Page 141 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes 1 to 3 years and (2) preferred to use several techniques in combinations. Seventy-five per cent of
the analysts followed rules of thumb to normalize P/E ratios.
1. They compared current actual P/E with what they considered normal for the stock in
question.
2. They compared price times estimated future earnings (1 to 3 years out) with what they
considered normal for the stock in questions.
3. They compared the multiplier and growth or earnings of individual stocks with industry
group multiple and earnings growth.

With and Kisor based on their study of a number of stocks, opined that differences in P/Es
between stocks were due to projected earnings growth, expected dividend payout, and variation

in rate of earnings growth or growth risk. Bower and Bower came up with similar conclusion.
They divided risk into marketability of stock, price variability, and conformity with market
behaviour. Malkiel and Cragg found positive effect of earnings growth on P/E. They further
found that dividend payout effect was not clear.

4.3.4 Dividend Discount Model of Valuation

In determination of the P/E ratio, the factors to be considered are
1. Capitalization rate (K)

2. Growth rate of dividend stream (g) and
3. Dividend pay-out ratio (d/e)
1. Capitalization rate (k): Capitalization rates vary with the firm’s risk-class and the
prevailing market conditions. Three risk classes may be considered for analysis – high,
medium and negligible. Based on market level and directions of change, markets can be
classified as:

(a) Normal market: In which most securities prices are experiencing slow steady growth
and the average price-earnings ratio is the low mid teens (13-18 times).
(b) Bear market: When average earnings multipliers drop below 13 times, many market
prices are deflated.
(c) Bull market: When average earnings multipliers rise above approximately 18, many
stocks are over-priced.
Since future expectations are influenced by past experience, a good way to estimate a
firm’s risk-class is to examine historical data. Capital Asset Pricing Model (CAPM) or
Security Market Line (SML) depicts the risk return relationships based on historical data.
It illustrates the positive relationship between assets, undiversifiable (as measured ROR)
for the asset. The fundamental analyst can measure the risk of the company in recent
periods, adjust it for anticipated changes and then us, these forecasted risk statistics to
obtain capitalization rates. Also adjustment upward or downward is to be made in earnings
multipliers in line with prevailing conditions, i.e., depressed or inflated.

2. Growth rate (g): Next step is determination of growth rates of earnings. If payout ratio in
constant, the multiplier is influenced by growth rate (g) conditions viz., zero growth,
perpetual growth and temporary growth.
3. Payout ratio (d/e): The effects of changes in dividend payout ratio (d/e) are direct and
proportional, direct as can be observed from the P/E model. The EPS and DPS are not

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