Portfolio Management

Prepared By: Noorulhadi Qureshi

Lecturer Govt College of Management Sciences Peshawar

LECTURE SIX

Share Valuation

Share Valuation• The Fundamental analysis and investment

decision is to buy or sell a share is based on comparison between the intrinsic value of a share than its market price.

• If Market price < intrinsic value : Purchase the share– (Under Price Consideration)

• If Market Price > intrinsic value : sell the share– (Over Price Consideration)

What is Value?In general, the value of an asset is the price that

a willing and able buyer pays to a willing and able seller

There are several types of value, of which we are concerned with three:Book Value - The asset’s historical cost less its

accumulated depreciationMarket Value - The price of an asset as determined

in a competitive marketplace Intrinsic Value - The present value of the expected

future cash flows discounted at the decision maker’s required rate of return

Concept of Present Value • Time Value of Money

(TVM) concept that a rupee received now is worth more than a rupee to be receive after one years, TVM suggests that earlier receipts is more desirable than later receipt, because it can be reinvested to generate additional return..

nkF)1(

PV

• F is the amount to be received after n period• N is the number of years • K is the discount rate• PV is the present value• For example if Rs.500 would received after 2

years and discount rate is 10% the PV can be calculated: P= 500/(1.10)2

• =413.22

nkF)1(

PV

Common Stocks• A share of common stock represents an

ownership position in the firm. Typically, the owners are entitled to vote on important matters regarding the firm, to vote on the membership of the board of directors, and (often) to receive dividends.

• In the event of liquidation of the firm, the common shareholders will receive a pro-rata share of the assets remaining after the creditors and preferred stockholders have been paid off.

Preferred Stock

• Preferred stock represents an ownership claim on the firm that is superior to common stock in the event of liquidation. Typically, preferred stock pays a fixed dividend periodically and the preferred stockholders are usually not entitled to vote as are the common shareholders.

Share Valuation Model

• The valuation model used to estimate the intrinsic value of a share is the present value model.

• The intrinsic value of a share is the present value of future amount to be received in form dividend and resale of share.

One Year holding period

• Investors intends to purchase a share and hold it for one year and sell it at the end of year. Investor expects to receive dividend and resale price of share.

1)1(1)1( kS

kD

So

• D is the amount of dividend• So is the Present value• K is the discount rate /required rate of

return• S is the selling price after one year

1)1(1)1( kS

kD

So

For example, if an investor expects to get Rs. 3.5 as dividend from a share next year and sell at Rs. 45, if required rate of return is 25% the present value will be

1)1(1)1( kS

kD

So

1)25.1(45

1)25.1(5.3

So

80.38368.2 So

Multiple-Year holding period• Investors intends to purchase a share and hold

it for more than one year and sell it at the end of that period. Investor expects to receive annual dividends and resale price of share.

nkSnDn

kD

kD

)1(....2)1(1)1(

21

So

• D is the dividend of each years• S the sale price at end of holding period• K is the required rate of return• n is number of holding periods.

For example investor expects to get Rs.3.5, Rs. 4 and Rs. 4.50 as dividends for 1st three years and sell at Rs. 75. the required rate is 25%, what is the present value.

nkSnDn

kD

kD

)1(....2)1(1)1(

21

So

3)25.1(75

)25.1(

50.4

)25.1(

00.4

)25.1(

5.3

321 So

06.46So

Constant Growth Model

gkgDo

So

)1(

In this model the dividend will grow at constant rate g into indefinite. This model shows the intrinsic value of a share is equal to next year’s expected dividend divided by th difference between the appropriate discount rate for the stock and its expected dividend growth rate.

The constant growth model is also known as Gordon’s share valuation model, named after the model’s originator, Myron J. Gordon.

55.RsSo

Constant Growth Model

gkgDo

So

)1(

A company has declared a dividend of Rs. 2.50 per share for the current year. The company has been following a policy of enhancing its dividends by 10% every year and is expected to continue this policy in the future also. An investor who is considering the purchase of the shares of this company has required rate of return of 15%. The intrinsic value of the company’s share can be calculated as

10.015.0)10.1(5.2

So

The investor should purchase if the current market price is lower than Rs. 55.

Multiple Growth Model• In many cases the constant growth rate may not be

realistic. In MGM the future time period is viewed as divisible into two different growth segments. Different variation growth and constant growth. i.e.

• So = value with different rate + value with constant rate

• So= V1+ V2

tKDt

V

nkDn

kD

kD

V

)1(1

)1(.....

2)1(2

1)1(1

1nkgk

gDnV

)1)(()1(

2

))1)(()1(

())1(

(

21

nkgkgDn

tKDt

So

vvSo

Multiple Growth ModelConsider a company paid a dividend of Rs. 2 per share next

year. And pay dividend of Rs. 3 and 3.5 in next consecutive years. After that an annual constant growth at 10% is expected to indefinite time. If the required rate of return is 20 %, what is the intrinsic value

06.2828.2278.5

2128.22

3)2.1)(10.020.0)1.1(50.3

2

787.53)2.1(

50.32)2.1(

31)2.1(

21

SoSo

VVSoRs

V

Rs

V

The investor should purchase if the current market price is lower than Rs. 28.06.