Page 181 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes 9.3.1 Dividend Discount Model of Valuation

In determination of the P/E ratio, the factors to be considered are
(a) Capitalization rate (k): Capitalization rates vary with the firm’s risk-class and the prevailing
market conditions. Three risk classes may be considered for analysis – high, medium and
negligible. Based on market level and directions of change, markets can be classified as:
(i) Normal market: In which most securities prices are experiencing slow steady growth
and the average price-earnings ratio is the low mid teens (13-18 times).

(ii) Bear market: When average earnings multipliers drop below 13 times, many market
prices are deflated.
(iii) Bull market: When average earnings multipliers rise above approximately 18, many
stocks are over-priced.
Since future expectations are influenced by past experience, a good way to estimate a
firm’s risk-class is to examine historical data. Capital Asset Pricing Model (CAPM) or
Security Market Line (SML) depicts the risk return relationships based on historical data.
It illustrates the positive relationship between assets, undiversifiable (as measured ROR)
for the asset. The fundamental analyst can measure the risk of the company in recent
periods, adjust it for anticipated changes and then us, these forecasted risk statistics to
obtain capitalization rates. Also adjustment upward or downward is to be made in earnings
multipliers in line with prevailing conditions, i.e., depressed or inflated.
(b) Growth rate (g): Next step is determination of growth rates of earnings. If payout ratio in
constant, the multiplier is influenced by growth rate (g) conditions viz., zero growth,
perpetual growth and temporary growth.
(c) Payout ratio (d/e): The effects of changes in dividend payout ratio (d/e) are direct and
proportional, direct as can be observed from the P/E model. The EPS and DPS are not
equal, for the reason some companies prefer a stable dividend policy and some others
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.

9.3.2 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:

(i) Determine the market P/E using dividend discount model.
(ii) 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?)

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