L6 - Valuation of Shares

Question 1

How is the Spot rate related to yield to maturity for zero coupon bonds?

Answer 1

The spot rate equals the yield to maturity rate for zero coupon bonds

Question 2

What is the Foward rate?

Answer 2

A forward rate is the settlement price of a transaction that will not take place until a predetermined date in the future; it is a forward-looking price. Forward rates typically are calculated based on the spot rate.

• Try to forcast a future cash flow

Question 3

How can do you calculate the Forward Rate?

Answer 3

Question 4

What are some different interest rate hypotheses?

Answer 4

Expectations

• Forward rate is the best market estimate of the future spot rate

Liquidity premium

• Lenders prefer to lend short (due to risk of having money tied up for 20+ years), whereas borrowers prefer to borrow long –> so borrowers pay a premium to give lenders an incentive to lend for longer periods –> that why yield curves are always increasing, meaning more interest is paid over a greater time period

Inflation premium

• Inflation risk is of greatest concern to investors.Inflation can be forecasted accurately only in the short run. In order to lend for longer, investors require inflation premium (cant predict Brexit or oil price shock so lenders will only agree at a higher rate or inflation premium)

Market segmentation

• Demand and supply for bonds of different maturities will vary –> signficant demand for short term bonds, as companies with excess cash can gain interest by holding them causing prices to increase and interest rate to fall, there is lower demand for mid-term bonds so we see an increase in interest rates, but for long term bonds which are held by pension funds there is a large demand so interest rates fall again

Question 5

What are Ordinary Shares?

Answer 5

• Ordinary shares represent the equity share capital of the firm
• Share in the rising prosperity of a company
• Owners of the firm
• The right to exercise control over thecompany
• Vote at shareholder meetings
• A right to receive a share of dividends distributed
• Each shareholder entitled to a copy of the annual report
• No agreement between ordinary shareholders and the company that the investor will receive back the original capital invested
• What ordinary shareholders receive depends on how well the company is managed

Question 6

What is the different between Debt and Equity?

Answer 6

• Looking at Bonds and Loans
• Usually the lenders of the firm have no official control
• Usually requires regular cash outlays in the form of interest and the repayment of the capital sum (firm will be obliged to maintain the repayment schedule through good years and bad)
• Have priority over everyone to get their money back

Question 7

What is a disadvantage of ordinary shares?

Answer 7

• Last in the queue to have their claims met

Question 8

What is the Importance of a well-run stock exchange?

Answer 8

• Firms can find funds and grow –> Liquid
• Allocation of capital
• For shareholders –> provide the value of company for you so you can easily calculate the wealth
• Status and Publicity
• Mergers
• Improves corporate behaviour –> highly regulated with rules on financial reporting etc

Question 9

What is the dividend valuation model?

Answer 9

Present value is simple discounted future cashflows (discounted dividends + discount future selling price)

Question 10

What is the dividend valuation model to infinity?

Answer 10

• Same formula as Perpetuity

Question 11

What is the dividend growth model?

Answer 11

• For non-constant growth you when the growth rate changes you will have to recalculate the present value at the new rate

Question 12

How do you find the growth rate of dividends for a set of date?

Answer 12

n-1th root[(dividend per share_n/dividend per share₀) - 1

where n is the number of period that the dividend is paid

Question 13

What is some issues with the dividend growth model?

Answer 13

• Companies may not pay dividends ( especially in bad economic, financial or business situations)
• Problems with dividend valuation models
  
  • They are highly sensitive to the assumptions ( a change in r by 0.5% can sometimes double the present value)
  • The quality of input data is often poor
  • If g exceeds r a nonsensical result occurs

Question 14

What are the determinants of growth for the dividend growth rate?

Answer 14

• Determinants of growth:
  
  • 1 The quantity of resources retained and reinvested within the business
  • 2 The rate of return earned on those retained resources
  • 3 Rate of return earned on existing assets
  • 4 Additional Finance –> debt for investment
• Growth - focus on the firm
  
  • 1 Strategic analysis –> how to company is valued in the industry, is the market growing or matured, has a competitor recent gone into liquidation
  • 2 Evaluation of management
  • 3 Using the historical growth rate of dividends
  • 4 Financial statement evaluation and ratio analysis
• Growth - focus on the economy

Question 15

What is the Price to Earning Ratio?

Answer 15

(P₀/E₀)

the multiple of current earning per share that you would have to pay to buy a share at its current price

• High ratio, growing company whereas low ratio is normal a large, established company where high growth is no longer seen

Question 16

What the issue with the basic Price to Earnings Ratio?

Answer 16

• Analysing through comparison lacks intellectual rigour
  
  • The assumption that the ‘comparable’ companies are correctly priced is a bold one
• It fails to provide a framework for the analyst to test the important implicit input assumption (required rate of return, risk and the growth rate of dividends):

Prospective Price to Earnings Ratio (using future earnings):

P₀=d₁/r-g

P₀/E₁=(d₁/E₁)/ r-g

high growth rate will lead to higher Price to Earnings ratio

d₁/E₁ –> dividend payout ratio, the proportion of earnings a company pays out in dividends –> if this increase it would suggest a lower P/E ratio, but if a company is paying out more in dividend it means it is reinvesting less money and a result their may be lower growth in the future

Question 17

How do you calculate dividend yield?

Answer 17

Dividend/Price

Question 18

How do you calculate dividend coverage?

Answer 18

dividend per share/Earnings

• The dividend coverage ratio measures the number of times that a company could pay dividends to its shareholders.
• The concept is used by investors to estimate the risk of not receiving dividends.
• Thus, if a company has a high proportion of net income to its total annual amount of dividend payments, there is a low risk that the business will not be able to continue making dividend payments of the same amount.
• Conversely, if the ratio is less than one, the business may be borrowing money in order to make dividend payments, which is not sustainable

Question 19

What is the dividend payout ratio?

Answer 19

E/dps

where dps denotes dividend per share and E denoted earnings per share

• The dividend payout ratio measures the proportion of earnings paid out to shareholders as dividends.
• The ratio is used to determine the ability of an entity to pay dividends, as well as its reliability in doing so.
• A public company in a mature industry, or one whose sales are no longer growing rapidly, usually has a high dividend payout ratio.
• Such companies tend to attract investors who buy shares almost exclusively for the reliability of dividend payments; growth investors do not invest in these companies.