📘 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.

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:

P₀ = D / r

Example – Zero Growth

Dividend (D) = Rs. 5 per year
Required return (r) = 10%

P₀ = 5 / 0.10 = Rs. 50

If market price is Rs. 40 → the stock is undervalued.

5. Constant Growth Model (Gordon Growth Model)

This model assumes dividends grow at a constant rate (g) forever.

Formula:

P₀ = D₁ / (r – g)

Example – Constant Growth

D₀ = Rs. 4
Growth rate (g) = 6%
Required return (r) = 12%

D₁ = 4 × 1.06 = Rs. 4.24

P₀ = 4.24 / (0.12 – 0.06) = Rs. 70.67

If market price is Rs. 60 → 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 – Supernormal Growth

D₀ = Rs. 2
Supernormal growth = 20% for 3 years
Stable growth = 5% thereafter
Required return (r) = 12%

Step 1: High-growth dividends

D₁ = 2 × 1.20 = 2.40
D₂ = 2.40 × 1.20 = 2.88
D₃ = 2.88 × 1.20 = 3.456

Step 2: Terminal Value

D₄ = 3.456 × 1.05 = 3.6288

P₃ = 3.6288 / (0.12 – 0.05) = 51.84

Step 3: Present Values

PV(D₁) = 2.40 / 1.12 = 2.14
PV(D₂) = 2.88 / 1.12² = 2.30
PV(D₃) = 3.456 / 1.12³ = 2.46
PV(P₃) = 51.84 / 1.12³ = 36.88

Total Value: P₀ = 2.14 + 2.30 + 2.46 + 36.88 = Rs. 43.78

If market price is Rs. 55 → 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 → stable	Advanced

8. Advanced Extensions

Two-Stage Growth Model: High growth → 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

✔ Stock valuation helps identify true worth of a stock.

✔ Different models apply to different types of firms.

✔ Supernormal growth models reflect real-world behavior.

✔ For advanced valuation, use FCF and relative valuation models.

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