CH3: Shareholders Flashcards
What companies issue shares?
Incorporated (private sector + profit seeking) : Ltd and PLC
What are shares?
represent the portion of the company owned by an investor - aka equity
Formula: proportion of the business owned by the shareholder %
% of company owned:
Number of shares owned / Total number of shares issued x 100
What are the two main types of shares/equity?
Ordinary shares - most common type, have voting right and dividend.
Preference shares - special class/not offered by all companies - paid dividend out of profits first (i.e. before ordinary shareholders) but have NO VOTING RIGHTS
What is a shareholder?
An investor show has bought shares (equity) in a company
What is the main objectives for most private companies?
maximise shareholder/investor wealth through profit maximisation and :
- paying these profits to shareholders as dividends
- OR re-investing profits into the company to increase share price
What are short term measures of shareholder wealth?
- measures that give indication of likely returns over the course of the next financial year
- examples: ROCE, EPS
Formula: Return On Capital Employed (ROCE)
ROCE = PBIT / (Total assets - Current liabilities) x 100%
PBIT - profit before Interest and Tax
What does ROCE tell us?
how well a company is utilising its assets to generate profits (the higher the % the better)
What is the biggest failure/limitation of using ROCE?
It does not take into account where profits go. the ROCE might be high but if the interest and tax are also high then shareholders will end up with little/no dividends.
What is a better way to look at shareholder wealth vs. ROCE?
Earnings per share - EPS
What does EPS show?
shows investors how much profit they earn per share owned (ie. the dividend paid per share)
Formula: EPS
Profit after tax and preference dividends / Number of outstanding ordinary shares
What should be kept in mind when using the EPS?
- only includes shares which have been issued/sold
- only uses ordinary shares, preference shares are excluded from the formula
What is one way to estimate long term shareholder wealth? and what are the issues of this?
Estimated:
Dividends received over the period + increase in share price (when the shares are sold)
Issues:
-Estimate values may differ from actuals
-Does not take in to account the cost of capital
-Shareholder may not know their cost of capital - return level required
-Ignores the time value of money - money earned today is worth more than money earned later
Secure more jobs
What is an alternative method to look at shareholder wealth?
Work out the value of a company (i.e. higher if it is expected to have higher returns/ higher net cash inflows)
such as using Net present value - based on cash flows and takes into account the cost of capital and time value of money
What are the general factors affecting share price?
Internal factors
External factors
Financial factors
Market expectations
What are INTERNAL factors?
Product releases, management policies, strategies, union influences
What are EXTERNAL factors?
Competitor action, the economy, government regulation
What are FINANCIAL factors?
company financial results
What are the two types of risk when investing in ashares of a company?
Systematic risk - uncertainty inherent in a particular market
e.g. the property market which tends to react in line with economic conditions so building companies have high systematic risk
Unsystematic risk - uncertainty inherent in a particular company due to factors unique to it
For investors, why is it riskier to invest in shares vs. investing money in the bank?
annual dividends from shares vary YoY vs. consistent/guaranteed interest from a Bank
The market value of shares vary vs. investment in the bank stays the same
Investors will lose the whole investment if the company closes down vs. banks are often guaranteed by governments
Why do shareholders require increasing rates of return?
If the risks associated with investing in shares is higher . ie. the higher the risk, the larger return should be.
Definition: risk free rate
The rate of return which would satisfy investors if they were guaranteed the return (when when the risk is 0).
closest we get to this is an investment backed by the government
What 2 things is the Risk Free Rate based on?
note. the risk free rate is determined by the time value of money
1) The rate required to compensate the individual for not being able to spend the money now
2) The rate of inflation
What are 3 factors affecting risk and return?
1) Company strategy- Returns may be low (in the short term) if the company reinvests profits but shareholders might accept this for higher returns in the future.
2) Economic conditions (during a recession) - higher returns expected vs. boom. However, the returns expected will depend on the returns available elsewhere - economy on the whole will be down/lower profits so shareholders will be likely to accept lower returns.
3) Expectations about the industry - if a particular market segment/industry is performing well, the required rate of return is likely to be higher on investments in that particular industry due to increased expectations across the whole sector
In summary, what should the return on investment take into account?
- Cost of capital
- Time value of money
- Level of risk
What is a tool used by management to keep shareholders happy/make sure they keep receiving investments from them?
Dividend policy
Definition: dividend policy
The determination of how MUCH and how FREQUENT cash is paid out of profits to shareholders in the form of dividends.
What must be considered by management when making decisions about taking on new projects?
- Shareholder’s cost of capital
- The level of risk their shareholders want to take
What is important to consider in coming up with the dividend policy?
management need to consider other financial needs of the business eg. R&D costs, funds for expansion of manufacturing etc.
What is signalling?
Dividend announcements convey information(sometimes intended or unintended) to the market, affecting share prices.
Management should choose projects which promise positive announcements.
Why is shareholder communication important and how is it achieved?
-Limits negative reactions from assumptions.
organisations do this by:
- holding shareholder meetings
- communicating details of all project decisions
- communicating details of all dividend announcements
