S1 - equity valuation

Question 1

what are the share types

Answer 1

usually an irredeemable contract with no maturity date
Shareholders tale a risky position as dividends are paid from net profit after tax and if the firm goes into liquidation, shareholders are last to receive funds
Not tax deductible
Ordinary shares
Preference shares
Cumulative - payments carried forward if missed
Participating - fixe plus share of excess profits
Redeemable - have a fixed date for capital redemption
Convertibles - converted into ordinary shares
Variable rate - dividends rates will vary
Other
Reduced or non voting
Golden - special powers
Deferred - dividends periodically rank lower than others

Question 2

what are primary and secondary markets

Answer 2

primary = money raised goes into firm, sold to investors, first share issue is an initial public offering, second issue is a seasoned offering
Secondary = investors trade with each other, money goes to seller

Question 3

what is a rights issue

Answer 3

invitation to existing shareholders to purchase additional shares in the company
Can be sold on if they don’t want it - dilutes control
Price of share represents overall value of a company

Question 4

how is market capitalisation calculated

Answer 4

for an individual share = number issued x share prices
For a stock market = total market capitalisation for all shares quoted on stock exchange
Can compare firms and markets

Question 5

what is the equity valuation formula

Answer 5

P0 = div1 + P1 / 1 + rE
E = cost of equity capital
Cost of equity capital = dividend yield + capital gain rate

Question 6

what is the dividend discount model

Answer 6

price of the stock is equal to the present value of the expected future dividends it will pay
Assumption - if a company exists for forever its terminal value disappears
P0 = div / rE
future dividends, share price, cost of equity capital
Builds up a sound relationship among the value of the common stock, dividends and the cost of equity capital
rE represents rate of return required by shareholders which is non observable and is impossible to calculate with precision
Dividends are difficult to forecast with accuracy because dividend payout is an internal issue of the company

Question 7

what are the assumptions of dividend based valuations

Answer 7

Assumptions
dividend is a constant is perpetuity - the value of a company’s equity equals dividend divided by the cost of equity capital
Dividends grow at a constant rate - cost of equity capital is the sum of dividend yield and dividend growth rate

Question 8

what is the relationship between intrinsic value and market price

Answer 8

undervalued: intrinsic value > market price
Fairly valued: intrinsic value = market price
Overvalued: intrinsic value < market price