Share Valuation Models and HPR
How much is a piece of a company really worth? In Unit II, we looked at the "Quality" of a company. In this unit, we look at the "Mathematics" of a company. Share valuation is the process of calculating the fair price of a stock today based on its future benefits.
1. Holding Period Return (HPR)
Before we value a stock, we must know how to measure the "Total Return" an investor gets during the time they hold it. This is called the Holding Period Return (HPR).
The Formula:
HPR = [D + (P1 - P0)] / P0 × 100
Where:
- D: Dividends received during the period.
- P1: Sale Price (Ending Price).
- P0: Purchasing Price (Beginning Price).
[!NOTE] HPR accounts for both Income (Dividends) and Capital Gain (Price change).
2. Share Valuation Models (Basis)
The "Intrinsic Value" of a stock is simply the Present Value of all future cash flows (dividends) it will provide to the owner.
A. The Constant Growth Model (Gordon Model)
This model is used for established companies that pay a dividend that grows at a steady rate forever.
Formula: V0 = D1 / (k - g)
Where:
- V0: Intrinsic Value today.
- D1: Expected dividend next year (D0 × (1+g)).
- k: Required rate of return (Discount Rate).
- g: Constant growth rate of dividends.
[!IMPORTANT] For this formula to work, the Required Return (k) must be greater than the Growth Rate (g).
B. Multiple Growth Model (Variable Growth)
Some companies (like startups) grow very fast for 3-5 years and then slow down. To value these, we calculate the dividends for the high-growth phase separately and then add the "Terminal Value" for the steady phase.
3. The Concept of Discount Rate (k)
The Discount Rate is the minimum return an investor expects to earn for taking the risk of buying the stock. It is usually higher than the interest rate on a bank FD.
- If the risk is high, the discount rate (k) increases.
- As k increases, the calculated Value of the stock (V0) decreases.
Practical Examples (Exam Style)
Problem 1: Mr. Raj bought a share at ₹200. He received a dividend of ₹10 and sold the share after one year for ₹230. Calculate his Holding Period Return (HPR).
Solution:
- P0 = ₹200
- D = ₹10
- P1 = ₹230
- HPR = [10 + (230 - 200)] / 200 × 100
- HPR = [10 + 30] / 200 × 100 = 40 / 200 × 100 = 20%
Problem 2: A company paid a dividend of ₹5 per share last year (D0). Dividends are expected to grow at 6% annually. If the required rate of return is 12%, calculate the intrinsic value of the share.
Solution:
- D0 = ₹5
- g = 6% (0.06)
- k = 12% (0.12)
- D1 = D0 × (1 + g) = 5 × 1.06 = ₹5.30
- V0 = 5.30 / (0.12 - 0.06) = 5.30 / 0.06 = ₹88.33
Exam Pattern Questions and Answers
Question 1: "What is Share Valuation? Explain the assumptions and limitations of the Gordon Growth Model." (8 Marks)
Answer: Share Valuation is the process of determining the fair market value of a company’s stock. It is primarily used by investors to decide if a stock is 'Undervalued' or 'Overvalued'.
Gordon Growth Model (Constant Growth Model): Assumes that dividends will grow at a constant rate 'g' forever.
Assumptions:
- Constant Growth: The company's growth stays the same indefinitely.
- Perpetuity: The company exists forever.
- Required Return > Growth Rate: Market return (k) must be higher than growth (g), otherwise the math fails.
- Stable Payout: The company consistently pays a portion of its profit as dividends.
Limitations:
- Unrealistic Growth: In reality, no company can grow at the exact same rate forever.
- Sensitivity: A small change in 'k' or 'g' leads to a massive change in the stock's value.
- Non-Dividend Stocks: This model cannot value companies that reinvest all profits and pay no dividends (like many tech firms).
Summary
- HPR measures the total gain from an investment.
- Gordon Model values a stock by dividing the future dividend by the "Spread" between return and growth.
- Discount Rate reflects the risk of the investment.
- If calculated value > market price, it's a buying opportunity.
Quiz Time! 🎯
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