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» Introduction  Manual for valuation of companies in the stock market

We have decided in Mofinet to offer some of our contents in a specific format, which we understand will have an special interest for those of our visitors focused in developing their understanding of different aspects for the valuation of the companies present in the stock exchange market.

In order to let you know a little more about the fundamentals of the valuation applied to the shares of companies in the stock market, we are going to guide you through some steps. Also, we intend to help you to judge by yourself about the reasonability of the values that some of the companies have in the market at present.

What we have calculated in the examples is the share value of the company. However, if you use the figures of dividends and profits for all the company (instead of dividend and profit per share), the same concepts will be applicable for valuation of the company as a whole.


  1. Calculation of cost of own sources of financing for
    the company.
  2. Calculation of share value of the company.
  3. Calculation of growth rate in perpetual dividends that the
    company should achieve, in order to justify the market value
    of its shares.
  4. Estimation of profits that the company would have to achieve
    in the next years in order to justify the share value that the
    company has in the market at present.

  1. Calculation of cost of own sources of financing for the company.
    First of all, you calculate the cost of the own sources of financing for the company that you want to get a value. To get this target, we propose you to apply the formula of the CAPM ("Capital Asset Pricing Model"): It is a method for the calculation of the yield to be requested to the own sources of financing.

    CAPM = FY + ß (MY - FY)

    Whereas:

    FY: Yield of non risk assets (normally treasury bonds)
    MY: Yield of the stock market
    (MY-FY): Risk premium of the stock market
    ß (or beta): Coefficient of variation of the company's own sources of financing in relation to the stock market own sources of financing. With a higher value of ß, the risk of the company will be higher.
    If ß>1: The expected yield of own resources of financing of the company will be higher than the one of the market.
    If ß<1: The expected yield of own resources of financing of the company will be lower than the one of the market.
    If ß=1: The expected yield of own resources of financing of the company will be equal to the one of the market.


    Example of CAPM calculation:




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  2. Calculation of share value of the company.
    When you have calculated the cost of the own sources of financing for the company, we invite you to apply the formula of Gordon & Shapiro: A simple method that is used to calculate the company's share value. Its general expression is:

    Vs = Div1/k-g = (Divo * (1+g))/k-g

    Whereas:

    Vs: Share value of the company
    Div1: Dividend per share that the company expects to obtain in the next year
    Divo: Dividend per share that the company expects to obtain this year
    k: Cost of own sources of financing for the company (CAPM)
    g: Constant rate of increase in perpetual dividends

    Please find in the following image an example of how this formula is applied to calculate the share value of the company:

    Example of calculation of the company's share value using the formula of Gordon & Shapiro (figures are in US$):



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  3. Calculation of growth rate in perpetual dividends that the company should achieve, in order to justify the market value of its shares.
    Now we invite you to apply the same formula to judge if the share value of company in the market is reasonable, considering the percentage of increase that its perpetual dividend should achieve.
    Please find in the following image an example which shows what we are saying:

    Example of the constant rate of increase in perpetual dividends per share that the company should achieve, in order to justify its present share value in the market:



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  4. Estimation of profits that the company would have to achieve in the next years in order to justify the share value that the company has in the market at present.
    And finally, we propose you a method for the valuation of the shares of a company which expects losses during the initial years of our projection, and after this initial period, it achieves enough profits to justify the present value of its shares in the market. This is the case of many internet start-up companies. To apply this model in a simple manner, we will substitute the figures of "dividend" or "cash flow", which would be the right figures to use from a technical point of view, for the figure of "profit", which is a more common and easy to figure out number.
    To get our target, we suppose an horizon for our projections of seven years, in which the company is going to post those profits (or losses) per share that we input. Starting from year eighth, we suppose that its profits will increase perpetually with a 3 % growth rate. We input the figure of the cost of own sources of financing (in these cases, given the implicit high risk, a reasonable rate would be around 20 % to 25 %), and we verify which are the values that we have to input as expected profits (or losses) by share within the next seven years in order to obtain a similar share value of the one that the company has presently in the stock market. After that, we evaluate if the figures that we have introduced in the projections seem reasonable, and, therefore, if the market value of the company's shares is reasonable or not.
    Another method to achieve the same target would be to input our actual expectations of profits (or losses) per share for the initial seven years, and to check if the share value which results from the projections is close to the present market value of the shares or not.
    Please find in the following image an example which shows what we are saying:

    Example of calculation of the company's share value:

    We have used the following abbreviations:

    P: Profit (or loss) per share of the company during the seven initial years.
    g: Forecast of perpetual growth rate for the company's profit per share starting from year seven
    k: Cost of capital that we are going to use for this company
    RV: Residual value of the share that results in the seventh year
    r: Discount rate (k)
    1/(1+r)^n: Discount factor for this rate
    Pnrv: Discounted profits without including residual value
    Prv: Discounted profits including residual value
    Vs: Valuation of share without including residual value
    V: Valuation of share including residual value (sum of Prv)



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If you have any doubt about the concepts which are mentioned in this page, you can consult our manual of financial concepts.


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