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ESTIMATION OF THE INTRINSIC VALUE OF A STOCK

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The procedure commonly used by investment analysts to estimate the intrinsic value of a stock traded in the stock market consists of the following steps: Estimate the expected earnings per share of the stock. Establish a price earning multiplier (or P/E ratio). Develop a value anchor and a value range. However, we consider it appropriate to advise you the investor at this stage itself, that there are three main obstacles in the way of successful  fundamental analysis. Namely: Inadequate and/or incorrect financial data pertaining to the stock under study. Future uncertainties. Irrational stock market behavior.

In the example above; the Cash flow per share  =  (75 + 34) / 15  =  INR 7.27

The reason for using cash flow per share is, that the depreciation charge is merely an accounting adjustment devoid of any real expenditure on the part of the company. We managed companies maintain plant and machinery in excellent condition through periodic repairs and overhauls. The related expenses are reflected in the manufacturing cost. Thus, we can ignore the book depreciation charges. However, this may not be valid for all companies, and we would have to look into the specific circumstances of a company to ascertain what adjustment would be appropriate.

Establishing a Price Earning ratio:

The price earning (P/E) ratio reflects the price investors are willing to pay per INR of earnings per share (EPS). It essentially reflects the market's summary valuation of a company's prospects. The price earning (P/E) ratio maybe derived from the:

• Constant growth dividend model;

• Cross-section analysis; or

• Historical analysis.

We shall now explain each of the above in greater detail:

• Constant growth dividend model:

In this model the price earning ratio is derived from the formula given below. And we shall explain the parts of the formula.

Price earning ratio  =  (Dividend payout ratio) / (Required return on equity  -  Expected growth rate in dividend)

Where,

Dividend payout ratio. Most companies are serious about their dividend commitments. Thus, once dividends are set at a certain level they are not reduced unless there is no alternative. Further, dividends are not increased unless it is clear and certain that a higher level of dividend can be sustained. By which we may conclude, that dividends adjust with a lag to earnings.

Keeping the above formula in view, if the dividend payout ratio increases, the numerator increases, which has a favorable effect on the price-earning  multiplier. However, this also has the effect of lowering the expected growth rate of dividends in the denominator, which has an effect of decreasing the price-earning multiplier. In most cases, these two effects are likely to balance out.

Required return on equity. Is a function of the risk-free rate of return and a risk premium. According to the Capital asset pricing model;

Required return on equity  =  Risk free return  +  (Beta of equity  X  Expected market risk premium)

Expected growth rate in dividend. The expected growth rate in dividend is calculated with the formula given below:

Expected growth rate in dividend  =  Retention ratio  X  Return on equity

For the example above, the dividend payout ratio, the required return on equity and the expected growth rate in dividends are developed for ABC Ltd.

The dividend payout ratio for 20X8 is set equal to the average dividend payout ratio for the period 20X5 - 20X7

=  (0.82 + 0.50 + 0.43) / 3  =  0.58

To get the required rate of return, the following assumptions have been made:

1. The risk free rate is 9%.

2. The beta of ABC Ltd is 1.1

3. The expected market risk premium is 7%.

Given these assumptions the required return on the equity stock of ABC Ltd is =  9 + 1.1(7)  =  16.7%.

The expected growth rate in dividends maybe set equal to the product of the average retention ratio and the average return on equity for the previous three years, 20X5 - 20X7. This works out to  =  0.417 X 18.2%  =  7.58%.

Using the above inputs the price-earning ratio for the stock of ABC Ltd works out to;

Price-earning ratio  =  0.58 / (0.167 - 0.0758)  =  6.36

• Cross section analysis:

In this analysis, we look at price earning (P/E) ratios of similar companies in the industry; and then take a view on what is a reasonable price earning ratio for the company under study.

You can also conduct a cross section regression analysis, where the price earning ratio is regressed on several fundamental variables. For instance, the following formula maybe applied:

Price-earning ratio  =  A1 + A2 Growth rate in earning + A2 Dividend payout ratio + A3 Variability of earning + A4 Company size

Based on the estimated coefficients of such cross section regression analysis, the price-earning ratio for the company under study maybe derived.

• Historical analysis:

We can look up the historical price-earning ratio of the company and take a view on a reasonable present day price-earning ratio; that is after taking into account the changes in the capital market and the evolving competition.

In the example given above; lets say the prospective price-earning ratio for ABC Ltd for the past 3 years was 9.25, 6.63 and 6.23. Then, the average price-earning ratio for the company would be (9.25 + 6.63 + 6.23) / 3  =  7.37.

Considering the changing conditions in the capital market and the evolving competition for ABC Ltd, we may say that the average price-earning ratio for the past three years is applicable in the immediate future also.

The weighted price-earning ratio:

We have arrived at two price-earning ratio estimates above; namely:

P/E ratio based on the constant growth dividend discount model  =  6.36

P/E ratio based on historical analysis  =  7.37

Now, we can combine these two estimates by taking a simple arithmetic average; that is giving equal weightage to both the estimates. So the weighted P/E ratio  =  (6.36 + 7.37) / 2  =  6.87.

Develop a value anchor and value range:

The value anchor is obtained as follows:

Value anchor  =  Projected EPS  X  Appropriate P/E ratio

In the example above of ABC Ltd, the projected EPS is INR 5.00 and the appropriate P/E ratio is 6.87.

Hence, the Value anchor for the stock of ABC Ltd  =  INR 5.00  X  6.87  =  INR 34.35

The investor would realize, that valuation of stocks is inherently an uncertain and imprecise exercise. It would not be reasonable to put great faith in a single point intrinsic value estimate.  Wisdom would call for an intrinsic value range around the single point estimate. For instance, in the above example where we have estimated an intrinsic value of INR 34.35; It would be sensible to talk in terms of an intrinsic value range from INR 30.00 to INR 38.00.

When we define a range, we are essentially saying that, "there maybe a bias and error in our estimate. In view of which, we feel that the value range is INR 30.00 to INR 38.00". Given this value range, our decision rule would be as follows:

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