Copyright: M. S. Humayun1 Financial Management Lecture No. 18 Common Stocks – Rate of Return & EPS Pricing Model

Copyright: M. S. Humayun2 Common Stocks - Rate of Return We can now Estimate the Present Value (or Estimated Share Price or Fair Price) of a Share. The Estimated Required Rate of Return for Investment in Common Equity (r CE ) can be calculated by re- arranging the same equation: Dividends Pricing Models: –Zero Growth: Po*=DIV1 / r CE (Po* is being estimated) r CE *= DIV1 / Po (r CE * is being estimated) –Constant Growth: Po*= DI V1/ (r CE -g) r CE *= ( DIV 1 / Po) + g Div Yield Cap.Gain Yield Gordon’s Formula:

Copyright: M. S. Humayun3 EPS APPROACH Common Stock Price Estimation Dividends Pricing Approach (or Gordon ’ s Formula): Estimated Fair Present Price (or Present Value) of Share calculated using Forecasted Future Cash Flows of Dividend Payouts to Shareholders and their growth. Earnings Per Share (EPS) Pricing Model: Estimated Fair Present Price of Share calculated based on Forecasted Future Cash Flows of Company ’ s Earnings and growth from Ploughed Back Reinvestments (from Retained Earnings)

Copyright: M. S. Humayun4 Stock ( Paper Direct Claim Security) issued by Company ABC Real Assets & Future Investments in Projects of Company ABC Forecasted Dividends (Cash Flows generated by Stocks) Forecasted Earnings & Sales Revenue (Cash Flows generated by real business operations) Present Value of Company ABC (with certain number of Common Shares Outstanding) Present Value of a Stock of Company ABC DIVIDEND PRICINGE.P.S PRICING COMMON STOCK PRICING APPROACHES

Copyright: M. S. Humayun5 EPS Approach Common Stock Price Estimation EPS Stock Price Estimation Formula –PV = Po* = EPS 1 / r CE + PVGO Po = Estimated Present Fair Price, EPS 1 = Forecasted Earnings Per Share in the next year (ie. Year 1), r CE = Required Rate of Return on Investment in Common Stock Equity –PVGO = Present Value of Growth Opportunities or Present Value of Potential Growth in Business from Reinvestments in New Positive NPV Projects and Investments. PVGO = NPV 1 / (r CE - g) = [-Io + (C/r CE )] / (r CE -g)

Copyright: M. S. Humayun6 PVGO - EPS Approach PVGO = NPV1/(r CE - g) =[-Io +(C/r CE )] / (r CE -g) –PVGO Model: Constant Growth “ g ” in NPV of new Reinvestment Projects (or Investment). Perpetual Net Cash Flows (C) from each Project (or Investment). –Io = Value of Reinvestment = Pb x EPS where Pb= Ploughback = 1 - Payout = 1 - (DIV/EPS) and EPS Earnings Per Share= (NI - DIV) / # Shares of Common Stock Outstanding where NI = Net Income from P/L Statement and DIV = Dividend, RE1= REo+ NI1+ DIV1 –C = Forecasted Net Cash Inflow from Reinvestment = Io x ROE where ROE = Return on Equity = NI / Book Equity of Common Stock Outstanding –NOTE: Revise Financial Accounting Formulas

Copyright: M. S. Humayun7 EPS Common Stock Price Estimation - Numerical Example The Common Stock of Company ABC is trading in the Islamabad Stock Exchange at a market price of Rs 105. You are considering investing in it so you study the company ’ s Annual Report, Financial Statements, and make some forecasts. The Data is as follows: –Forecasted Dividend Next Year = Rs 10 –Expected Dividend Growth = 10% pa –Forecasted Earnings Per Share = Rs 12 –Your Required Return on Investment in ABC Common Stock = 20% pa. Compute the Estimated Present Fair Price of Company ABC ’ s Common Stock.

Copyright: M. S. Humayun8 EPS - Numerical Dividend Pricing (Gordon ’ s) Approach –PV = Po* = DIV1 / (r CE - g) = 10 /(20%-10%) = 10/0.10 = Rs 100 (Estimated Fair Price is less than Market Price of Rs 110 so share is Overvalued in the Market) Earnings Per Share (EPS) Pricing Model –PV = Po* = EPS 1/ r CE + PVGO EPS 1 / r CE = 12 / 0.20 = Rs 60 PVGO = NPV1 /(r CE -g)=[-Io+(c/ r CE )] / (r CE -g) = [-(PbxEPS) + (IoxROE/ r CE ) ] / (r CE -g) – = [-(1/6 x 12) + (2 x 6/10 / 0.20) ] / ( ) – = [-2 + 6] / 0.10 = Rs 40 –Pb = 1 - Payout = 1 - DIV / EPS = /12 = 1/6 –g = Pb x ROE = 10% = 1/10 So ROE = 6/10 –PV = Rs 60 + Rs 40 = Rs 100 (Same as Dividend Approach) –EPS Approach shows that 40% (ie. Rs 40 out of Rs 100) of the Value is Growth Based (ie. PVGO) - Growth Stock