10 Chapter The Valuation and Characteristics of Shares Slides Developed by: Terry Fegarty Seneca College

1010Chapt

er

Chapt

er The Valuation and

Characteristics of SharesThe Valuation and

Characteristics of Shares

Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 10: Outline (1)

• Common Shares The Return on an Investment in Common Shares The Basis of Share Value Comparison of Cash Flows from Shares and Bonds

The Intrinsic (Calculated) value and Share Price

• Growth Models of Common Share Valuation Developing Growth-Based Models Working with Growth Rates Dividend Valuation Models Constant Normal Growth—The Gordon Model


Chapter 10: Outline (2)

The Expected Return Two-Stage Growth Practical Limitations of Pricing Models

• Some Institutional Characteristics of Common Shares

• Preferred Shares Valuation of Preferred Shares Characteristics of Preferred Shares

• Securities Analysis


Common Shares

• Common shares—evidence of ownership Common shareholders own firm Common shareholders elect Board of Directors

• Common shares—form of long-term equity financing for firm

• Common shares often called a residual security Value represents whatever assets are left after all

prior claims against assets have been settled.


Common Shares

• Background Common shareholders own corporation, but

share ownership often spread among large number of people• Most shareholders aren’t interested in role as

owners

Most equity investors are only interested in how much money they will receive as shareholders


The Return on an Investment in Common Shares• Future cash flows from share ownership consist of

Dividends Eventual selling price of shares

• If you buy a share for price P0, hold it for one year during which time you receive a dividend of D1, then sell it for a price P1, your return, k, would be:

1 1 0

0

1 01

0 0

dividend yield capital gains yield

D + P -Pk =

P

or

P -PDk = +

P P

A capital gain (loss) occurs if you sell the shares for a price greater (lower) than

you paid for it.


The Return on an Investment in Common Shares• Solve previous equation for P0, share’s price today:

0 1 1 0

0 0 1 1

0 1 1

1 10

kP

P kP

1 P

P1

D P P

D P

k D P

D P

k

• Return on our share investment is interest rate that equates present value of investment’s expected future cash flows to amount invested today, the price, P0


The Basis of Share Value

• Cash flows attributable to a common share accrue from:

Dividend stream (while owning the shares) Sale price

The market value of a common share is equal to the present value of its

expected future cash flows!


Comparison of Cash Flows from Shares and Bonds

Bonds Shares

Interest payments are guaranteed Dividends on common shares are not guaranteed

Interest payments are fixed Dividends on common shares may increase, decrease or stop at discretion of management

Maturity value is fixed Shareholder sells shares at prevailing market price

On maturity, investor receives par or face value from issuing company

Shares are sold to another investor


The Basis of Share Value

• Basis for share value is present value of expected cash inflows even though dividends and share prices are difficult to forecast Must make assumptions about what future dividends

and selling price will be• Discount these assumptions at an appropriate interest rate

0 1 k,1 2 k,2 n k,n n k,nP = D PVF D PVF D PVF P PVF


Figure 10.1: Cash Flow Timeline for Share Valuation


Example 10.1: The Basis of Value

Q: Joe Simmons is interested in the shares of Teltex Corp. Joe thinks the shares will pay a dividend of $2 next year and $3.50 the year after. By then he believes it will be selling for $75 a share, at which price he'll sell anything he buys now. People who have invested in shares like Teltex are currently earning returns of 12%. What is the most Joe should be willing to pay for a share of Teltex?

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Example 10.1: The Basis of Value

A: Joe shouldn’t pay more than the present value of the cash flows he expects: $2 at the end of one year and $3.50 plus $75 at the end of two years.

0 12%,1 12%,2 12%,2P = $2 PVF $3.50 PVF $75 PVF

$2[0.8929] $3.50[0.7972] $75.00[0.7972]

$64.37

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If the market price of Teltex is below about $64, Joe should buy; if not, he shouldn’t invest.


The Intrinsic (Calculated) Value and Market Price• Share’s intrinsic value is based on assumptions

made by potential investor Must estimate future expected cash flows

• Needs to perform fundamental analysis of firm and industry

• Different investors with different cash flow estimates will develop different intrinsic values

• Fundamental analysis: Developing intrinsic values and comparing them to market prices


Growth Models of Common Share Valuation

• Realistically most people tend to forecast growth rates rather than cash flows Because forecasting exact future prices and

dividends is very difficult


Working with Growth Rates

• Growth rates work like interest rates If growth is expected to be 6% next year then

$100 growing at 6% will increase by $6, ($100 x 1.06) to $106

0(1 )iiD D g Where:

D0 = Today’s dividend Di = Future dividend for year i

g = growth rate


Example 10.2: Growth RatesE

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Q: Apex Corp. paid a dividend of $3.50 this year. What are its next 3 dividends if it is expected to grow at 7%?

A: In this case D0 = $3.50 and g = .07, so

(1 + g) = 1.07. Then

D1 = D0(1 + g) = $3.50(1.07) = $3.75

D2 = D1(1 + g) = $3.75(1.07) = $4.01

D3 = D2(1 + g) = $4.01(1.07) = $4.29


Dividend Valuation Models

• Constant growth model • Zero growth model• Two-stage growth model


Developing Growth-Based Models

• A person who buys shares at time n will hold it until period m and then sell it Their valuation will look like this:

n + 1 m m

n m - n m - n

D D PP = +…+ +

1 + k 1 + k 1 + k

Repeating this process until infinity results in:

i

0 ii=1

DP

1 + k

Conceptually it’s possible to replace the final selling price

with an infinite series of dividends


Constant Normal Growth—The Gordon Model

10

DP

gk

k must be greater than g

Gordon model is simple expression for forecasting price of a share that’s expected to grow at a constant, normal rate

D1 = Dividend in Next Period [D1 = D0 x (1+g)]k = Required Rate of Returng = constant growth rate


Example 10.3: Constant Normal Growth—The Gordon Model

Q: Atlas Motors is expected to grow at a constant rate of 6% a year into the indefinite future. It recently paid a dividends of $2.25 a share. The rate of return on shares similar to Atlas is about 11%. What should a share of Atlas Motors sell for today?

A:

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DP

k - g

$2.25 (1.06)

.11 - .06$47.70


The Zero Growth Rate Case—A Constant Dividend• If share is expected to pay constant, non-

growing dividend, each dollar dividend is the same

• Gordon model simplifies to:

0

DP

k

• Zero growth share is a perpetuity to the investor

D = Dividendk = Required Rate of Return


Zero Growth: Example

Q. Firm ABC currently pays a dividend of $1.00 per share. This is expected to remain the same into the foreseeable future. If

shareholders require a return of 20% to hold the shares, what is each share worth in the market?

A. 0

DP

k

$1.00$5.00

.20

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The Expected Return

• Can recast Gordon model to focus on return (ke) implied by the constant growth assumption

• Expected return reflects investors’ knowledge of a company If we know D0 (most recent dividend paid) and

P0 (current actual share price), investors’ expectations are input via growth rate assumption

1

0eD

k gP


Two-Stage Growth

• At times, we may expect that firm’s future growth will not be constant

For example, new product may lead to temporary high growth

• Two-stage growth model allows us to value share that is expected to grow at unusual rate for limited time

1. Use the Gordon model to value constant portion2. Find the present value of non-constant growth

periods


Figure 10.2: Two-Stage Growth Model


Q: Zylon Corporation’s shares are selling for $48. The firm will make an exciting new product announcement next week. We’ve concluded that this new product will support an overall company growth rate of 20% for about two years. After that, growth will level off at about 6%. The firm currently pays an annual dividend of $2.00, which can be expected to grow with the company. The rate of return on shares like Zylon is approximately 10%. Is Zylon a good buy at $48?

A: We’ll estimate what we think Zylon should be worth given our expectations about growth.

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Example 10.5: Two-Stage Growth



First, draw a time line showing the expected cash flows. Each dividend must be calculated, using the growth rate for the period.

0 4321

∞$2.00 $2.40 $2.88 $3.05

20% 20% 6% 6%Exa

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Next, we’ll develop a schedule of expected dividend payments:

Next, we’ll use the Gordon model at the point in time where the growth rate changes and constant growth begins. That’s year 2, so:

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32

2

D $3.05P $76.25

k - g .10 - .06

6%$3.053

20%$2.882

20%$2.401

GrowthExpected DividendYear



Then we take the present value of D1, D2 and P2:

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0 1 k, 1 2 k, 2 2 k, 2

10, 1 10, 2 10, 2

P D PVF + D PVF + P PVF

$2.40 PVF + $2.88 PVF + $76.25 PVF

$2.40 0.9091 + $2.88 0.8264 + $76.25 0.8264

$67.57

Compare $67.57 to the listed price of $48.00. If we are correct in our assumptions, Zylon should be worth about $20 more than it is selling for in the market, so we should buy

Zylon’s shares.


Two-Stage Growth: Helpful Hints

1. Draw a timeline2. Calculate each dividend on the timeline3. During the period of non-constant growth,

present value dividends back to time zero4. Once growth has stabilized:

Calculate the present value of all dividends from that point forward out to infinity.

Calculated value must be brought back to time zero.


Practical Limitations of Pricing Models• Share valuation models give approximate results

because inputs are approximations of reality Bond valuation is precise because inputs are exact

• With bonds, future cash flows are contractually guaranteed in amount and time

• Actual growth rate and interest rate can be VERY different from predicted rates Even if rates differ only slightly, it can make big difference in

our decision So, it’s best to allow margin for error in estimations


Practical Limitations of Pricing Models• Shares That Don’t Pay Dividends

Some firms don’t pay dividends even if they are profitable

Many companies claim they never intend to pay dividends

• These firms can still have a substantial share price Firms of this type typically are growing and are using

profits to finance growth• However rapid growth won’t last forever• When growth slows, the firm will begin paying dividends

• It’s these distant dividends that impart value


Some Institutional Characteristics of Common Shares• Common Shareholder Rights

Right to vote at shareholder meetings Right to share in profits (either as a dividend

or as reinvested profits) Right to share in residual assets after all

other stakeholder (i.e. governments, creditors, employees) claims are satisfied

Preemptive Rights: If a firm issues new shares, existing shareholders may have right to purchase pro rata share of new issue


Some Institutional Characteristics of Common Shares• Corporate Organization and Control

Controlled by Board of Directors (elected by shareholders)

Board appoints top management who then appoint middle/lower management

Board consists of: top management and outside members (major shareholders, top executives at other firms, former presidents, etc.)

In widely held corporations, top management is effectively in control of firm because no shareholder group has enough power to remove it


Some Institutional Characteristics of Common Shares

• Voting Rights and Issues Shareholders may assign their voting rights

to someone else (proxy) Management actively solicits proxies Dissent shareholder group may try to solicit

proxies to wrest control away from management

Proxy fight occurs if parties with conflicting interests solicit proxies at same time


Some Institutional Characteristics of Common Shares• Voting for the Board of Directors • Majority voting

Each share carries one vote Requires more than 50% of votes to elect a director Gives control of the company to the larger group

• Cumulative voting Each share carries as many votes as there are

directors to be elected Shareholders may cast all votes for one candidate Gives minority interest a chance at some

representation on the board


Some Institutional Characteristics of Common Shares

• Shares With Different Voting Rights Different classes of shares can be issued with

different rights• Some shares may be issued with limited or no

voting rights


Some Institutional Characteristics of Common Shares• Shareholders’ Claim on Income And Assets

Common shareholders have a residual claim on the firm’s net income and assets

• Common shareholders are last in line to receive income or assets, after creditors and preferred shareholders

• Bear more risk than other investors

• However, residual interest is large when firm does well

• Residual income is paid out as dividends or retained (retained earnings) for investment in new projects

• Leads to future growth


Preferred Shares

• Form of equity financing • Intermediate position between common

shares and long-term debt No maturity date (like common shares) Fixed dividend payment (similar to bond

interest payment)


Valuation of Preferred Shares

• Value of preferred share is present value of all its future expected dividends.

• No growth rate in preferred share dividends, so growth rate equals 0

• Preferred shares are valued as a perpetuity

D = Dividend k = Required Rate of Return

pp

p

DP

k


Example 10.6: Preferred Shares

Q: Roman Industries’ $6 preferred originally sold for $50. Interest rates on similar issues are now 9%. What should Roman’s preferred sell for today?

A: Just substitute the new market interest rate into the preferred share valuation model to determine today’s price:

0

$6 $66.67P

.09

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Characteristics of Preferred Shares

• Cumulative Feature Common dividends can’t be paid unless

dividends on cumulative preferred are current



Preferred Common Bonds

Payments to Investors

Dividends are constant

Dividends are discretionary

Interest is constant

Maturity and Return of Principal

Issuing firm does not return principal. Holder must sell in market

Issuing firm does not return principal. Holder must sell in market

Issuing firm returns principal on maturity date

Assurance of Payment

Dividends can be passed but are cumulative

Dividends can be passed indefinitely

Interest must be paid or bondholders can put into bankruptcy



Preferred Common BondsPriority in Bankruptcy

Shareholders have claim on company assets after bondholders

Shareholders have last claim on company assets

Bondholders have first claim on company assets

Voting Rights None Right to vote None

Tax Deductibility of Payments

Dividends not deductible

Dividends not deductible

Interest payments are deductible

Risk to Investor Middle Highest Lowest


Securities Analysis

• Securities analysis—the art and science of selecting investments

• Fundamental analysis looks at company and its business to forecast value

• Technical analysis bases value on pattern of past share prices and volumes

• Efficient Market Hypothesis says information moves so rapidly in financial markets that price changes occur immediately, so it is impossible to consistently beat the market to bargains

Documents

10 Chapter The Valuation and Characteristics of Shares Slides Developed by: Terry Fegarty Seneca College