In this topic, you will learn how you can value the share of a company. A company may be public or private.

Public Company: Public company shares are traded in the stock market. However, private company shares are not traded. Public company shares are owned by thousands of investors. Therefore, ownership is more dispersed. Equity or shares are a company’s certificates of ownership. Once the company’s IPO is over, outstanding shares of a company are bought and sold among investors in the secondary markets. From the investors view, secondary markets provide marketability at a fair price for shares of securities they own. Virtually all secondary share market transactions in Australia take place on the Australian Stock Exchange.

Active secondary market enables companies to sell their new debt or equity issues at lower funding costs.

There are three types of secondary markets: Broker, Dealer, Auction

Broker: Brokers charge a commission to bring buyers and sellers together. Brokers’ extensive contacts provide a pool of information about prices that individual investors could not economically duplicate themselves. By charging a commission less than the cost of direct search, they give investors incentives to utilise information by hiring them as brokers.

Dealer: Market efficiency is improved if someone in the market can provide continuous bidding (selling or buying) for security. Dealers provide this service by holding inventories of securities, which they own, then buying (bid) and selling (ask) from inventory to earn profit based on the price difference (spread). NASDAQ is an example of a dealer market. Their electronic communications network systems provide additional price information to investors, increase marketability and competition, which should improve market efficiency.

Auction: In an auction market, buyers and sellers confront each other directly and bargain over price. The ASX originally operated as an ‘open out-cry’ market. In NYSE, auction for a security takes place at a specific location on the floor of the exchange, called a post. The auctioneer is the specialist designated by exchange and allowed to act as dealer to represent orders placed by public customers.

Private Company: On the other hand, private company ownership is concentred among a small group of investors. Irrespective of whether a company is public or private there are tools that can be utilised to value the company.

In this topic, you will learn the following concepts.

Concept 1: Articulate characteristics of equity.

Concept 2: Discounted cash flow valuation method to value share.

Concept 3: Market-based valuation method to value share.

Concept 4: Few important ratios to check the health of the company

Concept 1: Articulate characteristics of equity:

As a first step, it is important to understand the characteristics of a share or equity. Equity is another name for the share.

Ordinary and preference shares are the two types of equity securities.

Ordinary shares represent a basic ownership claim in a company. One of the owner’s rights is to vote on all important matters that affect life of company, such as vote to elect board of directors, capital budget, or proposed merger or acquisition.

Owners of ordinary shares are not guaranteed any dividend payments and have lowest priority claim on company’s assets in event of insolvency. Legally, ordinary shareholders enjoy limited liability.

Preference shares also represent ownership interest in a company, but gets preferential treatment over ordinary shares in certain matters. Preference share dividend payments are company’s fixed obligations, similar to interest payments on corporate bonds. Dividend payments are paid with after-tax dollars subject to taxation.

Preference share owners are given priority over ordinary share owners with respect to dividends payments and claims against company’s assets in event of insolvency or liquidation. Even though preference shares are equity, owners have no voting privileges. Preference shares are legally classified as perpetuities because they have no maturity. Preference shares often have “credit” ratings similar to those issued to bonds. Preference shares are sometimes convertible into ordinary shares. Most preference share issues today are not true perpetuities.

Legally, preference shares are equity. Like dividends on ordinary shares, preference share dividends are taxable. A strong case can be made that preference shares are really a special type of bond. Increasingly, preference share issues have the sinking fund feature, which requires mandatory annual retirement schedules. Valuation of ordinary and preference shares are done by using same basic methodology discussed under bond valuation topic.

Concept 2: Discounted cash flow valuation method to value share.

Applying a valuation procedure to ordinary shares is more difficult than applying it to bonds for various reasons. They are as follows:

• In contrast to coupon payments on bonds, size and timing of dividend cash flows are less certain.
• Ordinary shares are true perpetuities in that they have no final maturity date.
• Unlike rate of return, or yield, on bonds, rate of return on ordinary shares cannot be observed directly.

A one period model: This provides estimate of market price. Value of an asset is present value of its future cash flows – the future dividend and the end of period share price.

A two period model: This can be viewed as two one-period models tied together.

A perpetuity model: This is comprised of series of one-period share pricing models tied together. Although theoretically sound, this model is not practical to apply. The number of dividends could be infinite.

The general dividend valuation model

The general expression for the value of a share: Price of a share is present value of all expected future dividends. The formula does not assume any specific pattern for future cash dividends, such as a constant growth rate.

4.3

The general dividend valuation model

[latex]P_0=\sum_{t=1}^{\infty}\frac{D_t}{{(1+R)}^t}=\frac{D_1}{\left(1+R\right)}+\frac{D_2}{\left(1+R\right)^2}+\ldots+\frac{D_\infty}{\left(1+R\right)^\infty}[/latex]

This model makes no assumption about when the share is going to be sold in future. The model suggests that to calculate a share’s current value, you need to forecast an infinite number of dividends. The model implies that underlying value of a share is determined by market’s expectations of company’s future cash flows. In efficient markets, share prices change constantly as new information becomes available and is discounted into company’s market price. For publicly traded companies, a constant stream of information about company reaches the market, some having impact on share price while other information has no effect.

Another point to note is that the formula is completely general. The dividend in the numerator is always for one period later than the price you are computing. This is because you are computing a present value, so you have to start with a future cash flow.

The growth share pricing paradox

Growth Shares: Shares of companies whose earnings are growing at above-average rates and are expected to continue to do so for some time. Fast growing companies typically pay no dividends on their shares during the growth phase.

Management believes the company has a number of high-return investment opportunities, both the company and its investors will be better off if earnings are reinvested. Common sense suggests if you own shares in a company that will never pay you any cash, market value of those shares are worth absolutely nothing.

Do you think the above is true?

No. In reality, these companies will eventually pay out dividends in distant future. If internal investments succeed, the share’s price should go up significantly. Investors can then sell their shares at much higher price than what they paid.

Three different assumptions can cover most growth patterns:

• Dividend payments remain constant over time; i.e., they have growth rate of zero
• Dividends have constant growth rate
• Dividends have mixed growth rate pattern; i.e., they have one payment pattern then switch to another.

Example:

If you buy a share, you can receive cash in two ways: The company pays dividends and you sell your shares, either to another investor in the market or back to the company.

Suppose you are thinking of purchasing the share of MMM Ltd, which is expected to pay a $2 dividend in one year, and you can sell the share for $14 at that time.

If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay? Compute the PV of the expected cash flows.

Price = (14 + 2) / (1.2) = $13.33

Now, what if you decide to hold the MMM share for two years?

In addition to the dividend in one year, you expect a dividend of $2.10 in two years and a share price of $14.70 at the end of year 2.

Now how much would you be willing to pay?

PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)²

PV = 13.33

Finally, what if you decide to hold the MMM share for three years?

In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and the share price is expected to be $15.435.

Now how much would you be willing to pay?

PV = 2 / 1.2 + 2.10 / (1.2)² + (2.205 + 15.435) / (1.2)³

PV = 13.33

If you could continue to push back the year in which you will sell the share, you would find that the price of the share is just the present value of all expected future dividends.

To estimate all future dividend payments you will apply one of the three dividend valuation models discussed in this topic.

Example:

Suppose a firm’s share is selling for $10.50. It just paid a $1 dividend, and dividends are expected to grow at 5% per year.

What is the required return?

R = [1(1.05)/10.50] + 0.05 = 15%

What is the dividend yield?

1(1.05) / 10.50 = 10%

What is the growth rate?

g = 5%

The relationship between R and g

Constant-growth dividend model yields solutions that are invalid whenever dividend growth rate equals or exceeds discount rate (g ≥ R).

If g > R, the present value of the dividend gets bigger and bigger rather than smaller and smaller as it should. This implies that a company that is growing at a very fast rate, does so forever.

Concept 3: Market-based valuation method to value share

So far you learned about discounted cash flow valuation method to calculate share price. But think about the following situations:

First scenario: the firm may be new so do not have enough history for you to calculate future dividends.

Second scenario: firms may not pay any dividend.

Third scenario: suppose you are valuing a private firm, they are not traded in the stock market.

In these above situations, how do you calculate the firm’s share price? In these cases, you apply the method of relative valuation. In relative valuation, the objective is to value assets based on how similar assets are currently priced in the market. You will value the firm by looking at similar firms in the industry the firm in question is operating.

One of the ways you do relative valuation is by looking at the P/E ratio. P/E ratio is share price to earnings ratio. The intuition is to calculate the price per dollar of earnings. The P/E ratio is the average P/E ratio for the firms in the industry. Then we multiply the earnings per share (EPS) with the P/E ratio to calculate the share price of the firm. The P/E ratio in the formula below is the average P/E ratio of firms in the industry.

4.10

P/E Model

[latex]P_0=EPS\times\frac{P}{E}[/latex]

To do relative valuation follow the step below:

1. Identify comparable assets and obtain market values for these assets
2. Convert these market values into standardized values. This process of standardizing creates price multiples.
3. Compare the standardised value (or multiple) for the asset being analysed to the standardised values for comparable asset.

Concept 4: Few important ratios to check the health of the company

The ‘real-world’ financial statements are not as straightforward as the simplified ones presented in textbooks. That is why in this unit you are using actual financial statements to understand business finance concepts.

Financial ratios are calculated from a company’s financial statement variables. The financial ratios allow for better comparison through time or between companies. In other words, it helps you do a trend analysis. In ratio analysis you need to ask yourself what the ratio is trying to measure and why is that information important. Ratios are used for both companies and industry.

There are many ratios that can tell you the health of the company. However, for this unit you will focus on few ratios that can be used to gauge the wealth of the company. Please note that you need to observe these ratios over time to get a sense about the measure. The ratios are:

• Debt/Asset
• Debt/Equity
• EBIT (Earnings Before Interest and Taxes)/Interest expense
• Profit/Revenue
• Profit/Asset
• Profit/Equity
• Price/Earnings
• Market value of share/Book value of share

Long term Solvency ratios

Debt/Asset and Debt/Equity are long term solvency ratios. They are also called leverage ratios. The numerator has total debt and the denominator has total assets or total equity. The debt/asset ratio measures how much of the total asset are being used in financing debt. Suppose the debt/asset ratio is 52% then it means the firm finances about 52% of its assets with debt. The ratio debt/equity measures the relative proportion of debt and equity in the business. Suppose the debt/equity ratio is 2.5. This means if the firm has a $1 equity then it has $2.5 of debt. The amount of debt is 2.5 times the amount of equity.

(Interest) Coverage ratio

The coverage ratio measures the ability of the firm to service its debt. Higher the ratio better the ability. Higher debt in a firm is still OK as long as the company generates enough cash to pay interest on the debt. The coverage ratio measures this. Suppose the interest coverage ratio is 6. This means the company is generating earnings before paying interest and taxes 6 times the amount of interest that it has to pay on its debt.

Profitability ratio

Profit/Revenue, Profit/Asset and Profit/Equity are profitability ratios. This measures the firm’s ability to generate profit from $1 of revenue, asset, and equity respectively. Higher the number, better the profitability ratio.

Benchmark ratio

The Price/Earnings ratio measures the price of the asset per $ of earnings it generates. The price in the numerator measures the share price of the asset. This ratio is used to measure the relative performance of the firms in the industry.

Growth ratio

The market value of share/book value of share measures the growth opportunities of the firm. Higher the ratio better it is. Let’s say the ratio is 15. This means the market value of share has grown 15 times the book value of the share.