SECURITY ANALYSIS

AND PORTFOLIO
MANAGEMENT

UNIT 4: EQUITY SHARES

ANALYSIS AND VALUATION
 UNIT 4: EQUITY SHARES ANALYSIS AND
VALUATION

TOPICS TO BE COVERED:

 Fundamental Analysis

 Technical Analysis

 Efficient Market Hypothesis

 Valuation of equity shares

 Valuation based on dividends
 Valuation of equity shares based on earnings
 UNIT 4: EQUITY SHARES ANALYSIS AND VALUATION

TOPICS TO BE COVERED:

 Fundamental Analysis
 Economic Analysis, Industry Analysis, Company Analysis

 Technical Analysis
 Basic tool of technical analysis (Charting)
 Dow Theory
 Elloit Wave theory
 Price and volume charts
 Bar chart, Line chart, Point and figure chart, candlestick chart
 Pattern Analysis: Support and resistance level
 Indicator Analysis
 Weaknesses and shortcomings of technical analysis

 Efficient Market Hypothesis

 Weak form, semi strong form, strong form of market efficiency.

 Valuation of equity shares

 Valuation based on dividends
 Valuation of equity shares base on Earnings
EQUITY VALUATION

 Equity valuation is a blanket term, used to refer to all tools

and techniques used by investors to find out the true value of a
company’s equity

 It is often seen as the most crucial element of a successful

investment decision

 Investment Banks typically have an equity research

department, where research analysts produce equity research
reports of select securities in various industries
EQUITY VALUATION

 Equity Valuation is a method of deriving the

fair value of a firm or its equity stock

 Forthe stock market, value is the price that

someone is willing to pay for owning the
company
WHY VALUATION ?

 Prices of the securities in the stock exchange keep on

fluctuating

 Investors and other operators are always interested in

buying the shares at lower prices and selling them at
higher prices to make profit

 To achieve this objective, they estimate the share price

APPROACHES TO EQUITY VALUATION

FUNDAMENTAL
ANALYSIS

TECHNICAL
ANALYSIS
FUNDAMENTAL ANALYSIS

 Fundamental Analysis is the process of finding the

intrinsic value or worth of a share

 It is the study of a company's fundamentals with the aim

of determining its exact worth

 Process is based on analyzing the information that is

'fundamental' to the company

 Focuses on creating a portrait of a company, identifying

the intrinsic or fundamental value of its shares and
buying or selling the stock based on that information
FUNDAMENTAL ANALYSIS

 Aims to understand and forecast the intrinsic value of

stocks based on a thorough analysis of various macro,
company-specific as well as qualitative and quantitative
factors

 2 approaches to fundamental analysis as well

 Top-Down approach
 Bottom-up Approach
TOP-DOWN APPROACH

 Also known as the Economy-Industry-Company or the EIC

approach wherein the analyst starts analyzing the economy at
large and delving down further into the relevant sector and then
the company in particular

 Analyst first analyses the trends makes forecasts for the

economy, then he does the same for the particular industry
 Then he picks up the stocks from that industry and follows
the same approach for valuing the stocks

 Most attractive stocks are then chosen from amongst them for
investment purpose
EIC APPROACH
 BOTTOM UP APPROACH

 Opposite of top-down approach

 In this approach, the company is analyzed first and then it is validated in the
backdrop of the forces of economy and industry.

 In this, the details about the companies such as the financial statements, ratios,
management discussion & analysis are studied first and estimate its investment
potential

 Thrives under the assumption that individual companies can perform well even if
the overall economy or industry is not doing well

 Bottoms up investors do not ignore macro trends, but they assign more
weightage to the performance of the individual company

 However, critics of the Bottom-up approach say that no matter how well a
company’s financials are, if there is a massive meltdown in the market all the
stocks are bound to be affected by it. But still many asset management
companies have successfully used the Bottoms up approach over the years
BOTTOM UP APPROACH
 Valuation: Fundamental Analysis

 Fundamental analysis models a company’s value by assessing

its current and future profitability

 The purpose of fundamental analysis is

 to identify mispriced stocks relative to some measure of “true”

value derived from financial data

 Suppose the intrinsic value of a share is Rs.200, the fundamental

analyst suggests buying it if it is being traded in the market below
Rs.200; sale is recommended if it is traded above Rs.200.
Models of Equity Valuation
• Balance Sheet Models

• Dividend Discount Models (DDM)

• Price/Earnings Ratios
• Free Cash Flow Models
 VALUATION UNDER
FUNDAMENTAL ANALYSIS:
TWO BASIC APPROACHES

a. Discounted Cash Flow Approach

 Attempts to estimate the value of a stock using present value principle
 Present Value Rule: The value of any asset is the present value of all
expected future cash flows, discounted at a rate appropriate to the riskiness
of the cash flows being discounted

b. Relative Valuation Approach

 A Stock is valued relative to other stock on the basis of certain ratios such
as the P/E ratio, the price to book value ratio etc.

 Valuation ratios compare the company's market value with some financial
aspect of its performance--earnings, sales, book value, cash flow, and so on

1
DIVIDEND DISCOUNT MODELS

 Models which take into account

discounted value of expected future
cash flows to gain a reference for the
value of a company

 This is the oldest and simplest present

value approach to valuing a stock
Dividend Discount Models

 Since dividends are the only cash

flow stream to be received directly
by investors under normal
conditions
 It is appropriate to have a
valuation model based on
dividends
BASIC ASSUMPTIONS OF DIVIDEND
DISCOUNT MODEL

• Dividends are paid annually

• First dividend is received after one year

from the date of acquisition/purchase of
share

• Sale of equity shares if any occurs only

at the end of the year and at the ex-
dividend terms
 DIVIDEND DISCOUNT MODELS
AND PERIOD OF HOLDING

DEFINITE INDEFINITE
PERIOD OF PERIOD OF
HOLDING HOLDING
DEFINITE PERIOD OF HOLDING CASE

One Period Case:

E ( D1 )  E ( P1 )
V0 
1 k
Multi-period Case:
D1 D2 DH  PH
V0   ...
1  k 1  k  2
1  k  H

Where D1,…, DH and PH are expected values

Dividend Discount Models

Example: Whitewater Rapids Company is expected to have

dividends grow at a rate of 12% for the next three years. In
three years, the price of the stock is expected to be $ 74.46. If
Whitewater just paid a dividend of $2.00 and its level of risk
requires a discount rate of 10%, what is the intrinsic value of
Whitewater stock?
Dividend Discount Models

Dividend discount model (infinite horizon):

D1 D2 D3
V0    ...
1  k 1  k  2
1  k  3
VARIATIONS IN DIVIDEND
GROWTH (INFINITE HORIZON)

VARIATIONS IN
DIVIDEND GROWTH

NO GROWTH OR CONSTANT MULTI-STAGE

CONSTANT GROWTH IN GROWTH IN
DIVIDENDS DIVIDENDS DIVIDENDS
 No Growth Model

• Where the stock has earnings and dividends that are expected to
remain constant forever.

• Example: Preferred Stock

 No Growth Model: Example

E1 = D1 = $5.00
k = .15

Then, V0 = $5.00 / .15 = $33.33

Constant Growth DDM
(Gordon’s Model)

D0 1  g  D0 1  g  D0 1  g 
2 3
V0    ...
1 k 1  k  2
1  k  3

D0 1  g  D1
V0   , gk
kg kg
CONSTANT GROWTH:
ADDITIONAL ASSUMPTIONS

• Growth rate, g is constant and

compounding annually

• The growth rate g is less than the

required rate of return of the equity
shares (k>g)

• The growth rate , g is the subjective

estimate of a the investor
 Constant Growth Model

g = constant perpetual growth rate

 Constant Growth Model:
Example

E1 = $5.00 b = 40% (1-b) = 60%

k = 15% D1 = $3.00 g = 8%
(b: EPS retention ratio)

V0 = 3.00 / (.15 - .08) = $42.86

Constant Growth DDM

Example: Whitewater Rapids Company is expected to have

dividends grow at a constant rate of 6% for the foreseeable
future. If Whitewater just paid a dividend of $2.81 and its level
of risk requires a discount rate of 10%, what is the intrinsic
value of Whitewater stock?
Market Capitalization Rate

D1
Gordon’s Model: V0 
k g

D1
If V0 = P0 : k  g
P0
Dividend Capital
Yield Gains Yield
D0 1  g  D0 1  0  D1
If g = 0: V0   
kg k 0 k
Perpetuity
Implications of this Model
D1
V0 
k g
• If D1 increases, then V0 increases.
• If k decreases, then V0 increases.
• If g increases, then V0 increases.
• If D1 increases X%, then V0 will
increase X%.
• g = the capital gains yield
Dividend Payout Ratio and
Plowback Ratio
 Dividend Payout Ratio: Percentage of
earnings paid out as dividends

 Plowback (or Earning Retention) Ratio:

Fraction of earnings retained and reinvested
in the firm
Stock Prices and Investment Opportunities

If a firm retains earnings and reinvest

them in a profitable investment
opportunity, dividend may grow
“faster”.

If a firm pays out all dividends nothing

gets re-invested, nothing growths.
Dividend Discount Models (continued)

Estimating Dividend Growth Rates

g = ROE x b

g = growth rate in dividends

ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
Internal Growth Rate (ROE x (1-payout))
This is the rate that the company can continue to grow without any
additional external financing
Note: if the firm distributes all its earnings as dividends, there is nothing to
allow the firm to continue to grow
Life Cycles and the
Constant Growth Model

Changing growth rates:

D1 D2 DH DH  1
V0    ...    ...
1 k 1 k 2
1  k H
1  k H 1

temporary high permanent

(or low) growth constant growth
Changing Growth Rate
Example: Whitewater Rapids Company is expected to have
dividends grow at a rate of 12% for the next three years. In three
years, the dividends will settle down to a more sustainable growth
rate of 6% which is expected to last “forever.” If Whitewater just
paid a dividend of $2.00 and its level of risk requires a discount
rate of 10%, what is the intrinsic value of Whitewater stock?
Practical Difficulties with DDM

• Some firms do not pay dividends

• Can you forecast future dividends?

• Can you predict the terminal liquidation value Pn ?

• What about the discount rate k?

LIMITATIONS OF DDM

 More Changes to the DDM

 What about growth opportunities?
 Do those impact the value of the company?

 Does the DDM only look at dividends?

 What about earnings on specific projects?
 Can we fix the DDM to look at the value of new projects?

 There are a number of different DDM models that can handle

each of these situations
Challenges of Dividend Discount Models
A slight change in the discount rate can have a
huge change in the result

It is difficult to determine the terminal value

of the stock

A small change in the termination value (i.e.,

the PE multiple) can have a large change in
the result

Not all firms have dividends

 PRICE
EARNINGS
MODEL
PRICE EARNINGS APPROACH TO STOCK
VALUATION

• WHAT IS P/E RATIO

• The price earnings ratio, which is also known as the
P/E ratio for short is a useful metric for evaluating
the relative attractiveness of a company's stock price
compared to the current earnings of a firm

• Made popular by Benjamin Graham

• The P/E ratio is the price an investor is paying for

$1 of a company's earnings or profit.
• In other words, if a company is reporting
basic or diluted earnings per share of $2 and
the stock is selling for $20 per share, the p/e
ratio is 10 ($20 per share divided by $2
earnings per share = 10 P/E

Source: https://www.thebalance.com/using-price-to-earnings-356427
BASIC VERSUS DILUTED EPS

 An analyst should consider the impact of

potential dilution on earnings per share.
 Dilution refers to the reduction in the
proportional ownership interests as a result of
the issuance of new shares
 Companies are required to present both basic
earnings per share and diluted earnings per share
 Basic earnings per share reflect total earnings divided
by the weighted average number of shares actually
outstanding during the period.
 Diluted earnings per share reflect division by the
number of shares that would be outstanding if holders
of securities such as executive stock options, equity
warrants, and convertible bonds exercised their options
to obtain common stock.
 P/E RATIO EXPLAINED

• The price-earnings ratio, or earnings

multiple, is one of the most popular
measures of company value

• It is computed by dividing the current

stock price by earnings per share for
the most recent 12 months
 P/E RATIO EXPLAINED

• It is followed so closely because it relates the market’s expectation

of future company performance, embedded in the price component
of the equation, to the company’s actual recent earnings
performance.

• The greater the expectation, the higher a multiple of

current earnings investors are willing to pay for the
promise of future earnings

• If the market has low earnings growth expectations for a

firm, or views earnings as suspect, it will not be willing to
pay as much per share as it would for a firm with high and
more certain earnings growth expectations.
IS LOW P/E RATIO BAD?

• Stocks with low price-earnings ratios does not

necessarily mean that the company has little or no
growth prospects

• While most firms deserve their low ratios, value

investors seek companies with low price-earnings
ratios in the belief that through neglect or
overreaction to bad news, the market has not
correctly evaluated the earnings potential of the
company
UNDERSTANDING P/E RATIO

• P/E ratios of the companies whose earnings are expected to grow

rapidly are higher

• The market assesses the degree of risk involved in the expected

future growth of earnings
• If the higher growth carries a higher level of risk , P/E
multiple is adjusted accordingly

• P/E multiple reflects the investors’ expectations about the growth

potential of a stock and the risk involved
• These two factors offset each other
UNDERSTANDING P/E RATIO……
• P/E multiple is also related to investor’s required rate of return
• As the required rate of return increases, other things
being equal, P/E ratio decreases

• P/E ratio vs. interest rates

• The required rate of return is related to interest rates
• As interest rates increase, required rate of return
––––––––– and therefore P/E ratio –––––––––––––––
• By the other logic, As interest rates increases, bonds/
stocks become more attractive as compared to
stocks/bonds and therefore P/E ratio ––––––––––––––
• Inverse/direct relationship between interest rates and
P/E ratio
UTILITY OF P/E RATIO

• Inverting the p/e ratio i.e. by taking it divided by 1, we get

a stock's earnings yield

• Identifying value stocks

• Establishing benchmark comparisons

• Identifying overpricing/underpricing

• Comparing stocks

Source: https://www.thebalance.com/using-price-to-earnings-356427
UTILITY OF P/E RATIO explained

• Inverting the p/e ratio i.e. by taking it divided by 1, we

get a stock's earnings yield

• It can help you differentiate between a less-than-perfect

stock that is selling at a high price because it is the latest
fad among stock analysts, and a great company which
may have fallen out of favor and is selling for a fraction
of what it is truly worth

• Price-earnings relatives help to establish benchmark

comparisons that can help identify firms that have
deviated from their normal valuation levels, assuming
nothing has fundamentally changed in the company,
industry or market

Source: https://www.thebalance.com/using-price-to-earnings-356427
UTILITY OF P/E RATIO: explained

• One potential way to know when a sector or industry is

overpriced is when the average p/e ratio of all of the
companies in that sector or industry climb far above the
historical average.

• The p/e ratio can be used to compare the prices of

companies in the same sector of the economy.
• For example, if company ABC and XYZ are both
selling for $50 a share, one might be far more
expensive than the other depending upon the
underlying profits and growth rates of each stock

Source: https://www.thebalance.com/using-price-to-earnings-356427
STOCK VALUATION USING P/E
RATIO

• Stock price is the product of two variables when using this

type of approach:
• Earnings per share or EPS
• The P/E multiple

• If a stock is having a P/E multiple of 12 and the expected

EPS at the end of the year is Rs 5, What is the fair price of
the share at present?
• P0 = EPS X P/E Multiple
= 5*12
= Rs. 60 per share
P/E RATIO AND DDM RELATIONSHIP

 P0 = (D1/ k-g)

 DIVIDING BOTH SIDES BY EPS1

 P0/EPS1 = {D1/EPS1}/ {k-g}

P/E Ratio = DP RATIO/k-g

 k-g = {D1/EPS1}/{P0/EPS1}
 k = {D1/EPS1}/{P0/EPS1} + g
 k = {D1/{P0} + g
 k = dividend yield + g
 Determinants P/E ratio

 P/E Ratio = DP RATIO/k-g

Factors on which P/E ratio depends:

• Expected Dividend Payout Ratio (+ve)

• Required rate of return, k (-ve)

• Expected Growth rate in dividends, g (+ve)

Drawbacks to P/E ratios

 Drawbacks based on nature of EPS.

• EPS can be negative. The P/E ratio does not make
economic sense with a negative denominator.
• Components of earnings that are on-going or
recurrent are most important in determining
intrinsic value.
• However, earnings often have volatile, transient
components, making the analyst’s task difficult
• Management can exercise its discretion within
allowable accounting practices to distort earnings
per share as an accurate reflection of economic
performance.
• Distortions can affect the comparability of P/E
ratios across companies.
Accounting issues with P/E ratios
 In calculating a P/E ratio, the current price for publicly
traded companies is generally easily obtained and
unambiguous.

 Determining the earnings figure to be used in the

denominator, however, is not as straightforward. Two issues
are

 the time horizon over which earnings are measured, which results in
two chief alternative definitions of the price–earnings ratio; and

 adjustments to accounting earnings that the analyst may make so

that P/Es are comparable across companies.
Trailing and leading P/E’s

• Trailing P/E (sometimes referred to as current P/E) of

a stock is the current market price of the stock divided
by the most recent four quarters’ earnings per share

• The EPS in such calculations are sometimes

referred to as trailing twelve months (TTM) EPS

• Trailing P/E is the price–earnings ratio published

in stock listings of financial newspapers

• Leading P/E (also called the forward P/E or the

prospective P/E) is calculated by dividing the current
price by next year’s expected earnings
 Expected Holding Period Return
E  D1    E  P1   P0 
E(HPR) 
P0
E  D1    E  P1   P0 
 
P0 P0
expected expected
 dividend  capitalgain/loss
yield yield

• If E(HPR) > Required Rate of Return(RRR), the stock

is a good deal.
• RRR is from a pricing model, e.g. CAPM:

E (rXYZ )  rf   XYZ ( E (rm )  rf )

•In market equilibrium, E(HPR) = RRR.
 Refer to CLASS assignment #1 for
practice on DDM AND P/E MODEL
 END OF PART I OF UNIT 4

PART 2:
TECHNICAL ANALYSIS and EFFICIENT
MARKET HYPOTHESIS