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š Stock Valuation
1. Introduction
What Is Stock Valuation?
Stock valuation is the process of estimating the intrinsic value of a company’s shares based on its expected future cash flows, dividends, or earnings.
It helps investors determine whether a stock is undervalued, fairly valued, or overvalued.
2. Why Stock Valuation Is Important
a) Investment Decisions: Helps identify undervalued or overvalued stocks.
b) Portfolio Management: Supports balancing risk and return.
<strong)c) Corporate Finance: Used in mergers, acquisitions, cost of equity estimation.
d) Understanding Market Behavior: Provides a fundamental anchor for price movements.
3. Dividend Discount Models (DDM)
Dividend Discount Models value a stock by discounting future dividends. The key models include:
- Zero Growth Model
- Constant Growth Model
- Supernormal Growth Model
4. Zero Growth Dividend Model
This model assumes the company pays the same dividend every year forever.
Formula:
Pā = D / r
Example ā Zero Growth
Dividend (D) = Rs. 5 per year
Required return (r) = 10%
Pā = 5 / 0.10 = Rs. 50
If market price is Rs. 40 ā the stock is undervalued.
5. Constant Growth Model (Gordon Growth Model)
This model assumes dividends grow at a constant rate (g) forever.
Formula:
Pā = Dā / (r ā g)
Example ā Constant Growth
Dā = Rs. 4
Growth rate (g) = 6%
Required return (r) = 12%
Dā = 4 Ć 1.06 = Rs. 4.24
Pā = 4.24 / (0.12 ā 0.06) = Rs. 70.67
If market price is Rs. 60 ā undervalued.
6. Supernormal (Non-Constant) Growth Model
This model applies when a company experiences high or irregular growth for a few years before settling into stable growth.
Formula Structure:
- Calculate dividends during high-growth years
- Calculate terminal value (constant growth phase)
- Discount all cash flows to present
Example ā Supernormal Growth
Dā = Rs. 2
Supernormal growth = 20% for 3 years
Stable growth = 5% thereafter
Required return (r) = 12%
Step 1: High-growth dividends
Dā = 2 Ć 1.20 = 2.40
Dā = 2.40 Ć 1.20 = 2.88
Dā = 2.88 Ć 1.20 = 3.456
Step 2: Terminal Value
Dā = 3.456 Ć 1.05 = 3.6288
Pā = 3.6288 / (0.12 ā 0.05) = 51.84
Step 3: Present Values
PV(Dā) = 2.40 / 1.12 = 2.14
PV(Dā) = 2.88 / 1.12Ā² = 2.30
PV(Dā) = 3.456 / 1.12Ā³ = 2.46
PV(Pā) = 51.84 / 1.12Ā³ = 36.88
Total Value: Pā = 2.14 + 2.30 + 2.46 + 36.88 = Rs. 43.78
If market price is Rs. 55 ā stock is overvalued.
7. Summary Comparison of Models
| Model | Best For | Dividend Pattern | Difficulty |
|---|---|---|---|
| Zero Growth | No growth firms (utilities) | No change in dividends | Easy |
| Constant Growth | Mature, stable firms | Constant growth (g) | Medium |
| Supernormal Growth | Young or fast-growing firms | Variable ā stable | Advanced |
8. Advanced Extensions
Two-Stage Growth Model: High growth ā stable growth.
H-Model: Smooth transition from high to stable growth.
Free Cash Flow Model (FCF): Used for firms that do not pay dividends.
Relative Valuation: Uses ratios like P/E, P/B, EV/EBITDA.
9. Final Takeaways
ā Stock valuation helps identify true worth of a stock.
ā Different models apply to different types of firms.
ā Supernormal growth models reflect real-world behavior.
ā For advanced valuation, use FCF and relative valuation models.
Visit Practice Questions
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