Risk means the possibility of loss or

uncertainty in getting expected

outcomes.
Risk is about variation in returns.
In finance, it is measured using
standard deviation or beta.
Systematic Risk: Uncontrollable,
External risks that affect the entire
market (e.g., interest rate changes,
inflation).
Unsystematic Risk: Controllable ,
Internal risks specific to a company or
industry (e.g., poor management, labor
strike).
Valuation Inputs for Risk Measurement:
•Market Risk: Risk due to market-wide factors.
Example: Economic recession affects all companies.
•Company-Specific Risk: Related to individual company performance.
Example: A scandal in a company causes its stock price to fall.
•Expected Return: Return expected from an investment.
Calculated using historical data + market trends.
•Risk Tolerance: How much risk an investor can handle.
Example: Young investors often tolerate more risk than retirees.
•Discount Rate: Used to bring future cash flows to present value.
Discount Rate = Risk-free rate + Risk premium
Techniques to Find Risk Relationships:
1.Correlation Analysis: Measures how two variables move together.
Example: Stock price and earnings growth.
2.Regression Analysis: Predicts impact of one or more variables on
another.
Example: Effect of inflation on company profit.
3.Factor Analysis: Identifies main factors affecting multiple variables.
Example: Interest rate, oil price affecting all sectors.
4.Machine Learning: Advanced tool to identify data patterns for
forecasting.
Find the cost of equity using the CAPM model.
Cost of Equity (Ke) = Rf + β × (Rm − Rf)
Ke=5.5%+0.8×(13%−5.5%)
=5.5%+0.8×7.5%=5.5%+6.0%
=11.50%
•Companies that offer dividends calculate cost of equity using Dividend
Capitalization Model. To determine cost of equity using Dividend
Capitalization Model, use following formula:

Cost of Equity = (Dividends per Share / Current Market Value of

Stocks) + (Dividend Growth Rate)
Dividends: Amount of money a company pays regularly to its
shareholders
Market value stocks: Fractional ownership of equity in an organization
that’s value is determined by financial markets
Dividend growth rate: Annual percentage rate of growth of a dividend
over a period
Importance of Cost of Capital in Capital Structure
•Helps decide the ideal mix of debt and equity to minimize the overall
cost of capital (WACC).
•Aids in achieving an optimal capital structure that maximizes the value
of the firm.
•Lower cost of capital increases profitability and shareholder value.
•Highlights the cost-effectiveness of using debt (due to tax benefits) vs.
equity.
•Helps compare the risk and return associated with different sources of
finance.
•Encourages the use of cheaper sources of finance without increasing
financial risk.
•Acts as a benchmark to evaluate new financing options (e.g., issuing
bonds vs. shares).
•Guides management in restructuring existing capital to reduce financing
cost.
•Ensures that the firm maintains financial flexibility and
creditworthiness.
•Helps in maintaining a balance between risk and return while funding
growth.
The higher the debt-to-EBITDA, the more leverage a company is
carrying.
Debt-to-EBITDA = Total Debt ÷ Earnings Before Interest, Taxes,
Depreciation, and Amortization
Equity Multiplier: is a financial ratio that measures the proportion of a
company’s assets that are financed by shareholders' equity. It shows how
much financial leverage a company is using.
Equity Multiplier=Total Equity/Total Assets
Key Points:
A higher equity multiplier indicates higher financial leverage (more
use of debt).
A lower equity multiplier means the company is using less debt and is
more equity-financed.
It is used in the DuPont Analysis to break down Return on Equity
(ROE).
Degree of Financial Leverage (DFL) : Fundamental analysis uses the
degree of financial leverage (DFL).
The DFL is calculated by dividing the percentage change of a company's
earnings per share (EPS) by the percentage change in its earnings before
interest and taxes (EBIT) over a period.
Degree of Financial Leverage = % Change in Earnings Per Share ÷ %
Change in EBIT
The goal of DFL is to understand how sensitive a company's EPS is based
on changes to operating income.
A higher ratio will indicate a higher degree of leverage, and a company
with a high DFL will likely have more volatile earnings.
Advantages of Financial Leverage
•Increases Return on Equity (ROE) when returns exceed the cost of debt.
•Provides tax benefits as interest on debt is tax-deductible.
•Helps to retain ownership by avoiding dilution of equity.
•Enhances Earnings Per Share (EPS) if used efficiently.
•Enables business expansion without raising additional equity.
•Debt is often a cheaper source of finance than equity.
• Encourages efficient use of capital to earn higher returns.
• Allows companies to maximize shareholder wealth with limited
resources.
Disadvantages of Financial Leverage
• Increases financial risk due to fixed interest obligations.
• Can lead to insolvency or bankruptcy if the company fails to meet
debt repayments.
• Reduces creditworthiness, making future borrowing more difficult.
• Increases the company’s cost of capital if excessive debt is used.
• Limits financial flexibility in tough economic times.
• May lead to volatile earnings and unstable returns to shareholders.
• Too much leverage can result in loss of control to lenders or creditors.
• Interest payments reduce net profit, especially during low revenue
periods.
Eg.: A share is expected to pay the following dividends:
Year 1: ₹6
Year 2: ₹8
Year 3: ₹10
At the end of Year 3, investor expects to sell the share for ₹150. The
required rate of return is 14%.
Ans. : Given D1 = Rs. 6, D2 = Rs. 8, D3 = Rs. 10, Pn = Rs. 150, r = 14%
 The intrinsic value of the share is ₹119.39.
A shortcoming of DDM is that the model follows a perpetual constant
dividend growth rate assumption.
This assumption is not ideal for companies with fluctuating dividend
growth rates or irregular dividend payments, as it increases the chances
of imprecision.
Another drawback is the sensitivity of the outputs to the inputs.
 Furthermore, the model is not fit for companies with rates of return
that are lower than the dividend growth rate.
Zero Growth Model
This model assumes that the firm will pay the same amount of dividends
forever.

This implies that there will be zero or no growth in the dividend amount,
and hence, named Zero Growth Model.

Dividend for the first year will be equal to the second year, the third year,
up till the life of the company.

The stock valuation is very simple under this model.

Annual dividend is divided by the required rate of return, and the result is
the stock value.
Zero Growth Model
Primary benefit of this method is that it is easy to understand, calculate and
use.
Biggest drawback of this model is that it is not practical.
This is because if a firm grows bigger, then investors would expect the firm
to give more dividends per share.
It is unreal to assume that dividend would remain constant till perpetuity.
 There are several reasons why constant dividends may not be possible and
feasible –
need more funds for excellent business opportunity,
tax considerations may suggest skipping or lowering quantum of
dividends in a particular year,
cash flow issue,
business loss in a year, etc.
Eg.: Given, Current dividend D0​= ₹3.00
•Stage 1: Dividends grow at 18% per year for the next 3 years
(g1=18%)
•Stage 2: From year 4 onwards, dividends grow at a constant 6% per
year (g2=6%)
•Required rate of return r=11%
Calculate the intrinsic value of the stock today.
H Dividend Discount Model : is a refined version of the Dividend
Discount Model that assumes:
•A gradual decline in dividend growth from a high initial rate (g₁) to a
lower stable rate (g₂) over a certain period (half-life, H).
•After this transition period, the dividend grows at the stable rate (g₂)
indefinitely.
It’s useful for companies transitioning from high growth to stable
growth, but not abruptly, unlike the Two-Stage Model.
Purpose of H-Model (in points):
•To estimate stock value when growth slows gradually, not suddenly.
•Useful for companies maturing from high growth to stable phase.
•More realistic than the Two-Stage Model in many real-world cases.
•Helps investors and analysts make better long-term investment
decisions.
A company has just paid a dividend of ₹4 per share. It is expected that the
dividend growth rate will gradually decline from 12% to 6% over the next
8 years. After that, dividends will grow at a constant rate of 6% forever.
The required rate of return is 10%. Calculate the intrinsic value of the
stock using the H Model.

Where, P0 = Present value of stock

g1=High initial growth rate
g2= lower stable growth rate
H= transition period = 8/2 = 4 years
r= discounting rate 10%
The intrinsic value of the stock using the H Model is ₹130 per
share.
1. Income Approach : Focus: Value = Present Value of Future Cash
Flows
Methods: Discounted Cash Flow (DCF):
Estimate future cash flows and discount them to present value using a
discount rate.
•Free Cash Flow to Equity (FCFE):
Cash flows available to shareholders.
•Free Cash Flow to Firm (FCFF):
Cash flows available to all capital providers.
2. Market Approach : Focus: Value = Comparable Market Data
Methods: Comparable Companies (Trading Multiples):
Use ratios like:
EV/EBITDA where EV = Mkt. Cap + Debt - Cash
P/E Ratio
P/BV Ratio =MPS / BV if < 1 undervaluation
•Comparable Transactions: Look at prices paid in similar past deals.
3. Cost Approach : Focus: Value = Cost to Recreate or Replace Assets
Methods: Net Asset Value (NAV): Assets minus liabilities.
•Replacement Cost: Rebuilding the business from scratch.
Income Approach requires a lot more deeper insights to shortlist the key
valuation parameters
Company Background
Important: To understand the company’s position in the industry,
products, competitive advantage, and risks.
Includes:
Nature of business (manufacturing, service, fintech, etc.)
Industry position and market share
Historical performance (growth, profitability)
Risk factors (regulatory, competition, technology changes)
Example: A tech startup vs. a steel manufacturer will have very different
growth potential and risks.
Management & Business Plan
Important: Future performance depends on how well management
executes strategy.
Includes:
Vision & strategy (e.g., expansion, diversification, digitalization)
Capital expenditure plans (new plants, R&D investment)
Marketing & sales strategy
Example: Infosys’ business plan to expand in AI consulting can increase
future cash flows.
Free Cash Flows (FCF)
Core of Income Approach (DCF Method)
Free Cash Flow = Cash flow available to all investors (after paying for
operations & investments).
Discount Rate
Important: Future cash flows must be discounted to present value to
reflect risk and time value of money.
Common discount rates:
WACC (Weighted Average Cost of Capital) → for FCFF
Cost of Equity (Ke) → for FCFE
Factors:
Risk-free rate (Govt bond yield)
Market return expectations
Company’s beta (systematic risk)
Capital structure (debt vs equity)
Example: If WACC = 12%, a ₹100 cash flow next year is worth only ₹89
today.
Market Approach : The Market Approach values a business by comparing
it to similar companies that have been sold or are publicly traded.
It’s like valuing a house by comparing it to similar houses in the same
area.
Key Methods :
1. Public Company Method: Compare with similar listed companies
Use multiples like P/E ratio, EV/EBITDA, etc.
2. Precedent Transaction Method (M&A Method):Based on actual sale
prices of comparable companies. Useful in mergers and acquisitions.
3. Market Multiple Method: Uses valuation multiples like P/E,
EV/EBITDA, or EV/Sales to estimate value.
Commonly Used Multiples:
•P/E (Price-to-Earnings)

•EV/EBITDA (Enterprise Value to EBITDA)

•EV/Sales

•P/B (Price-to-Book)

These multiples are applied to the financial metrics of the company (like
earnings, revenue, or book value) to derive its estimated market value.
A Comparable Transaction (also called Precedent Transaction) in
valuation refers to a past sale or acquisition of a company that is similar
in size, industry, financial profile, and business model to the company
being valued. These transactions are used to benchmark the value of the
target company.
Purpose of Comparable Transactions: To estimate the fair market
value of a business based on what similar companies were acquired for
in the market.
Key Criteria for "Comparable" Transactions:
•Same industry or sub-sector
•Similar size (revenue, assets, market cap)
•Similar financial performance (profit margins, growth)
•Same geographic region or market
•Timing of transaction (recent transactions are more relevant)
Common Multiples Used in Comparable Transactions:
•Enterprise Value (EV) / EBITDA
•EV / Revenue
•Price / Earnings (P/E)
•Price / Book Value
Cost Approach in Valuation : (also known as the Asset-Based Approach)
is a method of business or asset valuation that estimates value based on the
cost to recreate or replace the company or its assets, minus depreciation
or obsolescence.
Book Value /Historical Cost: Cost incurred by the Business till date to
bring the asset to the current state
Replacement Cost : Replacement Cost Method refers to valuing an asset
based on the cost that a market participant shall have to incur to recreate an
asset with substantially the same utility (comparable utility) as that of the
asset to be valued, adjusted for obsolescence
Reproduction Cost: Reproduction Cost Method refers to the cost that a
market participant shall have to incur to recreate a replica of the asset to be
valued, adjusted for obsolescence
 Relative valuation is a method of
valuing a company by comparing it
with other similar companies based
on key financial ratios or multiples.
•Instead of estimating the company’s
intrinsic value, this approach evaluates
how the company is priced relative to
peers in the market.

Example:
Comparable companies have an average P/E ratio of 15 times.
Company has earnings (EPS) of ₹10.
•Estimated share price = 15 × ₹10 = ₹150
Thus, company is valued at ₹150 per share using relative valuation.
Relative valuation determines the value of a company based on the market
value of comparable companies, using valuation multiples like P/E,
EV/EBITDA, P/B, etc.
1.Price Earning Ratio = Price /EPS
It tells about how much investors are willing to pay for ₹1 of a company’s
earnings.
Reflects market expectations about growth, risk, and profitability.
Best Used For:
Profitable companies with consistent earnings.
Companies in mature industries (FMCG, auto, pharma).
Example: If a company has an EPS of ₹20 and the market price is ₹300.
P/E Ratio = 300/20 = 15 times means investors are paying 15 times the
company’s earnings.
2. EV/EBITDA (Enterprise Value to EBITDA)= (Market cap+ Deb –
Cash ) / EBITDA
It tells about to compare the total value of the business to its core
operating cash flows.
Best Used For: Companies with different capital structures (debt vs.
equity). Capital-intensive sectors like telecom, manufacturing, or energy.
3. P/S Ratio (Price-to-Sales): Market capitalisation / Total sales
It tells about how much investors are willing to pay for ₹1 of revenue.
Useful when earnings are negative or volatile.
Best Used For:
Early-stage or loss-making companies (e.g., tech startups, biotech).
Companies with low or negative net income but strong revenue growth.
4. P/B Ratio (Price-to-Book) : MPS / Book value per share
It tells about to compare a company’s market value to its net assets (book
value).
Indicates whether the stock is trading above or below its accounting value.
Best Used For:
Asset-heavy industries like banking, insurance, and real estate.
Companies with large tangible assets (plant, machinery, property).
Example:
If Market Price = ₹100, and Book Value = ₹50:
P/B = ₹100 / ₹50 = 2 times
Investors are paying ₹2 for every ₹1 of net assets on the balance sheet.