Chapter 3 - Equity Investments Flashcards
What is a preference share
3 main points
Types of preference share (5)
- Do not normally carry right to vote
- unlike ordinary shares, preference shares carry expectation of dividend (twice a year fixed - not profit based)
- Dividend paid after interest payments to bond holders and before ordinary shares dividends
Preference because they take preference over ordinary shares. All shareholder rights written in company articles of association
Types: Preference, Cumulative, Participating, Convertible, redeemable ,Zero
Cumulative preference shares
2 main. Points
- Means when a company does not pay a dividend on a Cumulative preference share, right to receive the dividend is rolled into next period
- Ordinary shares can’t be paid until all cumulative preference shares dividend paid
Think entitlement cumulates over to future years
Participating Preference Shares
- most preference shares are entitled to a fixed dividend.
- Where additional dividend could be paid over fixed rate, then participating preference dividends 9extra dividend) could be paid
Think participates in extra dividend
- Convertible preference shares
- Redeemable preference share
Convertible - Preference share able to be converted to an ordinary share.investor has decision- specific timeframe
Redeemable - Carry a specified redemption date when the company will refund nominal (par) value - company’s behest not investor.
AIM market
Principal features
- launched June 1995
- lists circa 1000 companies- total market caps £93 bn
- many AIM lack true liquidity
- lower listing standards. Lighter touch regulation than LSE
- Lower listing fees and ongoing costs
- Traded via CREST on LSE
- Exempt from Stamp Duty/Stamp Duty Reserve Tax
Advantages and disadvantages of investing in primary market
What is it known as when company listed on the primary market
When company listed on primary market known as initial public offer IPO
Advantages:
From investment view ,in vesting in IPO rather than secondary market
- Shares may be priced at attractive levels to ensure good take up
- transaction costs generally lower/no dealing commissions
- May be limited number of shares which may increase demand, forcing price up
Disadvantages
- no track record - lack of hard factual trading data
- companies usually list on IPO when times are favourable to investors. Financial window dressing may take place
- May be less stringent reporting requirements at time of IPO
- Share allocation may be scaled back if oversubscribed
- in initial trading, the share price may be subject to high volatility
Gordons Growth Model
- What is it
- What is formula
- Downside (7)
Quickest way of valuing a share that pays dividends to beat low interest rates
Formula:
Most Recent Dividend
——————————
Investor ‘s required return - growth rate of dividend
Example:
Dividend just paid of 8p. Expected growth rate of dividends is anticipated to be 8%. Investors are expecting a return of 12%. Current market price of shares is 225p
8p/ (0.12 - 0.08) = 200p
So shares are expensive (either hold or sell?)
- crude and simplistic
- gives arelative idea at a precise moment in time - should look at trends over a period of time
If required return is less than growth rate of dividend, model gives negative share valuation
- only measuring single fundemental ie dividends
- Expected return is tricky to quantify /trust CAPM unreliable
- Works best for steady long established dividend paying companies - blue chip
- Doesnt work for young quickly developing companies
- Assumes a constant growth of dividends
- Formula for Total return of a share over a given period (capital gain plus dividend income received)
Formula for Total return
Total Return = (End value - start value) + Divs received
_______________________________________
Start Value
What is a Rights Issue
Uses
Rights Issues = issuing new shares
- dilutes value (more shares)
• To fund expansion plans
• Strengthen balance sheet
• Refinance the company after a crisis
• Offered first to existing shareholders
• Expressed as ‘1 for 3’ or ‘2 for 5’ etc
• Price for new shares below current market price
• Rights issues lead to changes in share price
• Price original shares fall to - theoretical ex-rights price
Options under a rights issue
- What is Theoretical nil paid priced
Options Under a Rights Issue:
• Subscribe for new shares and pay full amount
• Sell rights in the market
• Sell enough to generate cash to take up remainder
• Lapse - company sells and distributes proceeds after costs
Theoretical nil paid p[rice is the price an investor would theoretically pay for the right to buy a discounted share (in rights issue)
Example - If ex-rights price is £1.96 and selling price (rights subscription) is £1.80 - difference is Theoretical nil paid price
Dividend cover ?
Two way to work out
- number of times a dividend can be paid out of current earnings (numbers of times dividend can be paid out of net profit)
Eg £100k net profit . Dividend £60k. Shares in issue 2m
NET PROFIT / DIVIDEND
£100k / £60k = 1.67 ….. company can pay out dividend 1.7 times
Small dividend cover (less than 1) could be issue - especially income investor
Second way:
EARNINGS PER SHARE/ DIVIDEND PER SHARE
Take EPS. 100,000/2,000,000 = 0.05 (5p)
Then DPS Dividend per share = 60,000/2,000,000 = 0.03
EPS/DPS - 0.05/0.03 = 1.67
Dividend Yield
Why use
Example Dividend £60k. Shares in issue 2m. Share price £1
1. Work out (DPS) Dividend per share
60,000/2,000,000 = 0.03 (3p)
- Work out yield
DIVIDEND PER SHARE/ SHARE PRICE
3p/£1 = 3%
Enables comparison between return on share to,say, property income in percentage terms.Important for income investors and value investors
A low yield indicates ability for high growth and vice versa.High yield indicates share may be undervalued and so often .looked out for by value investor
Price Earnings Ratio (P/E ratio)
What is it
Distortion?
PE ratio gives indication of markets view of a company’s earnings growth potential (potential for growth in net profit) …. growth in earnings per share (EPS)
HOW CHEAP IS IT?
- Time in years, it would take the current EPS to repay the share price
SHARE PRICE / Earnings per share (EPS)
Example Share price £1. Shares in issue 2m. Net profit £100,000
EPS = 100,000/ 2,000,000 = 0.05 (5p)
£1 / 0.05 = 20
NB : answer doesn’t tell us anything on its own .Need to compare with other PE ratio of company in same sector or same sector average.
Market values higher PE than lower PE
TESCO EXAMPLE Price £4.20 \_\_\_\_\_\_\_\_\_\_\_\_\_\_ EPS. 30 Answer - around 14 times
Distortion: Price or earnings can be changed
Eg takeover target could raise price
20 ish is average. 7.80/0.36 would be a 5% return ish
Zero Dividend Preference Shares (Zeros)
5 points
- Fixed maturity date
- Fixed return
- Get paid out before ordinary shares
- Lower risk
- Zeros have no voting rights
- Subject to CGT
Zeros
Describe
- Capital cover
- Hurdle rate
- Hurdle rate (to wipeout)
- Negative hurdle rate
- Capital cover : measures the assets liability to meet redemption price of zeros
(Capital cover of greater than 1 means zero fully covered by assets) - Hurdle rate (to redemption) : annual growth required in assets to cover zeros (only applicable if cover is less than 1)
- Hurdle rate (wipeout) : measures at what point zero dividend preference share holders receive nothing. EG Hurdle rate (wipeout) of 90% manes assets would have to fall by 90% before zero holders received nothing
- Negative hurdle rate: Amount that assets can fall each year (if capital cover already more than 1) and still be sufficient to repay the zeros in fall
Earnings Per Share EPS
Formula
What is it
TOTAL EARNINGS NET OF TAX ( - preference shares)/ No.OF ordinary SHARES IN ISSUE
Example £360 m. Net earnings/ 100M shares in issue
= £3.60 EPS.
Means for each share, the earnings (*yield) is £3.30
Measures profit available to ordinary shareholders - profit that could have been paid out as ordinary dividend
Useful for company comparisons, especially in same business / relative EPS’
*EPS could be distorted by accounting
Price Earnings Ratio
Critical Evaluation
- Price increases relative to earnings
- Price can increase independently
- Earnings can decrease independently
Higher ratio number > People prepared to pay higher price for earnings as confident growth in earnings compared to competitors
Lower > Less confidence in future
Equity Warrants (5)
- option to potentially purchase in the future. Piece of paper saying buy in future at agreed price and pay some premium now
“ Call option on an equity” - Equity warrants generally not traded through exchanges (secondary markets)
- Generally a lot longer dated
- As a company, it’s a way of getting extra income without having to pay dividends….cash now and participation in future for buyer
- dilution is share price if offer to buy taken up
Price to Book ratio
Formula
Use
Ratio :Share price/ Book value per share
(Book value is net asset position - assets - liabilities)
Is the share good value. Use this if assets are key driver to investor (maybe wrong ratio to use otherwise)
Tesco
BV 14,681 (in millions)/ 7,984 shares (in m) = £1.84
So for every share, Tesco has £1.84 worth of assets
Share price £4.30 / £1.84 = approx 2.34 times
( For every ratio well in excess of “1” argument that paying too much (share price is over x2 what assets are)… There would have to be a good reason to buy share in that case
Also less than “1” would indicate a bargain (trading at a discount to NAV)
Book value per share published. Takes assets
Statutory rights of Shareholders (4)
- Hold AGM at least annually
- Shareholders more than 10% voting rights can call EGM
- “. “. 5% “. Can propose resolutions
- Shareholders can petition courts on grounds of affairs of company that are unfairly prejudicial to interest of some or all of shareholders
Three ways to issue new shares and describe
- Fixed/Tender price
- Offer for sale: sold through issuing house (merchant bank, investment bank, broker). Issuing house buys new shares at discount and sells for profit. Co. Directors issue prospectus (offer document)Formal notice goes in newspaper
- Offer for subscription - Directly to general public and offer for sale direct. Issuing house underwrites offer, meaning they agree to buy any unsold shares for a fee. Rarely used - Investment Trusts. Fixed or tender price
- Placement /selective marketing:
Marketed directly to institutional investors ie Pension funds, banks, Life funds. prospectus doesn’t have to be so detailed. Cheapest for company to sell shares = popular
PE Ratios - Failings (like other ratios)
- `Based on historic data(unless forward forecasts used)
- Only one number and simplistic
- PER must considered relative to sector and competitors
- PER should be compared to past levels and trends within an industry sector
What is PEG ratio
Drawbacks
- PEG ratio:
P/E Ratio ———————- Expected Growth Rate
Looks at future growth rates - more accurate. PEG< 1. = Buy PEG 1. = Fair value PEG > 1 = Sell PEG > 2 = Strong Sell
Drawback: Based on earnings forecast
Doesnt tell you about dividends
Property Investment
Commercial or residential eg Buy to let
Leases?
- CGT has to be paid within 30 days of completion
- 3% stamp duty surcharge B2L
Only basic rate relief on mortgage costs
B2L - lease 6 months - tenant gives I months notice, landlord 2 months . Assured short hold tenancy
Commercial property:
- Leases typically 5 years plus, maybe long
- Maintenance normally by tenant
Bonus Issue (5)
- Additional shares issued two existing investors
- At no cost
- Not a method of raising additional capital
- Used to dilute share price that has become inflated
- designed to make share look cheap
