“An Empirical study Using Dividend Discount Models for Stock Prices Valuation

of IT Companies in India”

ByPreeti RajpalPrestige Institute of Management and Research

Dr.Punit Kumar DwivediPrestige Institute of Management and Research

Stock Prices Valuation of IT Companies in India: An Empirical Study

By -

Dr.Punit Kumar DwivediPrestige Institute of Management and Research

Prof. Deepesh MamtaniPrestige Institute of Management and Research

Preeti RajpalPrestige Institute of Management and Research

Introduction

Security analysis of software companies with specific emphasis on fundamental analysis using dividend discount models is the focus of this paper. The basic idea of the dividend discount models is that the intrinsic value of an equity share is a function of the earnings level, growth rate, and risk exposure of a company. These in turn depend to a great extent on the prospects of the industry to which company belongs. Indian IT industry continues to strengthen their market value. Indian companies such as with Tata Infotech, Infosys technologies, Cognizant etc. have outperformed the market significantly, and it is projected that the industry will grow at a fast rate in next few years. Therefore, the IT industry seems very attractive to investors. In this paper, we would like to answer the questions such as (1) is it worthwhile investing in such software companies?; and (2) will capital appreciation of software companies continue in the future? It is important to analyze whether investors will be benefitted by investing in this software industry or whether software companies’ outperformance over other industries is just the temporary phase. Finally, we would like to suggest our recommendations over software industries whether investors should buy/sell/hold the stock of these companies based on our analysis

Introduction

Security analysis of software companies with specific emphasis on fundamental analysis using dividend discount models is the focus of this paper. The basic idea of the dividend discount models is that the intrinsic value of an equity share is a function of the earnings level, growth rate, and risk exposure of a company. These in turn depend to a great extent on the prospects of the industry to which company belongs.

Indian IT industry continues to strengthen their market value. Indian companies such as with TCS, Infosys technologies, Cognizant etc. have outperformed the market significantly, and it is projected that the industry will grow at a fast rate in next few years. Therefore, the IT industry seems very attractive to investors.

Introduction

Security analysis of software companies with specific emphasis on fundamental analysis using dividend discount models is the focus of this paper. The basic idea of the dividend discount models is that the intrinsic value of an equity share is a function of the earnings level, growth rate, and risk exposure of a company. These in turn depend to a great extent on the prospects of the industry to which company belongs. Indian IT industry continues to strengthen their market value. Indian companies such as with Tata Infotech, Infosys technologies, Cognizant etc. have outperformed the market significantly, and it is projected that the industry will grow at a fast rate in next few years. Therefore, the IT industry seems very attractive to investors. In this paper, we would like to answer the questions such as (1) is it worthwhile investing in such software companies?; and (2) will capital appreciation of software companies continue in the future? It is important to analyze whether investors will be benefitted by investing in this software industry or whether software companies’ outperformance over other industries is just the temporary phase. Finally, we would like to suggest our recommendations over software industries whether investors should buy/sell/hold the stock of these companies based on our analysis

In this paper, we would like to answer the questions such as (1) Is it worthwhile investing in such software companies?(2) Will capital appreciation of software companies continue in the

future?

It is important to analyze whether investors will be benefitted by investing in this software industry or whether software companies’ outperformance over other industries is just the temporary phase. Finally, we would like to suggest our recommendations over software industries whether investors should buy/sell/hold the stock of these companies based on our analysis

If investor plans to hold a stock for two years, the value of the stock is the present value of the expected dividend in first year, plus the present value of the expected dividend in second year, plus the present value of the expected selling price at the end of two years. For an n-periods model, the value of a stock is the present value of the expected dividends for the n periods plus the present value of the expected price in n periods.

Formula

Pο= ∑ (d)(1+g)ⁿ + (p/e)(eₒ)(1+g)ᴺ+ˡ ( 1 +r)ⁿ (1+r)ᴺ

Where, d = recent dividend paid g = annual expected growth in earnings dividends and price. eₒ = most recent earnings per share p/e = price earning ratio r = required rate of return N = holding period in years

Multiple Year Holding Period Dividend Discount Model

Multiple Year Holding Period Dividend Discount Model

If investor plans to hold a stock for two years, the value of the stock is the present value of the expected dividend in first year, plus the present value of the expected dividend in second year, plus the present value of the expected selling price at the end of two years. For an n-periods model, the value of a stock is the present value of the expected dividends for the n periods plus the present value of the expected price in n periods.

Formula:

Pο= ∑ (d)(1+g)ⁿ + (p/e)(eₒ)(1+g)ᴺ+ˡ ( 1 +r)ⁿ (1+r)ᴺ

Where, d = recent dividend paid g = annual expected growth in earnings dividends and price. eₒ = most recent earnings per share p/e = price earning ratio r = required rate of return N = holding period in years

Shiller (1981) found the volatility of stock prices to be six to twelve times its upper limit .The research following this conclusion has been twofold. Firstly, much research has been done that accept the results from the variance bounds framework and set out to explain the excess volatility found. Most other research following the findings focused on the viability of the variance bounds framework. The research that set out to explain the observed excess volatility in stock prices found many different causes for this phenomenon. DeBondt and Thaler (1985) and West (1987) attributed it to rational bubbles while Gutierrez and Vazquez (2004) attributed it to regime-switching in the dividend process. DeLong et. al (1990) and Campbell and Kyle (1993) attributed it to the presence of noise traders in the market. For a complete review of the studies on stock price volatility, please refer to West (1988). None of these explanations, however, has led to a valuation model that explains the data better than the dividend discount model.The other strand of research has focused on the validity of the use of the variance bounds framework to test for the aforementioned relation. The frameworks used in both Shiller (1981) and Leroy and Porter’s (1981) have econometric problems which are considered to invalidate the results. By altering the variance bounds framework, Kleidon (1986) explicitly reject the framework used by Shiller (1981) that employs a time-series variance bounds test. By replacing this framework by a cross-sectional variance bounds test, they find that the validity of the traditional dividend discount model cannot be rejected. Flavin (1983) adopts a different point of criticism on the variance bounds framework.

Review Of Literature Review Of Literature

Shiller (1981) found the volatility of stock prices to be six to twelve times its upper limit .The research following this conclusion has been twofold.

Firstly, much research has been done that accept the results from the variance bounds framework and set out to explain the excess volatility found. Most other research following the findings focused on the viability of the variance bounds framework. The research that set out to explain the observed excess volatility in stock prices found many different causes for this phenomenon.

DeBondt and Thaler (1985) and West (1987) attributed it to rational bubbles while Gutierrez and Vazquez (2004) attributed it to regime-switching in the dividend process. DeLong et. al (1990) and Campbell and Kyle (1993) attributed it to the presence of noise traders in the market. For a complete review of the studies on stock price volatility, please refer to West (1988). None of these explanations, however, has led to a valuation model that explains the data better than the dividend discount model.

Shiller (1981) found the volatility of stock prices to be six to twelve times its upper limit .The research following this conclusion has been twofold. Firstly, much research has been done that accept the results from the variance bounds framework and set out to explain the excess volatility found. Most other research following the findings focused on the viability of the variance bounds framework. The research that set out to explain the observed excess volatility in stock prices found many different causes for this phenomenon. DeBondt and Thaler (1985) and West (1987) attributed it to rational bubbles while Gutierrez and Vazquez (2004) attributed it to regime-switching in the dividend process. DeLong et. al (1990) and Campbell and Kyle (1993) attributed it to the presence of noise traders in the market. For a complete review of the studies on stock price volatility, please refer to West (1988). None of these explanations, however, has led to a valuation model that explains the data better than the dividend discount model.The other strand of research has focused on the validity of the use of the variance bounds framework to test for the aforementioned relation. The frameworks used in both Shiller (1981) and Leroy and Porter’s (1981) have econometric problems which are considered to invalidate the results. By altering the variance bounds framework, Kleidon (1986) explicitly reject the framework used by Shiller (1981) that employs a time-series variance bounds test. By replacing this framework by a cross-sectional variance bounds test, they find that the validity of the traditional dividend discount model cannot be rejected. Flavin (1983) adopts a different point of criticism on the variance bounds framework.

Review Of Literature Review Of Literature

The other strand of research has focused on the validity of the use of the variance bounds framework to test for the aforementioned relation.

The frameworks used in both Shiller (1981) and Leroy and Porter’s (1981) have econometric problems which are considered to invalidate the results. By altering the variance bounds framework, Kleidon (1986) explicitly reject the framework used by Shiller (1981) that employs a time-series variance bounds test. By replacing this framework by a cross-sectional variance bounds test, they find that the validity of the traditional dividend discount model cannot be rejected. Flavin (1983) adopts a different point of criticism on the variance bounds framework.

Objective of Study

•To Study the variation between Market Value and Fundamental Value (interchangeably used as expected present value) of the stock of Five I.T. Companies in India.

• Determining price fluctuations in the form of under-price and over-price of share value.

Discussion

We performed a quantitative study to test the predictability of expected present value of shares of five IT companies. Further, we analysed whether the market price of shares of IT companies is overvalued or undervalued as of 26th August 2013.

We selected the following five IT companies for our study: Large scale companies: Tata Consultancy Services (TCS) and Infosys. Medium scale companies: Infotech Enterprises, Polaris Financial Technology and MindTree.

Assuming that the IT sector will replicate the past years performance during the next 5 years we are analysing the profits prospects for the worldwide investors.

Multiple Year Holding Period Dividend Discount Model therefore, this has been chosen to evaluate the expected Present Value of shares of five Indian IT companies.

Table1. Input Variables

Variables Definition

Growth Rate Annual expected growth of a company.

Earnings Per Share (EPS) Earnings after tax divided by number of shares outstanding.

Dividend Per Share (DPS) Actual dividend paid to shareholders.

Price Earning Ratio (PER) Market price per share divided by earning per share.

Required Rate of Return Discounting factor or inflation rate.

Current Share Price Share price prevailing in the market.

Figure 1. Trend Analysis of Inflation Rates between 2003 and 2017

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 20170%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Inflation Rates Trend Analysis

Findings And Results Table 2. Input data required in calculating

expected present value of shares

Company Name G EPS (Rs)

DPS (Rs)

P/E Ratio R MP (Rs)

TCS 8.65% 65.23 22.00 24.0970412 13.83% 1,571.85

Infosys 8.36% 158.75 42.00 18.2040945 13.83% 2,889.90

Infotech Enterprises 7.39% 16.52 4.50 10.2421308 13.83% 169.20

Polaris Financial Technology

9.55% 16.79 5.00 6.63490173 13.83% 111.40

Mind Tree 12.79% 81.59 12.00 11.1735507 13.83% 911.65

Table 3. Expected present value of shares and their valuation

Company Name

MP ∑(d)(1+g)ⁿ(1+r

)ⁿGrowth in dividends

(1)

(p/e)(eₒ)(1+g)ᴺ+ˡ (1+r)ᴺ

Growth in earnings(2)

Expected Present Value (1+2)

Suggested Position

VALUATION

TCS 1,571.85 95.86 1,353.02 1,448.89 Sell Over-Priced

Infosys 2,889.90 181.60 2,448.01 2,629.61 Sell Over-Priced

Infotech Enterprises

169.20 18.96 135.79 154.75 Sell Over-Priced

Polaris Financial Technology

111.40 22.32 100.76 123.07 Buy Under-Priced

MindTree 911.65 58.37 981.92 1,040.29 Buy Under-Priced

Table 4. Market Value V/S Fundamental Value

Company Name Market Value (Rs)

Fundamental Value (Rs)

Variation (Rs)

TCS 1571.85 1448.89 (122.96)

Infosys 2889.90 2629.61 (260.29)

Infotech Enterprises 169.20 154.75 (14.45)

Polaris Financial Technologies

111.40 123.07 11.67

MindTree 911.65 1040.29 128.64

Figure 3. Comparison between current market value and expected present value

TCS Infosys Infotech Enterprises Polaris Financial Technologies MindTree0

500

1,000

1,500

2,000

2,500

3,000

3,500

Current Market value Expected Present Value

Present value of shares of TCS is lower than current market price by Rs.122.96 so the shares of TCS are overpriced. The market is doing really good job but internally the firm may not succeed with the pace of the required rate of return over a period of five years.

Next is Infosys, it is also overpriced, as the present value is lower by Rs.260.29 than current share price. The variation is a little vast so it is guaranteed that the share value in future will fall.

InfoTech Enterprises yet another company showing the sign of downfall in near future but the difference is very low i.e. Rs 14.45. The investor can use futures and options for trading purpose. Suggested trading options is selling of shares of this company at current market price and buy them in future as prices are going to fall.

Polaris Financial Technology is showing an upward trend, the present value of shares of this company is more than the current price by Rs. 11.67.The shares are underpriced thus buying of shares of this company will benefit the investor in future.

Finally the last company of study Mind Tree is the most profitable option to invest in as the present value of shares is far more than the current market value (Rs.128.64). The shares are undervalued therefore one must add this company in their portfolio.

Present value of shares of TCS is lower than current market price by Rs.122.96 so the shares of TCS are overpriced. The market is doing really good job but internally the firm may not succeed with the pace of the required rate of return over a period of five years.

Next is Infosys, it is also overpriced, as the present value is lower by Rs.260.29 than current share price. The variation is a little vast so it is guaranteed that the share value in future will fall.

InfoTech Enterprises yet another company showing the sign of downfall in near future but the difference is very low i.e. Rs 14.45. The investor can use futures and options for trading purpose. Suggested trading options is selling of shares of this company at current market price and buy them in future as prices are going to fall.

Present value of shares of TCS is lower than current market price by Rs.122.96 so the shares of TCS are overpriced. The market is doing really good job but internally the firm may not succeed with the pace of the required rate of return over a period of five years.

Next is Infosys, it is also overpriced, as the present value is lower by Rs.260.29 than current share price. The variation is a little vast so it is guaranteed that the share value in future will fall.

InfoTech Enterprises yet another company showing the sign of downfall in near future but the difference is very low i.e. Rs 14.45. The investor can use futures and options for trading purpose. Suggested trading options is selling of shares of this company at current market price and buy them in future as prices are going to fall.

Polaris Financial Technology is showing an upward trend, the present value of shares of this company is more than the current price by Rs. 11.67.The shares are underpriced thus buying of shares of this company will benefit the investor in future.

Finally the last company of study Mind Tree is the most profitable option to invest in as the present value of shares is far more than the current market value (Rs.128.64). The shares are undervalued therefore one must add this company in their portfolio.

Polaris Financial Technology is showing an upward trend, the present value of shares of this company is more than the current price by Rs. 11.67.The shares are underpriced thus buying of shares of this company will benefit the investor in future.

Finally the last company of study Mind Tree is the most profitable option to invest in as the present value of shares is far more than the current market value (Rs.128.64). The shares are undervalued therefore one must add this company in their portfolio.

Implication of Study For Investors: There are basically two types of investors, i.e., (1) individual investors and (2) institutional investors. The portfolio is a combination of securities such as stocks, bonds, money market instruments, they are chosen on the basis of their level of risk and probability of higher returns, this study helps the investor in selecting the most appropriate option available in IT sector. This analysis is very helpful for investors in taking decision regarding buying, selling or holding the shares of the companies in IT sector.

For Researchers: This study helps researchers in conducting their research projects of similar nature.

For Financial Analyst/Fund Manager: The major task of an analyst is to help their clients in taking appropriate investment decision for optimum allocation of funds. Therefore our study facilitates financial analysts in taking correct decisions for their clients and maximizes client satisfaction level.

Suggestions and Conclusion

The research has shown that, among five companies’ two companies namely, Polaris Financial Technology and MindTree are undervalued and have promising growth respects. It is suggested that the shares of these companies should be bought.Some of the benefits are

(1) Higher dividends, (2) Capital appreciation, and(3) Minimization of portfolio risk.

Thus, it is found that the expected present value is more than the current share price of these companies, this increased expected present value depicts that both the IT Companies are fundamentally very strong and competent. As the fundamental strength of both the companies is good, shareholders are suggested to include these securities in their portfolio because risk is moderate and returns are reasonably high. The shares of these companies should be bought and can be held for multiple years as they have promising future ahead.

On the contrary, the other three companies: Tata Consultancy Services, Infosys, Infotech Enterprises are overvalued therefore shares of these companies should be sold, because, if an investor enters a future contract for five years he/she has an opportunity to make profits by selling them at current price prevailing in the market and buy the same at market value on the date of maturity of contract (after 5 years). This will ensure a profit despite of decreasing share value after five years.

In order to take investment decisions it is important to have an appropriate foresight and so our study provides investors with a direction heading towards profitable returns. This study is pervasive, as the procedure of estimation can be applied to all the companies listed in any Stock Exchange and their valuation can be examined quite easily.

References•Moneycontrol [Online] http://www.moneycontrol.com (Accessed 26 August

2013)•Shillers (1981) Siegel (1985) , Scott (1992) Review of literature [Online]

http://ceajournal.metro.inter.edu/fall06/torrezetal0202.pdf (Accessed 24 August 2013)•Ohlson (1995), Feltham & Ohlson (1995/1999) Review of literature [Online]

http://research.rmutp.ac.th/research/An%20Investigation%20of%20Stock%20Valuation%20Models.pdf (Accessed 24 August 2013)•C.R.J.M. Tilman (2009) ‘Explaining Equity Prices using a variable Equity Risk

Premium in a Three-Stage Dividend Discount Model’ Erasmus University [Online] thesis.eur.nl/pub/6216/315207Tilmanma1009.pdf •(Accessed September 30 2013)•Stock-analysis-on.net [Online] http://www.stock-analysis-on.net (Accessed 31

October 2013)•Iitk [Online] http://www.iitk.ac.in (Accessed 31 October 2013)•Punithavathy Pandian (2005) Securities Analysis and Portfolio Management,

New Delhi, India.

References

•Sharpe, William F, (1964) ‘capital asset prices; a theory of market equilibrium under conditions of risk.’ Journal of Finance. 19:3, pp. 425-442•Lintner, John. (1965) ‘The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets.’ Review of Economics and Statistics. 47:1, pp. 13–37.•Shiller, Robert J. (1981) ‘Do stock prices move too much to be justified by subsequent changes in dividends?’ American Economic Review 71, pp. 421-436. •Leroy. S.F., and Porter. R.D. (1981) ‘The present value relation: tests based on implied variance Bounds’, Econometrica, 49 pp 555-574.•Geykdajy Y. M. (1981) ‘Cost of equity capital and risk of 28 us multinational corporations vs. 28 us domestic corporations: 1965-1978’, Management International Review, 21(1), pp 89-94•Flavin. M. (1983) ‘Excess volatility in the financial markets: a reassessment of the empirical evidence’, Journal of Political Economy, pp. 89-111.

Thank You