Equity Valuation Flashcards
(16 cards)
Equities/ Shares
Owned by?
What type of contract?
4 benefits (+2)?
- Owned by Shareholders
- Shares are (usually) an irredeemable contract with no maturity date. (because assuming the business will continue forever)
- Shareholders liability is limited
- Can appoint/remove directors.
- Vote on major strategic and Policy Issues e.g.
- Director’s remuneration
- M&A (refers to the process where companies combine (merger) or one company purchases another (acquisition))
- if unhappy can sell shares/pass on ownership.
Shareholders take a risky position in the firm:
How do they get money back?
Why is it a risky position?
- Dividends (paid quarterly, semi-annually or annually) are paid from Net Profit after Tax. OR keep money to reinvest into business aka retained earnings
- Should the firm go into liquidation, shareholders are the last to receive their funds.
Comparing Debt and Equity Finance
Nature of finance
Cash flow rights
Control rights
Cost of finance
Tax implications
Equity Finance
Nature of finance
- Permanent capital
Cash flow rights
- Dividends are paid at the discretion of the company; no legal obligation exists to pay them.
Control rights
- Shareholders receive control rights through a voting system.
Cost of finance
- Relatively higher due to the higher risk associated with the equity market.
Tax implications
- Dividends are not tax deductible.
Debt Finance
Nature of finance
- Semi-permanent capital
Cash flow rights
- Interest payments are contractually required.
Control rights
- Typically, control rights remain with the company, though debt-holders may gain influence through debt covenants. (such as preventing the manager from distributing more than 10% of profits to shareholders)
Cost of finance
- Relatively lower due to the lower risk.
Tax implications
- Provides tax shields because interest payments on debt finance are tax deductible.
What is a tax shield?
Debt financing will pay interest on bonds before paying tax, so you will pay less tax and have a tax shield compared to equity financing
There are, many different types/classes of shares so company ownership may be created very flexibly:
(1,4,4,3)
- Ordinary Shares
-
Preference Shares - characteristics of them:
- Hybrid (bond/ Ordinary share)
- Constant dividends eg. £5 a year
- Higher claim against company assets & dividends than ordinary share
- Don’t having voting rights eg. family corporation may prefer this so family keeps full control
DIfferent types of Preference Share
Cumulative
- If missed, payments are carried forward
Participating
- Fixed plus share of excess profits
(Ir)redeemable
- Have a (no) fixed date for capital redemption
Convertibles
- May be converted into ordinary shares
Variable Rate
- Dividend rates will vary e.g. with LIBOR
Other Share Types
Reduced/Non Voting
- Like ordinary shares but altered voting rights
Deferred
- Dividends periodically rank ↓ other shares
Golden
- Shares with special powers (e.g. block M&A)
Blocking M&A deals - the ability to prevent a company from being taken over or merged.
Primary vs Secondary Markets
4 each
Primary Markets
- Securities are sold to investors
- Money that is raised goes to issuing firm
- First share issue is called an Initial Public Offering
- Second Share Issue is called a Seasoned Offering
Secondary Markets
- Investors trade securities with each other
- Money that is raised goes to Seller of Securities
- Share Prices
- Improve marketability of shares
To avoid losing voting rights
How? (2)
Seasoned Offering or placement/issue of additional shares to those in existence and already trading, it is often known as a ‘rights issue’.
A rights issue is an invitation to existing shareholders to purchase additional shares in the company.
Market Capitalisation
Definition
For an Individual Share?
For a Stock Market?
Market capitalisation, often referred to as “market cap,” is a measure of a company’s total value as determined by the stock market.
How do we value equity within one-year investment horizon?—The application of PV Formula
3 formulas
Example
- DBC plc plans to pay its first dividend of 140p in four years’ time, and analysts expect that the dividend will grow at 2% per year thereafter in perpetuity. What is the value of a share of DBC stock if the firm’s cost of equity capital is 9%? (to the nearest penny):”
Assumption: If a company exists for forever its terminal value disappears.
In practice, the DDM faces two challenges.
Challenge 1:
- r represents the rate of return required by shareholders, which is non observable and therefore impossible to calculate with precision.
Challenge 2:
- Dividends are difficult to forecast with accuracy because dividend payout is an internal issue of the company.
Estimated Value and Market Price
3 scenarios
Undervalued:
- Intrinsic value > market price
Fairly valued:
- Intrinsic value = market price
Overvalued:
- Intrinsic value < market price
How do we value equity within one-year investment horizon? — A discussion on Cost of Equity Capital
For example: XYZ Plc is trading at £100 per share today and it is expected to trade at £110 one year from now. What are the expected return, dividend yield and capital gain (loss) if the dividend one year from now is expected to be £5.00?
Assume that dividends are as follows:
Div 0 = 10, div 1 = 12, div 2 = 15, div 3 = 20,
div 4 = 28
