Chapter-Four, Investment Analysis And Portfolio Management (Acfn 3201), Jig-Jiga University. Sep, 2021.

(2013
E.C.)

CHAPTER-FOUR.
Stock and equity valuation.
Stock characteristic.
When you invest in stock, you buy ownership shares in a company—also known as
equity shares. Your return on investment, or what you get back in relation to what you
put in, depends on the success or failure of that company.
If the company does well and makes money from the products or services it sells, you
expect to benefit from that success. The share price rises and falls all the time—
sometimes by just a few cents and sometimes by several dollars—reflecting investor
demand and the state of the markets.

There are no price ceilings, so it's possible for shares to double or triple or more over
time—though they could also lose value. The issuing company may pay dividends, but it
isn't required to do so. If it does, the amount of the dividend isn't guaranteed, and it
could be cut or eliminated altogether—though companies may be reluctant to do either if
they believe it will send a bad message about the company's financial health.

There are two main ways to make money with stocks:

1. Dividends:
When publicly owned companies are profitable, they can choose to distribute some of
those earnings to shareholders by paying a dividend. You can either take the dividends
in cash or reinvest them to purchase more shares in the company.
Many retired investors focus on stocks that generate regular dividend income to replace
income they no longer receive from their jobs. Stocks that pay a higher than average
dividend are sometimes referred to as “income stocks.”

2. Capital gains:
Stocks are bought and sold constantly throughout each trading day, and their prices
change all the time. When a stock price goes higher than what you paid to buy it, you
can sell your shares at a profit. These profits are known as capital gains.

In contrast, if you sell your stock for a lower price than you paid to buy it, you've
incurred a capital loss. Both dividends and capital gains depend on the fortunes of the
company—dividends as a result of the company’s earnings and capital gains based on
investor demand for the stock. Demand normally reflects the prospects for the
company’s future performance.

Strong demand—the result of many investors wanting to buy a particular stock—tends

to result in an increase in the stock’s share price. On the other hand, if the company
isn’t profitable or if investors are selling rather than buying its stock, your shares may be
worth less than you paid for them.

The performance of an individual stock is also affected by what's happening in the stock
market in general, which is in turn affected by the economy as a whole. For example, if
interest rates go up and you think you can make more money with bonds than you can
with stock, you might sell off stock and use that money to buy bonds. If many investors

JJU, COBE, Dep’t Of ACFN, Compiled By Instructor;-

Page_ 1.
“Mahamedkeder Abdilahi Yusuf”.
Chapter-Four, Investment Analysis And Portfolio Management (Acfn 3201), Jig-Jiga University. Sep, 2021. (2013
E.C.)

feel the same way, the stock market as a whole is likely to drop in value, which in turn
may affect the value of the investments you hold.

Other factors, such as political uncertainty at home or abroad, energy or weather

problems, or soaring corporate profits, also influence market. However, this is an
important element of investing.

At a certain point, stock prices will be low enough to attract investors again. If you and
others begin to buy, stock prices tend to rise, offering the potential for making a profit.
That expectation may breathe new life into the stock market as more people invest.

4.2. Balance sheet valuation.

Purpose of Balance sheet Valuation.
The objective of balance sheet valuation is the calculation of material prices for
subsequent use in external or internal balance sheets, typically for valuation of the stocks
or current assets.

Generally, the conditions include meeting legal requirements, complying with corporate
group guidelines, and implementing internal company objectives regarding accounting
policy.

Balance sheet: Classification, & Valuation.

• Debt investments and equity investments recorded using the cost method are
classified as trading securities, available‐for‐sale securities, or, in the case of debt
investments, held‐to‐maturity securities.

• The classification is based on the intent of the company as to the length of time it
will hold each investment.

• A debt investment classified as held‐to‐maturity means the business has the

intent and ability to hold the bond until it matures.

• The balance sheet classification of these investments as short‐term (current) or

long‐term is based on their maturity dates.

• Debt and equity investments classified as trading securities are those which

were bought for the purpose of selling them within a short time of their purchase.

• These investments are considered short‐term assets and are revalued at each
balance sheet date to their current fair market value.

• Any gains or losses due to changes in fair market value during the period are
reported as gains or losses on the income statement because, by definition, a
trading security will be sold in the near future at its market value

• In recording the gains and losses on trading securities, a valuation account is

used to hold the adjustment for the gains and losses so when each investment is
sold, the actual gain or loss can be determined.
JJU, COBE, Dep’t Of ACFN, Compiled By Instructor;-
Page_ 2.
“Mahamedkeder Abdilahi Yusuf”.
Chapter-Four, Investment Analysis And Portfolio Management (Acfn 3201), Jig-Jiga University. Sep, 2021. (2013
E.C.)

• The valuation account is used to adjust the value in the trading securities account
reported on the balance sheet.

• For example, if the Brothers Quartet, Inc. has the following investments
classified as trading securities, an adjustment for $9,000 is necessary to record
the trading securities at their fair market value.

The entry to record the valuation adjustment is:

• Debt and equity investments that are not classified as trading securities or held‐
to‐maturity securities are called available‐for‐sale securities.

• Whereas trading securities are short‐term, available‐for‐sale securities may be

classified as either short‐term or long‐term assets based on management's
intention of when to sell the securities.

• Available‐for‐sale securities are also valued at fair market value.

• Any resulting gain or loss is recorded to an unrealized gain and loss account that
is reported as a separate line item in the stockholders' equity section of the
balance sheet.

• The gains and losses for available‐for‐sale securities are not reported on the
income statement until the securities are sold.

• Unlike trading securities that will be sold in the near future, there is a longer
time before available‐for‐sale securities will be sold, and therefore, greater
potential exists for changes in the fair market value.

• For example, assume the Brothers Quartet has available‐for‐sale securities,

whose cost and fair market value are:
JJU, COBE, Dep’t Of ACFN, Compiled By Instructor;-
Page_ 3.
“Mahamedkeder Abdilahi Yusuf”.
Chapter-Four, Investment Analysis And Portfolio Management (Acfn 3201), Jig-Jiga University. Sep, 2021. (2013
E.C.)

The entry to record the valuation adjustment is:

• In the balance sheet the market value of short‐term available‐for‐sale securities is

classified as short‐term investments, also known as marketable securities, and the
unrealized gain (loss) account balance of $15,000 is considered a stockholders'
equity account and is part of comprehensive income.

• When the balance is a net loss, it is subtracted from stockholders' equity.

JJU, COBE, Dep’t Of ACFN, Compiled By Instructor;-

Page_ 4.
“Mahamedkeder Abdilahi Yusuf”.
 Chapter-Four, Investment Analysis And Portfolio Management (Acfn 3201), Jig-Jiga University. Sep, 2021. (2013
E.C.)

• A partial balance sheet for Brothers Quartet, showing the current assets and the
stockholders' equity sections, follows:

4.3. Dividend Discount Model.

• The dividend discount model (DDM) is a method of valuing a company's stock
price based on the theory that its stock is worth the sum of all of its future
dividend payments, discounted back to their present value.

• In other words, it is used to value stocks based on the net present value of the
future dividends.

• The equation most widely used is called the Gordon growth model. It is named
after Myron J. Gordon of the University of Toronto, who originally published it.
The stock price can be valued as:

Where:  P is the current stock price. 

g is the constant growth rate in perpetuity expected for the dividends. 
r is the constant cost of equity capital for that company.   
D1 is the value of the next year's dividends i.e., D1=D0 (1+g), D2= D1(1+g),
……, Dn = Dn-1(1+g)
There are 3 models used in the dividend discount model:
 Zero-growth Model, which assumes that all dividends paid by a stock remain the
same;
 Since the zero-growth model assumes that the dividend always stays the
same, the stock price would be equal to the annual dividends divided by the
required rate of return (D1/r).
Example: Intrinsic Value of Preferred Stock;
If a preferred share of stock pays dividends of $1.80 per year, and the required rate
of return for the stock is 8%, then what is its intrinsic value?
JJU, COBE, Dep’t Of ACFN, Compiled By Instructor;-
Page_ 5.
“Mahamedkeder Abdilahi Yusuf”.
 Chapter-Four, Investment Analysis And Portfolio Management (Acfn 3201), Jig-Jiga University. Sep, 2021. (2013
E.C.)

 Intrinsic Value of Preferred Stock = $1.80/0.08 = $22.50.

 Constant-growth model, which assumes that dividends grow by a specific percent
annually;
• The constant-growth DDM (Gordon Growth model), because it was
popularized by Myron J. Gordon) assumes that dividends grow by a specific
percentage each year, and is usually denoted as g, and the Required rate of return
is denoted by r.
• Constant-Growth Rate DDM Formula;
Intrinsic Value (P) = D1/r-g.
Where; D1 = Next Year's Dividend.
r = Required rate of return/Capitalization Rate.
g = Dividend Growth Rate.
Example: Calculating Next Year’s Stock Price Using the Constant-Growth DDM
• If a stock pays a $4 dividend this year, and the dividend has been growing 6%
annually, then what will be the price of the stock next year, assuming a required
rate of return of 12%?
• Next Year’s Stock Price = $4 × 1.06 / (12% - 6%) = 4.24 / 0.06 = $70.67
• This Year’s Stock Price = $4 / 0.06 = 66.67
• Growth Rate of Stock Price = $70.67 / $66.67 = 1.06 = Dividend Growth Rate

 Variable-growth rate models (Multi-stage growth models).

It can take many forms, even assuming the growth rate is different for every year.

However, the most common form is one that assumes 3 different rates of growth: an
initial high rate of growth, a transition to slower growth, and lastly, a sustainable, steady
rate of growth.

The present values of each stage are added together to derive the intrinsic value of the
stock (P).

Sometimes, even the capitalization rate (k), or the required rate of return (r), may be
varied if changes in the rate are projected.
The formula for Variable-growth rate models is as follows:

Example: Calculate the value of common stock, an investor plans to hold Newco's
stock for 3 years. In that time period, Newco plans to grow at a rate of 6% in the first
two years and 3% thereafter. Newco's last dividend was $0.25. Given a rate of return of
10%, what is the value of Newco's common stock at the end of the three-year time
period?
Answer:
To begin, the dividend in each time period must be calculated;
D1 = D0(1+g)
D1 = (0.25)(1.06) = 0.265

JJU, COBE, Dep’t Of ACFN, Compiled By Instructor;-

Page_ 6.
“Mahamedkeder Abdilahi Yusuf”.
 Chapter-Four, Investment Analysis And Portfolio Management (Acfn 3201), Jig-Jiga University. Sep, 2021. (2013
E.C.)

D2 = (0.265)(1.06) = 0.281

D3 = (0.281)(1.03) = 0.289

Since we expect the dividend to grow indefinitely in year 3 and on, the present value of
the stock price in year 3 is calculated as follows:
P3 =  0.289  = 4.133
(0.10-0.03)
The value of Newco's common stock is as follows:
Newco'scs = $0.265 + $0.281 + 0.289 + $4.133 = $3.80
(1.10)1     (1.10)2    (1.10)3  (1.10)3

4.4. Free cash flow model.

Free Cash Flow: A measure of financial performance calculated as operating cash flow
minus capital expenditures.

Free cash flow (FCF) represents the cash that a company is able to generate after laying
out the money required to maintain or expand its asset base.

Free cash flow is important because it allows a company to pursue opportunities that
enhance shareholder value.

Without cash, it's tough to develop new products, make acquisitions, pay dividends and
reduce debt.

FCF is calculated as: EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net
Working Capital - Capital Expenditure.

It can also be calculated by taking operating cash flow and subtracting capital
expenditures.
• The free cash may be different from the net income for a particular accounting
period, as the free cash flow takes into account the consumption of capital
goods and the increases required in working capital.

Calculations: The free cash flow can be calculated as follows:

Element Data Source
EBIT x (1-Tax rate) Current Income Statement
+ Depreciation & Amortization Current Income Statement
Prior & Current Balance Sheets: Current Assets and Liability accounts
- Changes in Working Capital
 CA cash excluded - CL current financial debt excluded
- Capital expenditure Prior & Current Balance Sheets: Property, Plant and Equipment accounts
= Free Cash Flow
Note that the first three lines above are calculated for you on the standard Statement of
Cash Flows.

Example;- if GK Company has the following financial data in its Balance sheet and
Income statement in a particular accounting Period: Earnings before Interest and Tax

JJU, COBE, Dep’t Of ACFN, Compiled By Instructor;-

Page_ 7.
“Mahamedkeder Abdilahi Yusuf”.
Chapter-Four, Investment Analysis And Portfolio Management (Acfn 3201), Jig-Jiga University. Sep, 2021. (2013
E.C.)

(EBIT) is Br. 2000,000, Tax rate is 30%, Depreciation and Amortization is Br. 80,000,
Current Assets (excluding Cash) is Br. 150,000, Current Liabilities (excluding current
financial Debt) is Br. 70,000 and Property, Land, Plant and Equipment is Br. 200,000.
Then, what is the Free Cash Flow generated by GK during the period?

Solution;- FCF = EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net

Working Capital - Capital Expenditure.
= 2000,000 (1- 0.30) + 80,000 – (150,000 - 70,000) - 200,000 =
= 1400000 + 80,000 – 80,000 – 200,000
= 1480000 – 80,000 - 200,000
= 1200000.

4.5. Earning multiplier approach.

The earnings multiplier, also called the price-to-earnings ratio (P/E), is a valuation
method used to compare a company’s current share price to its per-share earnings.
One of the quickest ways to check how highly valued a stock is to look at its price-to-
earnings ratio (P/E), also known as an earnings multiple. The earnings multiple is the
stock price divided by earnings per share (EPS), and the units are expressed in years-
how many years of those earnings it would take to equal that stock price.

For example, if a stock Price is $50, and its EPS is $2.50, then the earnings multiple is
20.The stock price is expressed in dollars, the EPS is expressed in dollars per year, so
the earnings multiple of 20 is expressed in years- it would take twenty years of $2.50
each year to get $50.Of course, the earnings multiple alone doesn’t tell us much. If the
company is growing its EPS each year, then in reality it will take less than that number
of years for cumulative EPS to sum to the current stock price. Therefore, what
constitutes a “fair” earnings multiple depends on several factors like growth and
stability.

JJU, COBE, Dep’t Of ACFN, Compiled By Instructor;-

Page_ 8.
“Mahamedkeder Abdilahi Yusuf”.