INVESTMENT ANALYSIS – AREAS OF CONCENTRATION (TOPIC: EARNING MODEL)

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EARNING MODEL

Some investors like to use an earning approach for common stock valuation.

He did not say much about theory – he told us that this will be calculation. So, straight to it guys.

D= E (1-b)

Where:

D = dividend per share

E = Earning per share

(1-b) = Earning retention rate

Earning retention (1-b), is the dividend payout ratio.  Therefore an equivalent earning based valuation.

Po = E₁  (1-b)

              K-g

Where:

Po = is the stocks present value

E₁ = Earning expected at the end of year 1

g= expected earnings growth rate

K = stock required rate of return

note that E₁ = Eo(1+g).

So, we have to substitute Eo (1+g) into the E1.

So where have something like this.

Po = Eo(1+g) (1-b)

                K-g

ILLUSTRATION:

The M & M Corporation currently has earnings that are N4 per share.  In recent years, earnings have been growing at a  rate of 7.5% and this rate is expected to continue in the future, if M & M Corporation has a retention rate of 40% and a required rate of retune of 14%, what is M & M current value?

SOLUTION:

Po = Eo(1+g) (1-b)

                K-g

Eo= N4

(1+g) =  1+ 7.5%

(1-b)=   1 - 40%

K=   14%

Po =  4(1 + 0.075) (1-0.4)

             0.14 – 0.075

Po= 4 (1.075)(0.6)

           0.14-0.075

Po=  2.58

       0.065

Po = N39.69

Explanation:

I have to do some explanation here:  The 4 is earnings per share. The 1 is constant, while the 0.075 is the 7.5% when divided by 100.  Then 0.4 is the 40% in the question. 

Now below it, we have 0.14 which is 14% minus 0.075 which is the same 7.5% that represent (g) in our question.  Now you have to solve the ones in bracket then multiply with 4 before you solve the one below and divided your answer.

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