CHAPTER 3

STOCK VALUATION METHODS AND EFFICIENT

MARKET HYPOTHESIS

Learning Objectives

Explain the different approaches in the valuation of

stocks.

Analyze the different techniques in measuring stock

performances.

Describe the important features of the efficient

market hypothesis.

Chapter Outline

Why Valuations of Shares are Needed

Stock Valuation Methods
Asset-based Valuation
Income or Earnings-based Valuation
Dividend Valuation Model (zero growth,
constant growth & differential growth)
Factors Affecting Share Prices
Stock Risk

Chapter Outline

Sources of Investment Risk

Systematic Risk
Unsystematic Risk
Beta
Stock Performance Measurements
Treynor Index
Sharpe Index
Jensen Index
Efficient Market Hypothesis (EMH)

Valuation

Process of estimating the true value of an

asset which is known as INTRINSIC VALUE
To help in decision making.

Why Valuations of Shares are Needed

To fix an issue price for an unquoted company

to be listed.
Takeover bid and the offer price for the
purpose of merger and acquisition activities.
For the purposes of taxation and as collateral
for a loan made by a company.
When a group holding company is negotiating
the sale of its subsidiary to a management
buyout team or to an external buyer.

Why Valuations of Shares are Needed

(continuation)

When a shareholder wishes to dispose of his

holding especially if a large or controlling
interest is being sold..
When a company is being broken up in a
liquidation situation or the company needs to
obtain additional finance or refinance current
debt.

Stock Valuation Methods

Three main methods
The asset-based valuation method
The income-based valuation method
The dividend valuation method

Income or Earnings-based
Valuation

One of the most common methods for valuing share

price.
Apply the price-to-earnings ratio (P/E)
P/E ratio = Market price per share/Earnings per share.
By selecting a suitable P/E ratio and multiplying this
by the EPS, the market price per share or the the total
value of a company can be computed.
The Intrinsic value of a stock = EPS x P/E ratio.
Sometimes it represent the market price of a share

Income or Earnings-based
Valuation (continuation)
Example
The latest financial statements of food retail
company Kesang Berhad, show earnings per share
of RM0.20 and the average P/E for the companies
in the same industry is quoted at a ratio of 15 at the
time of valuation.
A possible value could be computed as follows:
The market price per ordinary share is RM3
(RM0.20 x 15).

Example 2
A. Seri Indah Bhds expected earnings after taxes (EAT) is
RM300 million. The current market price of its common stock
is RM5.00 per share. At present the company has 500 million
shares outstanding and a PE ratio of 10.
Calculate the intrinsic value of Seri Indah Bhds common
stock.
IV
= P/E x EPS
= 10 X
RM300M
= RM6.00
RM500M
ii. Would you buy the share at its current price? Why?
Yes, because the market price of the common stock is
undervalued. IV > market price
i.

Dividend Valuation Model

The equilibrium price for any

security depends on the future
expected stream of income
from the security discounted
using an appropriate cost of
capital or a required rate of
return.
Williams (1938) stated that the
price of a stock should reflect
the present value of the shares
future dividends. In equation
form, this is the statement of
the DVM:

Dt
Price
t
t 1 (1 k e )
Where Dt is the dividend paid in
time t and ke is the required
rate of return by investors at the
time of valuation t.

Dividend Valuation Model

(continuation)
The general model can be formulated if the
companys dividends are expected to follow these
basic patterns:
Zero growth (D0 = D1 = D2 ..... D)

Constant growth. (Dt = Dt-1 (1 + g))

Differential growth.

Dividend Valuation Model

(continuation)
Case 1 (Zero growth model)

Dt
Price
t
t 1 (1 k e )

D
D
D
Price (P0 )

.....
2
(1 ke ) (1 ke )
ke
where
D
ke
P0

=
=
=

Constant annual dividend

Shareholders required rate of return
Market value excluding any dividend currently payable

Dividend Valuation Model

Example
Mara Berhad is expected to pay a dividend of RM1.10
per share every year in the foreseeable future. Investors
require a return of 15% on investment in the companys
shares. Applying the DVM, what is a fair price for the
companys share?

Dt
D
RM 1.10
Price

RM 7
t
ke
15%
t 1 (1 k e )
If investor plan to sell the stock in year 5 at RM15. What is
the maximum price he would pay for the stock?
Max Price = 1.1 PVIFA15%, 5 + 15 PVIF15%,5 = RM11.15

Dividend Valuation Model

(continuation)

Case 2 (Constant growth model) Price

t 1

Dt
t
(1 ke )

D0 (1 g ) D0 (1 g ) 2
D0 (1 g )
D1
Price (P0 )

.....

2
(1 k e )
(1 ke )
(ke g ) ke g
where
D0
g ; ROE *RR
D0(1 + g)
ke
P0

=
=
=
=
=

Current years dividend

Growth rate in earnings and dividends (ROE * retention Ratio
Expected dividend in one years time (D1)
Shareholders required rate of return
Market value excluding any dividend currently payable

Dividend Valuation Model

(continuation)
Example
Suria Berhad is expected to pay a dividend of RM0.90 per
share in one year. In every subsequent year, the dividend is
expected to grow by 4% annually. Investors require a
return of 10% on the firms stock. Applying the DVM,
what is a fair price for the companys shares?

D0 (1 g ) t
D1
RM 0.90
Price

RM 15
t
k e g 10% 4%
t 1 (1 k e )

Current Dividend (D0)

Dividend in year T-t * (1+ growth rate)T-t

D0 = D T-t x (1+g)T-t
Example Problem 6 page 53.

A company is just about to pay a dividend

of RM0.50 a share this year. Four years
ago, its dividend was RM0.25 a share.
What was the average annual growth rate
of dividends over the four years?

Dividend 4 years ago x (1 + g) 4 = Current Dividend

(1 + g) 4 = Dividend this year/Div.four years ago
= RM 0.50/RM 0.25 = 2
(1 + g) = 2 = 1.189

Therefore g = 1.189 1 = 0.189 = 18.9%.

EXAMPLE

No. of shares : 10 million

Current Stock Price: RM5.85
EPS: RM0.60
Proposed payout: 70%
Div. per share 1 year ago: RM0.41
Div. per share 2 years ago: RM0.40
Beta: 1.5
PE: 11
Risk Free rate: 4%
Market Return: 8%

Calculate IV based on
Dividend Growth

D0 = 70% * RM0.60 = RM0.42

Div 2 years ago x (1 + g )2 = Proposed div.

0.40 (1+g)2 = 0.42
1+g
= (0.42/0.4)1/2 = 1.051/2
g
= 1.0247 1 = 2.47%
R = Rf + beta (Rm - Rf) = 4 + 1.5 (8-4) = 10%
IV = 0.42 (1+0.247)/(0.1-0.247) = RM5.72

Dividend Valuation Model

Case 3 (Differential growth model)
Two growth period;
Variable growth
Constant till perpetuity
The intrinsic value of the ordinary share can be computed
as follows:
PV period 1 ( variation) P1 + PV period 2 (constant) P2

Dividend Valuation Model

(continuation)
Example
Parabola Berhad paid RM1.50 dividend per ordinary share
last year. The company's policy is to allow its dividend to
grow at 5% for the first four years and then the rate of
growth changes to 3% per year from year 5 and so on.
What is the value of the ordinary share if the required rate
of return is 8%?

Dividend Valuation Model

(continuation)
P1 = PV up to year 4. (Variation)
t

Dt

PVIF8%, t

PresentValue PV

RM1.575
D0 (1+g)

0.926

RM1.46

RM1.653
D1(1+g)

0.857

RM1.42

RM1.737
D2(1+g)

0.794

RM1.38

RM1.824
D3(1+g)

0.735

RM1.34
PV PERIOD 1 (P1) = RM5.60

1.88
0.08 - 0.03

P2 = PV from beg of year 5 or end of yr 4 to

perpetuity. (Constant)
Expected Div. in year 5, D5 = 1.824 (1 + 0.03) = RM1.88
PV PERIOD 2 (P2)
= 1.88/(0.08-0.03) x 0.735
Price beginning of year 5
or end of year 4
(Expected Price in year 5)

Intrinsic Value of share

= RM37.60 x 0.735
= RM27.64
= P1 + P2
= RM5.60 + RM27.64
= RM33.24

EXERCISE

Hairee Bhds stock is selling at RM20 per

share. Its current EPS and dividend payout
ratio are RM2.50 and 30% respectively. Given
the slow economy, the firm expects that the
growth rate of EPS and dividend to decline by
5% for the next two years but then grow at a
more gradual rate indefinitely. If the required
rate of return for similar investment is 15%,
what is the projected price of the company at
the end of year 2?

Yea Dividend
PVIF15%
r
1
0.75 (1-5%) = 0.7125 0.8696
D0 = 0.3 x 2.50 = 0.75

PV

0.5118

0.6769

0.7561

0.61959

1.1314
V0 = PV1 + PV2
RM20 = 1.1314 + Price end 2 * PVIF 15%, 2
V0 = V2 (PVIF15% , 2) + 1.1314
V2 = (20 1.1314)/ 0.7561 = RM26.27m

Factors Affecting Share Prices

Earnings announcements
Industry performance
Dividend
Stock splits
Share buy-back
Product innovation
Takeover or merger
Major contracts
Insider trading
Analyst upgrade/downgrade
New technology
War
Natural disasters
Economic meltdowns
Etc.

Stock Performance Measurements

There are three techniques that have been developed to
measure portfolio performance. These measures are
sometimes known as composite performance measures.
Treynor Index
Sharpe Index
Jensen Index
All the three measures combine risk and return
performance into a single value. This makes it easier to
compare the performance of competing portfolios.

Treynor Index

This index therefore relates excess return over

the risk-free rate to the additional risk taken.
The focus of risk is on systematic risk instead
of total risk.
This performance measure should really only
be used by investors who hold diversified
portfolios.

Treynor Index (continuation)

The higher the Treynor Index, the higher the return

relative to the risk-free rate, per unit of risk.
The formula is as follows:

Treynor Index

Rp R f

Where
Rp

Portfolio return

Rf

Risk free rate of return

Beta of portfolio

Treynor Index (continuation)

Example
Assume that the five-year
average annual return for the
KLCI (proxy market portfolio)
is 10%, while the average
annual return on Malaysian
Government Securities is
5%. You, as the finance director
are evaluating three distinct
portfolio managers with the
following data:

Manager Average Portfolio

Annual
Beta
Return
A

10%

0.90

14%

1.03

15%

1.20

Treynor Index (continuation)

Computing the Treynor Index (TI) for each
manager yields the following risk-adjusted results:
TI (Market)
TI (Manager A)
TI (Manager B)
TI (Manager C)

= (.10 .05)/1 = .05

= (.10 .05)/0.90 = .056
= (.14 .05)/1.03 = .087
= (.15 .05)/1.20 = .083

If we are to evaluate base on performance alone, we will select Manager C as the best
performer.However, when considering the risks that each manager took to attain their
respective returns, Manager B demonstrated the better outcome. In this case, all three
managers performed better than the aggregate market.

Sharpe Index

The Sharpe ratio is almost similar to the Treynor measure, except

that the risk measure used is the standard deviation of the
portfolio instead of considering only the systematic risk, as
represented by beta.
The higher the portfolios mean return relative to the mean riskfree rate and the lower the standard deviation p, the higher the
Sharpe Index will be.
The formula can be expressed as follows:

Sharpe Index

Rp R f

Sharpe Index (continuation)

Example
Examine the following
example and assuming that
the KLCI had a standard
deviation of 18% over a fiveyear period, let us determine
the Sharpe ratios for the
following portfolio
managers:

Manager Average Portfolio

Annual Standard
Return Deviation
D

14%

11%

17%

20%

19%

27%

Sharpe Index (continuation)

The Sharpe Index (SI) computations are as follows:
SI (Market)
SI (Manager D)
SI (Manager E)
SI (Manager F)

=
=
=
=

(.10 .05)/.18 = .278

(.14 .05)/.11 = .818
(.17 .05)/.20 = .600
(.19 .05)/.27 = .519

Once again, we find that the best portfolio is not necessarily the one with the highest
return. Instead, it is the one with the most superior risk-adjusted return, or in this case
the fund headed by manager D.

Jensen Index

This measure is also known as alpha.

The Jensen Index measures how much of the portfolio's
rate of return is attributable to the manager's ability to
deliver above-average returns, adjusted for market risk.
A portfolio with a consistently positive excess return
will have a positive alpha, while a portfolio with a
consistently negative excess return will have a negative
alpha.
The higher the ratio, the better are the risk-adjusted
returns

Jensen Index (continuation)

The formula is as follows:
Jensen Index =
Portfolio return [Risk-free return + (Market
return Risk-free return) * Beta]

Jensen Index (continuation)

Example
Assume a risk-free rate of
5% and a market return of
10%, what is the alpha for
the following funds?

Manager Average Portfolio

Annual
Beta
Return
D

11%

0.90

15%

1.10

15%

1.20

Jensen Index (continuation)

First, we calculate the portfolio's expected return (ER).
ER (D) = .05 + 0.90 (.10 .05) = .0950 or 9.5%
ER (E) = .05 + 1.10 (.10 .05) = .1050 or 10.50%
ER (F) = .05 + 1.20 (.10 .05) = .1100 or 11%
Then, we calculate the portfolio's alpha by subtracting the expected
return of the portfolio from the actual return:
Alpha D = 11% 9.5% = 1.5%
Alpha E = 15% 10.5% = 4.5%
Alpha F = 15% 11% = 4.0%
Conclusion: Manager E produced the highest alpha and therefore the
best performance.

The rate of return and risk for three growth-oriented

unit trust funds were calculated over the most recent
5 years and are listed below:
Fund
Return
Risk ()
A
15%
16%
B
13
18
C
12
11
Rank each fund by applying the Sharpe Index of
portfolio performance if the risk-free rate is 7%.
SI(A) = (15 7)/16
SI(B) = (13 -7)/18
SI(C) = (12 7)/11

= 0.50
= 0.33
= 0.45

(First)
(Third)
(Second)