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
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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
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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
