Page 185 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes 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:
How to calculate the P/E ratio?

What is the normal P/E ratio?
What determines P/E ratio?
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
0
0
0
0
P/E = D /E (1 + g)

−
Kg
Here D (1 + g) – D
0 1
Based on the above model, decision rules become:
Higher the P/E ratio, other things remaining the same, higher would be the value of an
equity share.
Lower the P/E ratio, other things remaining the same, lower would be the value of an
equity share.
Looking at the above decision rules, it is not uncommon to find that investor prefer shares of
companies higher P/E multiple.
You will appreciate that the usefulness of the above model lies in understanding the various
factors determine P/E ratio is broadly determined by:

Dividend payout
Growth

180 LOVELY PROFESSIONAL UNIVERSITY