Valuation of Securities (LECTURE 4) Flashcards
What is EQUITY CAPITAL?
-Ordinary shares
ORDINARY SHARES and those who hold them.
Holders- shareholders.
Shareholders are owners of the firm.
Have voting rights most of the time.
Receive a share of the companies profits through dividends.
In the worst case scenario, they receive a share in proceeds of liquidation.
There is no agreement with the company to receive back the original amount invested.
Though have a right to get dividend, firm does not have an obligation.
Why do holders of equity need more return?
Two reasons:
- Claims on profit:
- they are last in the queue- debt holders, then preferred stock holders, then equity holders. - Claims on assets in case of liquidation, they are again last after debt holder, preferred stock holders, tax authorities and employees.
MORE RISK THEREFORE NEED MORE RETURN.
What is the attraction of holding equity?
No limit to the size of dividends.
PAR VALUE OF SHARES
Stated par value or nominal value.
The value at which shares are stated in the books of account.
No real significance.
SHARE PREMIUM
The difference between market price and par value.
RIGHT ISSUES
Invitation to existing shareholders to buy additional shares.
Issued at discounted price 10-40% discount.
SCRIPT ISSUE
Also called bonus issue or capitalisation issue.
To bring the price down; give shareholders more shares.
Different from script dividend.
SHARE SPLIT (stock split)
Reducing nominal value of shares to increase the no. of shares; total nominal book value remains the same.
Reverse stock split or consolidating shares.
NON-VOTING SHARES OR REDUCED VOTING SHARES
A class-B class shares.
PREFERENCE SHARES
Preference over dividends and claim on assets (in case of liquidation) compared to ordinary shareholders.
But they have characteristics of both debt and equity; hybrid securities.
More risky than bond/debt. Cost of preference share is therefore higher.
Dividend rate of debt?
Usually fixed like fixed interest on debt.
Right to receive dividend- equity?
Comes after debt holders.
Dividend amount- equity?
Dividend could be reduced even to zero if the firm has insufficient profits; could be cumulative preference shares.
Dividend guarantee-equity?
Optional; no guarantee just like equity holders.
Share of extra ordinary profits- debt?
Don’t share unless participating preference shares.
Voting rights- debt?
No voting rights
Tax deductibility- Equity?
Dividends on preference shares are not tax deductible.
What two groups is valuation of shares important to?
MANAGEMENT: important for decision making- responsibility of maximising shareholders’ wealth.
INVESTORS: who wants to estimate the value of a share.
What are the three main methods to value equity/shares?
- Net Asset Value (NAV)
- Price Earning Ratio
- Dividend Valuation Models
What is NAV concerned with?
Book value of assets.
Taken from balance sheet.
How is NAV calculated?
Calculated by deducting short-term and long-term obligations from a total of non-current and current assets.
(current assets + non-current assets) - (current liabilities + non-current liabilities)
Advantages of using NAV?
- Useful when firm is in financial difficulty
- Useful in merger and acquisition
- Other methods like dividend valuation cannot be used
Disadvantages of NAV?
- Balance sheet approach: value of assets can be significantly different from current value of assets (plant and building, value of intangible assets, value of human capital)
- Off-balance sheet liabilities not included
- Ignores earning power
- Are accounts reliable?
PRICE EARNING RATIO
Compares the share price with earnings per share.
PE Ratio = Current market price of share (MP) / Last year’s Earning per share (EPS)
High PE companies= more growth in future (expectation of profits to rise)
Advantage of PE ratio?
- Easy to calculate and interpret
- Inputs easily available for public firms
Disadvantages of PE ratio?
- Comparability of quoted and unquoted companies
- Uses accounting profits as a basis, with all its distortions
Dividend Valuation Model
Market value of share = PV of all future dividends
Return expected by an investor: dividend and capital gain (difference between purchase price and sale price)
If keep share for 1 year:
d1 + P1
If keep share for 2 years:
d1 + d2 + P2
If keep share for 3 years:
d1 + d2 + d3 + P3
If keep share forever:
d1 + d2 + d3 + d4…+d∞
If the investor keeps the share for 1 year:
d1 + P1
Then the value of the share for him today:
P0= d1/(1+kE) + P1/(1+kE)
DIVIDEND VALUATION MODEL EXAMPLE:
Suppose you want to buy a share of Marks and Spencer and keep it for a year. You expect that Marks and Spencer will pay a dividend of 22p next year. You also expect to sell the share in 1 years time at 490p. Given the risk associated with this kind of security, you expect at least 12% return.
t0 —–> t1
P0=? d1 + P1
Discount dividend and price at the investor’s required rate of return for the no. of years.
P0 = d1/(1+kE) + P1/(1+kE)
P0 = 22/(1+0.12) + 490/(1+0.12) = 457.14p
Dividends to Infinity
P0 = d1/kE
DIVIDENDS TO INFINITY EXAMPLE:
What if Marks and Spencer is expected to pay 22p per year forever and your required rate of return is 12%?
22p/0.12 = 183.33p
What are the two forms of the dividend growth model?
- Constant growth model
2. Non-constant growth model
CONSTANT GROWTH MODEL
Dividends expected to grow from year to year in response to earnings.
Normally firms try to have more or less the same growth rate in dividends.
- smooth fluctuations in the event of lower earnings and higher earnings.
- Constant growth model could be used even when there are year to year fluctuations.
P0 = d0 (1+g)/ke-g
can be written as:
P0 = d1/ke-g
CONSTANT GROWTH MODEL EXAMPLE:
M&S plc has just paid a dividend of 22p and the growth rate in the dividends is 7 percent. If your required rate of return is 11%, what is the price of this share?
P0 = d0(1+g)/ke-g
P0 = 22(1+0.07)/0.11-0.07 = 588.5p
NON-CONSTANT GROWTH MODEL
Firms go through many different growth phases.
There could be two or more growth phases.
How would you value a two stage growth phase?
NCGM
- Calculate dividends of the first growth phase, starting from next year.
- Calculate share price at point where the growth rate shifts.
- Discount all dividends from step 1 and discount share price from step 2.
- Add all the discounted numbers to calculate the value.
Two stage NON-CONSTANT GROWTH MODEL EXAMPLE:
Growth plc. dividends to increase by 25% for the first 3 years and then to revert to the company’s existing growth rates of 9.5% per year. Investors rate of return is 16%. What is today’s share price if the dividend today is 7p?
g1 = 25% fo first 3 years g2 = 9.5% forever
d0 = 7p ke = 16%
P0 = ? STEP 1: Year 1: 7(1+0.25)^1 = 8.75p Year 2: 7(1+0.25)^2 = 10.94p Year 3: 7(1+0.25)^3 = 13.67
STEP 2:
Calculate the share price at the point where the growth rate shifts:
P3 = d3(1+g2)/ke-g
P3=13.67(1+0.095)/0.16-0.095
=230.29p
STEP 3:
Discount all dividends from step 1 and discount share rice from step 2:
Year 1: Dividend = 8.75p PVIF(16%,1) = 0.8621 PV = 7.54p Year 2: Dividend = 10.94p PVIF(16%,2) = 0.7432 PV = 8.13p Year 3: Dividend = 13.67p PVIF(16%,3) = 0.6407 PV = 8.76p
Year 3:
Share price = 230.29
PVIF(16%,3) = 0.6407
PV = 147.61
STEP 4:
Add all the discounted numbers to calculate value:
7.54+8.13+8.76+147.61 = 172.04
VALUATION OF PREFERENCE SHARES
Usually no maturity date- perpetual dividends.
Treat them as perpetuities.
P0 = Dp/kp
PREFERENCE SHARES EXAMPLE:
Crown plc. has issued irredeemable (perpetual) preference shares with a nominal value (par value) of £20 each and with a dividend rate of 10%. What is the maximum price you should be prepared to pay today for an irredeemable preference share in Crown plc. if you have available an alternative perpetual investment opportunity of equivalent risk which has a rate of return of 12%?
Dividend is 10% of nominal value (£20) = £2
P0= £2/0.12 = £16.67
