5.3 Equity Valuation: DDM and P/E Basics

Why equity valuation belongs in UITF fundamentals

Equity and multi-asset UITFs hold shares (and equity-linked instruments) that trade at market prices. Those prices embed investors’ views of earnings, dividends, growth, and risk. You are not training to be a sell-side analyst for the UCP exam, but you must understand two workhorse ideas:

1. Absolute / intrinsic intuition — Dividend Discount Model (DDM): value from discounted expected dividends.
2. Relative valuation — Price-to-Earnings (P/E): price as a multiple of earnings versus peers or history.

Both connect to earlier sections: the discount rate in DDM is a required return (CAPM-style thinking), and noisy prices create the volatility that Sharpe ratios evaluate after the fact.

Cash flows that matter to equity holders

Bond valuation discounts coupons and principal. Equity valuation discounts expected residual cash flows to shareholders—commonly framed as dividends (or free cash flow to equity in more advanced models). If a company never pays a dividend and never returns cash, pure DDM needs a terminal story (eventual dividends or sale). For UCP, focus on the principle: today’s fair price is the present value of expected future owner cash flows.

Dividend Discount Model — one-period intuition

Suppose you expect a stock to pay dividend D1 in one year and then sell at price P1. If your required return is k:

P0 = (D1 + P1) / (1 + k)

You are discounting next year’s cash (dividend + sale proceeds) at the return your risk requires. If risk rises, k rises, P0 falls—same direction as “higher discount rate → lower present value” from bond math, applied to equities.

Gordon growth model (constant-growth DDM)

If dividends are expected to grow forever at constant rate g, and k > g, the infinite series collapses to:

P0 = D1 / (k − g)

Worked peso example

• Expected dividend next year D1 = PHP 4.00 per share
• Required return k = 12% (could come from CAPM with rf, beta, and market premium)
• Growth g = 4%
• P0 = 4.00 / (0.12 − 0.04) = 4.00 / 0.08 = PHP 50.00

Sensitivity (exam gold)

Same stock, risk premium rises so k = 14%:

• P0 = 4.00 / (0.14 − 0.04) = 4.00 / 0.10 = PHP 40.00

Higher required return (higher beta, higher market fear, higher rf) compresses valuation. Equity UITF holdings reprice lower; NAVPU pressure follows even if the company still pays dividends.

If growth expectations rise to g = 6% with k still 12%:

• P0 = 4.00 / (0.12 − 0.06) = 4.00 / 0.06 ≈ PHP 66.67

Optimistic growth supports higher prices—until growth disappoints.

Critical conditions

1. k must exceed g — otherwise the formula breaks (denominator zero or negative).
2. Constant growth is a simplification — real firms cycle; multi-stage models exist beyond UCP depth.
3. Non-dividend payers — pure Gordon formula is awkward; markets still value expected future cash or use earnings multiples.
4. k is not the dividend yield alone — required return includes growth and risk compensation.

Required return k and CAPM

In teaching examples, k is often the CAPM expected/required return:

k = rf + β(rm − rf)

Thus a high-beta Philippine stock should be discounted at a higher k, producing a lower present value for the same dividend stream than a defensive stock. That is how risk enters valuation without rewriting the entire DDM.

BSP-driven increases in peso risk-free rates can lift rf, lift k, and—through higher discount rates—weigh on equity valuations market-wide, all else equal. Simultaneously, rate hikes can hurt bond sleeves of balanced UITFs. Clients see both channels in multi-asset NAVPU.

P/E ratio — relative valuation basics

Price-to-Earnings (P/E) = Market price per share ÷ Earnings per share (EPS)

How to use P/E at exam level

• Peer comparison: A bank stock at P/E 8 vs sector at P/E 12 may be “cheaper” on earnings—or riskier, lower growth, or lower quality. Multiple alone is not a buy signal.
• History: Same stock at P/E 20 vs its five-year average of 12 may look expensive if growth has not improved.
• Market level: Aggregate index P/E high vs history can signal rich valuations and less cushion if earnings fall.

Earnings yield bridge

Earnings yield ≈ EPS / Price = 1 / (P/E) (when P/E is the same ratio inverted).

A stock with P/E 10 has earnings yield 10%; P/E 20 has earnings yield 5%. Investors sometimes compare earnings yields with bond yields when allocating between equity and fixed-income UITFs—again conceptual, not a trading rule you must compute under time pressure.

Worked P/E example

• Price = PHP 80
• EPS = PHP 5
• P/E = 80 / 5 = 16×

If a peer with similar growth and risk trades at 12×, the PHP 80 stock is richer on P/E. If earnings are expected to grow much faster, a higher multiple may be justified—this is the “growth deserves higher P/E” intuition, parallel to g in the Gordon model.

DDM vs P/E — when each shines

UCP questions usually test definitions, direction of changes, and simple plug-ins, not full analyst models.

Equity UITF and balanced-fund product links

Recall BSP-oriented product facts used across the guide:

• Equity fund: typically ≥80% of NAV in equities → NAVPU is dominated by equity market and valuation moves.
• Multi-asset / balanced fund: mix of equities and fixed income → equity valuation risk plus interest-rate mark-to-market risk.
• Daily mark-to-market: portfolio holdings valued at current market prices; participants redeem at NAVPU, not at a private DDM “fair value” computed by the marketing desk.

Client conversation angles

1. “The market is cheap on P/E” still allows large interim drawdowns; multiples can stay low while prices fall further if earnings collapse.
2. “This stock pays dividends” does not eliminate price risk; DDM shows dividends are valuable, but k and g shifts reprice principal.
3. “Balanced is always safe” is false: equity sleeve valuation shocks and bond yield shocks both hit NAVPU.
4. Suitability: Growth-oriented clients may accept equity valuation volatility for higher long-run expected return (CAPM); conservative clients may not—even if trailing equity Sharpe looked attractive.

Never present DDM intrinsic values or P/E screens as guarantees of future UITF performance. Trust marketing is constrained by plan rules, RDS, and fair representation under TOAP/BSP expectations.

Market risk, valuation risk, and hours on task

For exam narratives, group equity risks as:

CAPM explains required return; DDM/P/E explain how prices embed growth and risk; Sharpe scores how the journey paid per unit of volatility after the fact.

Exam traps for this section

1. Gordon with k ≤ g — formula invalid when required return does not exceed growth.
2. Using D0 without care — Gordon uses D1 (next year’s dividend); if given D0, D1 = D0(1+g).
3. P/E = EPS / Price — inverted; that is earnings yield.
4. Higher risk → higher DDM price — false; higher k lowers price.
5. Treating UITF NAV as lockable intrinsic value — participants transact at market-based NAVPU.
6. Assuming high P/E always means “better company” — high P/E often means higher growth expectations or lower earnings today, not automatic quality.

Quick checklist

1. DDM: price = PV of expected dividends (Gordon: P0 = D1/(k−g)).
2. Link k to risk (CAPM).
3. P/E = Price / EPS for relative value.
4. Equity UITF NAVPU moves with market prices that embed these valuation forces.
5. Balanced funds add rate risk—do not sell them as “no equity valuation risk.”