UNIT - 4 𝐷0 [1+𝑔𝑁 ]

P0 = =Rs………
𝐾𝑆 − 𝑔𝑁
OR
Security analysis
Common stock analysis
𝐷1
Valuation of common stock P0 = =Rs……….
𝐾𝑆 − 𝑔𝑁
A) Dividend discount model: Where, Ks = cost of stock
Under this model determination of stock values are taken from present gN = constant growth rate / normal growth rate
value of all expected future cash flows ( i.e expected dividend and Note :- Intrinsic value can be determined when KS > gN.
selling price of stock). Dividend is the base factor, which can use for 1st condition:- Determination of constant growth rate.
calculation of intrinsic value. Valuation of stock can be calculating by When retention ratio and return on equity are given:
using following dividend models g n= b × r
1. Zero growth model:- where, b = retention ratio = 1- dividend payout ratio (DPR)
Amount of DPS never increases or decreases or constant for 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
r = return on equity = 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟′ 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦 × 100
infinite period are known as zero growth model.
Formula used - 2nd condition:-
𝐷 (i) When past DPS or EPS were given:-
P0 = 𝐾0
𝑆 Example:
= Rs…. year 2001 2002 2003 2004 2005
Where, DPS 5 5.50 6.05 6.655 7.3205
P0 = intrinsic value / current market price / actual price / Now,
fair price DPS2005 = DPS2001[1 + 𝑔𝑁 ]4
D0 = current dividend 1⁄
𝐷𝑃𝑆2005 4
Ks = cost of stock / required rate of return / market rate Or g n= [ ] −1
𝐷𝑃𝑆2001
of return/ capitalization rate of return 1⁄
7.3205 4
2. Constant growth model :- =[ ] -1
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Amount at EPS or DPS increases or decreases with a constant
growth rate for infinite period of time is known as constant
= 10%
growth rate model. Under this model stock value can be Thus, constant growth rate (g n) = 10%
calculate by using following equation:
Formula used:- Dividend and earning approach:-
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 This approach is based is based on the future dividends and its own historical record or to compare aggregate markets against
the future selling price of the stock as the relevant each flows. one another or over time. It can be calculate by using following
According to this model, value of stock is present value of equation.
dividends that are expected to receive during the holding 𝑃0 = m × E = Rs………..
Persil plus present value of the stock price at the date of sales. Where,
IT is noted that D&E model is similar to non-constant growth m = price earning ratio
model and multiple holding period model. But this model 𝐷𝑃𝑅(1+𝑔𝑁 )
= = ……….times
uses future earnings and price earnings (PIE) ratio to estimate 𝐾𝑆− 𝑔𝑁

selling price of stock. It can be calculate by using following 𝑀𝑃𝑆

Or, = = ……….times
𝐸𝑃𝑆
equations:
E= Earning Per Share
Example:- 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
3 years of holding stock = 𝑁𝑜.𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑂/𝑆
Now, = Rs……../ share

𝑃𝑜 = (1+𝐾1
𝐷
)1
𝐷
+ (1+𝐾2 )2
𝐷 +𝑃
+ + (1+3 𝐾 3)3 # Cost of stock:-
𝑆 𝑆 𝑆
Working Note :- Cost of stock is a discount rate which makes NPV zero. In
𝐷1 = D0 (1 + 𝑔𝑆.𝑁 ) = 𝑅𝑆 … … … .. another word's, It is a discount rate which makes present value
𝐷2 = D1 (1 + 𝑔𝑆.𝑁 ) = 𝑅𝑆 … … … .. of all expected cost follows [I.e. expected dividend and selling
𝐷3 = D2 (1 + 𝑔𝑆.𝑁 ) = 𝑅𝑆 … … … .. price of stock ] Which are equals to their current market price
P3 = 𝑃𝑟𝑖𝑐𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑖𝑜 (𝑚) × 𝐸𝑃𝑆3 = 𝑅𝑆 … .. of stock. It is also called market capitalization rate or required
Price -Earning [P/E] approach:- rate of return etc. It can be calculate by using following
➔ Price earnings ratio (P/E ratio) is the ratio for valuing a company equation :-
that measures its current share price relative to its per share A) Dividend discount model:
earnings (EPS). It is also known as price multiple or the earnings 1. Zero growth model:
multiple. 𝐷
𝑃0 = 𝑃0
➔ PIE ratio are used by investors and analysis to determine the 0
𝐷0
relative value of a company's shares in an apples- to-apples 𝐾𝑆 = 𝑃 × 100 = ………%
0
comparison. It can also be used to compare a company against
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2. Constant growth model: IRR/Ks = LR + 𝑁𝑃𝑉
𝑁𝑃𝑉𝐿𝑅
[HR-LR]
𝐷1 𝐿𝑅 −𝑁𝑃𝑉𝐻𝑅
𝑃0 = 𝐾 = ……..%
𝑆 − 𝑔𝑁

𝐷1
Where,
𝐾𝑆 = 𝑃 + 𝑔𝑁 = ………% LR = Low rate
0
HR = High rate
Where,
NPVLR = Net present value at lower rate
𝐷1
= Dividend yield NPVHR = Net present value at higher rate
𝑃0
KS = Cost of stock/ invest required rate of return/
𝑔𝑁 = Constant growth rate market capitalization rate
B) Capital assets pricing model [CAPM approach]
Thus, KS =R F +[E(R m )- R F]βj= …..%
Where,
𝐾𝑆 = Dividend yield + Normal growth rate
KS = Cost of stock/ Required rate of return / Market rate of return
3. Multiple growth model or D/E model: market capitalization rate etc.
R F = Risk free return /Return on Treasury bill [T-bill]
E(R m ) = Expected return ofg market
Step:-1st βj= Beta co-efficient
To calculate approximate Ks: [E(R m )- R F] = Market risk premium
𝐷1
Approximate 𝐾𝑆 = +g N [E(R m )- R F] βj= Risk premium
𝑃0
Step:-2nd
To calculate positive and negative NPV Bond Analysis
Year CF PVIF@....% PV PVIF@...% PV
0 (XX) 1 (XX) 1 (XX) Meaning:
1 XX XX XX XX XX
2 XX XX XX XX XX It is also called intrinsic value of debt or real price or fair price. It is the
3 XX XX XX XX XX present value of all expected cash flow. It can be compared with current
NPV = XX (XX) market price.
By interpolation,
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1. If current market price is greater than intrinsic value, stock is n = Maturity Period
overvalued and in this time it will sold in the market. C = Coupon Payment
2. When current market price is equal to intrinsic value, stock is correctly MV = Maturity Value
priced and no activity done by stockiest. Y = Yeild to Maturity/ required rate of return / realize rate of
3. When current market price is less than intrinsic value, market stock is return/ market rate of interest.
underpriced and in this time stock will purchased by new investors. Note:- Intrinsic value commencing 1 year from now(𝑉1 )
V1 = C × 𝑃𝑉𝐼𝐹𝐴𝑦%,𝑛−1 + MV × 𝑃𝑉𝐼𝐹𝑦%,𝑛−1
Valuation Model of Debt V1 = C [
1−
1
(1+𝑦)𝑛−1 𝑀𝑉
] + (1+𝑦)𝑛−1
1. Zero Coupon bond: 𝑦

When company should not give interest on debt security, It is called HRP / Annualized return =
[𝑉1 −𝑉0 ]+𝐶1
,
𝑉0
Zero coupon Bond. Intrinsic value can be calculated by using [𝑉2 −𝑉0 ]+ 𝐶1 −𝐶2
following equation: HPR (for 2 year) = 𝑉0
𝑀𝑉
Intrinsic Value (vd) = (1+𝑌)𝑛 Annualizesed return = [1 + 2𝑦𝑟 𝑜𝑓 𝐻𝑃𝑅]𝟏/𝟐–1
2. Perpetual Bond:
The bond which never mature or the bond, which doesn't carry
maturity period, are known as Perpetual bond.
Callable Bond:-
𝑐
Intrinsic value of bond (vd) = 𝑦 The bond which can be called before the rate of maturity is known as
3. Redeemable Bond: callable bond. In callable bond the date on which the bond are called
The bond Which carry coupon rate and terms to maturity period are call period and the price. Generally, market rate of interest will fall
known as Redeemable bond. then the bond can be called by the company but this feature most be
included, the bond cannot be called before the date of maturity. It can
Intrinsic Value of bond (Vd) = 𝐶 × 𝑃𝑉𝐼𝐹𝐴𝑦%,𝑛 + 𝑀𝑉 × 𝑃𝑉𝐼𝐹𝑦%,𝑛 = Rs…. be calculated by the use of following equation:
VC = C × 𝑃𝑉𝐼𝐹𝐴𝑦%,𝑐𝑛 + CP × 𝑃𝑉𝐼𝐹𝑦%,𝑐𝑛
1
1−(1+𝑦)𝑛 Or
𝑀𝑉
(Vd) = 𝑐 [ ] + (1+𝑦)𝑛 1
1−(1+𝑦)𝑛 𝐶𝑃
𝑦
VC = C [ ] + (1+𝑦)𝑛
𝑦
Where,
Vd = Value of debt/ Intrinsic value/ Fair value/ Real Value/ # Cost of debt/ Yeild to Maturity (YTM):
Theoretical value

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 YTM is a discount rate which makes present value of all expected cash Annual YTM = LR + 𝑁𝑃𝑉
𝑁𝑃𝑉𝐿𝑅
[HR - LR]
𝐿𝑅 −𝑁𝑃𝑉𝐻𝑅
flows which is equal to their current investment price on bond. Expected
Note:-
cash flow represents expected coupon payment and selling price of bond
If interest is compounding semi-annually
or maturity value received from bond. It can be calculated on the basis of
Step-1
types of bond.
To calculate approximate semi-annual YTM
1. Zero coupon bond :-
𝐶 𝑀𝑉−𝑉𝑑
𝑀𝑉 +
Vd = 2 𝑛
(1+𝑦)𝑛 Approximate semi-annual YTM = [ 𝑀𝑉 + 2𝑉𝑑 ] × 100
1
𝑀𝑉 ⁄𝑛 3
∴ y = [𝑉 ] −1
𝑑 =……..%
2. Perpectual bond:- e.g. 5.38%
𝐶
Vd = 𝑦 Step-2
𝐶 To calculate positive and negative NPV
Y = 𝑉 × 100 = ………% 𝑦
𝑑 (i) NPV at LR [2 = 5%]
3. Redeemable Bond (If annual coupon payment are given) 𝐶
NPV = 2 × 𝑃𝑉𝐼𝐹𝐴 𝑦%,2𝑛 + 𝑀𝑉 × 𝑃𝑉𝐼𝐹 𝑦%,2𝑛 − 𝑉𝑑
Step-1 2 2

To calculate approximate YTM = …………(+ve)

𝑀𝑉−𝑉 𝑦
𝐶+ 𝑛 𝑑 (ii) NPV at HR [2 = 6%]
Approximate YTM = [ 𝑀𝑉+2𝑉𝑑 ] × 100 𝐶
3
NPV = 2 × 𝑃𝑉𝐼𝐹𝐴 𝑦%,2𝑛 + 𝑀𝑉 × 𝑃𝑉𝐼𝐹 𝑦%,2𝑛 − 𝑉𝑑
2 2
e.g. 10.53% = ………….(-ve)
Step-2 Step-3
To calculate positive and negative NPV To calculate semi-annual actual YTM
(i) NPV at LR [i.e. y = 10%] By interpolation,
NPV = C × 𝑃𝑉𝐼𝐹𝐴𝑦%,𝑛 + MV × 𝑃𝑉𝐼𝐹𝑦%,𝑛 -𝑉𝑑 𝑁𝑃𝑉𝐿𝑅
Semi-annual YTM = LR + 𝑁𝑃𝑉 [HR - LR]
= positive(+ve) 𝐿𝑅−𝑁𝑃𝑉𝐻𝑅

(ii) NPV at HR [i.e. y = 11%] Step-4

NPV = C × 𝑃𝑉𝐼𝐹𝐴𝑦%,𝑛 + MV × 𝑃𝑉𝐼𝐹𝑦%,𝑛 -𝑉𝑑 To calculate annual YTM
Annual YTM = semi-annual YTM × 2
= negative(-ve)
Step-5
Step-3
To calculate EAR
To calculate actual YTM
EAR = (1 + 𝑠𝑒𝑚𝑖 − 𝑎𝑛𝑛𝑢𝑎𝑙 𝑌𝑇𝑀)2 − 1
By Interpolation,
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 𝐴𝑛𝑛𝑢𝑎𝑙 𝑌𝑇𝑀 2
EAR = [1 + ] -1 =………..%
2
N0TE
𝐶
1. Current yield = 𝑉1 × 100 =………..%
0
Where, C1 = coupon interest payment after one year
V0 = Current selling price
2. Capital gain appreciation = YTM - current yield =………%
3. YTM = Capital gain appreciation + current yield
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 (𝐶)
4. Current yield = × 100
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 (𝑉𝑑 )

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