Security price depends on a host of factors like earnings per share, prospects of expansion, future earnings potential, possible issue of bonus or rights shares, etc. Some demand for a particular stock may give pleasure of power as a shareholder or prestige and control on management. Satisfaction and pleasure in the non-monetary sense cannot be considered in any practical and quantifiable sense. Many psychological and emotional factors influence the demand for a share.
In money terms, the return to a security on which its value depends consists of two components:
(i) Regular dividends or interest, and
(ii) Capital gains or losses in the form of changes in the capital value of the asset.
If the risk is high, return should also be high. Risk here refers to uncertainty of receipt of principal and interest or dividend and variability of this return.
The above returns are in terms of money received over a period of years. But money of Re. 1 received today is not the-same as money of Re. 1 received a year hence or two years hence etc. Money has time value, which suggests that earlier receipts are more desirable and valuable than later receipts. One reason for this is that earlier receipts can be reinvested and more receipts can be got than before. Here the principle operating is compound interest.
Thus, if Vn is the terminal value at the period n, P is the initial value, g is rate of compounding or return, n is the number of compounding periods, then Vn = P (1 + g)n.
If we reverse the process, the present value (P) can be thought of as reversing the compounding of values. This is discounting of the future values to the present day, represented by the formula-
P = Vn /(1+ g)n
where the meaning of the terms used is the same as indicated above.
The major factor which influences security prices is the return on equity capital to the investor. This return may be in the form of dividends or net earnings of the company. Thus, the value of a share is a function of the company’s dividend paying capacity or its earnings capacity. The dividends may be different from the earnings depending on the amount of profits retained by the company for the requirements of liquidity, expansion, modernization, etc.
Normally, the value of a share is its book value, if the shares are not quoted on the market. On the other hand, the market price of shares quoted will differ from the book value based on investors’ perception of the future earning potential of the company, growth prospects and the industry prospects, quality of management, the goodwill or the intangibles of the company.
If the security is an equity share, its return is Dividend + Capital appreciation. Then the future dividends may not be constant or fixed as also the degree, of capital appreciation.
Graham’s Approach to Valuation of Equity:
In their book on Security Analysis (1934) Benjamin Graham, and David Dodd, argued that future earnings power was the most important determinant of the value of stock. The original approach of identifying the undervalued stock is to find out the present value of forecasted dividends, and if the current market price is lower, it is undervalued. Alternatively, the analyst could determine the discount rate that makes the present value of the forecasted dividends equal to the current market price of the stock. If that rate (I.R.R. or discount rate) is more than the required rate for stocks of similar risks, then the stock is underpriced.
Graham and Dodd had argued that each dollar of dividends is worth four times as much as one dollar of retained earnings (in their original Book); but subsequent studies of data showed no justification for this. Graham and Rea have given some questions on Rewards and risks for financial data analysts to answer yes or no and on the basis of these ready to answer questions, they decided to locate undervalued stocks to buy and overvalued stocks to sell.
Such readymade formulas or questions are now out of favour due to various empirical studies which showed that earnings models are as good as or better than dividend models and that a number of factors are ably studied for common stock valuation and no unique formula or answer is justifiable.
Securities Valuation in India:
In India, the valuation of securities used to be done by the CCI for the purpose of fixing up the premium on new issues of existing companies. These guidelines used by CCI were applicable upto May 1992, when the CCI was abolished. Although the present market price will be taken into account a more rational price used to be worked out by the CCI on certain criteria.
Thus, the CCI used the concept of Net Asset Value (NAV) and Profit-Earning Capacity Value (PECV) as the basis for fixing up the premium on shares. The NAV is calculated by dividing the net worth by the number of equity shares. The net worth includes equity capital plus free reserves and surplus less contingent liabilities. The PECV is estimated by multiplying the earnings per share by a capitalisation rate of 15% for manufacturing companies, 20% for trading companies and 17.5% in the case of intermediate companies. Earnings Per Share (EPS) is calculated by dividing the three-year average post-tax profits by the total number of equity shares. Thus, if EPS is Rs. 5 and if the price earnings multiplier is 15, the price of share, which is reflected by the PECV, should be Rs. 5 x 15 = 75 (if it is a manufacturing company).
To be more specific,
The Net Asset Value of a company (NAV) = Total assets less liabilities, borrowings, debts, preference capital and contingent liabilities which is to be divided by the number of shares.
The (PECV) is obtained by capitalising the average profits after tax (over the past three years) by a rate varying from 15% to 20% depending on the nature of the activity of the company.
Factors that influence share prices
In case of lower bank rate (lower interest rate), the demand for funds would be higher and the demand for securities would he high. Whereas in case of higher bank rate (high interest rate). The demand for funds would be lower and therefore the demand for securities would be lower.
Demand and supply
Demand and supply of securities influence price of securities. If the demand of securities is more than the supply (buyers are more than the sellers), prices of securities increase. On the other hand if the demand of securities is less than the supply (buyers are less than the sellers), prices of securities decrease.
Security prices are influenced by the market players. If the number of bulls are more than the bears, then the prices of securities would increase. On the other hand, if the bears are more than the bulls, the prices of securities would decline.
Management profile significantly influences success of companies and therefore they have an important influence on share prices. If the management comprises of educated, experienced professionals with a successful track record then share prices would be higher. In case the company is taken over by a management having a poor reputation then the share prices would fall.
Dividends act as a signalling device for share price movement. Dividend announcements influence share prices. If companies announce dividends, generally share prices of those companies tend to increase. An important point to note is, if the rate of dividend announced is less than what was expected by investors, share prices would decline, whereas if they are up to are more than expectations. Share prices would increase.
Trade cycles refer to cyclical fluctuations in economic activity. During boom conditions the share prices would be at their peak and during depression they would be at their lowest point. Share prices would gradually increase during recovery conditions and would fall during conditions of recession.
Political factors such as ideology of the party in power, policies of the government, and relations with other countries influence share prices. For e.g. when the UPA government won elections, share prices fell to a great extent because it was felt that the government policies would be influenced by the communist parties.
In case speculation in the market is high or in case speculation in a stock is high, then the price of that share would be showing high fluctuations. In case speculation is at a low level then the fluctuations in share price would be lower.
In case there is good relationship between the workers and the management of a company, the productivity would be high leading to better profits. Therefore share prices would be higher. In case of companies where industrial relations are poor and strikes and lockouts occur regularly, performance of the company would be poor. Therefore share prices would fall.
Stability of government
When there is a stable government, businessmen feel confident to invest in new businesses and expand existing businesses. Production, sales and profits are higher and consequently share prices would increase. In case of instability in the government, new investments do not take place. Demand, production and profits are lower and share prices fall.
General market sentiments
It is generally said that sentiments move the markets. If there is optimism among market players, more buying would take place leading to increase in share prices. In case market players are pessimistic, then more selling would take place pushing down share prices.
Level of foreign investment
In recent times, the level of foreign institutional investors (FII’s) have played a significant role in influencing share prices. If the level of foreign investment in the market increases (more buying of shares), then the share prices increase. If the level of foreign investment decreases of if FII’s sell their investments, then the markets fall.
Returns offered by other markets
If the Indian markets offer high returns, institutional investors (especially FII’s) would invest in Indian markets. Demand for shares would increase and prices rise. In case returns offered by markets in other countries are attractive, then institutional investors would sell their securities in order to invest in those markets. In such cases, shares would be sold in large quantities lowering prices.
Actions of institutional investors
Share prices are influenced by Institutional investors such as mutual funds, investment trusts, pension funds etc. They have large amount of funds at their disposal. When they start buying, share prices would increase and when they sell, share prices decline.
Availability of credit
In case credit is available without much restriction, then investors would borrow to invest in the markets. Demand for shares would be more and therefore prices rise. In case credit is restricted, then the level of borrowing would be less and demand for shares would also be lower.
If the stock market is run in a transparent manner with effective regulation then the investors would feel confident to invest. Therefore more buying would take place and share prices increase. But when regulation is ineffective and if scams occur (Harshad Mehta scam, MS Shoes scam, CRB scam, Ketan Parekh scam and the recent IPO scam) investors would lose confidence. They would panic and sell their shares. So prices would fall.