Stock Valuation in Capital Markets - Essay Example

Stock Valuation Introduction Stock valuation is essential for every organisation as it helps in determining future ability of a firm’s stock to generate healthy returns in future (Sharpe, Alexander and Bailey, 1999). In this paper, the stock valuation has been performed for Pennon Group, Severn Trent, United Utilities Group and National Grid for 2012. The method that has been implemented in the assessment is Gordon’s dividend growth model. Furthermore, relative valuation has also been performed for understanding agility of the stock. Lastly, the stock value measured in 2010 has been compared and contrasted with that in 2014 and suitable advice or suggestions has been provided for potential investors. Equity valuation using Gordon’s dividend growth model The price of the shares of each company has been calculated using Gordon’s Dividend growth model where cost of equity has been measured using Capital Asset Pricing model. These values are: Table 1 (Source: Author’s creation) In the above assessment, the expected value of dividend for 2013 has been measured by taking into account a dividend growth rate that has been proposed by board of each company which is atleast few percentage above the prevailing inflation rate. The expected value has been calculated using Gordon’s formula: D1=D0 (1+g); where g is the dividend growth rate. The dividend growth rates have been sourced from annual report of each company for 2012 (Pennon Group Plc, 2012; Severn Trent, 2012; United Utilities, 2012; National Grid, 2012). The risk free return value has been obtained by taking into account yield on 10 year UK government bonds. It was considered risk free because only government bond investments are considered absolutely safe. The data has been sourced from Open Knowledge (2015) and annual value has been taken into account. The beta represents systematic risk of an organisation. In this paper, the beta value of each company against all FTSE shares has been considered (Caldwell, 2013). The price earnings (P/E) ratio reflects healthy prospects of a company in the stock market. It is calculated as: Market price of share/ Earning per Share. As per instruction of the paper, the market price of share of each company has been calculated on 01 October 2012. However, the EPS value was measured from the respective annual reports. The expected market return has been calculated as reverse of the price earnings ratio. The cost of equity herein has been calculated as: Ke = Rf + β * (Rm – Rf) and Share price = D1 / (Ke – g) (Sharpe, Alexander and Bailey, 1999). Merits and limitations of Gordon’s dividend growth model Stock valuation can be largely categorised as absolute valuation model and relative valuation model. For absolute valuation, the paper has considered dividend discount model. One of the important dividend models is Gordon’s dividend growth model. This model is essentially utilised for valuation of equity stocks and is based on the notion that dividend of a firm observes constant growth. The model was proposed by Myron J. Gordon, who suggested that the model will be useful in determining the intrinsic value of an organisation’s stock without taking into account existing market conditions. The model has two forms, namely, multistage growth model and constant growth model. In this paper, the later has been implemented (Sharpe, Alexander and Bailey, 1999). The Gordon’s dividend growth model is implemented at organisations that have stable growth values and stable leverage position. In addition, the dividend payout should be consistent in these organisations. Erratic dividend policy will not generate appropriate outcome in such cases. The model is considered as the most simple method of stock valuation as it evaluate stock of a company by discounting its dividend that is distributed among its common stockholders. Nonetheless, as discussed previously, this model requires further modification for implementing in different organisations. For instance, multistage growth model is implemented in an organisation where the growth rate is not constant. In such situations, dividend for each year is discounted individually for achieving the final value (Sharpe, Alexander and Bailey, 1999). There are certain kinds of organisations who prefer adopting Gordon’s dividend model for stock valuation. The model is useful at regulated organisations such as utilities because growth rate of these corporations are constrained by demographic factors such as population and geography. Largely, these growth rates are very close to the value of economic growth in the country of operation. The model is used by financial service corporations as well; because these firms tend to witness extraordinary growth and pay off large amount of dividend. Furthermore, such firms have very stable capital structure in terms of leverage and it is difficult for them to determine free cash flow with respect to equity. Lastly, real estate organisations prefer Gordon’s model because they need to pay off atleast 95 percent of their earnings as dividend and they do not grow at supernatural rate (Sharpe, Alexander and Bailey, 1999). Relative valuation of the companies Relative valuation is an essential aspect of stock valuation process and it is conducted for comparative analysis. In this valuation method, value of a particular stock or asset is compared to the value of comparable stocks in the same industry or market. Unlike fundamental valuation which is intrinsic in nature, relative valuation is performed on the basis of market value. In this valuation, comparable organisations and their assets are identified and their respective market value is gathered. Moving on, these values are converted into standardised values in the form of multiples so that comparison can take place. The multiples are essential in relative valuation because comparison cannot be performed on the basis of absolute price (Sharpe, Alexander and Bailey, 1999). By contrasting the multiples, the undervalued or overvalued status of an asset is determined. In this paper, the relative valuation has been done for Pennon Group, Severn Trent, United Utilities Group and National Grid using P/E ratio. The four companies are important parts of the utilities industry of the UK. The P/E ratio will compare proportion of market price of share of each company with its earnings per share. Earnings per share (EPS) point towards the proportion of net profit that is allocated to each outstanding common share. It is an important measure of firm’s profitability and the P/E ratio helps investors in selecting right stock for investment. The P/E ratio for 2012 for each of the company has been represented in the figure 1. The P/E ratio reflects projected earnings of a company’s stock in near future. Additionally, it denotes that amount investors are keen to pay per unit of earnings. Figure 1 (Source: Author’s creation) The P/E ratio of Severn Trent was determined to be highest while that of National Grid was observed to be lowest. Severn Trent stocks can be considered as growth stock as high P/E ratio reflects higher return from the stock in the near future. Stock with low P/E ratio are often considered unattractive stocks and are generally purchased by value investors based on the assumption that in future these stock will perform better. Another advantage of stocks having low P/E ratio is that they are generally not overpriced. In this context, Pennon and United Utilities are at a moderate position among the four companies. Comparison of determined value and quoted value of each company’s stock Pennon Group Severn Trent United Utilities National Grid Calculated price of share £ 61.98 £ 201.58 £ 21.35 £ 71.30 Market value of share (1st Oct. 2012) £ 7.35 £ 17.05 £ 7.25 £ 6.96 Pennon Group is one of the undervalued stocks of the utilities industry of the UK. The market value of the company’s share in 2012 was determined to be at least 88% less than its book value. The possible reasons for undervalued stocks can disinterest in the particular sector, poor performance of the sector or the company. On an average, it was determined that all the four companies had undervalued stock. Severn Trent was observed to be undervalued by around 91%; whereas those of United Utilities and National Grid were observed to be around 92.5% and 90% respectively. This suggests two possibilities that either the industry is least attractive to common shareholders or the undervaluation is an outcome of economic downturn. During 2012, most companies in the US and the UK were recovering from the recession and it may have affected their performance in terms of their market value. It is possible that during this period of economic turbulence, investors lost confidence in stock market and it affected their market prices. However, it is noteworthy that the utilities stocks are largely defensive in nature, which implies that they are generally not affected by disturbance in economic cycle as they are least correlated therein (Pennon Group Plc, 2012; Severn Trent, 2012; United Utilities, 2012; National Grid, 2012). Comparison of market value of equity in 2012 with that in 2014 Pennon Group Severn Trent United Utilities National Grid Market value of share (1st Oct. 2012) £ 7.35 £ 17.05 £ 7.25 £ 6.96 Market value of share (1st Oct. 2014) £ 7.85 £ 18.53 £ 7.85 £ 8.86 Growth 7% 9% 8% 27% Figure 2 (Source: Author’s creation) Pennon Group: Pennon Group is an undervalued utilities share in the UK stock market. The company had a market value of £7.35 in 2012 which improved only by 7% in last two years. In 2014, the quoted value of the stock was determined to be £7.85. the main reason for the poor performance can be loss of revenue in 2014 due to tarrif freeze and poor performance of Viridor (Yahoo finance, 2015a; Pennon Group Plc, 2015). Severn Trent: Severn Trent was recognised as a growth stock in 2012 even when its share price was undervalued. Severn Trent had the high P/E ratio suggesting strong growth prospect. It was however, observed recently that the stock did not performed really well in past two years. The rise in its market value was determined to be only by 9% in 2014. The raise was as low as £1.50. arguably, it did not perform as it was expected by its investors (Severn Trent, 2015; Yahoo finance, 2015b). United Utilities: Similar trend was observed for UnitedUtilities as well. The growth was slow and was around 8%. The market value of share of the company increased only by 60p in last two years. Ironically, United Utilities had the second best prospect of improvement in future earnings as per its P/E ratio in 2012. It is possible that the company failed to meet expectations of investors and as a result, shareholders started selling off their shares (United Utilities, 2015; Yahoo finance, 2015c). National Grid: Among all the four companies, it was interesting to observe that National Grid was observed to witness a strong growth. The company had lowest P/E ratio in 2012 and consequently, had lowest prospect of investment and gerenating earnings. It was also observed that the company was considered as an underperformer. However, in past two years the share price has increased from £6.96 to £8.86 reflecting 27% growth. One possible reason for this favourable growth is sudden increase in revenue of the company and development of asset backed shares (National Grid, 2015; The Telegraph, 2014). Advice to a long term potential investor The advice to a potential investor can be classified in two parts: reason for investing in utilities sector and reason for investing one of the above mentioned four companies. Utilities are referred to as income generating stock and mainly comprise organizations such as electricity, water and gas. The industry is driven by stability as it is least associated with economic cycle (The Telegraph, 2014). Therefore, they are not affected by cyclic disturbances. Additionally, companies in this industry mainly distribute majority of its earnings as dividend. Government utilities companies are largely categorized as value stock while some are also addressed as growth stocks. The companies have monopoly in their specific sectors and as a result remain profitable because of negligible level of competition. Such organizations do not go out of business, especially because of their nature of business. Among the above three companies, the potential investor should invest in National Grid. National Grid is currently an undervalued but value stock which is experiencing slow yet steady growth. The investor will be able to purchase the stock at a low price presently, while it can sell off the stock later as its price increases. Reference list Caldwell, R., 2013. Estimate of BT’s equity beta. [pdf] The Brattle Group. Available at: [accessed 06 April 2015]. National Grid, 2012. Annual report 2012. [pdf] National Grid. Available at: [accessed 06 April 2015]. National Grid, 2015. Dividend history. [online] Available at: [accessed 06 April 2015]. Open Knowledge, 2015. 10yr UK Government Bond Yields (long-term interest rate). [online] Available at: [accessed 06 April 2015]. Pennon Group Plc, 2012. Annual report 2012. [pdf] Pennon Group. Available at: [accessed 06 April 2015]. Pennon Group Plc, 2015. Dividend: Historical information. [online] Available at: [accessed 06 April 2015]. Severn Trent, 2012. Annual report 2012. [pdf] Severn Trent. Available at: [accessed 06 April 2015]. Severn Trent, 2015. Dividend payment history. [online] Available at: [accessed 06 April 2015]. Sharpe, W. F., Alexander, G. J. and Bailey, J. V., 1999. Investments (Vol. 6). Englewood Cliffs, NJ: Prentice-Hall. The Telegraph, 2014. Questor share tip: National Grid hits record highs. [online] Available at: [accessed 06 April 2015]. United Utilities, 2012. Annual report 2012. [pdf] United Utilities. Available at: [accessed 06 April 2015]. United Utilities, 2015. Dividend. [online] Available at: [accessed 06 April 2015]. Yahoo finance, 2015a. Pennon Group. [online] Available at: https://uk.finance.yahoo.com/q/hp?s=PNN.L&b=15&a=08&c=2012&e=30&d=09&f=2012&g=d> [accessed 06 April 2015]. Yahoo finance, 2015b. Servent Trent. [online] Available at: [accessed 06 April 2015]. Yahoo finance, 2015c. United Utilities. [online] Available at: [accessed 06 April 2015]. Read More