Valuation of shares

Estimating EPS-Growth rate

You know what EPS is. It’s earnings per share. EPS-GR stands for Earnings per share growth rate. This estimated growth rate is an important figure for valuing a company. When you compare the EPS history with the stock price history, it helps you determine the most likely future direction of the stock price.

  • Take note: In calculating a company’s earnings growth rate, you need to decide whether growth should continue at that same rate. Studying the firm, its products, and its competitive environment will help guide your decision to adjust the growth rate up or down.

Why is EPS-GR important?

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Concept 5: Cost of equity.

In concept 4, towards the end, I gave a hint on what cost of equity is all about. It is the rate of returns expected by an investor. A decision to invest is made only if the current market price of a share is consistent with its likely return.

What is it?

Cost of equity is the rate of return that an investor expects when he invests in a company. This rate of return   has two components-

  • Dividends expected from the investment and
  • Capital appreciation.

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Concept 4: Risk premium

We know that risk is the other side of return. When we invest money, our decision to invest in that asset is partly based on our estimate of the return it generates and the relative risk it carries. It’s a trade off. If you want more returns, you have to take more risks.

Risk may have different meanings. To investors, risk is the likelihood that the outcome of an investment is different from what was calculated.

One point to note here is that – the term risk is a combination of two parts- systemic risk and unsytemic risk.

  • Systemic risk is the risk beyond the control of any investor. For example – recession, war, inflation etc. It’s also called non diversifiable risk. Once the investor is in the market, he has to face it.

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Concept 3: Margin of Safety

‘As humans, we need to acknowledge the fact that all of us are flawed.’

In one of the previous article, I discussed about ‘intrinsic value’, an estimated figure which varies according to the investor’s perception about a company.

Margin of safety is a concept that accompanies the intrinsic value concept.

For example – An investor may find that stock ‘x’ is currently trading at Rs 130. The intrinsic value of stock ‘x’ is Rs 100 according to his calculations. The margin of safety he would like to maintain is 30%. So, if the price gradually drops to Rs 70, and if he finds nothing suspicious about it, he buys the stock. This allows him to make investments with moderate downside risk.

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