Page 146 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 4: Fundamental Analysis

These inferences clearly highlight the effect of different variables on the future price of equity Notes
shares.
When applying this approach, one has to be careful about using discount rate k. A higher value
of discount could unnecessary reduce the value of share and equity, while a lower value
unreasonably increase it; this will induce a complication to invest/disinvest the shares. A discount
rate is based on the risk rate and risk premium. That is
Discount risk free rate + Risk premium
K = r + r
1 2
Where, r = Risk free rate of return
t
r = Risk premium
2
Thus, higher the risk free interest rate with rp remaining the same would increase the discount
rate, which in turn would decrease the value of the equity. In the same way, higher risk premium
with of remaining the same increase the overall discount rate and decrease the value of the
equity. Like discount rate, growth equally critical variable in this method of share valuation. It
may be pointed out that growth from internal of it depends on the amount of earnings retained
and return on equity. Thus, higher is the retention rate, highly be the value of the firm, other
things remaining constant.

Price Earnings Approach

According to this method, the future price of an equity share is calculated by multiplying the P/
E ratio by the price. Thus,
P = EPS × P/E ratio
The P/E ratio or multiple is an important ratio frequently used by analyst in determining the
value of an equity share. It is frequently reported in the financial press and widely quoted in the
investment community. In India, we can gauge its popularity by looking at various financial
magazines and newspapers.
This approach seems quite straight and simple. There are, however, important problems with
respect calculation of both P/E ratio and EPS. Pertinent questions often asked are

1. How to calculate the P/E ratio?
2. What is the normal P/E ratio?
3. What determines P/E ratio?
4. How to relate company P/E ratio to market P/E ratio?

The problems often confronted in calculating this ratio are: which of the earnings – past, present
or future to be taken into account in the denominator of this ratio? Likewise, which price should
be put in the numerator ratio? These questions need to be answered while using this method.
Indeed, both these methods are inter-related. In fact, if we divide the equation of dividend
discounted made under constant growth assumption by E (Earnings per shares), we get
0
P /E = D /E (1 + g)
0 0 0 0
K - g

Here D (1 + g) – D
0 1

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