Hey guys ,
So far i;ve completed 5 readings of FRA , microeconomics , Ethics till standard 6 . and just started off with equity evalv. did reading 49and 50 although found it kinda hard as they seem to be theorotical steps which we need to mug up (not all but some) . Anyways i am in reading 51 where we see the diffrent type of evaluation tools and while using all the youtube videos or matrials , they just seem to give away the formula without any explantion on how it was derived or any kind of insight .
For ex :
Price = D[1+growth]/k-G
where D = Earning[1-reten. rate]
and G = Reten.rate*ROE .
There doesnt seem to be any kind of explanation on these forumulas in kaplan books and videos , afrif irfans 2011 videos .
Could any of you give me an insight on these forumals or atleast direct me towards somekind of youtube video which would help .
Thanks ,
HedgeFudge
The growth rate of the book value of equity G is the amount of return you earn and reinvest on initial eqiuty investment. In other words, your company grows on it’s ability to increase invested capital (g) as a proportion (RR) of returns on investment equity in this case (ROE).
So G = RR * ROE. The proportion that is not reinvested (1-RR) is distributed away in dividends But this assumes a clean surplus accounting, and is not always accurate. But assume it’s so for exam purposes.
Divedends per share DPS is the EPS * (1-RR), likewise the total dividends D is the E * (1-RR) as explained above. This is amount of income you get on equity investment, after reinvestments of earnings are ploughed back in invested capital.
The price of a stock, or the market value of equity is a perpetuity formula of D, assuming that the total value of a stock is exlusively on it’s ability to generate income on a stable growth rate. The constant growth model is generally CF for t=1 divided by the required rate of return k - the growth rate g. Giving you D[1+growth]/k-G
The last two are pretty straightforward; for the first:
D / E = dividend payout ratio
= 1 – retention rate
D = E (1 – retention rate)
As for the growth rate, if ROE is constant, then if equity is constant, earnings will be constant, and if equity grows, earnings will grow by the same percentage. Equity grows when earnings are retained, so the growth rate equity is the increase in equity from earnings (ROE) times the percentage of those earnings that is retained (retention rate):
g = ROE × retention rate
As for the Gordon Growth formula, that requires summing an infinite series. Here goes:
V0 = D1 / (1 + k) + D2 / (1 + k)² + D3 / (1 + k)³ + . . . + D_n_ / (1 + k)^n + . . .
= D0(1 + g) / (1 + k) + D0(1 + g)² / (1 + k)² + D0(1 + g)³ / (1 + k)³ + . . . + D0(1 + g)^n / (1 + k)^n + . . .
Multiplying both sides by (1 + g) / (1 + k), we get:
V0(1 + g) / (1 + k) = D0(1 + g)² / (1 + k)² + D0(1 + g)³ / (1 + k)³ + . . . + D0(1 + g)^n / (1 + k)^n + . . .
Subtracting the first second formula from the second first, and noting that all of the terms but one on the right cancel, we have:
V0 – V0(1 + g) / (1 + k) = D0(1 + g) / (1 + k)
V0(1 + k) – V0(1 + g) = D0(1 + g)
V0(k – g) = D0(1 + g)
V0 = D0(1 + g) / (k – g)
Voilà!
Thanks for explaining it guys !
Both your answers gave me a significant insight on the topic .
Thanking ,
HedgeFudge
