Chapter 7 share valuation

Ordinary Share Valuation A market price adjustment will occur when Where: = expected return r = required return = expected benefit during each period current price of asset [Equation

to accompany

Chapter 7Share Valuation

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –

9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition

Learning Goals:

 Differentiate between debt and equity capital

 Describe the rights, characteristics and features of ordinary and preference shares

 Describe how shares are issued

 Understand the concept of market efficiency and

Debt & Equity Capital

firm (loans, bonds etc)

firm’s shareholders (preference and ordinary)

Can be raised internally (retained earnings) or

externally (selling of shares)

Debt & Equity Capital

Page 302.

Ordinary Shares

 The basic and most common type of issued share

 Ordinary shareholders are the residual owners of the firm

 Liability is limited

 No guarantee of cash flows

 Holder’s are usually rewarded with dividends and

capital gains

 Holder’s have pre-emptive rights.

 Generally have voting rights attached (but in some

cases wont).

 Can be issued internationally

Preference Shares

 May have a par value

 Are generally by nature quasi debt

 Less risk than ordinary shares

 Generally no voting rights

 Preference over ordinary shareholders in the

distribution of income and assets

 Generally place restrictive covenants upon the

firm

 Generally cumulative

 May have a conversion feature

Venture Capital

 Privately raised external equity capital used to

fund early stage firms with attractive growth

prospects

capital: typically formal businesses that

maintain strong oversight of the firms they

invest in and have clearly defined exit

strategies

who do not operate as a business but invest in promising early-stage companies in exchange for a portion of the firm’s equity

Issuing Ordinary Shares

 Ordinary shares can be sold to the primary market via:

 A Public Offering

 A Rights Offering

 A Private Placement Figure 7.1, page 307.

Share Quotations

 Are used by financial managers, existing and

potential investors to monitor share price

 Include information such as current price data and statistics on recent price behaviour

 Published in financial newspapers (Australian

Financial Review) and business sections of major newspapers

Share Quotations

Page 308.

Ordinary Share Valuation

 A market price adjustment will occur when

Where:

= expected return

r = required return

= expected benefit during each period

current price of asset [Equation 7.1]

 When investors would buy the shares, price

would rise and expected return would decrease until it equalled the required return

Ordinary Share Valuation

 When investors would sell the shares, price would decrease and expected return would increase until it equalled the required return

r

rˆ <

The Efficient Market Hypothesis

 The basic theory describing the behaviour of a

“perfect” market

 States that:

1. Securities are typically in equilibrium

2. Security prices reflect all publicly known

information about the firm, and these prices react swiftly to new information

3. Shares are fully and fairly priced

The Behavioural Finance

Challenge

 Securities market exhibits many anomalies that contradict the Efficient Market Hypothesis (EMH)

 Buyers and sellers are behavioural, in that

emotions and other subjective factors play a role

in investment decisions

 Asset prices will reflect these psychological

influences

The Basic Share Valuation

Equation

 The value of a share is equal to the present value of all future dividends it is expected to provide over an

infinite time horizon

 Can be calculated by:

[Equation 7.2]

Where:

Dt = Per share dividend expected at end of year t

P0 = Value of a share

rs = Required return on ordinary share

 Can be simplified by redefining each year’s dividend in terms of anticipated growth

∞

∞

+ +

+ +

+ +

=

) 1

(

) 1

( )

1

2 1

1 0

s s

D r

D r

D P

 Assumes a constant non growing dividend stream.

rs = Required return on ordinary share

Share Valuation Based On

Zero Growth

Share Valuation Based On

 Assumes that dividends will grow at a constant rate (g) that is less than the required return (rs)

D P

s −

0

Share Valuation Based On

Share Valuation Based On

Variable Growth

 Allows for a change in the dividend growth rate

 Five step calculation procedure:

1. Find the value of cash dividends at the end of each year Dt, during the initial growth period

2. Find the present value of the dividends expected during the initial growth period

t g

Share Valuation Based On

Variable Growth

3. Find the value of the share at the end of the

initial growth period

4. Find the present value of the dividends

expected during the initial growth period

5. Add the present value components found in

steps 2 & 4 to find the value of the share

2

1

g r

D P

s

N N

N r

N PVIF s

P

1

,

Share Valuation Based On

Variable Growth

Share Valuation Based On

Variable Growth

Page 316.

Share Valuation Based On

Variable Growth

Free Cash Flow Valuation

Model

 Useful when valuing firms that have no dividend

history, are starting up, or for valuing a division of a larger public company

 Based on the same idea as the dividend valuation model, except it values the firm’s expected free cash flows rather than expected dividends

 Estimates the value of the entire company by finding the present value of its expected free cash flows

discounted at its weighted average cost of capital

(WACC)

 Can be calculated by:

[Equation 7.7]

Where:

Vc = Value of the entire company

FCFt = Free cash flow expected at the end of year t

ra = The firm’s weighted average cost of capital

 To find the value of the ordinary shares :

+

+ +

+ +

=

) 1 (

) 1 ( ) 1

2 1

1

a a

a

c

r

FCF r

FCF r

FCF

V

Free Cash Flow Valuation

Model

Page 318.

Free Cash Flow Valuation

Model

Free Cash Flow Valuation

Model

Page 319.

Free Cash Flow Valuation

Model

Other Approaches To

Ordinary Share Valuation

received if all assets are liquidated at their book

value, and surplus after paying all liabilities divided among shareholders

 Liquidation Approach: The amount per share to be

received if all assets are liquidated, liabilities are paid and any surplus divided among shareholders

Other Approaches To

Ordinary Share Valuation

 Price/Earnings Multiples: Reflect the amount

investors are willing to pay for each dollar of

earnings

Share value is estimated by multiplying the firm’s expected EPS by the average P/E ratio for the

industry

Helpful in valuing firms that are not publicly traded

Considered superior to the book and liquidation values as it considers expected earnings

Other Approaches To

Ordinary Share Valuation

Decision Making & Share

Value

Page 322.

 Changes In Expected Return: If risk remains stable,

an increase in dividend expectations should lead to

an increase in firm value

increase in required return and a decrease in share value and consequently shareholder wealth

financial manager will affect both risk and return to some extent Assessment will need to be made of the net effect of the changes to these variables

Decision Making & Share

Value