Valuing Equity Shares

The stock market in India weights and combines certain fundamental factors in determining share prices. One of the equations estimated by him is given as:

Υ = α0 Dα1 Gα2 Oα3 Fα4 Sα 5 ε ————eq 1

On logarithmic transformation this becomes:

In Υ = 1nα0 + α1 1nD + α2 1nG + α3 1nO + α4 1nF + α5 1nS + 1n ε —eq 2


Υ = share price
D = dividend per share
G= Growth rate
O= operating risk
F= financial risk
S= company size
ε = error term

The estimated relationship for one of the samples in 1970 was as follows:

In Υ = 10.65 + 0.926 1n D + 3.85 1n G – 0.044 1n O – 0.063 1n F + 0.093 1n S —eq 3

Predicting Bonds ratings:

In the US Moody’s bond ratings and Standard and Poor’s bond ratings are most widely used. Naturally, financial managers are interested in guessing the ratings the bonds of their firms would get from these agencies. Hence, a question that concerns them is: can financial ratios be used for predicting bond ratings? Empirical research suggests that the answer to this question is a ‘yes’.

In an interesting study conducted in 1983, Belkaoui analyzed bond ratings for an estimation sample of 266 industrial bonds, all with a rating of B or above by Standard and Poor’s in 1981. He employed a linear multiple discriminant analysis model in which the following nine independent variables were considered: (1) total assets, (2) total debt, (3) long term debt / total invested capital, (4) current assets / current liabilities, (5) fixed charge coverage ratio, (6) five year cash flow divided by five year sum of capital expenditure, (7) common dividends, (8) stock price / common equity per share, and (9) subordination status (represented by a dummy variable) Belkaoui selected status variables after analyzing variables which are supposed to determine the investment quality of boned.

Belkaoui’s principal finding were a follows: (1) In the estimation sample, 72.9 per cent (194 / 266) of the bond ratings were correctly classified and 24.4 percent (65 / 266) of the bond rating were within one rating of the actual ones. (2) In the validation sample 67.8 percent (78/115) of the bond ratings were correctly classified and 23.5 per cent (27/155) of the bond ratings were within one rating of the actual ones. Belkaoui’s percentages of correct classification compare favorably with those reported in previous studies of industrial bind ratings.

Estimating Market Risk:

The market risk of company’s stock, as measured by beta is an important determinant of the return required by investors. To estimate a stock’s beta you need sufficient history of stock price data. Since this may not always be available, financial economists examined whether accounting data can be used to get a handle over equity beta. For example, economic logic tells us that if the debt equity ratio is high, other things being equal, equity beta is also high. No wonder, empirical evidence supports such a relationship.

You can also calculate the “accounting beta” of a firm. It reflects the sensitivity of the form’s earnings changes in the aggregate earnings of all firms.

Instead of looking at one measure at a time, you can look at a combination of several of them. For example, Hochman found that the debt ratio, dividend yield, and accounting beta when combined provide an estimate of a stock’s equity beta which is as good as that obtained from stock’s price history.

Using financial statement analysis:

Financial statement analysis can be a very useful tool for understanding a firm’s performance and condition. However, there are certain problems and issues encountered in such analysis which call for care, circumspection and judgment.