CHAPTER FOUR

STOCK AND EQUITY VALUATION

4.1. Stock characteristics

A stock represents an ownership interest in a corporation, but to the typical investor, a share of stock is
simply a piece of paper characterized by two features:
1. It entitles its owner to dividends, but only if the company has earnings out of which dividends
can be paid and management chooses to pay dividends rather than retaining and reinvesting all
the earnings. Whereas a bond contains a promise to pay interest, stock provides no such
promise—if you own a stock, you may expect a dividend, but your expectations may not in fact
be met.
2. Stock can be sold, hopefully at a price greater than the purchase price. If the stock is actually
sold at a price above its purchase price, the investor will receive a capital gain. Generally,
when people buy common stock they expect to receive capital gains; otherwise, they would not
buy the stock. However, after the fact, they can end up with capital losses rather than capital
gains.
Applying the valuation procedure to common stocks is more difficult than applying it to bonds for
various reasons.
 First, in contrast to coupon payments on bonds, the size and timing of the dividend
cash flows are less certain.
 Second, common stocks are true perpetuities in that they have no final maturity date.
 Finally, unlike the rate of return, or yield, on bonds, the rate of return on common
stock is not directly observable.
4.2. Dividend discount model
One of the most widely used equity valuation model is the dividend discount model(DDM). According
to the dividend discount model, the value of a share of stock is equal to the present value of all the
future dividends it is expected to provide over an infinite time horizon.
∞
D1 D2 D3 D∞
∑ (1+ ks )1 + (1+ k )2 + (1+k 3
+−−−
(1+k s )∞
Vs = t=1 s s)
The dividend discount model is based on the following assumptions:
 The future value of dividend is known by the investor
 Dividends are expected to be distributed at the end of each year until infinity
 Dividends are the only way investors get money back from the company
4.2.1. Single period valuation model
The investor expects to hold the equity share for one year. The price of the equity share will be:
D1 P1
Po = +
(1+ K s ) (1+ K s)
Where:
 PO = current price of the equity share
 D1= dividend expected a year hence
 P1= Price of the share expected a year hence
 Ks= rate of return required on the equity share
Illustration
Suppose you are thinking of purchasing the stock of Samsung and you expect it to pay a $2 dividend in
one year and you believe that you can sell the stock for $14 at that time. If you require a return of 20%
on investments of this risk, what is the maximum you would be willing to pay?
2 14
Po = +
(1+0 . 2) (1+0 . 2)

Po= 13.34

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 4.2.2. The zero-growth model
The most basic of all DDM is the zero growth models. This model assumes that dividend will be
constant over time, so that growth is zero, and that the investor’s required rate of return is constant.
D D −−+ D D
Po = + + +
(1+ K s ) (1+ K s) (1+ K s ) (1+ K s )∞
The above equation, on simplifiaction becomes;
D
Po =
Ks
For example, if a stock paid a (constant) dividend of $3 a share and you wanted to earn 10% on your
investment, the value of the stock would be $30 a share ($3/0.10=$30).

As you can see, the only cash flow variable that’s used in this model is the fixed annual dividend.
Given that the annual dividend on this stock never changes, does that mean the price of the stock never
changes? Absolutely not! For as the capitalization rate that is, the required rate of return changes, so
will the price of the stock. Thus, if the capitalization rate goes up to, say, 15%, the price of the stock
will fall to $20 ($3/0.15).
4.2.3. The constant-growth model
The zero-growth model is a good beginning, but it does not take into account a growing stream of
dividends, which is more likely to be the case in the real world. The standard and more widely
recognized version of the dividend valuation model assumes that dividends will grow over time at a
specified rate. In this version, the value of a share of stock is still considered to be a function of its
future dividends, but such dividends are expected to grow forever (to infinity) at a constant rate of
growth, g. accordingly the value of a share of stock can be found as follows:

Next year ’ s dividends

value of a share of stock=
(requierd rate of return−constant rate of growth∈dividends)
Or
D1
V s=
K s−g

Illustration
Suppose XYZ-Company plans to pay $2.30 per share in dividends in the coming year. If its equity cost
of capital is 7% and dividends are expected to grow by 2% per year in the future, estimate the value of
XYZ-Company’s stock.
D1 2.30
V s= = = 46
K s−g 0.07−0.02

You would be willing to pay 20 times this year’s dividend of $2.30 to own XYZ-Company stock
because you are buying a claim to this year’s dividend and to an infinite growing series of future
dividends.
Once you’ve determined the dividend growth rate, g, you can find next year’s dividend, D1, as:

D1=D0× (1+ g)
Where;
 D0 equals the actual (current) level of dividends.

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 Let’s say that in the latest year ABC-Company paid $2.50 a share in dividends. If you expect these
dividends to grow at the rate of 6% a year, you can find next year’s dividends as follows:
D1= D0×(1 +g)
= $2.50×(1+.06)
= $2.50×(1.06)= $2.65
The only other information you need is the capitalization rate, or required rate of return, k. (Note that k
must be greater than g for the constant-growth model to be mathematically operative.)

CHAPTER FIVE
SECURITY ANALYSIS
5.1 Economic Analysis

The economic analysis is the study to determine if overall conditions are good for the stock market. Is
inflation a concern? Are interest rates likely to rise or fall? Are consumers spending? Is the trade
balance favorable? Is the money supply expanding or contracting? These are just some of the questions
that the fundamental analyst would ask to determine if economic conditions are right for the stock
market.

The macro-economy is the overall economy environment in which all firms operate. The key
variables/factors commonly used to describe the state of the macro-economy are:

 Growth rate of gross domestic product

 Industrial growth rate
 Agriculture and monsoons (heavy rain)
 Savings and investments
 Government budget and deficit
 Price level and inflation
 Interest rate
 Balance of payment, foreign exchange reserves, and exchange rate
 Infrastructure facilities and arrangements sentiments
5.2 Industry Analysis

Industry analysis is a market assessment tool designed to provide a business with an idea of the complexity of a
particular industry. Industry analysis involves reviewing the economic, political and market factors that influence
the way the industry develops. Major factors can include the power wielded by suppliers and buyers, the condition
of competitors, and the likelihood of new market entrants.

Industry analysis is a market strategy tool used by businesses to determine if they want to enter a
product or service market. Company management must carefully analyze several aspects of the industry
to determine if they can make a profit selling goods and services in the market. Analyzing economic

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factors, supply and demand, competitors, future conditions and government regulations will help
management decide whether to enter an industry or invest money elsewhere.
a) Economic Factors: Economic factors of industry analysis include raw materials, expected profit
margins and the interference of substitute goods. The cost of raw materials is an important factor in
industry analysis because over-priced goods will not sell in an established market. Profit margins
are closely linked to materials costs because offering discounts or sales prices will shrink company
profits and lessen cash inflows for future production activity. Substitute goods allow consumers to
purchase a cheaper good that performs relatively like the original item.
b) Supply and Demand: A supply and demand analysis helps management understand if enough
consumers are willing to purchase more goods in an industry. If demand is high and supply is low, a
company may be willing to enter the market and offer goods near the market price to gain a
competitive advantage in the industry. A trend of declining demand indicates an industry that is
oversold, and any new competitors will likely lose money because consumers are not interested in
current goods or services.
c) Competitors: The number of competitors is an important factor for proper industry analysis. If few
competitors exist in a market, they may be charging consumers higher prices because of limited
availability of products or services. As new competitors enter the market, existing companies can
lower prices to maintain their current market share; newer competitors may not be able to match
these price cuts if their products costs are too high. As industries contract, inefficient producers are
forced out.
d) Future Conditions: While no company managers can predict the future of an industry, they can try
to determine where the industry is in the business cycle. If the industry is in an emerging market
stage, companies can enter an industry and expect to earn a profit from rising consumer demand. If
the industry is in a plateau stage, then only the most efficient producers with the lowest costs can
continue to earn profits. At the end of a business cycle, demand is declining and producers leave the
industry for more profitable markets.
e) Government Regulations: Some industries have heavier regulations or taxes than others, which
must be considered by companies looking to enter new markets. Taxes and other government fees
add to the cost of doing business, which eats into profits earned by companies. Properly
understanding the amount of government regulation in an industry helps management to determine
if expected profit margins will earn a high enough return to cover these costs.

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 5.2.1 Techniques for evaluating relevant Industry Factors

Each industry has differences in terms of its customer base, market share among firms, industry-wide growth,
competition, regulation and business cycles. Learning about how the industry works will give an investor a
deeper understanding of a company's financial soundness.

i) Customers Base: Some companies serve only a handful of customers, while others serve millions.
In general, it's a red flag (a negative) if a business relies on a small number of customers for a large
portion of its sales because the loss of each customer could dramatically affect revenues.
ii) Market Share: Understanding a company's present market share can tell volumes about the
company's business. The fact that a company possesses an 85% market share tells you that it is the
largest player in its market by far. Furthermore, this could also suggest that the company possesses
some sort of "economic moat," in other words, a competitive barrier serving to protect its current
and future earnings, along with its market share. Market share is important because of economies of
scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the high
fixed costs of a capital-intensive industry.
iii) Industry Growth: One way of examining a company's growth potential is to first examine whether
the amount of customers in the overall market will grow. This is crucial because without new
customers, a company has to steal market share in order to grow. In some markets, there is zero or
negative growth, a factor demanding careful consideration. For example, a manufacturing company
dedicated solely to creating audio compact cassettes might have been very successful in the '70s,
'80s and early '90s. However, that same company would probably have a rough time now due to the
advent of newer technologies, such as CDs and MP3s. The current market for audio compact
cassettes is only a fraction of what it was during the peak of its popularity.
iv) Competitions: Simply looking at the number of competitors goes a long way in understanding the
competitive landscape for a company. Industries that have limited barriers to entry and a large
number of competing firms create a difficult operating environment for firms. One of the biggest
risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to
increase prices and pass those costs on to customers. Companies operating in industries with few
alternatives have the ability to pass on costs to their customers. A great example of this is Wal-
Mart. They are so dominant in the retailing business, that Wal-Mart practically sets the price for any
of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have little,
if any, pricing power.
v) Regulation: Certain industries are heavily regulated due to the importance or severity of the
industry's products and/or services. As important as some of these regulations are to the public, they
can drastically affect the attractiveness of a company for investment purposes.

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In industries where one or two companies represent the entire industry for a region (such as utility companies),
governments usually specify how much profit each company can make. In these instances, while there is the
potential for sizable profits, they are limited due to regulation.

In other industries, regulation can play a less direct role in affecting industry pricing. For example, the drug
industry is one of most regulated industries. And for good reason no one wants an ineffective drug that causes
deaths to reach the market.

5.3 Company Analysis

At the final stage of fundamental analysis, the investor analyzes the company. The Company is one's perception
of the state of a company - it cannot necessarily be supported by hard facts and figures. A company may have
made losses consecutively for two years or more and one may not wish to touch its shares - yet it may be a good
company and worth purchasing into. There are several factors one should look at this analysis:

Which company has performed well in comparison with other similar companies?

Which company is performing well in comparison to earlier years?

Which company is better by its management, policies, location and labor relations?

Which company is the market leader by its productions and segment?

5.3.1 Objectives of Company analysis

Company analysis focuses on finding attractive firms by:

a) Analyzing individual firms.

b) Understanding each firm's strengths and risks.
c) Identifying attractive firms with superior management and strong performance (measured by sales
and earnings growth).
Stock selection focuses on finding attractive stocks by:

a) Computing each stock’s intrinsic value.

b) Comparing the intrinsic value to the stock’s market price.
c) Identifying attractive stocks, which are substantially undervalued.
5.3.2 Significant Factors to be Considered for Company Analysis

It is imperative that one completes the politico economic analysis and the industry analysis before a company is
analyzed because the company's performance at a period of time is to an extent a reflection of the economy, the
political situation and the industry. The different issues regarding a company that should be examined are:

1. The Management: The single most important factor one should consider when investing in a company and
one often never considered is its management. It is upon the quality, competence and vision of the

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 management that the future of company rests. A good, competent management can make a company grow
while a weak, inefficient management can destroy a successful company.

2. The Annual Report: The primary and most important source of information about a company is its Annual
Report. By law, this is prepared every year and distributed to the shareholders. The Annual Report is broken
down into the following specific parts:

a) The Director's Report: The Director’s Report is a report submitted by the directors of a company to its
shareholders, advising them of the performance of the company under their stewardship

b) The Auditor's Report: The auditor represents the shareholders and it is his duty to report to the
shareholders and the general public on the stewardship of the company by its directors. Auditors are
required to report whether the financial statements presented do, in fact, present a true and fair view of
the state of the company.

c) The Financial Statements: The published financial statements of a company in an Annual Report
consist of its Balance Sheet and other statements.
3. Ratios: No person should invest in a company until he has analyzed its financial statements and compared
its performance in the previous years, and with that of other companies. This can be difficult at times
because:
(a) The size of the companies may be different.

(b) The composition of a company's balance sheet may have changed significantly.

Ratios can be broken down into four broad categories:

a) Profit and Loss Ratios: These show the relationship between two items or groups of items in a
profit and loss account or income statement. The more common of these ratios are:
1. Sales to cost of goods sold.
2. Selling expenses to sales.

3. Net profit to sales and

4. Gross profit to sales.

b) Balance Sheet Ratios: these deals with the relationship in the balance sheet such as:
(i) Shareholders’ equity to borrowed funds.
(ii) Current assets to current liabilities.
(iii) Liabilities to net worth.
(iv)Debt to assets and
(v) Liabilities to assets

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c) Balance Sheet and Profit and Loss Account Ratios: These relate an item on the balance sheet to
another in the profit and loss account such as:
1. Earnings to shareholder's funds.
2. Net income to assets employed.
3. Sales to stock.
4. Sales to debtors and
5. Cost of goods sold to creditors.
d) Financial Statements and Market Ratios: These are normally known as market ratios and are
arrived at by relation financial figures to market prices:
1. Market value to earnings and

2. Book value to market value.

These ratios have been grouped into eight categories that will enable an investor to easily determine the strengths
or weaknesses of a company. Market value, Earnings, Profitability, Liquidity, Leverage, Debt Service Capacity,
Asset-Management/Efficiency, and Margin.

It must be ensured that the ratios being measured are consistent and valid. The length of the periods being
compared should be similar. Large non-recurring income or expenditure should be omitted when calculating
ratios calculated for earnings or profitability, otherwise the conclusions will be incorrect.

Ratios do not provide answers. They suggest possibilities. Investors must examine these possibilities along with
general factors that would affect the company such as its management, management policy, government policy,
the state of the economy and the industry to arrive at a logical conclusion and he must act on such conclusions.

4. Cash flow Analysis: In cash flow analysis, investors must always checks; how much is the company's cash
earnings? How is the company being financed and using it? The answers to these questions can be
determined by preparing a statement of sources and uses of funds. A statement of sources and uses begins
with the profit for the year to which are added the increases in liability accounts (sources) and from which
are reduced the increases in asset accounts (uses). The net result shows whether there has been an excess or
deficit of funds and how this was financed.
5.3.3 Company Analysis using the Relative Valuation Approach

The relative valuation approach of company analysis involves three steps:

i. Estimate future earnings per share (EPS) for the company.

ii. Estimate an earnings multiplier (P/E ratio) for the company.

iii. Therefore the future stock value is estimated as EPS x P/E ratio.

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i. Estimate the EPS

Expected earnings per share are a function of the sales forecast and the estimated profit margin. Time-series
analysis is often used here.

Company sales forecast: It includes an analysis of the relationship of company sales to various relevant
economic series and to the company's industry series.

Profit margin estimate: You need to identify and evaluate the firm's Specific competitive strategy - e.g. low-
cost (the firm seeks to become the low-cost producer in the industry)? Differentiation (the firm seeks to identify
itself as unique in some attributes that are important to the customers)?

Internal performance: Relationship with its industry, which should indicate whether the company's past
performance is attributable to its industry or if it is unique to the firm.

EPS = (Sales x Net Profit Margin)/Number of Outstanding Shares

ii. Estimate the P/E

Assuming a firm has constant dividend growth rate, the value of its stock is determined by P = D 1/ (k - g).
Therefore the firm's P/E ratio is: P/E = Payout ratio / (k - g), where the payout ratio is D1/EPS.

Analysts can use two approaches here, as in the industry analysis:

a) Macro analysis: Estimate a P/E ratio from the relationship among the firm, its industry and the
market.

 Identify the projected P/E multiples of the market and the industry.
 Use time-series analysis to examine the relationship among the P/E ratios for the firm, the industry and
the market.
 Estimate the firm’s P/E ratio by adjusting the market or industry P/E multiple upwards or downwards.
b) Micro analysis: estimate a multiplier based on three components:

 The dividend payout ratio (based on the firm’s dividend payout history, investment plans, industry trend
and current economic events).
 The required rate of return: consider fundamental factors and market-determined risk (beta) based on
CAPM.
 The rate of growth: use DuPont model.