Simple valuation method- II

This is an alternative to the valuation method we discussed in our earlier post. Let’s value an imaginary company which is trading at Rs. 33.50, Earnings Per share of Rs. 2.12 and an average 10 year dividend payout of 4.2%. You assume that the stock will be having the average P/E and dividend payout of the past, in the future 10 years also. The average P/E of 10 years is assumed to be 18.7. The expected annual return is 12%. You want to invest in this company with a target of 10 years.

CASH EPS GROWTH RATE

From the historical analysis, you estimate that the stock will continue to grow at 13 % per year for the next ten years. Instead of estimating normal EPS growth rate, you can use cash EPS.

  • Cash EPS = (Profit after tax + Depreciation + Other non-cash charges) / Number of equity shares. The logic behind cash earnings per share is, that the depreciation charge is merely an accounting adjustment devoid of any real expenditure on the part of the company
  • The advantage of using cash EPS is that it is a more realistic figure than normal earnings figure. The higher a company’s cash EPS, the better it is considered to have performed over the period. You need not calculate cash EPS separately since the data is available in most financial web sties.

Step 1: Forecast share price
First of all, you need to forecast its share price ten years down the road. In this case, we project the price for the next ten years using 13 per cent per year growth.

  • Stock price after 10 years = EPS after 10th year x Average P/E
  • (2.12 x 1.13 (10) )  x 18.7 = Rs 134.57

Step 2: Forecast Total Future Value.
Secondly, you need to calculate the total future value. If you believe that the company is a consistent high dividend payer, you can consider the potential dividend as well.

Dividend Payout = Total dividends / Total EPS

  • Year 0 - 2.12 x 1.00 = 2.12
  • Year 1 - 2.12 x 1.13 = 2.40
  • Year 2 - 2.40 x 1.13  = 2.71
  • Year 3 - 2.71 x 1.13 = 3.06
  • Year 4 - 3.06 x 1.13 = 3.46
  • Year 5 - 3.46 x 1.13  = 3.91
  • Year 6 - 3.91 x 1.13  = 4.41
  • Year 7 - 4.41 x 1.13  = 4.99
  • Year 8 - 4.99 x 1.13  = 5.64
  • Year 9  - 5.64 x 1.13  = 6.37
  • Year 10 - 6.37 x 1.13 = 7.20
  • TOTAL EPS     = 46.25

Total dividends = Total EPS x Average Dividend Payout

  • Rs 46.25 x 4.2% = Rs 1.94

FUTURE VALUE OF THE STOCK

Future value 10 years hence would be the total of future stock price plus the total dividends expected to be paid by the company. In our example it would be as follows:

  • Rs 134.57 + Rs 1.94 = Rs 136.51

Step 3: Calculate Intrinsic Value


You can now calculate the intrinsic value of the stock as follows:

  • Present value of stock = Future value / Expected ROI for 10 years.

= Rs 136.51/ 1.12 (10) = Rs 43.95

Step 4: Compare with Current Stock Price


The intrinsic value above is because your goal was to get 12 per cent per annum from this stock. If so, current stock’s price, which is Rs 33.50, is acceptable indeed ie, the stock price is below the intrinsic value. But, if you set your goal to get 25 per cent per annum return on investment, the intrinsic value will be Rs 22. In this case, the current stock price will no longer acceptable and you will have to wait till the stock price falls to that level. For this same reason, we can say that current stock price is right to those who are aiming for 15 per cent return per annum.

As you can see, intrinsic value can be relatively different from one investor to another depending on the expected rate of return, period of investment etc..

Expecting very high return will limit your investment options. As an investor, it is crucial to set a realistic target on the expected profits.

You may like these posts:

  1. Simple Valuation Method- I
  2. Lessons in computing returns – II Simple returns
  3. Concept 5: Cost of equity.

3 Responses to “Simple valuation method- II”

nikhil

April 8, 2012 at 11:37 am

plz explain the DCF method in detail.

J Victor

April 8, 2012 at 9:14 pm

sure. DCF will be explained later in this site.

Manish Patel

November 22, 2012 at 5:17 am

How do you incorporate Margin of Safety and Inflation in this method?

Leave a Comment