Applying Dividend Discount Model (DDM) to 'State Bank of India' (SBI)

Dividend Discount Model values a firm's equity on the basis of the future dividends that the company is expected to give. Discounting all the future dividends gives the value of the stock as this is the only money an investor is going to get if he keeps the stock till perpetuity.

The general valuation formula for DDM is:
P = D1/(k - g)

where
P - ideal price of the stock
D1 - dividends for the year 1
k - cost of equity/ discounting rate
g - growth rate of the dividends

There are some assumptions in this model which require careful use of this model for finding the intrinsic value of a stock based on its dividends.

We will use a live example of State Bank of India (SBI) to illustrate the use of DDM. The following is the last 10 year dividend history of the company:

Year End	Total Dividends paid (Rs crores)	PAT (Rs crores)	Retained Earnings (Rs crores)	Retention ratio, b
Mar-98	211	1861	1650	0.89
Mar-99	211	1029	818	0.8
Mar-00	263	2051	1788	0.87
Mar-01	263	1880	1617	0.86
Mar-02	316	2423	2107	0.87
Mar-03	447	3105	2658	0.86
Mar-04	579	3681	3102	0.84
Mar-05	658	4305	3647	0.85
Mar-06	737	4405	3668	0.83
Mar-07	737	4534	3797	0.84

Using this we find that SBI has policy to retain about 85% of their earnings and distribute 15% as dividends to its shareholders. The retained earnings add on to the shareholder's equity and should earn profits for SBI. For each year we also looked into the returns on the equity (ROE) for SBI. the data is as follows:

Year End	Retention ratio, b	ROE	Growth rate, g
Mar-98	0.89	21.2	18.8
Mar-99	0.8	10.3	8.2
Mar-00	0.87	18.2	15.9
Mar-01	0.86	14.7	12.6
Mar-02	0.87	17	14.7
Mar-03	0.86	19.2	16.4
Mar-04	0.84	19.7	16.6
Mar-05	0.85	19.4	16.5
Mar-06	0.83	17	14.2
Mar-07	0.84	15.4	12.9

We have calculated the growth rate of dividends using:
growth rate = retention ratio X Return on equity ; g = b*ROE
Since dividends next year will be equal to this year's dividends plus the earnings on the retained earnings of this year with SBI.

The average growth rate for the 10 year period was about 14.7%.

SBI paid dividends of Rs 14 per share in 2007. Hence D0 = 14.
D1= 14*(1+g) = 14 * 1.147 ~ 16

Finding the discount rate is the trickiest part of the valuation and it depends on many factors and can be estimated using CAPM or other similar models. For simplifications we will take cost of equity as given in this case. We will take cost of equity as 15% and assume that SBI will enjoy this high growth for next 20 years before settling at something less than India's GDP growth rate (~ 7 %) and find out the value in the next article. Till then you can try it on your own.

[Hint: SBI is currently trading at 2400]


[To be completed in next post...]

What are hedge funds?

Hedging means reducing risk of adverse price movements in a security generally by taking an offsetting position in a related security. So, essentially hedging leads to lower risks.

The term "hedge" was coined by the agriculture industry and farmers were the first "hedgers". They hedged the risk of losing their agricultural produce. Insurance is also a type of hedging method.

A Hedge Fund is fund which can take advantages of any of the hedging strategies, trade in any financial instrument, but produce above average gains at reduced risks. A hedge fund is genrally expected to have positive returns under all market conditions.

Timeline of Hedge Funds
In 1949: Alfred Jones started first hedge fund in the US
In 2005: USD 1 trillion industry with 9,000 Hedge Funds
Oct 2007: Hedge Funds: 2.5 trillion USD

By some estimates the size of Hedge Funds industry has crossed 3 trillion dollars. This is huge when we consider the fact that the total domestic market capitalization of all the stock markets of the world is less than 60 trillion dollars and that of NASDAQ is 4 trillion dollars.

What are bonds?

Bonds are debt instruments that are used by government and corporate to raise money on contractual basis. Generally bonds issuer promises a regular payment of interest which is known as bond’s coupon in finance parlance. In US the period for payment of coupon is every six months. Besides coupon, generally the bond issuer also promises to payback principal at the end of a particular time known as maturity of bond. The payment at maturity is equal to face value/par value of bond.

Coupon rate is the annual coupon payment divided by the face value of the bond. Coupon yield is coupon payment divided by the market price of the coupon.

Those bonds which do not offer any coupon are called zero-coupon or discount bonds.

Bond yield is similar to interest rate which the investor wants on the money he/she is lending to the bond issuer. It is dependent on the coupon rate, maturity, and risk associated with that particular bond.

Bonds issued by government are regarded as risk-free bonds, while those issued by corporate carry some risk of default depending on the company. This risk is reflected in the bond yield requirement. The bond yield of corporate is higher than of government bond. This gets adjusted through the price of the bond. Generally, if the coupon rate is higher than the yield then the bond’s price will be higher than its face value (premium), otherwise it will set at less than face value (discount). The risk associated with the corporate bonds is classified by rating agencies which classify the bonds based on their quality.

Capital Budgeting : Cash Flow Components

As discussed earlier capital budgeting is identifying, selecting the best of available options and implementing long-term investment project whose returns are positive.
For selecting the best investment option future cash flow from the project are estimated and analyzed.

Relevant Cash Flow:
For decision making only incremental cash flow analysis is sufficient.
Sunk Cost is irrelevant for decision making purposes.
Opportunity Cost is relevant.

The cash flow as a result of undertaking a project can be divided into three components:
Initial Cash Flow
Operating Cash Flow
Terminal Cash Flow

Initial Cash Flow (ICF):
Cash flow in acquiring new assets/ initial investment for project. It includes cost of the machines and its shipping and installation, testing etc. For using an already owned asset the opportunity cost of the asset has to be added to cash outflow.
From this we have to subtract the after tax proceeds from the sale of old assets.
Initial cash flow also includes cash flow due to change in net working capital (NWC). Net Working Capital = Current Assets - Current Liabilities. Increase in NWC means cash outflow. Change in NWC is not tax deductible.
All these cash flows are assumed to be occurring at the beginning of the project.

Operating Cash Flow (OCF):
It is estimated after-tax cash flow due to the project during its operating life-time. These cash flow generally vary from year to year. Conservatively, the operating cash flows are taken at the end of a year. First the accounting income is calculated by subtracting depreciation for tax purposes. Taxes are deducted from this income. Depreciation is added back to get Net Operating Cash Flow for that accounting period. For a replacement project incremental analysis can be done. Everything has to be calculated on an incremental basis.

Terminal Cash Flow (TCF):
It is the cash flow when the project is terminated. The TCF will be the salvage value of the project and the recovery of the working capital employed.

All these cash flows have to be discounted to find out the net present value (NPV).
Cash flows due to financing activities are implicit in the discounting rate used for finding NPV and are not relevant for decision making purposes.

P/E ratio (PE ratio, Price to earnings ratio)

P/E ratio
= Market price of a share / Earnings per share (EPS)

= Market Capitalization / Earnings

where

Market Capitalization = Number of shares outstanding * Market price of a share

For calculating the earnings there are several variations.

1. Following measure of Earnings are generally used

Earnings after tax (EAT) {most commonly used}

Earnings before tax (EBT)

Earnings before interest and tax (EBIT)

Earnings before depreciation interest and tax (EBIDT)

Earnings before depreciation interest tax and amortization (EBIDTA)

2. For which period the earnings should be taken for?

Generally the earnings are for a period of one year. Now since prices change on every trading day and can be tracked the earnings can be measured efficiently only for a larger period of time generally a quarter. Another question which arises is which period should be considered. There are two variations to this:

TTM (trailing twelve months) – for past 4 quarters

Annual – For last financial year

Leading – Using projected EPS

Can P/E ratio be negative?

Sometimes companies earn zero profit or even run into losses. Is the P/E ratio significant there? For knowing this we have to find out the purpose of finding the P/E ratio.

What is the purpose of P/E ratio?

It shows how much the investors are willing to par for one dollar of company’s earnings. When compared with the industry average and leader we can find out the level of confidence that investors have in the company. But P/E ratio alone is not a sufficient measure to arrive at any conclusion about the stock.

What are the limitations of P/E ratio?

Inability to capture non-monetary aspects.

No standard for using a measure of earnings

Doesn’t cover the past growth and the future growth projection

Can be interpreted in different ways

A one period exceptional income can distort the picture

Capital Budgeting

This Article tells us about what Capital Budgeting is and what are the various methods used to evaluate projects.

Capital Investment is spending on long-lived assets.
Capital Budgeting is choosing which project to put money. Its not just choosing best project. It involves identifying potential projects, choosing best out of alternatives and implementing it.

Key parameter for decision making:

1. Simplicity of method of arriving at decision
2. Cash Flows from project
3. Accounting for time value of money
4. Risk-return management
5. Stockholder's value

Methods used for decision making:

1) Payback Period: In this method we choose between the projects based on the time taken to recover the initial investment. We choose the project which has the shortest time period.
Limitations with this method is that it does not take into account the time value of money. also, it is not dependent on the initial investment and ignores the cash flow occurring after the payback period

2) Accounting rate of return(ARR): In this method, we find the ratio of accounting profit, i.e. EBIT and average assets. Whichever project has higher ARR, we take that project.
Limitations with this method is that it also ignores time value of money. Moreover, accounting profit is an ambiguous term. It can vary as per the accounting principles followed.

3) Net Present Value(NPV): In this method, we bring all the cash flows to occur in future at the present value.(discounting them using cost of capital) If the net cash flow comes out to be positive, then project is accepted. Project having higher NPV is selected.
Advantage of this method is that it takes into account the time value of money

4) Internal rate of Return(IRR): this is one of the most widely used method. In this we find out the rate or the cost of capital, at which NPV becomes zero. This rate is known as IRR. In normal cases, i.e. positive cash flows occurring in future, if IRR is higher than present cost of capital, project is accepted. Project having higher IRR is selected.
Limitation of this method is that in case, cash flows sign changes, we get multiple values of IRR which creates problem in taking decisions

5) Profitability Index: this is the ratio of present value of cash inflows to cash outflows.

Fisher Equation - Real & Nominal Interest Rate under Inflation

Equation was derived by Irving Fisher
Effect of inflation on interest rates

Let
Rn = Nominal Rate of Interest
Rr = Real Rate of Interest
Ri = Expected Rate of Inflation.
The above rates are in terms of per $ (not %); then according to Fisher

(1+Rn)=(1+Rr)(1+Ri)

which can be approximated as
Rn = Rr + Ri , since interest rates are quite less than 1.

What is Corporate Finance?

Finance is the heart of all the disciplines and no business or person can be competitive without sound financial system.

Corporate Finance is the area of finance in which financial managers manage cash flow in a business environment. It includes things like where to get money from, where to put that money in, when to get money out of a business and so on and so forth.

There are some evergreen principles of finance which are so very basic but are as solid as a rock, and entire foundation of this discipline stands comfortably on these principles. We will discuss these one by one later. Briefly they are:

Time Value of Money
Higher Risk should come with higher returns
Never put all your eggs at one place
Markets are smarter than the smartest individual
Arbitrage chances are rare

Role of Corporate Finance
Financing
Capital Budgeting
Risk Management
Corporate Governance