There are various ways of valuing a security. The most acceptable one calculates value as the present value of all cash flows over the life of the security discounted at a rate appropriate with their riskiness.
If we consider equity, the value of equity then represents the present value of all cash flows from equity (including cash outflows) over the life of equity, that is, life of the business itself. Cash flows depend on the nature of business, its reinvestment needs, growth periods and growth rate.
Since values are only estimates, these are highly subjective and depend on the perceptions of the valuer. Hence, these will invariably differ when estimated by different analysts. Also, the value will differ at various points of time when calculated by the same analyst due to changes in perceptions.
We can also extend this equation to the entire market such as an equity index. The value of the index then becomes present value of all cash flows from owning that index over its life which is a very long period of time.
Since we know the present value of the index (which is its current value), we can calculate growth rates and expected returns (discount rate) implied in the index value.
We can calculate implied rate of growth by keeping the index value and discount rate constant or calculate implied discount rate by keeping the index value and growth rate constant.
Based on this equation, the implied rates of nifty as of 4 October 2012 (index value: 5787.60 with a dividend yield of about 1.5%) are as follows:
Note: We have to view the following in the context of high inflation and government bond rates.
A 5-year growth period is assumed.
1) Keeping discount rate of 10.50% and terminal (stable period) growth rate of 8%, the implied growth rate (growth period) is about 18%.
2) Keeping discount rate of 13% and terminal growth rate of 8%, the implied growth rate is about 37%.
3) Keeping discount rate of 13% and growth rate of 18%, the implied terminal growth rate is about 10.75%. This means the market is implying that the companies will be able to sustain a growth rate of 10.75% until almost infinity.
These implied values are indicative of what the investors, speculators, analysts and others are expecting from the underlying businesses.
We can change any variable and see how it affects other variables. It is an interesting exercise just for fun to see the ingredients in the market.
This is just a nice little game when you are in that mood; not to be taken too seriously. Play it at your own risk.
If we consider equity, the value of equity then represents the present value of all cash flows from equity (including cash outflows) over the life of equity, that is, life of the business itself. Cash flows depend on the nature of business, its reinvestment needs, growth periods and growth rate.
Since values are only estimates, these are highly subjective and depend on the perceptions of the valuer. Hence, these will invariably differ when estimated by different analysts. Also, the value will differ at various points of time when calculated by the same analyst due to changes in perceptions.
We can also extend this equation to the entire market such as an equity index. The value of the index then becomes present value of all cash flows from owning that index over its life which is a very long period of time.
Since we know the present value of the index (which is its current value), we can calculate growth rates and expected returns (discount rate) implied in the index value.
We can calculate implied rate of growth by keeping the index value and discount rate constant or calculate implied discount rate by keeping the index value and growth rate constant.
Based on this equation, the implied rates of nifty as of 4 October 2012 (index value: 5787.60 with a dividend yield of about 1.5%) are as follows:
Note: We have to view the following in the context of high inflation and government bond rates.
A 5-year growth period is assumed.
1) Keeping discount rate of 10.50% and terminal (stable period) growth rate of 8%, the implied growth rate (growth period) is about 18%.
2) Keeping discount rate of 13% and terminal growth rate of 8%, the implied growth rate is about 37%.
3) Keeping discount rate of 13% and growth rate of 18%, the implied terminal growth rate is about 10.75%. This means the market is implying that the companies will be able to sustain a growth rate of 10.75% until almost infinity.
These implied values are indicative of what the investors, speculators, analysts and others are expecting from the underlying businesses.
We can change any variable and see how it affects other variables. It is an interesting exercise just for fun to see the ingredients in the market.
This is just a nice little game when you are in that mood; not to be taken too seriously. Play it at your own risk.
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