Page 164 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 5: Equity Valuation Models

Unforeseeable Circumstances Notes

The earnings of a company may show a negative result due to a one-time unforeseen
event. The extent of downtrend could depend on both external and internal factors relating
to the company.
Poor Management

The company might have a team at the top that is responsible for the wrong business
decisions or the company could have been affected by fraud or mismanagement issues.
However, if it is felt that the negative earnings due to this mismanagement has been
identified and corrective action by the company is on the agenda of the board, the valuation
of such companies has to be done considering the industry earnings record.

Example: Zee Ltd. is paying dividends on its equity shares at 8 per share and expects to
pay it for an undefined long period in future. The equity share currently sells for 65 and
investor's required rate of return is 10. Determine if the Zee share is fairly priced using P/E
approach valuation.
Solution:
This is a zero-growth case and the normal price-earnings ratio can be found as under
V/E = 1/K = 1/10 = 10
0
The actual price earnings ratio = P/E = 65/ 8=81. Since the normal price-earnings ratio of 10
is more than the actual price-earnings ratio of 8.1, the share at 65.0 is under priced.

Example: Now, assume that Zee paid a dividend of 1.80 per share over the past year
and the forecast then is that would grow at 5% per annum forever. The required rate of return is
11% and the current market price is 40 per share. Using P/E approach, determine if the Zee
share is fairly priced. E may be taken as 2.70.
0
Solution:
This is a constant growth case. The normal price earnings ratio (V/E ) can be
0
V (1 g )
e
= P
E K g
0
1 0.5
= 1.80/2.70
.11 0.5
1.05
= .6667 11.67
.05
P 40.0
= 14.81
E 2.70
0
V P
Since 11.67 14.81, the share is overpriced
E 0 E 0

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