Page 162 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 5: Equity Valuation Models

Notes

Task Will Equity Value be the same under Firm and Equity Valuation? Discuss
with reasons.
5.4 Earnings

1. The P/E approach to Equity Valuation: The first step here consists of estimating future
earning per share. Next, the normal price-earnings ratio will be estimated. Product of
these two estimates will give the expected price. For a single year holding period, with D
1
as the referred dividends in the coming year, the expected return of an investor can be
found as under.
D (p P)
Expected Return = 1 1 ....(1)
P
Stagnating normal price-earning ratio is central to the P/E approach for valuing equity
shares. The procedure has been described in the following paragraphs.
You may go back to original equation and introduce the earnings variable in it by
expressing
D = p – E ....(2)
t 1 1
Where P = pay-out ratio, and E = earnings per share in time 't' so, if you forecast earnings
1 t
per share and layout ratio you have in fact forecast dividends per share. Now, the above
equations to restore following:
D 1 D 1 D 1
V= 2 3 ....... .....(3)
1 K (1 K) (1 K)

p E p E p E
1 1 2 2 3 3
= 2 3 .....(4)
1 K (1 K) (1 K)
= P E 1 .....(5)
1
t 1 (1 K) 1
Now, if earnings like dividends also grow at a rate 'ge' in future time periods as
E = E (1+g ) .....(6)
1 t–1 et
And which would also imply that
E = E (1+g )
1 t–1 et
E = E (1+g ) = E (1+g ) (1+g )
2 1 et 0 e1 e2
E = E (1+g ) = E (1+g ) (1+g )
3 2 e3 0 e3 e3
and so, on where E is the actual level of earnings per share over the past year, E is the
0 1
expected level of earnings per share for the year after E and E is expected level of
1 2
earnings per share for the year after E .
2
Substituting these equations in equation (4), we get
P [E (1 g )] P [E (1 g ) (1 g )] P [E (1 g ) (1 g ) (1 g )]
1 0 e1 2 0 e1 e2 2 0 e1 e2 e3
V = 2 3 .........
1 K (1 K) (1 K)
......(7)

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