Page 142 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 4: Fundamental Analysis

equal, for the reason some companies prefer a stable dividend policy and some others Notes
retain earnings and maintain low dividend pay out ratios. It implies that analysts have to
study the history of dividends announcements by the firm to make proper prediction of
future pay out ratios.
Empirical studies have produced the following relevant findings:

1. Companies seem to have a predetermined payout ratio that they appear to adhere to over
the long run.
2. Dividends are raised only if corporate management feels that a new higher level of earnings
can be supported in the future; and
3. Managements are extremely reluctant to cut the absolute monetary amount of cash
dividends.
It gives price earrings ratios or various risk classes and various rates of dividends or earnings
growth in normal market along with formulae for computing value of stocks.

Example: A firm’s earnings per share are 8. Dividend payout ratio is 0.5; systematic
risk coefficient is 0.1. What will be the firm’s share value when the growth rate is zero?
Solution: The firm’s normalized EPS (e) = 8
Average payout ratio d/e = 50%

Beta Coefficient (B) = 0.1
Capitalisation rate (k) = 10%
(i) When growth rate (g) is zero

di/e
Earnings multiplier =
k g

d i/e 0.5
When g = 0 earnings multiplier = 5
k 0.10
Firm’s share value = 7 × 5 = 40

4.3.5 Comparative P/E Approach

Comparative or relative valuation makes use of the average P/E of market or industry to
determine the P/E for an individual stock. The procedure is as follows:
1. Determine the market P/E using dividend discount model.
2. Determine the market pay back period based on earnings growth rate of market. (How
many years it takes to obtain market P/E at the given growth factor?)
3. Assign P/E to the stock based on its growth rate and market payback period.
4. Make adjustments for dividend pay out ratio and earnings volatility.

5. Find volume of stock by multiplying normal earnings with the determined P/E.

LOVELY PROFESSIONAL UNIVERSITY 137