One thing we know is that share prices fluctuate. We also learnt in Economics 101 that the price of a commodity is determined by the demand and supply. If supply remains constant the increasing demand for a commodity (in our case shares) go up, share prices go up and when demand goes down or supply increases price goes down. This is the BEST THING to say about price volatility – because it is the truth.

However, what makes people ready to pay a higher price for a share and what makes them sell a share at the given price?

Well earnings, expectations of future earnings, visibility of future earnings, dividend payout (Modigliani and Miller said people are indifferent to dividends, but we will ignore that for now), return expectation by the investor, ..are all factors which make a share price fluctuate. We do not have enough Indian research, but let’s use the American research – ‘Share prices fluctuate about 30% more than corporate operating earnings and about 250% more than dividend changes’.

Why do share prices jump up / move down more than earnings or dividends? Purists claim that the market widely overreacts to earnings data, and that may be true – but not always. Mathematically, the so called volatile share prices are acting rationally as growth and risk expectations change. Large swings in share price can (read can not must) occur with only minor changes in these expectations. Exactly like the leverage effect. So for a share with a PE of 30 a Re. 1 change in earning HAS to see a Rs. 30 fluctuation in price.

All asset prices are subject to risk (volatility in this case) because future cash flow could be affected by many factors, including inflation AND international interest rates and international investment opportunities. A small change in the probability that a risk (yes risk) could occur can impact a big cash flow differences over the life of an investment.

There are 3 important ingredients for figuring out the price of ANY asset using this THEORY. They are

current cash flow,

the expected change in future cash flow,

and the risk to the expected cash flow stream.

There are many cash flow discount models for calculating prices. We’ll use the Dividend Discount Model (DDM) for this exercise. The DDM is a way of valuing stocks based on the theory that a company is just the discounted sum of all of its future dividend payments. Of course this theory cannot be used for companies growing very fast and not willing to be good dividend paymasters – which means this valuation method is good only for VALUE INVESTORS, and not really for GROWTH INVESTORS.

Dividends paid today are worth the full cash value of the payment.  The dividends to be paid in the future are not worth have to be discounted (obviously because of interest rates / inflation). Future expected dividends must be “discounted” by a factor to find their present (real) value and the price of the stock.

Successful companies without much growth opportunities increase their dividends regularly. This growth rate logically has to be factored in too for doing the valuation.

Finally, there is always a risk (chance) that the company may not be able to pay dividends because it fell on bad times. Investors price this risk by asking for (expecting) a higher return during normal times.

Mathematically, the DDM equation is:

where Po is the price of the share today,

D1 is the dividend expected to be paid in the current or next year,

r is the required return on the investment based on its risk,

and g is the growth rate of the dividends.

OK, not mathematically inclined? well this is simple, sit tight.

  • D1 is the expected dividend payment over the next 12 months. Assuming that Rs. 10 was paid last year we can expect to get Rs. 10.50 next year.
  • g is the growth rate of the dividend. Since we’re expecting 10.00 to grow to 10.50, it’s a 5 percent growth rate.
  • r is your expectation. It is the require return you need to own this share based on its expected cash flow and risk. This number has to be higher than a bank return that you get. It has to be higher than the bond return that this company would pay you for the bonds that you subscribe – OBVIOUSLY the risk in bonds is lesser. On average, shares should / do deliver about 5 percent more than government bonds. However this is still an arbitrary figure. You may factor in more risk for micro cap shares and mid cap shares vis a vis large cap shares. All this is built into r.

Let’s assume a 10 percent required return for this example.

Here’s what we have so far:

D1 = Rs 10.50, g = 5 percent (0.05) and r = 10 percent (0.10)

Now we can calculate the price of the stock today.

Po = 10.5 / (0.10 – 0.05) =Rs. 210

Rs.210 is what the price of the share should be, given the DDM data. Pick an equity share and do this exercise. Pick Rico Auto, Coromandel International, Cholamandalam Investment and Finance for starters.

Tomorrow we will see how prices fluctuate….oops that was the title today too!! However to know how prices fluctuate, you needed to know how prices got determined, right?

 

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  1. This is one of the best articles you have ever written of this blog Subraji.

    This is what I am searching for so many years.

    Please pubilsh a article of valuation of growth companies also.

    Also,please write a series of articles on fine points to be kept in mind while applying these valuation methods.

    Again , million thanks for to start such initiative.

  2. sorry Neal..do not expect a pattern. Subramoney is not about a book with an index. I may or may not write about growth companies – I routinely reject growth stories in my portfolio – Mindtree, Biocon, Equitas..being exceptions…

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