Stock Valuation & Returns: Models, Metrics & Market Applications

Core Concepts: What is Stock Valuation?

Stock valuation determines the intrinsic value of a share—what it should cost based on future cash flows—versus its market price (what traders pay now). The gap between these drives investment decisions.

Why Valuation Matters

graph LR
    A["Intrinsic Value"] -->|"vs"| B["Market Price"]
    A --> C["Buy if Intrinsic > Market"]
    B --> D["Sell if Market > Intrinsic"]
    C --> E["Potential Profit"]
    D --> F["Avoid Overpaying"]

Key Idea: If a stock’s market price is below its intrinsic value, it’s undervalued (buy opportunity). If above, it’s overvalued (sell or avoid).

1. Dividend Discount Model (DDM): The Foundation

The simplest model assumes a stock’s value equals the present value (PV) of all future dividends. Two versions:

A. Gordon Growth Model (Constant Growth DDM)

For stable, growing dividends (e.g., Ncell, NTC): $$P_0=\frac{D_1}{r-g}$$

• $P_0$: Current stock price
• $D_1$: Next year’s dividend
• $r$: Required return (discount rate)
• $g$: Constant growth rate of dividends

Worked Example: Ncell’s Stock Valuation

• Given:
  • Current dividend ($D_0$) = Rs 12/share
  • Growth rate ($g$) = 5% (historical average)
  • Required return ($r$) = 12% (risk-adjusted)
• Find: Intrinsic value of Ncell’s stock.
• Solution: $$D_1=D_0\times (1+g)=12\times 1.05=\text{Rs 12.60}$$ $$P_0=\frac{12.60}{0.12-0.05}=\frac{12.60}{0.07}=\text{Rs 180/share}$$ Interpretation: If Ncell trades below Rs 180, it’s undervalued.

B. Multi-Stage DDM

For companies with changing growth (e.g., Daraz pre-IPO vs. post-IPO):

1. High-growth phase: Use supernormal growth rates.
2. Stable phase: Switch to Gordon Growth. Example: A tech startup with 20% growth for 3 years, then 5% forever.

2. Free Cash Flow to Equity (FCFE) Model

Values stocks based on cash available to shareholders after operations and debt obligations: $$P_0=\sum _{t=1}^n\frac{FCF{E}_t}{(1+r{)}^t}+\frac{FCF{E}_{n+1}}{(1+r{)}^n(r-g)}$$ When to Use: For companies with no dividends (e.g., Nepal’s real estate firms like Mahabir Group).

Worked Example: Himalaya Company (No Dividends)

• Given:
  • FCFE Year 1 = Rs 50/share
  • FCFE Year 2 = Rs 60/share
  • FCFE Year 3 = Rs 70/share
  • Growth rate ($g$) = 4%
  • Required return ($r$) = 10%
• Find: Intrinsic value.
• Solution: $$P_0=\frac{50}{1.10}+\frac{60}{1.10^2}+\frac{70}{1.10^3}+\frac{70\times 1.04}{1.10^3(0.10-0.04)}$$ $$P_0=45.45+49.59+52.34+1200.00=\text{Rs 1347.38/share}$$

3. Relative Valuation: Multiples Approach

Compares a stock’s metrics to peers (e.g., P/E, P/B, EV/EBITDA). Formula: $$\text{Stock Price}=\text{Multiple}\times \text{Fundamental Metric}$$ Example: If NEPSE’s average P/E is 12x and Mega Company earns Rs 10/share, its fair price = 12 × 10 = Rs 120/share.

Comparison Table: Valuation Methods

Stock Returns: Measuring Performance

Returns come from dividends and capital gains (price appreciation).

A. Total Return

$$\text{Total Return}=\frac{(P_1-P_0)+D_1}{P_0}$$ Worked Example: Himalaya Company

• Given:
  • $P_0$ = Rs 200
  • $P_1$ = Rs 250
  • $D_1$ = Rs 20
• Solution: $$\text{Total Return}=\frac{(250-200)+20}{200}=\frac{70}{200}=35\%$$

B. Dividend Yield vs. Capital Gains Yield

In the Real World

1. NEPSE’s Blue Chips (Ncell, NTC, Nepal Bank)

   • Idea Used: Dividend Discount Model
   • How: Investors use DDM to value Ncell’s stock (Rs 12 dividend, 5% growth) to decide if it’s worth Rs 180/share. If the market price drops to Rs 150, it’s undervalued.

2. Daraz’s IPO (2021)

   • Idea Used: FCFE Model
   • How: Before listing, analysts projected Daraz’s free cash flows to justify its Rs 100/share valuation. Post-IPO, traders compared its P/E (30x) to Amazon’s (60x) to assess over/undervaluation.

3. Kathmandu’s Real Estate (Mahabir Group, Karkhana)

   • Idea Used: Multiples (P/B Ratio)
   • How: With no dividends, investors use Price-to-Book (P/B) ratios. If Mahabir’s P/B is 2x and book value is Rs 50/share, its fair price = Rs 100/share.

Risk and Return: Beta and CAPM

Stocks with higher beta (volatility vs. market) demand higher returns. CAPM Formula: $$r=r_f+\beta (r_m-r_f)$$

• $r_f$ = Risk-free rate (Nepal Treasury Bill: ~6%)
• $r_m$ = Market return (NEPSE index: ~14%)
• $\beta$ = Stock’s risk (e.g., Mega Company: 1.8)

Worked Example: Mega Company

• Given:
  • $\beta =1.8$
  • $r_f=6\%$
  • $r_m=14\%$
• Find: Required return.
• Solution: $$r=6\%+1.8(14\%-6\%)=6\%+14.4\%=20.4\%$$ Interpretation: Mega’s stock must yield 20.4% to compensate for its risk.

Exam Tip: How to Score Full Marks

1. Show All Steps: Even simple questions (e.g., total return) lose marks for missing intermediate calculations.
2. Label Assumptions: If using DDM, state whether growth is constant or multi-stage.
3. Compare Methods: For valuation, briefly contrast DDM vs. multiples (e.g., “DDM is better for dividend stocks; multiples work for peers”).
4. Real-World Tie-Ins: Link answers to NEPSE/Ncell/Daraz (e.g., “Like Ncell, this stock has stable dividends, so DDM applies”).
5. Units and Precision: Always include Rs, %, and decimal places (e.g., Rs 180.00, not 180).

Visual Summary

mindmap
  root((Stock Valuation))
    DDM
      Gordon Growth
      Multi-Stage
    FCFE
      Cash Flows
      Terminal Value
    Multiples
      P/E
      P/B
    Returns
      Total Return
      Dividend Yield
    Risk
      Beta
      CAPM