Page 136 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 4: Fundamental Analysis

Notes
t
d (1 g )
o
i
= t
t 1 (1 k )
i
d i1
=
k g
Where, P = Value of share i
io
D = Dividends of share i in the t th period
it
K = Equity capitalization rate
1
G = Growth rate of dividends of share i (a constant)
it
This value is obtained by stock analysts y multiplying the ‘i’ the stock’s normalized earnings per
share (e) with price-earnings ratio or earnings multiplier (m)
P = e . M
io io io
Where, P = Value of share ‘i’
io
e = Earning of share ‘c’
io
m = Earnings multiplier of share ‘i’
io
The ratio of d /e is known as dividend payout ratio. From the above model it is obvious that,
io io
to determine the appropriate earnings multiplier an analysis must consider the following:
1. Earnings of the security
2. Risk of the security
3. Growth rate of the dividend stream
4. Duration of the expected growth and

5. Dividend payout ratio

Earnings Analysis

As seen earlier, to value common stocks or other risky assets, the present value model is
employed.
Present value = AQ
Where t = time period

This model gives rise to two questions.
1. How does the investor measure the income from the common stocks?
2. What discount or capitalization rate should be used?
The income question is discussed here:

Income concepts: Accountants and economists have provided two different concepts of income.
Accountant’s income is the revenue over the above all the costs incurred. Economists define the
income of a firm as the maximum amount, which can be consumed by the owners of the firm in
any period without decreasing their future consumption opportunities.
Adjusting for economic income: Since income, which is very important is determining the value
of a security, is vaguely reported by accountants, it is necessary to adjust or normalize it in a
consistent manner.

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