SAPM
Session 21
Agenda
Fundamental Analysis
Intrinsic value calculations
Motivation
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Fundamental Analysis
• Understanding the Business
• Application of the checklist
comprehend the numbers and actually evaluate if
both the nature of the business and the business’s financial
performance complement each other. If they do not
complement each other, then clearly the company will not
qualify as an investible grade.
• Intrinsic Value estimation (Valuation) to understand
the fair price of the stock
Problem 1
1. Reema, a lead fundamental analyst was trying to calculate the intrinsic value of X
co. stock in order to provide some investment recommendations (buy, sell or hold)
on the stock. Stock of X co. was currently trading in the market at ₹200 per share. X
Co. just gave a dividend of ₹6.00 per share. It is expected that dividend will grow by
8.00% over the next 3 years. Subsequently, dividend will grow by 6.00%
indefinitely. The relevant cost of capital is estimated at 10.00%. What is the
intrinsic value of the stock per share (nearest integer) and what should the
investment recommendation be (buy, sell or hold) for this stock? (Note: If IV>
Market Stock price, buy; if IV<Market Stock price; sell and if IV=Market Stock
price; hold where IV is intrinsic value.) Provide the Equations as well.
a) ₹168, buy
b) ₹225, buy
c) ₹168, sell
d) ₹225, sell
e) None of the above…….What is your answer?
Problem 2
An analyst was trying to calculate the intrinsic value (IV) of ABC Co. stock to provide some
investment recommendations (buy, sell) on the stock. ABC Co. just gave (at t=0) a dividend
of ₹5.00per share. EPS (Earnings per share) currently (at t=0) is ₹20per share. The company
plans to maintain the same (as t=0) dividend payout ratio every year for the next four years.
The return on retained earnings is expected to be the same as the historical ROE of 20% per
annum EAR for all years till perpetuity. After four years, the dividend payout ratio will be
50% every year until perpetuity, with the ROE remaining the same as before (causing the
growth rate in dividends to change from 5th year onwards, i.e., 5-6 and so on). The stock of
ABC co. was currently trading in the market at ₹80per share (Market price) after the dividend
is paid at t=0. (Note: If IV> Market Stock price, buy; if IV<Market Stock price; sell where IV
is intrinsic value.).What is the intrinsic value (range in ₹per share) of the stock today if the
discount rate is 30%, and What should the investment recommendation be (buy, sell) for this
stock today?
Problem 3
1. Astock of XCo. just gave a dividend of Rs.6 per share. It is expected that dividends
will growby 8.00% over the next 3 years (0-1, 1-2, 2-3, 3-4 years); dividend payout
of 20% and ROE as 10%. Beyond 3 years, X Co. will be retaining 50% of the
earnings and investing in a project which is expected to return a 10% p.a. (EAR)
return on equity (ROE) from the investment. This retention ratio of 50%is going to
continue forever thereafter, and the ROE is also expected to continue at 10% p.a.
EAR forever thereafter. The relevant cost ofequitycapital is estimated at10.00%
p.a. [Link] youplanto buythe stock at the endofYear3
and plan to hold it for two years (at which point you will sell it at the end of Year 5),
what is your expected capital gains yield (return due to just appreciation in price)?
(Price of the share is the present value of future expected dividends).
How toValue Stocks?
Two broad categories of Valuing models
1. Absolute Valuation models (based on fundamentals)
• Dividend Discount model
• NPVGO model
• Discounted CF model (where you forecast the free cash
flows and find the Present value of forecasted free cash
flows)
2. Relative Valuation models (based on comparison)
• Price/Earnings multiple
• EV/EBITDA multiple
Dividend Discountmodel
▪ The value of any asset is the present value of its expected future cash
flows.
▪ Stock ownership produces cash flows from:
▪Dividends
▪Capital Gains
Investor 1: Buys stock at Year 0 and holds it for one year. At the End of year 1he
sells it.
P0 = Div1/(1+R) + P1/(1+R)....................................(1)
Now there has to be a buyer to buy it at P1. Why will he buy at P1? Buyer
determines the Price P1 (again he buys it at 1 and sells it at end of year 2)
P1 = Div2/(1+R) + P2/(1+R)......................................(2)
And so on
Putting value of P1 from equation 2 in equation 1 we get
P0 = Div1/(1+R) + Div2/(1+R)2 + P2/ (1+R)2
If we put the value of P2 in terms of Div3 and so on we get
P0 = Div1/(1+R) + Div2/(1+R)2+ Div3/(1+R)3 +.....
Dividend Discount modelcontd.
➢The price of a stock is equal to the present value of all expected future
dividends
Which is the same as saying
➢The price of a stock is equal to the present value of sum of next
period’s dividend and next period’s stock price.
How do we estimate all future dividend payments?
Estimating Dividends
➢ Constant dividend (Zero growth)
➢ The firm will pay a constant dividend forever
➢ The price is computed using the perpetuity formula
➢ Constant dividend growth (Constant growth) – Gordon growth model
➢ The firm will increase the dividend by a constant percent every
period
➢ Supernormal growth (Differential growth)
➢ Dividend growth is not consistent initially, but settles down to
constant growth eventually
Dividend Discount models – Zero growth
Assume that dividends will remain at the same level forever
Div1 = Div2 = Div3 =
Since future cash flows are constant, the value of a zero growth stock is
the present value of a perpetuity:
Div1 Div2 Div3
P0 = + + +
(1+ R)1 (1+ R) 2 (1+ R)3
Div
P0 =
R
Dividend Discount models –Constant
Growth (Gordon Growthformula)
Assume that dividends will grow at a constant rate, g, forever, i.e.,
Div2 = Div1 (1+ g)
Div3 = Div2 (1+ g)
Since future cash flows grow at [Link] rate forever, the value of a constant
growth stock is the present value of a growing perpetuity:
Div1 .
P0 =
R −g
;R>g for the above formula to hold
Constant GrowthExample
Suppose Big D, Inc., just paid a dividend of $.50. It is expected to increase
its dividend by 2% per year. If the market requires a return of 15% on
assets of this risk level, how much should the stock be selling for?
P0 = .50(1+.02) / (.15 - .02) =$3.92
Dividend Discount models –Differential
growth
❑ Assume that dividends will grow at different rates in the foreseeable future
and then will grow at a constant rate thereafter.
❑ To value a Differential Growth Stock, we need to:
❑ Estimate future dividends in the foreseeable future.
❑ Estimate the future stock price when the stock becomes a Constant
Growth Stock
❑ Compute the total present value of the estimated future dividends and
future stock price at the appropriate discount rate
Differential Growth
Assume that dividends will grow at rate g1 for N years and grow at rateg2
thereafter.
Div1 = Div0 (1+ g1 )
Div 2 = Div1(1+ g 1 ) = Div 0 (1+ g1)2
..
Div N = Div N −1 (1+ g1) = Div 0 (1+ g1 ) N
Div = Div (1+ g ) = Div (1+ g ) N (1+ g )
N +1 N 2 0 1 2
..
Differential Growth
Dividends will grow at rate g1 for N years and grow at rate g2 thereafter
Div0 (1+ g1 ) 2
Div0 (1+ g1 )
…
0 1 2
Div0 (1+ g1 ) N Div N (1+ g 2 )
= Div 0 (1+ g1) N (1+ g 2 )
… …
N N+1
Differential Growth
We can value this as the sum of:
▪ an N-year annuity growing at rate g1
C (1+
g ) N
PA = 1−
1
N
R − g1 (1+ R)
▪ plus the discounted value of a perpetuity growing at rate g2 that starts in
year N+1
DivN+1
R −g 2
PB =
(1+ R) N
Example
A common stock just paid a dividend of $2. The dividend is expectedto
grow at 8% for 3 years, then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.
With theFormula
$2(1.08)3 (1.04)
$2 (1.08) (1.08)
3
.12 −.04
P= 1− 3
+
.12 −.08 (1.12) (1.12)3
P = $54 1−.8966+
($32.75)
3
(1.12)
P = $5.58 + $23.31 P = $28.89
Estimates of Parameters – Growth rate of
dividends
Earnings next year are expected to be the same as earnings this year unless a net investment is made
Net Investment occurs when you plowback certain earnings (or retain certain earnings)
Earnings next year = Earnings this year + Retained earnings x Return on
Retained earnings
Dividing both sides by Earnings this year we get
Earnings next year/Earnings this year = 1+ (Retained Earnings/Earnings this year) x Return on
Retained earnings
1+ g = 1+Retention ratio X Return on Retained earnings
Assumption: Return on retained earnings is assumed to be equal to historical Return on Equity
g = Retention ratio × Return on retained earnings (ROE)
Now growth rate in earnings = growth rate in dividends if the ratio of dividends /Earnings is
constant
Estimates of Parameters – Discount rate R
❑ The discount rate can be broken into two parts.
❑ The dividend yield
❑ The growth rate (in dividends)
D1
P0 =
R -g
D1
R = + g
P0
R = D iv id e n d y ie ld + C a p ita l g a in s y ie ld
The dividend growth rate is also the stock price’s growth rate since it is
the rate at which value of investment grows.