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Valuation of Equity
Introduction
■Valuation of an equity would depend on the required return the
investor would demand to invest in the equity.
■What are the factors that determine the required rate of return on an
investment?
◻Risk associated with the investment. The greater the risk, greater
will be the required return.
◻The size of the cash flows received from it. Greater the cash flow
greater would be the valuation
◻The timing of the cash flows.
■How do we define and measure risk of an investment and what do we
mean when we say that investment in asset A is riskier than the
investment in asset B?
◻What is the relationship between an asset’s risk and its required
return?
■Risk associated with an asset can be of two types
◻Systematic risk: The risk contributed by the factors that affect all
the assets. For example decline in growth rate of the economy.
◻Unsystematic risk: The risk contributed by the factors that affect
only the asset under consideration. For example decline in growth
rate of the company where the investment has been made.
Introduction
■Valuation of an equity would depend on the required return the
investor would demand to invest in the equity.
■What are the factors that determine the required rate of return on an
investment?
◻Risk associated with the investment. The greater the risk, greater
will be the required return.
◻The size of the cash flows received from it. Greater the cash flow
greater would be the valuation
◻The timing of the cash flows.
■How do we define and measure risk of an investment and what do we
mean when we say that investment in asset A is riskier than the
investment in asset B?
◻What is the relationship between an asset’s risk and its required
return?
■Risk associated with an asset can be of two types
◻Systematic risk: The risk contributed by the factors that affect all
the assets. For example decline in growth rate of the economy.
◻Unsystematic risk: The risk contributed by the factors that affect
only the asset under consideration. For example decline in growth
rate of the company where the investment has been made.
■When an investor makes an investment he takes two kind of risk
◻One that is specific to the equity
◻Other that is related to the macro economic factor, which would affect all
equities
■If two equities are co-related with each other by combining these two
equities one can reduce the risk associated with individual equities.
■If we take a very large number of equities and the investors will
Equity Valuation: Role of Diversification
