TOPIC 4

SHARE VALUATION AND

EFFICIENT MARKET
HYPOTHESIS

Chapter 7 and 10

1
Learning objectives
37
Weak-form efficiency
Prices reflect all past market information such as price and volume.


If the market is weak-form efficient, investors cannot earn abnormal returns by trading on market


information. The investors can earn abnormal returns by fundamental analysis or base securities
analysis.
Implies that technical analysis will not lead to abnormal returns.


Empirical evidence indicates that markets are generally weak-form efficient.


Stocks and Shares

Some terms:

Stocks – US

Shares – UK / Australia

Bear market: a market
in which stock prices are
falling

Bull market: a market in
which stock prices are
increasing

Going Long:=buy shares

Going Short:=an act of borrowing
shares and selling it in hopes that the
price of shares would fall and then buy
back the shares to return to the owner,
they believe the share is overvalued and
the price will fall

3
1. Cash flows for shareholders

If you own a share, you can receive
cash in two ways:

1. The company pays dividends.

2. You sell your shares, either to
another investor in the market or back to
the company.(the selling price of shares
higher than the buying price)

As with bonds, the price of the share
is the present value(meaning
excluding inflation or interest, how
much u should pay for the cash flow)
of these expected cash
flows(dividends or capital gains from
selling shares).

Dividends → cash income

Selling → capital gains

Why is it harder to
measure price
of shares
than bonds?

Yield of maturity(market
interest rate,aka what dividends
do they give), Maturity (when
the company will close down)
and future cash flows are known
for bonds but shares do not have
this information.(don’t know if
companies will give dividends
or not or how much profits they
have if profiting from the
dividend. Don’t know the future
price of shares if profiting from
selling price)

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Share price

One-period example 1

Suppose you are thinking of
purchasing the share’s of Moore Ltd.

You expect it to pay a $2 dividend in one
year.

You believe you can sell the share for $14 at
that time.

You require a return of 20% (R) on
investments of this risk.
 
What is the maximum you would be willing to
pay?

5
One-period example continued
Cash flows=2(dividend after one year)+14(selling
price)/(1+20%)^1(rate of return of 20% is expected
for every year)
-Estimation of dividends are hard
6
Two-period example 2

Two cash flows at two different

time:
1 In first year, rate of
st (

return=(1+20%)^1):2 dollar
dividend
2 nd (In
second year, rate of
return=(1+20%)^2):2 dollar
dividend+ selling price
Answer:
 Calculate share price at each year(since share price
will change, share price after 1 year, share price after
2 years….)
Share price when buying(P0):

Share price after 1 year(at year 1,P1):

Dividend expected at year 2 and expected selling price of the stock at year 2
 Share price after 2 years: (at year 2,P2):
Dividend expected at year 3 and expected selling price of the stock at year 3

Formula:Share price after t years:

7
For calculating share price if
holding shares more long-
termly

=Share value = PV of
dividends

D1 + D2 + D3
P0 = +…+ D∞
1 2 3 ∞
(1+R) (1+R) (1+R) (1+R)
 How can we estimate all future
dividend payments?

= The formula only can be used at special

cases:

10
2. Special cases

Constant dividend

The firm will pay a constant dividend
forever(they don’t grow or reduce)

This is like a preference share

The price is computed using the perpetuity
formula

Constant dividend growth

The firm will increase the dividend by a
constant percentage every period(then we
can estimate dividend of each year)

Supernormal growth

Dividend growth is not consistent initially

It settles down to constant growth
Eventually(then can
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estimate dividends at a
later stage)
Constant dividend
Zero growth

If dividends payments are to remain
the same and are expected at regular
intervals forever.

A preference share usually has fixed
dividends

Then this is valued as a perpetuity:

P0(price) = D/R-G(D=constant
dividend),R=required return adjusted to
number of payments in a year,e.g. if paid
quarterly, then rate/4, if paid twice a year,
then rate/2

Shares that give Price=D/R

dividends
indefinitely(Perpetuity
)
Price of Share at year Dividend given at
t t year/r-g
R: Required
return- growth
rate
12
 Constant growth shares

Dividends are expected to grow at a
constant percentage per period.

D0 = Dividend JUST
PAID

D1 = D0 (1 + g(growth
1
rate))
 1
D2 = D1(dividend at first year) (1 + g)

Or

or can be written as D2 =
1 1
D0 (1 + g) (1 + g)
 2
D2 = D0 (1 + g)
 t
Dividend Formula: Dt = D0 (1 + g)

D1 to Dt = Expected dividends
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Formula of share price for
constant growth share:
(Dividend growth model,
DGM)
1.For required return>growth
rate
*the growth rate must be
smaller than required return
for using this formula
Example

This company is expected to pay a dividend of
$4 next period and dividends are expected to grow
at 6% per year. The required return is 16%.

What is the current price?
D1 4.00
P0 : P0 =$40
0.16-
R-g 0.06

Remember that we already have the
dividend expected next year, so we don’t
multiply the dividend by 1+g.

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2.For required return<growth rate
Not reasonable for a company to grow higher than
market’s required return forever. Only will have
supernormal growth when it is a young company or have
an expansion.

->So, have to make some judgements on how long the

company can grow(then becomes a share that grows
inconstantly initially , then grow constantly afterwards, see
how to calculate below)
Non-constant growth share
Example:

A firm is expected to increase dividends
by 20% in Year 1 and by 15% in Year 2.
After that dividends will increase at a rate
of 5% per year indefinitely.

If the last dividend was $1 and the
required return is 20%.

What is the price of the share?

Remember that we have to find the PV of all
expected future dividends.

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 We calculate the price of year 2 with constant share formula because that is the starting point when the growth
becomes more stable, meaning price of year 2=PV of all the indefinite cashflow in the future

Use year 2 price as PV of all indefinite cash flows and then add PV of dividend 1 and 2

Non-constant growth problem: Solution

 Compute the dividends until growth levels off
 (because D0 = 1)

D1 = 1(1.2) = $1.20

D2 = 1.20(1.15) = $1.38

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 Non paying dividends(not paying dividends)
-Why not pay?
1.Not enough money
2.Prefers to reinvest and not borrow loans to finance its company(some are
non-mature companies will use this as they can’t afford to lose capital or
some just think they don’t want to pay dividends to reinvest)
-Some shareholders buy this kind of shares to profit from increased selling
price of shares
-Examples of non paying dividends shares: amazon(growth of 40%)
-Formula:

-PE=Price/earnings per share ratio, if the share price is lower than the P0, it is a good
share price but if share price is higher than P0,it is a bad share price
Expected return

P0=Current price
Example

A share is selling for $20.

The next dividend is $1(D1) and the
dividends will increase at a rate of
10% per year indefinitely.

What is the expected return?

1
Summary of share valuation
22
 3. Features of ordinary shares

Voting rights

Shareholders elect directors(one
share one vote)

Proxy voting(can grant your voting
power to another person)

Classes of share(different classes of shares have
different voting rights)

Other rights. (those who own more shares also enjoy
other rights)

Share proportionally in declared dividends

Share proportionally in remaining assets
during liquidation

Right to buy new share issue to maintain
proportional ownership if desired
23
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(because
it is not considered as an expense) for a firm

Taxed as ordinary income for individuals
24
Features of preference
shares(different from ordinary
share)

Dividends

Stated dividend must be paid
before dividends can be paid to
ordinary shareholders

These are not a liability of the firm
and preference dividends can be
deferred indefinitely(but Australian
companies are only allowed up to 2
years)
 
Most preference dividends are cumulative—
any missed preference dividends have to be
paid before ordinary dividends can be paid
some are non-culmulative- no
need to pay
back missed preference

Preference shares generally do not carry
voting rights
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4. Share markets

Primary versus secondary markets

Primary = new-issue market(bhb issues new
shares->trade in primary)

Secondary = existing shares traded among
investors(when the shareholders sell their
shares)

Two types of traders: Dealers versus
brokers

Dealer: Maintains an
inventory(already bought many shares)

Ready to buy or sell at any time

Think ‘Used car dealer’

Broker: Trade using client’s money and buy on
behalf on clients, Brings buyers and sellers together

Think ‘Real estate broker’

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 Share market reporting

Bid:the price investors are willing to pay

Ask:the price which seller sells
EPS:given so that they know the view of market on the stock(compared to how much the investors are willing to pay)

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Risk, return and financial
markets

Lessons from capital market history:

There is a reward for bearing risk.

The greater the potential reward, the
greater the risk(=higher the volatility in
price).

This is called the risk–return trade-off.
28
Risk premium

Reflects the excess return required
from an investment in a risky
asset(calculated by return of a risker
share-return of a more stable share)
over that required from a risk-free
investment. Expected return=risk
free return+ risk premium. In this
case, government bond is used as a
benchmark(as a more stable share).

Comparison ASX v Govt Bonds
ASX Total Index Annual YTM 10 Govt
 Return Index Return Bond Risk Premium
Jan-19 57,894.4 1.0% 2.27% -1.32%
Jan-18 57,348.5 11.8% 2.80% 9.04%
Jan-17 51,275 17.0% 2.73% 14.25%
Jan-16 43,833 -6.4% 2.67% -9.09%
Jan-15 46,839.48
Calculating average returns=
Arithmetic v Geometric
average returns

-Arithmetic average=
total annual return(e.g.
add index annual
return, which is a
percentage)/number of
periods
-Geometric average
return= compounding
average return , same
as calculating future
value, but there are
different interest rates
5. Efficient capital markets

Investors want to outperform the
market(e.g. get more interest rate than
everybody else),to achieve it, investors have
to get more information(e.g. companies will
release new products and no one else knew.
So you can buy shares first and wait for the
shares to increase as the new product is
released)

The efficient market hypothesis

Stock prices are in equilibrium

Stocks are ‘fairly’ priced:adjust quickly and correctly
when a new information arrives.(Information is public, but not
everybody will take notice of the information. The ability to earn abnormal return
depends on the quality of the information.->price might be overvalued or
undervalued because they don’t have that information)


Informational efficiency: all
information is available and the
market all receive the information at
the same time

If true, you should not be able to earn
‘abnormal’ or ‘excess’ returns. Only
receive return exactly enough to
compensate the risk.

Efficient markets DO NOT imply that
investors cannot earn a positive return
on the stock market.

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 Reaction of stock price to new
information in efficient and
inefficient markets

Suppose the share price is 100 and the market is efficient. The share price will react immediately at the same time. Delayed reaction is because of some
investors not knowing new information and therefore reacts after some time and so the price adjusts slowly.(happens in an inefficient market) Over-
reaction is because people overreacts on the new information and the price keeps increasing and the price drops when the investors realised it is
overvalued.
32
What makes markets efficient?

There are many investors out there
doing research.

As new information comes to market,
this information is analysed and trades
are made based on this information.

Therefore, prices should reflect all
available public information.

The more investors are researching,
the more efficient the market. (e.g. if
9 investors out of 10 investors are
doing a lot of research, then 90% of
people in the market receive
information)

If investors stop researching share
prices, the market will no longer be
efficient.
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Common misconceptions
about EMH

EMH doesn’t mean that you can’t make
Money, but just enough to cover the risks.

EMH does mean that:

on average, you will earn a return
appropriate for the risk undertaken

there is no bias in prices that can be
exploited to earn excess returns

market efficiency will not protect you from
wrong choices if you do not diversify—you
still don’t want to put all your eggs in one
basket(e.g. risky assets are still risky and
EMH only provides you information that
something has happened to the risky
assets quickly, so if you only invest in
risky assets, once they collapsed, there
will still be losses.
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Forms of market efficiency

Strong-form Semi strong-form Weak-form

efficient market efficient market efficient market
Information Information Information
• available = • available = • available =
Only past prices
public or private publicly and
volume data(only
history is
available, instead
of new
• ‘Inside available information)
information’ is Information • Technical
•chance of
earning abnormal
profits
of little use
because
everybody has
the information
required
•Nobody earns
supernormal
returns, but only
enough to cover
the risk • Fundamental analysis is of
little use
because
everybody uses
the same
analysis is of technique
little use
because
everybody uses
the same
technique
35
Strong-form efficiency

Prices reflect all information, including
public and private.

If the market were strong-form
efficient, investors could not earn
abnormal returns regardless of the
information they possessed.

Empirical evidence indicates that
markets are NOT strong-form
efficient and that insiders can earn
abnormal returns.
36
Semi strong-form efficiency

Prices reflect all publicly available
information, including trading
information, annual reports and
press releases, but does not reflect
real prices that can be affected by
private information.

If the market is semi strong-form
efficient, investors cannot earn
abnormal returns by trading on
public information. Key to earn
abnormal returns is how to get the
private information.

Implies that fundamental analysis will
not lead to abnormal returns.

37
Weak-form efficiency

Prices reflect all past market information
such as price and volume.

If the market is weak-form efficient,
investors cannot earn abnormal returns
by trading on market information. The
investors can earn abnormal returns by
fundamental analysis or base securities
analysis.

Implies that technical analysis will not
lead to abnormal returns.

Empirical evidence indicates
that markets are generally weak-
form efficient.
38
Efficient market hypothesis
STRONG
Public & private
information

WEAK
Security market
SEMISTRONG information
Public information
39
Topic outline

Share valuation

Some features of ordinary and
preference shares

Capital market efficiency

40