Chapter 7: Common Stock Analysis and Valuation

Very Short Answer Question

1. What is economic analysis?

Economic analysis is the process of studying general state of economy to assess economic movements in country and their impact on stock price. In the process of economic analysis, we study the pattern of movement in macroeconomic variables to forecast how they affect specific industry and company.

2. What are the major variables used in stock valuation?

 Variables used in stock valuation depend on the approaches used in stock valuation. The basic approach to stock valuation is the dividend discount model. According to this approach, major variables used is stock valuation consists of expected dividend, expected growth rate in company’s earnings and dividends and the stockholder’s required rate of return consistent to the risk level.

3. A company’s common stock has price-earnings ratio of 12 times. If its per share earning is Rs 15, what is its stock price?

SOLUTION

Given:

Price-earrings ratio (PE) = 12 times

 Earnings per share (EPS) = Rs 15

The stock price is given by:

Stock price = PE x EPS = 12 x Rs 15 = Rs 180

4. Over the past 6 years of period dividend per share on ABC stock increased from Rs 10 per share to Rs 16 per share. What is the annual growth rate on dividend?

SOLUTION

Dividend per share before six year (Do) = Rs 10

Dividend per share at present (D6) = Rs 16

 The annual growth rate in dividend is given by:

Do = Do (1 + g) ^6

Rs 16 = Rs 10 (1 +g) ^6

(1 + g) ^6 = 1.6

= 0.0815 or 8.15%

5. A company’s stock is expected to pay a dividend of Rs 5 per share. Its annual growth rate of dividend is constant at 6 percent. If stockholders required rate of return is 18 percent, what is the value per share of common stock?

SOLUTION

Given:

Expected dividend per share (D₁)= Rs 5

 Annual growth rate in dividend (g) = 0.06

Stockholders’ required rate of return (ks) =0.18

The value per share of common stock is given by: D₁ Rs 5

Po = D₁ / k_s – g = rs 41.67

Short Question Answer

1. What is technical analysis? What are its limitations?

Technical analysis is a method of security analysis. This method of security analysis is based on the assumption that past market trends can predict the future behavior for the market as a whole and for individual stocks. One basic principal of technical analysis is that stock prices reflect all relevant information and, thus, it is important to understand what investors think of known and perceived information rather than to rely on other economic fundamentals. In this method, past prices of stocks are examined first to identify the most recurring patterns in price movements. Then, most recent stock prices are also analyze to identify emerging trends that are similar to the past ones. The matching of emerging trends with past one is done in the belief that trends in price movements will repeat themselves. The major limitations of technical analysis are as follows:

Several indicators used in technical analysis may give mixed signals. One of the technical indicators may show a buy signal while another may show a sell signal.

The forecasting accuracy under technical analysis may not be perfect. For example, when a possible entry or exit point for a stock is suggested, it does not guarantee a successful trade. One technical analyst’s opinion may contradict another analyst’s opinion for the same stock.

2. What are the reasons for financial analysis?

Financial analysis is the process of examining financial strengths and weaknesses associated with a firm or security issuer. Basically there are two primary reasons why financial analysis is undertaken. They are as follows:

• To examine the issue and issuer characteristics: There are certain features associated with the type of securities and the security issuers. These features include the cash flow pattern, dividend and interest yield, future earnings prospects, financial conditions of the issuer and so on. These factors affect the risk level of investing in securities. Therefore, one reason for financial analysis is to examine the issue and issuer characteristics.
• To identify the mis-priced securities: Another reason for financial analysis is to identify the mis-priced securities. Mis-priced securities are those which are either under-valued or over-valued. In the process of financial analysis, we examine a number of individual securities or a group of securities within broad categories of financial assets to identify thosè securities that are currently mis-priced. A rational investor finds ample scope of profit by trading. on mis-priced securities and thereby restoring the securities’ price into equilibrium.

3. What is technical analysis? Why technical analysis is needed for investing in securities?

Technical analysis is a method of security analysis. This method of security analysis is based on the assumption that past market trends can predict the future behavior for the market as a whole and for individual stocks. One basic principal of technical analysis is that stock prices reflect all relevant information and, thus, it is important to understand what investors think of known and perceived information rather than to rely on other economic fundamentals. In this method, past prices of stocks are examined first to identify the most recurring patterns in price movements. Then, most recent stock prices are also analyzed to identify emerging trends that are similar to the past ones. The matching of emerging trends with past one is done in the belief that trends in price movements will repeat themselves.

 The technical analysis is needed for investing in securities primarily due to the following reasons:

• Reflection to stock price: The stock price is a reflection of all fundamental news in the market. Technical analysis helps in identifying the crowd market psychology using the patterns of security price movement to make informed investment decision.
• Identification of trend: Technical analysis is useful to identify the direction of stock market trend. The stock market may be in up-trend or down-trend. The direction of stock market trend is important in buy-sell decision.
• Entry and exit recommendation: Technical analysis is able to recommend entry or exit strategy for short-term and long-term trading. By using combinations of trend indicators, patterns, volume, and moving averages under technical analysis, the investors can determine the entry and exit point.

4. Ganga Lal Company is a little known producer of heart pace makers. The earnings and dividend growth prospects of the company are disputed by analysis. Sachin is forecasting 5 percent growth in dividends indefinitely. However, Binayak is predicting a 20 percent growth in dividends, but only for the next three years, after which the growth rate is expected to decline to 4 percent for the indefinite future. Ganga Lal dividend per share is currently Rs 3. Stocks with similar risk are currently priced to provide a 14 percent expected return.

1. What is the value of Ganga Lal stock according to Sachin?
2. What is the value of Ganga Lal stock according to Binayak?
3. Assume that Ganga Lal stock now sells for Rs 39.25 per share. If the stock is fairly priced at present time, what is the implied perpetual dividend growth rate?

SOLUTION

Given:

5. Annapurna Trek Pvt. Ltd. had been undergoing growth for the last three years. The current dividend of Rs 3 per share is expected to grow at a rapid rate of 20 percent per year for next three years. After that time Annapurna is expected to grow at a moderate rate of 6 percent a year for the indefinite future. Because of the risk involved in such rapid growth, the required rate of return is 22 percent. Calculate the implied price for the Annapurna’s stock

7. Current dividend per share on a common stock is Rs 40 and required rate of return is 20%, (1) Find the intrinsic value of the stock under the assumption of zero growth rate (2) If dividend grows at 10%, what will be the intrinsic value of stock? (3) Would you sell the stock if it is selling at Rs 500 based on intrinsic value of (2)?

SOLUTION

Given:

Current dividend (Do) = Rs 401

Required rate of return (ks) = 20%

The intrinsic value of the stock (Po) if growth rate (g) is 0:

P = Do / ks = Rs. 40 / 0.20  = Rs 200

The intrinsic value of the stock (Po) if growth rate (g) is 10 percent:

Po =  Do (1+g) /  ks – g = Rs 40(1 + 0.1) /  0.20 -0.10

= Rs 440

If the stock is selling at a price of Rs 500 we would prefer to sell the stock because its market price is higher than the intrinsic value calculated in part (2).

8. The dividend per share for Annapurna Finance Company is Rs 12 in 1985 and it increased to Rs 22 in 1990. The required rate of return on the stock is 15%. Dividend will continue to grow at the same rate as they did over the period of 1985 1990.

1. Calculate the intrinsic value of stock.
2. If company’s target dividend payout ratio (DPR) is 20%, what is the current price of a share based on price earning ratio? All other information is same.

9. You are analyzing the common stock of Mountain Air Ltd. for investment purpose. It is estimated that Mountain Air Ltd. will pay a dividend on its stock of Rs6 per share this year. The following year, the dividend is expected to be the same, increasing to Rs7 the year after. From that point on, the dividend is expected to grow at 4% per year indefinitely. Stocks of other airlines with similar risk are currently priced to provide a 10% expected return. Based on the intrinsic value of the stock, would you invest on the stocks of Mountain Air if they are selling at Rs 100 each in the market?

SOLUTION

Given:

10 Assume that a preferred stock is currently priced to provide a 12 percent required rate of return and pays a Rs 6 dividend.

1. Calculate the intrinsic value of the stock.
2. Assume that the required rate of return declines to 11 percent. Calculate the new intrinsic value for the stock.
3. Calculate the holding period return, assuming that you purchased the preferred stock when it was priced to provide a 12 percent required rate of return and sold when the required rate of return reached 11 percent. Also assume that you held the stock long enough to receive an annual dividend.

SOLUTION

Given:

Long Question Answer

1. Why is it important to analyze securities before investing into them?Discuss the methods used for analyzing the stocks.

Financial analysis is the process of examining financial strengths and weaknesses associated with a firm or security issuer. Basically there are two primary reasons why financial analysis is undertaken. They are as follows:

• To examine the issue and issuer characteristics: There are certain features associated with the type of securities and the security issuers. These features include the cash flow pattern, dividend and interest yield, future earnings prospects, financial conditions of the issuer and so on. These factors affect the risk level of investing in securities. Therefore, one reason for financial analysis is to examine the issue and issuer characteristics.
• To identify the mispriced securities: Another reason for financial analysis is to identify the mispriced securities. Mispriced securities are those which are either under-valued or over-valued. In the process of financial analysis, we examine a number of individual securities or a group of securities within To broad categories of financial assets to identify those securities that are currently mis-priced. A rational investor finds ample scope of profit by trading on mispriced securities and thereby restoring the securities’ price into equilibrium.

There are two approaches to security analysis: technical analysis and fundamental analysis. We describe below in brief how security analyses are conducted under technical analysis and fundamental analysis.

Technical Analysis

 Technical analysis is a method of security analysis. This method of security analysis is based on the assumption that past market trends can predict the future behavior for the market as a whole and for individual stocks. The security analysts involved in technical analysis are called technical analysts or technicians. One basic principal of technical analysis is that stock prices reflect all relevant information and, thus, it is important to understand what investors think of known and perceived information rather than to rely on other economic fundamentals. The technical analysts use different charts and figures to identify the movement in securities prices. In this method, past prices of stocks are examined first to identify the most recurring patterns in price movements. Then, most recent stock prices are also analyzed to identify emerging trends that are similar to the past ones. The matching of emerging trends with past one is done in the belief that trends in price movements will repeat themselves.

Fundamental Analysis

 Fundamental analysis attempts to measure intrinsic value of securities by assessing fundamental qualitative and quantitative factors associated with broader economy, related industry and the companies issuing the securities. The security analysts involved in fundamental analysis are called fundamental analysts or fundamentalists. They believe that value of securities is affected by the financial performance and risk exposure of the company issuing the securities. So they use company’s overall revenues, earnings per share, dividend per share, future growth potential, return on equity, profit margin and other fundamental data from financial statements along with the qualitative factors such as quality of management, competitive strength, production and cost efficiency, etc for determining company’s underlying value and the value of its securities. Besides, they examine the underlying forces affecting economy and industry groups. They conduct economic analysis to assess the present status and future growth potential of overall economy. They conduct industry analysis to examine the demand and supply forces affecting the products and services offered. Finally, they combine the economic, industry and company specific analysis to provide an estimate of fair value of securities. The fair value of securities is compared against its current market price to identify the mispriced securities. Finally, the fundamental analysis recommends for buying undervalued securities and selling overvalued securities.

2. Why do investors need to make financial analysis? Briefly describe how technical analysts and fundamental analysts analyze securities.

Financial analysis is the process of examining financial strengths and weaknesses associated with a firm or security issuer. Basically there are two primary reasons why financial analysis is undertaken. They are as follows:

• To examine the issue and issuer characteristics: There are certain features associated with the type of securities and the security issuers. These features include the cash flow pattern, dividend and interest yield, future earnings prospects, financial conditions of the issuer and so on. These factors affect the risk level of investing in securities. Therefore, one reason for financial analysis is to examine the issue and issuer characteristics.
• To identify the mispriced securities: Another reason for financial analysis is to identify the mispriced securities. Mispriced securities are those which are either under-valued or over-valued. In the process of financial analysis, we examine a number of individual securities or a group of securities within To broad categories of financial assets to identify those securities that are currently mis-priced. A rational investor finds ample scope of profit by trading on mispriced securities and thereby restoring the securities’ price into equilibrium.

There are two approaches to security analysis: technical analysis and fundamental analysis. We describe below in brief how security analyses are conducted under technical analysis and fundamental analysis.

Technical Analysis: Technical analysis is a method of security analysis. This method of security analysis is based on the assumption that past market trends can predict the future behavior for the market as a whole and for individual stocks. The security analysts involved in technical analysis are called technical analysts or technicians. One basic principal of technical analysis is that stock prices reflect all relevant information and, thus, it is important to understand what investors think of known and perceived information rather than to rely on other economic fundamentals. The technical analysts use different charts and figures to identify the movement in securities prices. In this method, past prices of stocks are examined first to identify the most recurring patterns in price movements. Then, most recent stock prices are also analyzed to identify emerging trends that are similar to the past ones. The matching of emerging trends with past one is done in the belief that trends in price movements will repeat themselves.

Fundamental Analysis: Fundamental analysis attempts to measure intrinsic value of securities by assessing fundamental qualitative and quantitative factors associated with broader economy, related industry and the companies issuing the securities. The security analysts involved in fundamental analysis are called fundamental analysts or fundamentalists. They believe that value of securities is affected by the financial performance and risk exposure of the company issuing the securities. So they use company’s overall revenues, earnings per share, dividend per share, future growth potential, return on equity, profit margin and other fundamental data from financial statements along with the qualitative factors such as quality of management, competitive strength, production and cost efficiency, etc for determining company’s underlying value and the value of its securities. Besides, they examine the underlying forces affecting economy and industry groups. They conduct economic analysis to assess the present status and future growth potential of overall economy. They conduct industry analysis to examine the demand and supply forces affecting the products and services offered. Finally, they combine the economic, industry and company specific analysis to provide an estimate of fair value of securities. The fair value of securities is compared against its current market price to identify the mispriced securities. Finally, the fundamental analysis recommends for buying undervalued securities and selling overvalued securities.

3. Distinguish between technical and fundamental analysis? Explain why technical analysis is important in making investment decision.

 Technical and fundamental analyses represent two different approaches of security analysis. Therefore, these methods of security analysis contradict with each other. We can distinguish between these two methods as follows:

Technical Analysis	Fundamental Analysis
Technical analysis looks at the charts and figures to figure out the pattern of historical price movement of securities and to identify the most recurring trend that are consistent to the current trends.	Fundamental analysis relies on the fundamental factors such as overall revenues, earnings per share, dividend per share, future growth potential, return on equity, profit margin etc of the company.
Technical analysis believes that all fundamental factors are reflected in the market prices of securities.	Fundamental analysis believes that long-term performance of securities depend on the underlying prospects of the issuer, industry and economy as a whole.
Technical analysis does not examine the fair value of securities but look at the historical pattern of movement in securities prices to forecast the future prices.	Fundamental analysis is concerned with providing an estimate of fair value of securities and identifying the missed-priced securities.
Technical analysis can be of any time horizon ranging from few hours to years.	The time horizon of fundamental analysis is relatively longer.
Technical analysis is generally carried out for trade.	Fundamental analysis is generally carried out for investment.

Most investors tend to be either technicians or fundamental investors though many analysts believe that combining technical and fundamental analysis is the best way to evaluate entry and exit points. For example, some fundamental analysts use technical analysis to figure out the best time to enter into an undervalued security in the event that a security is oversold. On the other hand, technical analysts might look at fundamental factors to add strength to a technical signal while buying and selling stocks. For example, if a buy signal is given through technical analysis, a technical investor might look to confirm her/his decision by looking at some key fundamental data. The technical analysis is important for making securities investment decision primarily due to the following reasons:

• Reflection to stock price: The stock price is a reflection of all fundamental news in the market. Technical analysis helps in identifying the crowd market psychology using the patterns of security price movement to make informed investment decision.
• Identification of trend: Technical analysis is useful to identify the direction of stock market trend. The stock market may be in up-trend or down-trend. The direction of stock market trend is important in buy-sell decision..
• Entry and exit recommendation: Technical analysis is able to recommend entry or exit strategy for short-term and long-term trading. By using combinations of trend indicators, patterns, volume, and moving averages under technical analysis, the investors can determine the entry and exit point.

4. Assume that risk-free rate is currently 5 percent, which is expected remain at the same level for foreseeable future. The rate of return on average stock in the market is 15 percent. You are evaluating the prospects of investing in HPC stock which is currently paying Rs. 10 per share in dividend. The stock has a beta coefficient of 1. Your analysis has revealed that new production. system and aggressive marketing campaign launched by the company will boost up its earnings significantly. As a result, the dividend on this stock is expected to grow at 20 percent for the coming two years. After this period, the growth rate is expected to slow down to a normal level of 5 percent, indefinitely.

• What is the required rate of return on HPC stock?
• What is the expected dividend per share on HPC stock for next two years?
• At what price the stock is expected to sell at the end of year 2?
• What is the fair value of this stock today?
• If the stock is currently trading at Rs. 130 per share, would you prefer to buy the stock? Explain.

SOLUTION

Given