Valuation of Securities (LECTURE 4)

Question 1

What is EQUITY CAPITAL?

Answer 1

-Ordinary shares

Question 2

ORDINARY SHARES and those who hold them.

Answer 2

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.

Question 3

Why do holders of equity need more return?

Answer 3

Two reasons:

1. Claims on profit:
   - they are last in the queue- debt holders, then preferred stock holders, then equity holders.
2. 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.

Question 4

What is the attraction of holding equity?

Answer 4

No limit to the size of dividends.

Question 5

PAR VALUE OF SHARES

Answer 5

Stated par value or nominal value.

The value at which shares are stated in the books of account.

No real significance.

Question 6

SHARE PREMIUM

Answer 6

The difference between market price and par value.

Question 7

RIGHT ISSUES

Answer 7

Invitation to existing shareholders to buy additional shares.
Issued at discounted price 10-40% discount.

Question 8

SCRIPT ISSUE

Answer 8

Also called bonus issue or capitalisation issue.

To bring the price down; give shareholders more shares.

Different from script dividend.

Question 9

SHARE SPLIT (stock split)

Answer 9

Reducing nominal value of shares to increase the no. of shares; total nominal book value remains the same.

Reverse stock split or consolidating shares.

Question 10

NON-VOTING SHARES OR REDUCED VOTING SHARES

Answer 10

A class-B class shares.

Question 11

PREFERENCE SHARES

Answer 11

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.

Question 12

Dividend rate of debt?

Answer 12

Usually fixed like fixed interest on debt.

Question 13

Right to receive dividend- equity?

Answer 13

Comes after debt holders.

Question 14

Dividend amount- equity?

Answer 14

Dividend could be reduced even to zero if the firm has insufficient profits; could be cumulative preference shares.

Question 15

Dividend guarantee-equity?

Answer 15

Optional; no guarantee just like equity holders.

Question 16

Share of extra ordinary profits- debt?

Answer 16

Don’t share unless participating preference shares.

Question 17

Voting rights- debt?

Answer 17

No voting rights

Question 18

Tax deductibility- Equity?

Answer 18

Dividends on preference shares are not tax deductible.

Question 19

What two groups is valuation of shares important to?

Answer 19

MANAGEMENT: important for decision making- responsibility of maximising shareholders’ wealth.

INVESTORS: who wants to estimate the value of a share.

Question 20

What are the three main methods to value equity/shares?

Answer 20

1. Net Asset Value (NAV)
2. Price Earning Ratio
3. Dividend Valuation Models

Question 21

What is NAV concerned with?

Answer 21

Book value of assets.

Taken from balance sheet.

Question 22

How is NAV calculated?

Answer 22

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)

Question 23

Advantages of using NAV?

Answer 23

• Useful when firm is in financial difficulty
• Useful in merger and acquisition
• Other methods like dividend valuation cannot be used

Question 24

Disadvantages of NAV?

Answer 24

• 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?

Question 25

PRICE EARNING RATIO

Answer 25

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)

Question 26

Advantage of PE ratio?

Answer 26

- Easy to calculate and interpret | - Inputs easily available for public firms

Question 27

Disadvantages of PE ratio?

Answer 27

- Comparability of quoted and unquoted companies | - Uses accounting profits as a basis, with all its distortions

Question 28

Dividend Valuation Model

Answer 28

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)

Question 29

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.

Answer 29

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

Question 30

Dividends to Infinity

Answer 30

P0 = d1/kE

Question 31

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%?

Answer 31

22p/0.12 = 183.33p

Question 32

What are the two forms of the dividend growth model?

Answer 32

1. Constant growth model | 2. Non-constant growth model

Question 33

CONSTANT GROWTH MODEL

Answer 33

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

Question 34

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?

Answer 34

P0 = d0(1+g)/ke-g P0 = 22(1+0.07)/0.11-0.07 = 588.5p

Question 35

NON-CONSTANT GROWTH MODEL

Answer 35

Firms go through many different growth phases. There could be two or more growth phases.

Question 36

How would you value a two stage growth phase? | NCGM

Answer 36

1. Calculate dividends of the first growth phase, starting from next year. 2. Calculate share price at point where the growth rate shifts. 3. Discount all dividends from step 1 and discount share price from step 2. 4. Add all the discounted numbers to calculate the value.

Question 37

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?

Answer 37

``` 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

Question 38

VALUATION OF PREFERENCE SHARES

Answer 38

Usually no maturity date- perpetual dividends. Treat them as perpetuities. P0 = Dp/kp

Question 39

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%?

Answer 39

Dividend is 10% of nominal value (£20) = £2 P0= £2/0.12 = £16.67