Price to sales is calculated by dividing a stock's
current price by its revenue per share for the
trailing 12 months.

PSR= Market Price/ Revenue per share
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