THREE Bonds and Stock Valuation

Stock Valuation
 Concept of Stock Market
• The stock market refers to the collection of
markets and exchanges where regular activities
of buying, selling, and issuance of shares of
publicly-held companies take place.
• Such financial activities are conducted through
institutionalized formal exchanges or over-the-
counter (OTC) marketplaces which operate
under a defined set of regulations. 
• While both terms - stock market and stock
exchange - are used interchangeably, the latter
term is generally a subset of the former.
 Concept of Stock Market
• Operating under the defined rules as stated by the
regulator, the stock markets act as primary markets and
as secondary markets.
Primary market,
• The stock market allows companies to issue and sell
their shares to the common public for the first time
through the process of initial public offerings (IPO) or the
additional capital through further public offering (FPO).
• This activity helps companies raise necessary capital
from investors.
• Done through investment bankers or financial
intermediaries.
 Concept of Stock Market
Secondary market.
• The stock exchange earns a fee for every trade
that occurs on its platform during the secondary
market activity.
• The stock exchange shoulders the responsibility
of ensuring price transparency, liquidity, price
discovery and fair dealings in such trading
activities.
• Done through registered brokers.
 Common Stock
• A stock (also known as equity) is a security that represents the
ownership of a fraction of a corporation.
• This entitles the owner of the stock to a proportion of the
corporation's assets and profits equal to how much stock they
own. 
• Units of stock are called "shares."
• Stocks are bought and sold predominantly on stock exchanges,
though there can be private sales as well, and are the
foundation of many individual investors' portfolios.
• These transactions have to conform to government regulations
which are meant to protect investors from fraudulent practices.
• Corporations issue (sell) stock to raise funds to operate their
businesses. There are two main types of stock: common and
preferred.
 Features of Stock
• Par Value
• No maturity period (Perpetual)
• Voting right
• Unlimited Return
• High risk investment alternative
• Annual Dividend
• Preemptive Right (Right Share)
• Claim on Income and assets
• Market value and Book value
• Intrinsic/Investment Value
 Stock Valuation
• It is a process of determining the investment
value of stock for investment.
• The basic valuation models to value a stock is as:
– Dividend Discounting Valuation Model
• These methods are focused on the assumptions that
investors invest on the market/Stock for the future
dividend that is going to be distributed by company.
• Dividend Discounting Valuation model
– Zero Growth Model
– Constant growth Model/ Gordon Model
– Non Constant Growth Model
 Zero Growth Model
• In this method it is assumed that the dividend will be
constant forever.
• Value of stock is the discounted value of future
dividend of company.
• P0 =
• Where, P0 = Value of stock today,
D= Expected Future Dividend and
Ks= Required rate of return or opportunity cost or
interest rate etc.
• The required rate of return is 12% and the
company is expected to pay a constant
dividend of Rs. 10 per share forever. Calculate
the value of its stock.
• Would you buy the stock which is expected to
pay a constant dividend of Rs 12 with the
opportunity cost of 12%, if it is trading for Rs.
120?
• Capital Gain Yield

• Dividend Yield
 Constant growth Model/Gordon Model
• In this model the growth is assumed in
dividends and the growth rate is infinite for
ever and same in each year.
• P0 =
• Where,
• P0 = Value of stock today,
• D1= Expected Future Dividend= D0 (1+gn)
• D0 = Just paid or declared dividend
• g= Constant Growth in Dividends
• Ks= Required rate of return or opportunity cost or interest
rate etc.
• Annapurna company is expected to pay a Rs 15 per
share dividend at the end of the year. The dividend is
expected to grow at a constant rate of 8 percent a
year forever. The required rate of return on the stock
is 15 percent. What is the stock’s current value per
share?
• Ewald Company’s current stock price is $36, and its
last dividend was $2.40. In view of Ewald’s strong
financial position and its consequent low risk, its
required rate of return is only 12%. If dividends are
expected to grow at a constant rate g in the future,
and if ks is expected to remain at 12%, then what is
Ewald’s expected stock price 5 years from now?
 Supernormal Growth model
• It is a model based on the approach that allows for a
change in the dividend growth rate.
• The divided will be grow for non-constant or variable rate
for certain period of time then it will grow by constant
growth.
• In this model firstly we calculate the future dividend for
non constant period.
• Then, we calculate the present value of dividends and
value of stock at non constant growth period, which is
known as the horizon value or terminal value (Vn).
• Then both the present value of dividend and value of
stock at horizon date will be added to find the value of
stock.
• P0 = + …….. +
• Where,
» V0 = Value of stock today,
» D1= Expected Future Dividend in year 1,
» D2= Expected Future Dividend in year 2,
» Dn= Expected Future Dividend in year n,
» Vn= Value of stock at horizon date or terminal
date and
» gn= Constant Growth in Dividends
» Ks= Required rate of return or opportunity cost
or interest rate etc.
National hydro recently paid a dividend of Rs.
20. The company expects to have supernormal
growth of 10% for 2 years; 8% for 3rd year; and at
a constant rate of 5% thereafter. The firm's cost
of equity is 15%.
• What is the stocks terminal value?
• What is the stocks intrinsic value today?
• Invercargill Company stock has paid a $6.00
annual dividend in 2003 and a $6.50 dividend
in 2004. This growth in dividends will continue
in the future. The stockholders of Invercargill
require a 17% return on their investment.
Calculate the price of one share of Invercargill
stock in 2005.
• $88.02
• Boston Corporation stock currently pays $6
annual dividend and sells at $62 per share.
The company expects to show continued
growth at the rate of 4% per year. Find the
required rate of return by the stockholders.
• 14.06%
ABC $ Co. recently paid a dividend of Rs. 20. The
company expects to have supernormal growth
of 10% for 3 years and at a constant rate of 5%
thereafter. The firm's cost of equity is 15%.
• What is the stocks terminal value?
• What is the stocks intrinsic value today?
• Explain what happens to the stock value if the
cost of equity rises to 17%.
 Revision Questions
• Mr. X takes a loan of Rs 50,000 from HDFC Bank. The
rate of interest is 10% per annum. The first installment
will be paid at the end of year 5. Determine the
amount of equal annual installments if Mr. X wishes to
repay the amount in five installments.
• You have started a job with an annual salary of
$48,000. You will get the paycheck at the end of each
month, and your deductions for taxes will be 34%.
Using a discount rate of 0.8% per month, find the
present value of the take home pay for the whole year.