FINAL PROJECT REPORT ON “Research on Equity valuation of Nifty stocks”
-----------------------------------------------------------------------------------------UNDER THE GUIDANCE OF Prof SAMEER SALUNKE SUBMITTED BY REEPAN SHAH Roll no: 34 PGDM 2011-13 -----------------------------------------------------------------------------------------IN PARTIAL FULFILLMENT OF TWO YEAR FULL TIME POST GRADUATE DIPLOMA OF MANAGEMENT STUDIES
GURU NANAK INSTITUTE OF MANAGEMENT STUDIES MATUNGA, MUMBAI 400 019
1
PROJECT GUIDE CERTIFICATE FORM
This is to certify that the dissertation submitted in partial fulfillment of the requirement for the award of PGDM of the University of Mumbai is a result of the bonafide work carried out by Mr. REEPAN SHAH under my supervision and guidance no part of this report has been submitted for award of any other degree, diploma fellowship or other similar titles or prizes. The work has also not been published in any scientific journals/ magazines.
Date: Place:
Name: REEPAN SHAH Roll No.: 34
Name of the Guide:
Signature of (Project Guide)
Director’s Signature:
2
DECLARATION
I, Mr. Reepan Shah student of PGDM second year (4th semester) at Guru Nanak Institute of Management Studies, hereby declare that I have completed my project entitled “Research on Equity valuation of Nifty stocks” as final project for 4th semester for the academic year 2012-2013 under the guidance of Prof Sameer
Salunke. The data collected and work done by me is truly authentic and is not borrowed or copied from any dissertation report. The project contains true and complete information. Whenever references have been made to previous work of others, it has been clearly predicted as such and included in the Bibliography.
Certified by Signature of guide Sign of a candidate
Place: MUMBAI Date:
3
“Research on Equity valuation of Nifty stocks”
A PROJECT SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR POST GRADUATION IN FINANCIAL MANAGEMENT
2011 - 2013
Name of the Student: REEPAN SHAH
ROLL NO: 34
NAME OF THE INSTITUTE:
GURU NANAK INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH
4
PROJECT GUIDE CERTIFICATE FORM I REEPAN SHAH the undersigned Roll No. 34 studying in the Second Year of PGDM is doing my project work under guidance of Ms. SAMEER SALUNKE wish to state that I have met my internal guide on the following dates mentioned below for Project Guidance:-
Sr. No. Date
Signature of the Internal Guide
____________________________ Signature of the Candidate
__________________________ Signature of Internal Guide
5
INDEX
SR. NO
PARTICULARS
PG. NO
3
RATIONALE OF STUDY
1
4
OBJECTIVE OF STUDY
2
5
LITERATURE REVIEW
3
6
OBSERVATIONS AND FINDINGS
13
7
RESEARCH METHODOLOGY
15
8
INTERFERENCE AND CONCLUSIONS
16
9
BIBLIOGRAPHY
17
6
RATIONAL OF THE STUDY:
Research shows that only 1% of Indian population invest in equities despite the fact that equities can give returns of more than 20%pa.there are several reasons for it but one of the main reasons in lack of knowledge about investing in equities, more specifically lack of valuation skills of equities. If we can strike right valuation of equity of any company at any given time, then the risk of investing in equities can be reduced as well as returns we can get can be maximum as compared to any other investment products, in return will also promote retail participation in equity instruments in India, which is crucial to the growth of the economy The project will also help understand: 1. Role of various factors and financial ratios in driving current market price of equities. 2. The important factor and key financial ratio in driving current market price of equities for specific sector which varies from sectors.
7
OBJECTIVE OF THE STUDY:
Current market price (CMP) is the reflection of investor’s perception of any particular stock at any given time.in quantifiable terms, investors perception is nothing but price/earnings (PE) of any stock. The fact that there are several companies which belong to same industry & have same EPS, but their share price are trading at different PE. Hence this research project objective is to understand the reason for companies having different PE of their share price despite same EPS & develop a formula which can give you perhaps what can be the right valuation or in other words the right perception (PE) of any stock at any given time (i.e. CMP), which in turn will help to categorize the stock valuation into overvalued, undervalued or fairly valued?
The research also intends to prove that the book value play least role in valuations of stocks & hence doesn’t reflect in CMP at any point of time until unless the company intends to close & liquidate.
8
LITERATURE REVIEW:
Price Earnings to Growth (PEG) Ratio. This valuation technique has really become popular over the past decade or so. It is better than just looking at a P/E because it takes three factors into account; the price, earnings, and earnings growth rates. To compute the PEG ratio, divide the Forward P/E by the expected earnings growth rate (you can also use historical P/E and historical growth rate to see where it's traded in the past). This will yield a ratio that is usually expressed as a percentage. The theory goes that as the percentage rises over 100% the stock becomes more and more overvalued, and as the PEG ratio falls below 100% the stock becomes more and more undervalued. The theory is based on a belief that P/E ratios should approximate the longterm growth rate of a company's earnings. Whether or not this is true will never be proven and the theory is therefore just a rule of thumb to use in the overall valuation process. Here's an example of how to use the PEG ratio. Say you are comparing two stocks that you are thinking about buying. Stock A is trading at a forward P/E of 15 and expected to grow at 20%. Stock B is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A is 75% (15/20) and for Stock B is 120% (30/25). According to the PEG ratio, Stock A is a better purchase because it has a lower PEG ratio, or in other words, you can purchase its future earnings growth for a lower relative price than that of Stock B.
Sum of Perpetuities Method The PEG ratio is a special case in the Sum of Perpetuities Method (SPM) [3] equation. A generalized version of the Walter model (1956), SPM considers the effects of dividends, earnings growth, as well as the risk profile of a firm on a stock's value.
9
Derived from the compound interest formula using the present value of a perpetuity equation, SPM is an alternative to the Gordon Growth Model. The variables are:
? ? ? ? ?
is the value of the stock or business is a company's earnings is the company's constant growth rate is the company's risk adjusted discount rate is the company's dividend payment
In a special case where reduces to the PEG ratio.
is equal to 10%, and the company does not pay dividends, SPM
10
THEORY:
Introduction
An equity investment generally refers to the buying and holding of shares of stock on a stock market by individuals and firms in anticipation of income from dividends and capital gains, as the value of the stock rises. Typically equity holders receive voting rights, meaning that they can vote on candidates for the board of directors (shown on a proxy statement received by the investor) as well as certain major transactions, and residual rights, meaning that they share the company's profits, as well as recover some of the company's assets in the event that it folds, although they generally have the lowest priority in recovering their investment. It may also refer to the acquisition of equity (ownership) participation in a private (unlisted) company or a startup company. When the investment is in infant companies, it is referred to as venture capital investing and is generally regarded as a higher risk than investment in listed goingconcern situations. in financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall. In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of their intrinsic value of the stock, based on predictions of the future cash flows and profitability of the business. Fundamental analysis may be replaced or augmented by market criteria – what the market will pay for the stock, without any necessary notion of intrinsic value. These can be combined as "predictions of future cash flows/profits (fundamental)", together with "what will the market pay for these profits?" These can be seen as "supply and demand" sides – what underlies the supply (of stock), and what drives the (market) demand for stock?
11
Fundamental criteria (fair value)
The most theoretically sound stock valuation method, called income valuation or the discounted cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposal. The discounted rate normally includes a risk premium which is commonly based on the capital asset pricing model.
Definition of 'Gordon Growth 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.
Where: D = Expected dividend per share one year from now k = Required rate of return for equity investor G = Growth rate in dividends (in perpetuity)
Definition of 'Modigliani-Miller Theorem - M&M'
A financial theory stating that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. Remember, a firm can choose between three methods of financing: issuing shares, borrowing or spending profits (as opposed to dispersing them to shareholders in dividends). The theorem gets much more complicated, but the basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity.
12
Definition of 'Capital Asset Pricing Model - CAPM'
A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). Before coming out with the formula which can give us CMP OF ANY STOCK, we have to discuss what can be the inputs or variables which can give us the right CMP OF any stock. The variables which are being taken to develop a formula are: 1. EPS of a company for the last financial year 2. DIVIDEND PAYOUT RATIO (%) 3. EPS GROWTH RATE ESTIMATION (%) for one year forward 4. BETA of a company 5. RISK FREE RATE IN THE COUNTRY 6. Companies INDUSTRY GROWTH RATE (%)
13
7. DEBT/EQUITY RATIO 8. TAX RATE 9. RATE OF INTEREST ON DEBT EPS of a company for the last financial year: EPS of the company is nothing but earning per share which means the amount company is earning for its one share, after having deducted expenditures, finance cost, depreciation & tax from sales OR simply it is calculated as PROFIT AFTER TAX (PAT)/NO OF SHARES. IT IS TAKEN AS the main component because any investor investing in the equity of the company looks for EPS as it represents the amount it can earn per one share which should also give him return on equity i.e. (ROE) which ultimate investors look for i.e. RETURNS
DIVIDEND PAYOUT RATIO (%): in simper terms it is DIVIDEND PAID TO ORDINARY SHARES/EPS.
the ultimate decision to invest in equities is to fetch dividend which the investors can invest or spend for their livelihood & therefore the companies paying high dividends are generally traded at higher PE in stock market as compared to their peers which gives low or zero dividend despite both the companies having same EPS. EPS GROWTH RATE ESTIMATION (%) for one year forward: assuming the market to be EFFICIENT MARKET HYPOTHESIS (EMH), the market will always factor in one year forward EPS as it is also predictable, hence we have to consider one year forward earnings estimates. Valuations rely very heavily on the expected growth rate of a company. One must look at the historical growth rate of both sales and income to get a feeling for the type of future growth expected. However, companies are constantly changing, as well as the economy, so solely using historical growth rates to predict the future is not an acceptable form of valuation. Instead, they are used as guidelines for what future growth could look like if similar circumstances are encountered by the company. Calculating the future growth rate requires personal investment research. This may take form in listening to the company's quarterly conference call or reading a press release or other company article that discusses the company's growth guidance. However, although companies are in the best position to forecast their own growth, they are
14
far from accurate, and unforeseen events could cause rapid changes in the economy and in the company's industry. BETA of a company: it simply represents the systematic risk to the investor by investing in particular companies as returns expected by any investor will depends upon the risk of that instrument. More the risk more will be the expected returns & vice versa RISK FREE RATE IN THE COUNTRY: this variable is also important as it will determine the expected returns from equities as investors will always expect more returns than risk free rate when investing in equities, as risk in equities is much higher & hence are not risk free. GOVT BOND YEILDS can be the best representative of risk free rate. Companies INDUSTRY GROWTH RATE (%): it represents the expected growth rate of the industry in which the company is operating its business. for e.g.: MARUTI SUZUKI’s industry is car manufacturing, HUL’s industry is FMCG. DEBT/EQUITY RATIO: it is calculated as consolidated debt/net worth of a company. This is also one of the important as the companies having higher debts trade at lower PE as compared to their peers despite same EPS, the reason for these is investors will always preferred companies with zero debt as it enables the company to pay higher dividend also the risk associated with investing in debt companies is at premium as compared to no debt companies thus high debt companies will always have low PE. The fact that Higher the debt of the company more the pressure on its earnings which will never be preferred by the equity Investors TAX RATE: the tax rates can’t be neglected as any increase in tax rates can lead to pressure on earnings thus affecting investors’ sentiment which would affect CMP OF a Company. RATE OF INTEREST ON DEBT: for the companies having debt, this variable is very important as higher the rate of debt, higher the finance cost of companies thus affecting their earnings which in turn affecting investors’ sentiment & CMP OF a company.
15
After having discussed the key variables which could help us to find right CMP OF a company, let us find how we can use these variables & find formula to find CMP. To start with let us look & analyze the famous valuation model i.e. GORDEN’S GROWTH MODEL & see whether we can use this formula to find CMP OF Company The GORDENS growth model is given by CMP= EPS+ dividend payout ratio/ (ke-g) where, Ke-cost of equity g- Estimated one year forward EPS Growth rate of company But the question arises how to arrive at ke i.e. cost of equity, the solution to this might be the CAPM MODEL, Because it will quantify the risk premium added to risk free rate as investing in equities is not risk free. Ke= RISK FREE RATE+RISK PREMIUM Ke= RFR+B (INDUSTRIAL PE-RFR) where B=BETA OF STOCK which represents systematic risk Industrial PE which will give the perception of industry in which the company is operating its business but WHAT creates current industrial Perception? The answer to this can be estimated industrial growth rate of that industry. Hence industrial PE can be calculated as Industrial PE= 10+exp (industrial growth rate (&)) Hence Ke = RFR+B (10+exp (industrial growth rate (&))-RFR) But simply applying Gordon model will not work since the answer we would be getting will be imperfect if,
16
For e.g.: 1. when the growth rate of a company is greater than cost of equity (Ke), the answer we would get is negative 2. Even when the growth rate of a company is equal to cost of equity (Ke), the answer we would get is infinite which is invalid, hence this formula will not work & thus we need to modify the Gordon’s formula to get standardized formula The modification would be CMP= (EPS+ dividend payout ratio)*(ke+ g) Hence by this modification we would solve above problems & also the result we would get will be more magnified as compared to conservative results earlier. Till now we have not considered debt of the company which plays a major role in determining CMP as no debt company will always have a higher PE compared to its peers. Also while calculating Ke using CAPM model, it doesn’t take into account the UNSYSTEMATIC RISK i.e. debt of the company but the question is how to take in account the debt while calculating Ke? The answer to this could be MM MODEL which states that Ke i.e. cost of equity will rise as equity investor will expect more returns from debt company as there is additional risk involved than no debt company, thus for debt company Ke will be Ked= ke of no debt company+ additional risk premium Additional risk premium= D/E (1-T) (ke of no debt company-Rd) where, D/E= debt/equity T=tax rate Rd= interest rate on debt Thus ked= ke + (debt/equity (1-T) (ke of no debt company-Rd)) but we need to modify formula as we want negative effect on final CMP FORMULA, which is
17
CMP= (EPS+ dividend payout ratio)*(ked+ g), where ked would be Ked= ke - (debt/equity (1-T) (ke of no debt company-Rd)) After having developed final formula let us discussed its limitations, The above formula is limitated to 1. Positive EPS 2. Positive Ked To give limitations in terms of variable, 1. EPS should be above 1 2. For g=0, D/E<=1.3 3. For g=positive, D/E<=1.4 4. For g=negative, D/E<=1: beta<=1 The existence of above limitations is due to fact that putting values of these variables above mentioned limits will give negative CMP which is distortion. Hence for variables beyond above limitations, we will be calculating Ked with the original formula i.e. CMP= (EPS+ dividend payout ratio)/ (ked- g), where ked would be Ked= ke + (debt/equity (1-T) (ke of no debt company-Rd))
18
OBSERVATIONS & FINDINGS:
To test this formula, we’ll be taking the sectors & its 2 stocks present in the Nifty The below table indicates the sector, stocks, actual CMP & calculated CMP
SECTOR STOCKS ACTUAL CMP ACTUAL CMP in CALCULATED 1 YR as on 27th FEB 2012 289.61 414.59 738.38 354.38
AS in RS as on RS as on 25th FEB FUTURE CMP in RS 27th FEB 2012 FMCG FMCG OIL & GAS OIL & GAS BANKING BANKING AUTO AUTO IT IT TWO WHEELERS TWO WHEELERS ITC HUL RELIANCE IND ONGC HDFC BANK ICICI BANK MARUTI SUZUKI M&M INFOSYS TCS BAJAJ AUTO HERO CORP STEEL STEEL CAPITAL GOODS CAPITAL GOODS POWER MINING/MINERALS MINING/MINERALS TATA STEEL JINDAL STEEL L&T BHEL NTPC COAL INDIA SESA GOA 442 582 1301 289 180 322 203 360 (455) 357 (198) 1401 (478) 207 (102) 149 (215) 325 (63.6) 161 (95) 236 281 1138 200 105 313 127 1255 695 2880 1250 1711 1444 (532.5) 894 (271) 2917 (546) 1471 (150) 2006 (209) 1703 (215) 1143 825 3298 1043 1967 1758 202 380 781 280 2013 (book value) 292 (24.5) 451.70 (17) 854.35 (507) 318.20 (161.5)
MOTOR 1935
? ?
The actual CMP as on 25 FEB 2013 The CONSOLIDATED EPS is of FY12 & ESTIMATED CONSOLIDATED EPS is of FY13
19
RESEARCH METHODOLOGY:
Type of research: Descriptive research. Source of data:
? Secondary Data: The source of secondary data would be various publications, journals, reports of the organizations involved and reports & journals of private bodies. Numerous websites on the topic ? The stocks selected are from nifty index such that they represent the sector & chosen on the basis of market capitalization i.e. stocks with highest market capitalization in nifty index & consequently have given highest priority & so on
INTERFERENCE & CONCLUSION:
20
Interference:
From the observation table, we can infer that actual CMP coincides with the calculated market prices however with subject to the limitations, which creates distortion between actual cmp & calculated CMP & hence we get calculated values near actual values & may not the exact values. The limitations may be 1. The EPS growth rate estimation of companies differ from investor to investor in & is never the same in the market 2. The industry growth rate estimation companies differ from investor to investor in & is never the same in the market 3. The beta values are historic & can change in future
Conclusion:
Thus we can conclude that EPS is the core variable behind the equity valuation & is reflected in current market prices (CMP) & not the book value as seen from the observations most of the current stock prices are trading above or below book value.
BIBLIOGRAPHY:
21
? www.Moneycontrol.com ? Economic times dated
23rd FEB 2013 25TH FEB 2013
? www.wikipedia/equityvaluation.com ? www.investopedia.com
22
doc_304121347.docx
-----------------------------------------------------------------------------------------UNDER THE GUIDANCE OF Prof SAMEER SALUNKE SUBMITTED BY REEPAN SHAH Roll no: 34 PGDM 2011-13 -----------------------------------------------------------------------------------------IN PARTIAL FULFILLMENT OF TWO YEAR FULL TIME POST GRADUATE DIPLOMA OF MANAGEMENT STUDIES
GURU NANAK INSTITUTE OF MANAGEMENT STUDIES MATUNGA, MUMBAI 400 019
1
PROJECT GUIDE CERTIFICATE FORM
This is to certify that the dissertation submitted in partial fulfillment of the requirement for the award of PGDM of the University of Mumbai is a result of the bonafide work carried out by Mr. REEPAN SHAH under my supervision and guidance no part of this report has been submitted for award of any other degree, diploma fellowship or other similar titles or prizes. The work has also not been published in any scientific journals/ magazines.
Date: Place:
Name: REEPAN SHAH Roll No.: 34
Name of the Guide:
Signature of (Project Guide)
Director’s Signature:
2
DECLARATION
I, Mr. Reepan Shah student of PGDM second year (4th semester) at Guru Nanak Institute of Management Studies, hereby declare that I have completed my project entitled “Research on Equity valuation of Nifty stocks” as final project for 4th semester for the academic year 2012-2013 under the guidance of Prof Sameer
Salunke. The data collected and work done by me is truly authentic and is not borrowed or copied from any dissertation report. The project contains true and complete information. Whenever references have been made to previous work of others, it has been clearly predicted as such and included in the Bibliography.
Certified by Signature of guide Sign of a candidate
Place: MUMBAI Date:
3
“Research on Equity valuation of Nifty stocks”
A PROJECT SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR POST GRADUATION IN FINANCIAL MANAGEMENT
2011 - 2013
Name of the Student: REEPAN SHAH
ROLL NO: 34
NAME OF THE INSTITUTE:
GURU NANAK INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH
4
PROJECT GUIDE CERTIFICATE FORM I REEPAN SHAH the undersigned Roll No. 34 studying in the Second Year of PGDM is doing my project work under guidance of Ms. SAMEER SALUNKE wish to state that I have met my internal guide on the following dates mentioned below for Project Guidance:-
Sr. No. Date
Signature of the Internal Guide
____________________________ Signature of the Candidate
__________________________ Signature of Internal Guide
5
INDEX
SR. NO
PARTICULARS
PG. NO
3
RATIONALE OF STUDY
1
4
OBJECTIVE OF STUDY
2
5
LITERATURE REVIEW
3
6
OBSERVATIONS AND FINDINGS
13
7
RESEARCH METHODOLOGY
15
8
INTERFERENCE AND CONCLUSIONS
16
9
BIBLIOGRAPHY
17
6
RATIONAL OF THE STUDY:
Research shows that only 1% of Indian population invest in equities despite the fact that equities can give returns of more than 20%pa.there are several reasons for it but one of the main reasons in lack of knowledge about investing in equities, more specifically lack of valuation skills of equities. If we can strike right valuation of equity of any company at any given time, then the risk of investing in equities can be reduced as well as returns we can get can be maximum as compared to any other investment products, in return will also promote retail participation in equity instruments in India, which is crucial to the growth of the economy The project will also help understand: 1. Role of various factors and financial ratios in driving current market price of equities. 2. The important factor and key financial ratio in driving current market price of equities for specific sector which varies from sectors.
7
OBJECTIVE OF THE STUDY:
Current market price (CMP) is the reflection of investor’s perception of any particular stock at any given time.in quantifiable terms, investors perception is nothing but price/earnings (PE) of any stock. The fact that there are several companies which belong to same industry & have same EPS, but their share price are trading at different PE. Hence this research project objective is to understand the reason for companies having different PE of their share price despite same EPS & develop a formula which can give you perhaps what can be the right valuation or in other words the right perception (PE) of any stock at any given time (i.e. CMP), which in turn will help to categorize the stock valuation into overvalued, undervalued or fairly valued?
The research also intends to prove that the book value play least role in valuations of stocks & hence doesn’t reflect in CMP at any point of time until unless the company intends to close & liquidate.
8
LITERATURE REVIEW:
Price Earnings to Growth (PEG) Ratio. This valuation technique has really become popular over the past decade or so. It is better than just looking at a P/E because it takes three factors into account; the price, earnings, and earnings growth rates. To compute the PEG ratio, divide the Forward P/E by the expected earnings growth rate (you can also use historical P/E and historical growth rate to see where it's traded in the past). This will yield a ratio that is usually expressed as a percentage. The theory goes that as the percentage rises over 100% the stock becomes more and more overvalued, and as the PEG ratio falls below 100% the stock becomes more and more undervalued. The theory is based on a belief that P/E ratios should approximate the longterm growth rate of a company's earnings. Whether or not this is true will never be proven and the theory is therefore just a rule of thumb to use in the overall valuation process. Here's an example of how to use the PEG ratio. Say you are comparing two stocks that you are thinking about buying. Stock A is trading at a forward P/E of 15 and expected to grow at 20%. Stock B is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A is 75% (15/20) and for Stock B is 120% (30/25). According to the PEG ratio, Stock A is a better purchase because it has a lower PEG ratio, or in other words, you can purchase its future earnings growth for a lower relative price than that of Stock B.
Sum of Perpetuities Method The PEG ratio is a special case in the Sum of Perpetuities Method (SPM) [3] equation. A generalized version of the Walter model (1956), SPM considers the effects of dividends, earnings growth, as well as the risk profile of a firm on a stock's value.
9
Derived from the compound interest formula using the present value of a perpetuity equation, SPM is an alternative to the Gordon Growth Model. The variables are:
? ? ? ? ?
is the value of the stock or business is a company's earnings is the company's constant growth rate is the company's risk adjusted discount rate is the company's dividend payment
In a special case where reduces to the PEG ratio.
is equal to 10%, and the company does not pay dividends, SPM
10
THEORY:
Introduction
An equity investment generally refers to the buying and holding of shares of stock on a stock market by individuals and firms in anticipation of income from dividends and capital gains, as the value of the stock rises. Typically equity holders receive voting rights, meaning that they can vote on candidates for the board of directors (shown on a proxy statement received by the investor) as well as certain major transactions, and residual rights, meaning that they share the company's profits, as well as recover some of the company's assets in the event that it folds, although they generally have the lowest priority in recovering their investment. It may also refer to the acquisition of equity (ownership) participation in a private (unlisted) company or a startup company. When the investment is in infant companies, it is referred to as venture capital investing and is generally regarded as a higher risk than investment in listed goingconcern situations. in financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall. In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of their intrinsic value of the stock, based on predictions of the future cash flows and profitability of the business. Fundamental analysis may be replaced or augmented by market criteria – what the market will pay for the stock, without any necessary notion of intrinsic value. These can be combined as "predictions of future cash flows/profits (fundamental)", together with "what will the market pay for these profits?" These can be seen as "supply and demand" sides – what underlies the supply (of stock), and what drives the (market) demand for stock?
11
Fundamental criteria (fair value)
The most theoretically sound stock valuation method, called income valuation or the discounted cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposal. The discounted rate normally includes a risk premium which is commonly based on the capital asset pricing model.
Definition of 'Gordon Growth 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.
Where: D = Expected dividend per share one year from now k = Required rate of return for equity investor G = Growth rate in dividends (in perpetuity)
Definition of 'Modigliani-Miller Theorem - M&M'
A financial theory stating that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. Remember, a firm can choose between three methods of financing: issuing shares, borrowing or spending profits (as opposed to dispersing them to shareholders in dividends). The theorem gets much more complicated, but the basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity.
12
Definition of 'Capital Asset Pricing Model - CAPM'
A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). Before coming out with the formula which can give us CMP OF ANY STOCK, we have to discuss what can be the inputs or variables which can give us the right CMP OF any stock. The variables which are being taken to develop a formula are: 1. EPS of a company for the last financial year 2. DIVIDEND PAYOUT RATIO (%) 3. EPS GROWTH RATE ESTIMATION (%) for one year forward 4. BETA of a company 5. RISK FREE RATE IN THE COUNTRY 6. Companies INDUSTRY GROWTH RATE (%)
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7. DEBT/EQUITY RATIO 8. TAX RATE 9. RATE OF INTEREST ON DEBT EPS of a company for the last financial year: EPS of the company is nothing but earning per share which means the amount company is earning for its one share, after having deducted expenditures, finance cost, depreciation & tax from sales OR simply it is calculated as PROFIT AFTER TAX (PAT)/NO OF SHARES. IT IS TAKEN AS the main component because any investor investing in the equity of the company looks for EPS as it represents the amount it can earn per one share which should also give him return on equity i.e. (ROE) which ultimate investors look for i.e. RETURNS
DIVIDEND PAYOUT RATIO (%): in simper terms it is DIVIDEND PAID TO ORDINARY SHARES/EPS.
the ultimate decision to invest in equities is to fetch dividend which the investors can invest or spend for their livelihood & therefore the companies paying high dividends are generally traded at higher PE in stock market as compared to their peers which gives low or zero dividend despite both the companies having same EPS. EPS GROWTH RATE ESTIMATION (%) for one year forward: assuming the market to be EFFICIENT MARKET HYPOTHESIS (EMH), the market will always factor in one year forward EPS as it is also predictable, hence we have to consider one year forward earnings estimates. Valuations rely very heavily on the expected growth rate of a company. One must look at the historical growth rate of both sales and income to get a feeling for the type of future growth expected. However, companies are constantly changing, as well as the economy, so solely using historical growth rates to predict the future is not an acceptable form of valuation. Instead, they are used as guidelines for what future growth could look like if similar circumstances are encountered by the company. Calculating the future growth rate requires personal investment research. This may take form in listening to the company's quarterly conference call or reading a press release or other company article that discusses the company's growth guidance. However, although companies are in the best position to forecast their own growth, they are
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far from accurate, and unforeseen events could cause rapid changes in the economy and in the company's industry. BETA of a company: it simply represents the systematic risk to the investor by investing in particular companies as returns expected by any investor will depends upon the risk of that instrument. More the risk more will be the expected returns & vice versa RISK FREE RATE IN THE COUNTRY: this variable is also important as it will determine the expected returns from equities as investors will always expect more returns than risk free rate when investing in equities, as risk in equities is much higher & hence are not risk free. GOVT BOND YEILDS can be the best representative of risk free rate. Companies INDUSTRY GROWTH RATE (%): it represents the expected growth rate of the industry in which the company is operating its business. for e.g.: MARUTI SUZUKI’s industry is car manufacturing, HUL’s industry is FMCG. DEBT/EQUITY RATIO: it is calculated as consolidated debt/net worth of a company. This is also one of the important as the companies having higher debts trade at lower PE as compared to their peers despite same EPS, the reason for these is investors will always preferred companies with zero debt as it enables the company to pay higher dividend also the risk associated with investing in debt companies is at premium as compared to no debt companies thus high debt companies will always have low PE. The fact that Higher the debt of the company more the pressure on its earnings which will never be preferred by the equity Investors TAX RATE: the tax rates can’t be neglected as any increase in tax rates can lead to pressure on earnings thus affecting investors’ sentiment which would affect CMP OF a Company. RATE OF INTEREST ON DEBT: for the companies having debt, this variable is very important as higher the rate of debt, higher the finance cost of companies thus affecting their earnings which in turn affecting investors’ sentiment & CMP OF a company.
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After having discussed the key variables which could help us to find right CMP OF a company, let us find how we can use these variables & find formula to find CMP. To start with let us look & analyze the famous valuation model i.e. GORDEN’S GROWTH MODEL & see whether we can use this formula to find CMP OF Company The GORDENS growth model is given by CMP= EPS+ dividend payout ratio/ (ke-g) where, Ke-cost of equity g- Estimated one year forward EPS Growth rate of company But the question arises how to arrive at ke i.e. cost of equity, the solution to this might be the CAPM MODEL, Because it will quantify the risk premium added to risk free rate as investing in equities is not risk free. Ke= RISK FREE RATE+RISK PREMIUM Ke= RFR+B (INDUSTRIAL PE-RFR) where B=BETA OF STOCK which represents systematic risk Industrial PE which will give the perception of industry in which the company is operating its business but WHAT creates current industrial Perception? The answer to this can be estimated industrial growth rate of that industry. Hence industrial PE can be calculated as Industrial PE= 10+exp (industrial growth rate (&)) Hence Ke = RFR+B (10+exp (industrial growth rate (&))-RFR) But simply applying Gordon model will not work since the answer we would be getting will be imperfect if,
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For e.g.: 1. when the growth rate of a company is greater than cost of equity (Ke), the answer we would get is negative 2. Even when the growth rate of a company is equal to cost of equity (Ke), the answer we would get is infinite which is invalid, hence this formula will not work & thus we need to modify the Gordon’s formula to get standardized formula The modification would be CMP= (EPS+ dividend payout ratio)*(ke+ g) Hence by this modification we would solve above problems & also the result we would get will be more magnified as compared to conservative results earlier. Till now we have not considered debt of the company which plays a major role in determining CMP as no debt company will always have a higher PE compared to its peers. Also while calculating Ke using CAPM model, it doesn’t take into account the UNSYSTEMATIC RISK i.e. debt of the company but the question is how to take in account the debt while calculating Ke? The answer to this could be MM MODEL which states that Ke i.e. cost of equity will rise as equity investor will expect more returns from debt company as there is additional risk involved than no debt company, thus for debt company Ke will be Ked= ke of no debt company+ additional risk premium Additional risk premium= D/E (1-T) (ke of no debt company-Rd) where, D/E= debt/equity T=tax rate Rd= interest rate on debt Thus ked= ke + (debt/equity (1-T) (ke of no debt company-Rd)) but we need to modify formula as we want negative effect on final CMP FORMULA, which is
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CMP= (EPS+ dividend payout ratio)*(ked+ g), where ked would be Ked= ke - (debt/equity (1-T) (ke of no debt company-Rd)) After having developed final formula let us discussed its limitations, The above formula is limitated to 1. Positive EPS 2. Positive Ked To give limitations in terms of variable, 1. EPS should be above 1 2. For g=0, D/E<=1.3 3. For g=positive, D/E<=1.4 4. For g=negative, D/E<=1: beta<=1 The existence of above limitations is due to fact that putting values of these variables above mentioned limits will give negative CMP which is distortion. Hence for variables beyond above limitations, we will be calculating Ked with the original formula i.e. CMP= (EPS+ dividend payout ratio)/ (ked- g), where ked would be Ked= ke + (debt/equity (1-T) (ke of no debt company-Rd))
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OBSERVATIONS & FINDINGS:
To test this formula, we’ll be taking the sectors & its 2 stocks present in the Nifty The below table indicates the sector, stocks, actual CMP & calculated CMP
SECTOR STOCKS ACTUAL CMP ACTUAL CMP in CALCULATED 1 YR as on 27th FEB 2012 289.61 414.59 738.38 354.38
AS in RS as on RS as on 25th FEB FUTURE CMP in RS 27th FEB 2012 FMCG FMCG OIL & GAS OIL & GAS BANKING BANKING AUTO AUTO IT IT TWO WHEELERS TWO WHEELERS ITC HUL RELIANCE IND ONGC HDFC BANK ICICI BANK MARUTI SUZUKI M&M INFOSYS TCS BAJAJ AUTO HERO CORP STEEL STEEL CAPITAL GOODS CAPITAL GOODS POWER MINING/MINERALS MINING/MINERALS TATA STEEL JINDAL STEEL L&T BHEL NTPC COAL INDIA SESA GOA 442 582 1301 289 180 322 203 360 (455) 357 (198) 1401 (478) 207 (102) 149 (215) 325 (63.6) 161 (95) 236 281 1138 200 105 313 127 1255 695 2880 1250 1711 1444 (532.5) 894 (271) 2917 (546) 1471 (150) 2006 (209) 1703 (215) 1143 825 3298 1043 1967 1758 202 380 781 280 2013 (book value) 292 (24.5) 451.70 (17) 854.35 (507) 318.20 (161.5)
MOTOR 1935
? ?
The actual CMP as on 25 FEB 2013 The CONSOLIDATED EPS is of FY12 & ESTIMATED CONSOLIDATED EPS is of FY13
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RESEARCH METHODOLOGY:
Type of research: Descriptive research. Source of data:
? Secondary Data: The source of secondary data would be various publications, journals, reports of the organizations involved and reports & journals of private bodies. Numerous websites on the topic ? The stocks selected are from nifty index such that they represent the sector & chosen on the basis of market capitalization i.e. stocks with highest market capitalization in nifty index & consequently have given highest priority & so on
INTERFERENCE & CONCLUSION:
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Interference:
From the observation table, we can infer that actual CMP coincides with the calculated market prices however with subject to the limitations, which creates distortion between actual cmp & calculated CMP & hence we get calculated values near actual values & may not the exact values. The limitations may be 1. The EPS growth rate estimation of companies differ from investor to investor in & is never the same in the market 2. The industry growth rate estimation companies differ from investor to investor in & is never the same in the market 3. The beta values are historic & can change in future
Conclusion:
Thus we can conclude that EPS is the core variable behind the equity valuation & is reflected in current market prices (CMP) & not the book value as seen from the observations most of the current stock prices are trading above or below book value.
BIBLIOGRAPHY:
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? www.Moneycontrol.com ? Economic times dated
23rd FEB 2013 25TH FEB 2013
? www.wikipedia/equityvaluation.com ? www.investopedia.com
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