The topics discussed in this chapter are equity markets and stock valuation. After completing this unit, you should be able to: Understand how share prices depend on future dividends and dividend growth, be able to compute share prices using the dividend growth model, understand how share markets work, understand how share prices are quoted.
Equity markets and share valuation Chapter Key concepts and skills • Understand how stock prices depend on future dividends and dividend growth • Be able to compute stock prices using the dividend growth model • Understand how corporate directors are elected • Understand how stock markets work • Understand how stock prices are quoted Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-2 Chapter outline • Ordinary share valuation • Some features of ordinary and preference shares • The share markets Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-3 Cash flows for stockholders • If you own a share of stock, you can receive cash in two ways: The company pays dividends You sell your shares, either to another investor in the market or back to the company • As with bonds, the price of the stock is the present value of these expected cash flows – Dividends → cash income – Selling → capital gains Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-4 One-period example • Suppose you are thinking of purchasing the stock of Moore Oil Inc – You expect it to pay a $2 dividend in one year – You believe you can sell the stock for $14 at that time – You require a return of 20% on investments of this risk – What is the maximum you would be willing to pay? Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-5 One-period example (cont.) • D1 = $2 dividend expected in one year • • R = 20% P1 = $14 • CF1 = $2 + $14 = $16 • Compute the PV of the expected cash flows P0 • • ( 14 ) 1.20 $13.33 Calculator: 16 [FV]; 20 [I/Y]; [N]; [CPT] [PV] = -13.33 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-6 Two-period example • • Now, what if you decide to hold the share for two years? In addition to the dividend in one year, you expect a dividend of $2.10 and a share price of $14.70 at the end of year Now how much would you be willing to pay? P0 • 1.20 ( 2.10 14.70 ) (1.20 )2 $13.33 • Calculator: CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1; • [NPV]; I = 20; [CPT][NPV] = $13.33 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-7 Three-period example • What if you decide to hold the stock for three years? • In addition to the dividends at the end of years and 2, you expect to receive a dividend of $2.205 at the end of year and a share price of $15.435 • Now how much would you be willing to pay? P0 1.20 2.10 (1.20)2 ( 2.205 15.435 ) (1.20)3 $13.33 • Calculator: • CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03 = 17.64; F03 = 1; • [NPV]; I = 20; [CPT] [NPV] = $13.33 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-8 Developing the model • You could continue to push back when you would sell the share • You would find that the price of the share is really just the present value of all expected future dividends Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-9 Stock value = PV of dividends P0 = D1 D1∞ + (1+R) D2 D3 (1+R)2 (1+R)3 + (1+R)∞ P0 t +…+ Dt t (1 R ) How can we estimate all future dividend payments? Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-10 Quick quiz: Part • What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%? 2.00 P0 15 $13.33 • What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required 215% .00(1.03) return remains at P $17.17 15 03 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-27 Using the DGM to find R • Start with the DGM: P0 D0 (1 g) R-g D1 R-g Rearrange and solve for R: R D0 (1 g) P0 g Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh D1 P0 g 7-28 Finding the required return — Example • Suppose a firm’s shares are selling for $10.50 They 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] + 05 = 15% • What is the dividend yield? – 1(1.05) / 10.50 = 10% • What is the capital gains yield? – g = 5% Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-29 Summary of share valuation Table 7.1 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-30 Features of ordinary shares • Voting rights – Stockholders elect directors – Cumulative voting vs straight voting – Proxy voting • Classes of share – ‘One share, one vote’ Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-31 Features of ordinary shares (cont.) • Other rights – Share proportionally in declared dividends – Share proportionally in remaining assets during liquidation – Pre-emptive right • Right of first refusal to buy new stock issue to maintain proportional ownership if desired Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-32 Dividend characteristics • Dividends are not a liability of the firm until declared by the Board of Directors – A firm cannot go bankrupt for not declaring dividends • Dividends and taxes – Dividends are not tax deductible for a firm – Taxed as ordinary income for individuals – Dividends received by corporations have a minimum 100% exclusion from taxable Copyright 2011 McGraw-Hill Australia Pty Ltd 7-33 PPTsincome t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh Features of preference shares • Dividends – Stated dividend must be paid before dividends can be paid to ordinary shareholders – Dividends are not a liability of the firm and preference dividends can be deferred indefinitely – Most preference dividends are cumulative — any missed preference dividends have to be paid before ordinary dividends can be paid • Preference shares generally not carry voting rights Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-34 The share markets • Primary vs secondary markets – Primary = new-issue market – Secondary = existing shares traded among investors • Dealers vs brokers – Dealer: Maintains an inventory Ready to buy or sell at any time Think ‘Used car dealer’ – Broker: Brings buyers and sellers together Think ‘Real estate broker’ Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-35 Australian Stock Exchange (ASX) • Australian Stock Exchange (ASX)—1987 – Result of amalgamation of state-based exchanges • 1987—Introduction of Stock Exchange Automated Trading System (SEATS) • 1998—Demutualisation of ASX • 2006—Merger with Sydney Futures Exchange and now called Australian Securities Exchange • New Zealand Stock Exchange – Created in 1974 – 1991—Introduction of Computer Based Trading System – Demutualised in 2002 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-36 ASX and NZX operations • Operational goal = Attract order flow • Both ASX and NZX are auction markets – Agency trading—Brokers buying and selling for clients – Principal trading—Brokers buying and selling their own accounts • Orders – Limit order—specified sell/buy price – Market order—at best market price • Trading in both ASX and NZX takes place on computer network Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-37 Share market reporting Figure 7.2 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-38 Work the Web • Click on the information icon to go to < http:// markets.smh.com.au/apps/qt/index.ac> • Search for other equities like the one in the last example • Understand the reported figures Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-39 Quick quiz: Part • You observe a share price of $18.75 You expect a dividend growth rate of 5% and the most recent dividend was $1.50 What is the required return? • What are some of the major characteristics of ordinary shares? • What are some of the major characteristics of preference shares? Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-40 Chapter END 7-41 ... directors are elected • Understand how stock markets work • Understand how stock prices are quoted Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al... PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-30 Features of ordinary shares • Voting rights – Stockholders elect directors – Cumulative... t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 7-34 The share markets • Primary vs secondary markets – Primary = new-issue market – Secondary