Investment Analysis & Portfolio Management: Equity Valuation

Investment Analysis & Portfolio Management: Equity Valuation
Valuation of Preference Share
To determine the rates of return earned, the preference shareholders use following three
yields:
1. Current Yield: When preference share does not have a maturity date, the investor
use the current yield measure the return available from dividends. They merely
divide the annual dividend payment by the current market price to calculate yield:
Current Yield = Annual dividend /

Market Price
E.g. A 9% preference share of XYZ Company are sold for Rs. 72. Calculate Current
yield
2. Holding Period Return:
HPR =
Dt +(P t+1 −P t )
Pt
3. Yield to call
YTC =
C p−P i
Dt +
n
(P ¿ ¿ i+C p )
¿
2
E.g. A 9% (Rs. 100 par) will be called in 3 years at Rs. 108. The current market price
of this issue is Rs. 72.
(Ans: 43.13%)
4. Valuing Irredeemable Preference Share
P0 = P (DIV) /Kp
5. Yield on Preference Share

P (¿)
Kp=
Po
Constant Growth Model/ Gordon’s model
A model for determining the intrinsic value of a stock, based on a future series of
dividends that grow at a constant rate. Given a dividend per share that is payable in one
year, and the assumption that the dividend grows at a constant rate in perpetuity, the
model solves for the present value of the infinite series of future dividends.
Do ( 1+ g ) D 1
Po= = Where :D 1 = Expected dividend per share one year from now
r −g r−g
r = Required rate of return for equity investor
g = Growth rate in dividends (in perpetuity)
Two Stage Growth Model
The constant growth rate model is extended to two stage growth model. Here the growth
stages are divided into two, namely a period of extraordinary growth (or decline) and a
constant growth period of infinite nature.
Present value of Share = PV of Dividend during growth rate + PV

of share price at the end
Valuation through P/E ratio method
P/E =
d
e
d
r – ROE(1− )
e
Practical Problem
Valuing Preference Share
1. An investor is considering the purchase of a 12-year, 10% Rs 100 par value

preference share. The redemption value of the preference share on maturity is
Rs.120. The investor’s required rate of rate is 10%. What should he be willing to pay
for the share now?
2. Company is offering a 10-year, 12% Rs 1000 par value preference share. The
redemption value of the preference share on maturity is Rs.950. The investor’s
required rate of rate is 12%. Being an investor whether you should purchase share
or not?
3. Investors in ABC were paid Rs.2.40 as dividend per share last year on their equity
and these are expected to grow indefinitely at 8% rate. What is the value of the
equity if the investors require an 12% return?
4. Consider a Company is issuing a Rs. 1000 irredeemable preference share on which it
pays a dividend of Rs. 9. Assume that investor’s cost of capital is 11%. What is the
value of Preference Share? (Ans: Rs 81.82)
5. PQR ltd. has issued a Rs. 100 irredeemable preference share on which it pays a
dividend of Rs. 3.5. Assume that investor’s cost of capital is 12%. What is the value
of irredeemable Preference Share?(Ans: Rs. 21.67)
Yield on Preference Share
6. Maruti Ltd. is following a dividend payout of 30%.The current market price of share
is Rs. 95. Find out investor’s cost of capital. Consider face value of share is Rs. 10.
(Ans: 3.16%)
Constant Growth Model/ Gordon’s model
7. A Company paid a dividend of Rs.3.70 in the previous year. The dividends in the
future are expected to grow perpetually at a rate of 8%. Find out the share’s price
today if the market capitalizes dividend at 12%.(Ans: Rs. 100)
8. The Company ABC’s next year dividend per share is expected to be Rs. 3.50. The
dividend in subsequent years is expected to grow at a rate of 10% per year. If the
required rate of return is 15% per year, what should be its price? The prevailing
market price is Rs. 75.(Ans Rs.70)
9. Anil estimate that from investment on stock A he would get 15% dividend next year.
It would continue to grow by 10% for rest of the years. The selling price is Rs. 40. He
needs a return of 20% per year for his son’s education expenses. Can he invest on
stock “A”? (Ans. No, as r=10.37)
10. ABC ltd. has bought a stock that has Rs. 3.00 as dividend per share during the
last financial year. He anticipates two situations either a 5% decline in the dividend
or 5% growth in the dividend in the next year. His anticipated return is 20%. Find
out the price in both the situations. (Ans: Rs 21, Rs 11.4)
11. Maxima solutions is expected to pay a dividend of Rs. 4 at the end of 1 st year,
Rs. 7 at the end of 2nd year, Rs. 11 at the end of 3rd year. From the fourth year
onwards the dividend are expected to grow at constant growth rate of 4%. If the
required rate of return is 14%, compute the present value of the stock.(Rs.93.54)
Two Stage Growth Model
12. The growth rate of ABC ltd. For the past 5 years is 18.58%. This is assumed to
continue for next five years and after that rate of return is assumed to have a growth
rate of 10% indefinitely. The dividend paid for the year is Rs. 1.8. The required rate
return is 20%. Estimate the stock price according to the two stage model assuming
share price is Rs. 14. (Ans. Rs 27.34)
13. A company earned Rs. 6 per share and paid Rs. 3.48 per share as dividend in
the previous year. It’s earning and dividends are expected to grow at 15% for six
years and then at a rate of 8% indefinitely. The capitalization rate is 18%. What is
the price of share today?(Ans: Rs. 51.29)
14. Berger Ltd. earned Rs. 7 per share during the last year and paid a dividend of
Rs. 2.50 per share. The earning were expected to grow at the rate of 10% for the
next three years and thereafter stabilizes at 3%. The pay-out is expected to remain
at the same level during three years and then increase to 60%. If the required rate of
return is 16%. Compute:
(a) The expected price of Berger at the end of 3rd year.
(b) The current price stock.(Ans: (a) 44.31,(b) Rs. 35.14)
15. The return of PQR Ltd. at present is 21%. This is assumed to continue for the
next five years and after that it is assumed to have a growth rate of 10% indefinitely.
The dividend paid previous year was 32%. The required rate of return is 20% and
the present price is Rs 57. What is the estimated price according to the two stage
model?(Ans: Rs. 53.06 )
16. Van products currently pays a dividend of Rs.2 per share and their dividend is
expected to grow at a 15% annual rate for 3 years then at a 12% rate for the next 3
years. After it is expected to grow at 5% forever. What value would you place on the
equity if the required rate of return were 9%.
Three Stage Growth Model

17. For the first 4 years XYZ firm is assumed to grow at a rate of 10%. After four
years the growth rate of dividend is assumed to decline linearly to 6%. After 7 years,
the firm is assumed to grow at a rate of 6 % indefinitely. The next year dividend is
Rs. 2 and the required rate of return is 14%. Find out the value of the stock.(Ans: Rs.
28.69)
18. A Company is currently paying a dividend of Rs.2.00 per share. The dividend
is expected to grow at a rate of 15% annual rate for 3 years, then at 10% rate for the
next 3 years, after which it is expected to grow at a 5% rate forever. What is the
present value of the share if the Capitalization rate is 9%?(Ans: Rs 77.18)

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Investment Analysis & Portfolio Management: Equity Valuation

Valuation of Preference Share

Current Yield = Annual dividend /

2. Holding Period Return:

5. Yield on Preference Share

Constant Growth Model/ Gordon’s model

Two Stage Growth Model

Present value of Share = PV of Dividend during growth rate + PV

Valuation through P/E ratio method

Valuing Preference Share

1. An investor is considering the purchase of a 12-year, 10% Rs 100 par value

Yield on Preference Share

Constant Growth Model/ Gordon’s model

Two Stage Growth Model

Three Stage Growth Model

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