Share Valuation Lecture # 6

Basic Facts

The Market for Shares

Equity securities are a companys

certificates of ownership.

As of today, more than Rs11.5 Billion worth

of public shares are traded.

The mar et for equities is di!ided into the

primary mar et and the secondary mar et. The primary mar et is where new shares are issued and then traded for the first time. E"istin# shares are bou#ht and sold in the secondary mar et.
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Secondary Markets

The Market for Shares

$utstandin# shares are bou#ht and

sold amon# in!estors.

%rom in!estors perspecti!e, secondary

mar ets pro!ide mar etability at a fair price for the shares and bonds they own.

Types of !uity Securities

"rdinary Shares and #reference Shares
Two types of equity securities

1& $rdinary shares

$rdinary shares represent the basic '& (reference shares

ownership claim in a company.

$ne of the owners ri#hts is to !ote on all important

matters that affect the life of the company, such as !ote to elect the board of directors, the capital bud#et or a proposed mer#er or acquisition.

Types of !uity Securities

"rdinary Shares and #reference Shares
$wners of ordinary shares are not

#uaranteed any di!idend payments) and ha!e lowest priority claim on the firms assets in the e!ent of ban ruptcy.
*e#ally, ordinary shareholders en+oy

limited liability.

Types of !uity Securities

"rdinary Shares and #reference Shares
(reference shares also represent

ownership interest in a company but #et preferential treatment o!er ordinary shares in certain matters.
(reference share di!idend payments are a

firms fi"ed obli#ations, similar to interest payments on corporate bonds.

,i!idend payments are paid after company

ta".
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Types of !uity Securities

"rdinary Shares and #reference Shares
$wners of preference shares are #i!en

priority o!er ordinary share owners with respect to di!idends payments and claims a#ainst firms assets in e!ent of ban ruptcy or liquidation.

E!en thou#h preference shares are equity,

owners ha!e no !otin# pri!ile#es.

(reference shares are #enerally !iewed as perpetuities

because they ha!e no maturity.

Types of !uity Securities

#reference Shares' (e)t or !uity*
*e#ally, preference shares are equity. *i e di!idends on ordinary shares,

preference share di!idends are ta"able.

A stron# case can be made that preference shares are really a

special type of bond.

1& Re#ular preference shares confer no !otin# ri#hts.

&

Types of !uity Securities

#reference Shares' (e)t or !uity*
'& -olders of preference shares recei!e fi"ed di!idend re#ardless of the firms earnin#s) if the firm is liquidated, they recei!e a stated !alue .usually par&/not the residual !alue of the firm.
0& (reference shares can ha!e 1credit2 ratin#s similar to those issued to bonds.

3& (reference shares are sometimes con!ertible into ordinary shares.

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Types of !uity Securities

#reference Shares' (e)t or !uity*
5& 4ost preference share issues today are not true perpetuities.
5ncreasin#ly, preference share issues ha!e

a sin in# fund feature, which requires mandatory annual retirement schedules.

1,

!uity Valuation
- "ne.#eriod Model
This pro!ides estimate of mar et price. 6alue of an asset is present !alue of its

future cash flows/the future di!idend and the end7of7period share price. ,19(1 (8 : 19R

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!uity Valuation
- T/o.#eriod Model
This can be !iewed as two one7period

models strun# to#ether. ,1 ,' 9(' (8 : 9 19R .19R&'

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!uity Valuation
- #erpetuity Model
;omprised of a series of one7period

share pricin# models strun# to#ether.

Althou#h theoretically sound, this model is not practical to

apply. The number of di!idends could be infinite.

,t (t ,1 ,' (8 : 9 9...9 9 19R .19R&' .19R&t .19R&t

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The 0eneral (i1idend Valuation Model

The price of a share is the present !alue of all e"pected future di!idends.
D3 Dt D1 D2 D P0 = + + + ... + = 2 3 t 1 + R (1 + R) (1 + R) (1 + R) t =1 (1 + R)

!uity Valuation

The formula does not assume any specific

pattern for future cash di!idends, such as a constant #rowth rate.

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The 0ro/th Shares #ricin2 #arado3

<rowth shares

!uity Valuation

=hares of companies whose earnin#s are #rowin# at abo!e7a!era#e rates and are e"pected to continue to do so for some time.

1$

The 0ro/th Shares #ricin2 #arado3

%ast7#rowin# companies typically pay no di!idends on their shares durin# the

!uity Valuation

#rowth phase.

4ana#ement belie!es the company has a number of

hi#h7return in!estment opportunities) both company and its in!estors will be better off if earnin#s are rein!ested.

The last Equation predicts/and common

sense says/if you own shares in a company that will ne!er pay you any cash, the mar et !alue of those shares are worth absolutely nothin#. 16

The 0ro/th Shares #ricin2 #arado3

5n reality, these firms will e!entually pay out

!uity Valuation

di!idends in distant future.

5f internal in!estments succeed, the share price should #o

up si#nificantly. 5n!estors can then sell their shares at a much hi#her price than what they paid to buy them.

1%

Share Valuation' So4e Si4plifyin2 -ssu4ptions

!uity Valuation

To ma e Equation more applicable, some

simplifyin# assumptions about the pattern of di!idends are necessary.

1&

Share Valuation' So4e Si4plifyin2 -ssu4ptions

most #rowth patterns.

!uity Valuation

Three different assumptions can co!er

1& ,i!idend payments remain constant o!er time) i.e., they ha!e #rowth rate of >ero.

'& ,i!idends ha!e constant #rowth rate.

0& ,i!idends ha!e mi"ed #rowth rate pattern) i.e., they ha!e one payment pattern then switch to another.
1+

!uity Valuation
5ero 0ro/th (i1idend Model
The di!idend payment pattern remains

constant o!er time? , 1 : ,' : , 0 : . . . : , @

5n this case the di!idend7discount model

.Equation& becomes? , , , , (8 : 9 9 ...9 19R .19R&' .19R&0 .19R&

2,

!uity Valuation
5ero 0ro/th (i1idend Model
This cash flow pattern essentially describes

a perpetuity with a constant cash flow.

5n the last lecture, we de!eloped the present

!alue of a perpetuity with a constant cash flow as ;%Bi, where ;% is the constant cash flow and i is the interest rate. =imilarly, equation A.' #i!es the !aluation model for a >ero #rowth share. , (8 : R .A.'&
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!uity Valuation
5ero 0ro/th (i1idend Model 3a4ple
En#ro pays Rs 5 di!idend per year and the board of directors has no plans to chan#e the di!idend. The firms in!estors e"pect a '8 per cent return on in!estment. Chat should be the price of the firms sharesD

D Rs5 P0 = = = Rs 25 per share R 0.20

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6onstant 0ro/th (i1idend Model

!uity Valuation

;ash di!idends do not remain constant

but instead #row at some a!era#e rate g from one period to ne"t fore!er.
;onstant di!idend #rowth is appropriate

assumption for mature companies with history of stable #rowth.

Chile an infinite hori>on is hard to comprehend, far7

distant di!idends ha!e a small present !alue and contribute !ery little to the price of the share.

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6onstant 0ro/th (i1idend Model

!uity Valuation

,eri!in# the constant7#rowth di!idend

model is fairly strai#htforward. Ce must build a model to compute !alue of di!idend payments for any time period.

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6onstant 0ro/th (i1idend Model

!uity Valuation

Recall that equation for a #rowin#

perpetuity in ;hapter E is equation E.E? (6A@ : ;%1B.i F #&

The constant7#rowth di!idend model tells us that the

current price of a share is the ne"t period di!idend di!ided by the difference between the discount rate and the di!idend #rowth rate.

2$

6onstant 0ro/th (i1idend Model

formula for di!idend !alues is as follows?

!uity Valuation

Cith the constant7#rowth di!idend model, the #eneral

,t : ,8 G.19#&t
Equation A.3 shows how to !alue constant7#rowth

.A.0&

shares?

,1 (8 : R7#

.A.3&
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6onstant 0ro/th (i1idend Model 3a4ple This years di!idend will be H3.I1 for Bayern
Automoti!e. The di!idends will #row at a constant 3 per cent and in!estors who own shares in similar types of firms e"pect to earn a return of 1I per cent. Chat is the !alue of the firms sharesD

!uity Valuation

D1 = D8 (1 + g ) = H3.I1 (1 + 8.83 ) = H3.I1 1.83 = H5.88

P8 = D1 H5.88 H5.88 = = R 8.1I 8.83 8.13 = H05.J1
2%

6o4putin2 Future Share #rices

!uity Valuation

The constant7#rowth di!idend model

.Equation A.3& can be #eneralised to determine the !alue, or price, of a share at any point in time.
Equation A.5 shows the price of a

share at any time t as follows? ,t91 (t : R7# .A.5&

2&

6o4putin2 Future Share #rices 3a4ple

A firm has a current di!idend .,8& of H'.58, R is 15 per cent, and # is 5 per cent. Chat is the price of the share today .(8& and what will it be in fi!e years .(5&D

!uity Valuation

D1 = D8 (1 + g ) = H'.58 1.85 = H'.E'5

D1 H'.E'5 H'.E'5 P8 = = = = H'E.'5 R g 8.15 8.85 8.18

DE = D8 (1 + g ) = H'.58 (1.85 ) = H'.58 1.03 = H0.05

E E

DE H0.05 H0.05 P5 = = = H00.58 R g 8.15 8.85 8.18

2+

The 7elationship )et/een 7 and 2

;onstant7#rowth di!idend model yields

!uity Valuation

solutions that are in!alid whene!er di!idend #rowth rate equals or e"ceeds discount rate .# K R&.
5f # : R, the !alue of the denominator is

>ero and the !alue of the share is infinite/ which ma es no sense.

3,

The 7elationship )et/een 7 and 2

5f # L R, the present !alue of the

!uity Valuation

di!idend #ets bi##er and bi##er rather than smaller and smaller as it should. This implies that a firm that is #rowin# at a !ery fast rate does so fore!er.

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Supernor4al.0ro/th (i1idend Model

,urin# the early part of their li!es, !ery

!uity Valuation

successful firms e"perience a supernormal rate of #rowth in earnin#s.

To !alue the shares for a firm with

supernormal di!idend #rowth patterns, we can apply Equation A.1, our #eneral di!idend model, and Equation A.5, which #i!es the price of a share with constant di!idend #rowth at any point in time.

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3hi)it +84' (i1idend 0ro/th 7ate #atterns

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3hi)it +8$' Ti4eline for 9on. 6onstant.(i1idend #attern

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Supernor4al.0ro/th (i1idend Model

Thus, our !aluation model is?

!uity Valuation

(8 : (6 .4i"ed di!idend #rowth& 9 (6 .;onstant di!idend #rowth& ,t (t ,1 ,' (8 : 9 9...9 9 ' t 19R .19R& .19R& .19R&t .A.E&

3$

Supernor4al.0ro/th (i1idend Model 3a4ple

!uity Valuation

%ind the !alue of the shares described in E"hibit A.5. D3 = D0 (1 + g ) = H0.88 1.8E = H0.1I
D3 H0.1I P0 = = R g 8.15 8.8E = H05.00
H1.88 H'.88 H0.88 H05.00 P8 = + + + ' 0 1.15 (1.15 ) (1.15) (1.15) 0 = H8.IJ + H1.51 + H1.AJ + H'0.'0 = H'J.5I
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Valuin2 #reference Shares

!uity Valuation

5n computin# the !alue of preference

shares, one must now whether preference shares ha!e an effecti!e 1maturity2 because of a sin in#7fund option or call option.

The most si#nificant difference between

preference shares with a fi"ed maturity and a bond is the ris of default.

3%

Valuin2 #reference Shares

!uity Valuation

=ince preference share di!idends are

declared by the board of directors, failure to pay di!idends does not result in default.
%ailure to pay a preference share di!idend

as promised is a serious financial breach and si#nals to the mar et that firm is in serious financial difficulty.

3&

#reference Shares /ith a Fi3ed Maturity

Ce can use the bond !aluation model

!uity Valuation

de!eloped in ;hapter I to determine its price, or !alue.

Equation I.' in chapter I can be restated

as the price of a preference share .(=8&.

3+

#reference Shares /ith a Fi3ed Maturity

(reference share price

!uity Valuation

: (6 .,i!idend payments& 9 (6 .(ar !alue&

,Bm + (mn ,Bm ,Bm ,Bm (=8 = + + + ... + .A.J& 1 + iBm .1 + iBm&' .1 + iBm&0 .1 + iBm&mn
=ince most preference shares ma e semi7

annual di!idend payments, m equals '.

4,

#reference Shares /ith a Fi3ed Maturity 3a4ple

!uity Valuation

A utility companys preference shares ha!e an semi7annual di!idend payment of H5, a stated .par& !alue of H188 and an effecti!e maturity of '8 years. 5f similar preference share issues ha!e mar et yields of I per cent, what is the !alue of the preference sharesD
H5 H5 H185 PS8 = + + + ' 1.83 (1.83 ) (1.83 ) 38 = H11A.JA
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#erpetual #reference Shares

!uity Valuation

=ome preference share issues ha!e no maturity.

,i!idends are constant o!er time .# : 8&. %i"ed di!idend payments #o on fore!er.

Ce can use Equation A.' to !alue such

preference share issues. , (8 : R

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#erpetual #reference Shares 3a4ple

*ineas Aereas de Espana =A has a perpetual preference share issue that pays a di!idend of H5 per year. 5n!estors require an 1I per cent return on such an in!estment. Chat should be the !alue of the preference sharesD

!uity Valuation

D H5.88 P8 = = = H'J.JI R 8.1I

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