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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:
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:
Estimate the expected earnings per share:
Assess how the underlying company has performed in the past, how it is doing at present how it is likely expected to perform in the future. This leads the investment analyst to estimate the future expected earnings per share (EPS) of the stock under study. The reader must understand that this EPS is an educated guess about the future earning capacity and profit generating ability of the company.
A good estimate would be based on a careful projection of the revenues and costs; starting a few from a few years in the past up to the present and then projecting it into the future. We shall explain this through an example.
The estimate of the projected earnings per share (EPS) is based on a number of assumptions about revenue and costs behaviour. Thus, the reliability of the earnings per share forecast critically depends on how realistic these assumptions are.
In addition to the earnings per share, the cash flow per share is also estimated:
Cash flow per share = (Profit after tax + Depreciation + Other non-cash charges) / Number of equity shares.
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:
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
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.
The weighted price-earning ratio:
We have arrived at two price-earning ratio estimates above; namely:
Now, we can combine these two estimates by taking a simple arithmetic average; that is giving equal weightage to both the estimates.
Develop a value anchor and value range:
The value anchor is obtained as follows:
Value anchor = Projected EPS X Appropriate P/E ratio
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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