Page 145 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes practice, does not form large part of the total returns of the investor. It is an important constraint,
as indicated above.
Estimation of future price of the share that contributes a major portion in the total returns of the
investor is the problematic and is discussed in detail in the following section. In order to
estimate future price of share, you may adopt two approaches, namely Quantitative analysis
and attractive analysis. Let us elaborate each of the two approaches.

Quantitative Analysis

This approach helps us to provide a measure of future value of equity share based on quantitative
factors. The methods commonly used under this approach are

1. Dividend discounted method, and
2. Price-earnings ratio method

Dividend Discounted Method

Dividend discounted method is based on the premise that the value of an investment is the
present value, its future returns. The present value (PV) calculated by discounting the future
returns, which are divided in the formula, thus, is

D D D
PV = 1 + 1 + 1
(1+ K) (1+ K) 2 (1+ K) 3
Under the constant growth assumption, this boils down to

D 1
PV =
K - g
K = Discount rate, g = Growth rate

DPS = EPS × (1 – b)
DPS = Dividend Per Share
b = Proportion of earnings retained such that (1 – b) is the dividend payout
Substituting the above in the formula, it becomes

EPS (1 - b)
K - g

On the basis of the above model, the following inferences can be drawn
1. Higher the EPS, other things like b, k, g remaining the same, higher would be value of the
share.
2. Higher the b, retention rate, or lower the 1-b, i.e., g remaining the same, higher would be
value of the share.

3. Higher the k, i.e., discount rate, other things like b, g remaining the same, higher would
be value of a equity.

4. Higher the growth rate, other things like EPS, b, k remaining constant, higher would be
value of the share.

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