Lesson 5

Equity

Learning objectives
In this module, we will look at equity as a source of funds. After completing this
module, you should be able to:
 distinguish between the different types of equity
 use the constant dividend model to value shares
 use a dividend growth model to value shares
 calculate price earnings ratio
 interpret and calculate the return on the stock market indices
This module uses the concepts of present value in valuing shares. In
understanding the above, you should be able to have a better appreciation of how
the equity market works and how shares can be valued.

Introduction
The equity market holds a lot of fascination for investors. The share market
provides an avenue for the buying and selling of shares. How are these shares
valued? How do you really know you are not paying too much for a share?
These are difficult questions. Hopefully, at the end of the module you will have
some on idea how the value of a share is arrived at. The cash flow provided by a
share is dividend. Dividends are not certain. They can change depending on how
the company performs. Therefore, the present value calculations that we use to
value shares have to be done with some strong assumptions about these cash
flows.
Before we go into the valuation of shares, let us first understand equity as a source
of fund. Equity owners are owners of the company. What are the advantages and
disadvantage of issuing equity rather than issuing debt?

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Some advantages
Some of the advantages include:
 companies are not required to pay dividends to ordinary shareholders
 there is no maturity date (no need to redeem shares)
 issuing shares provide a positive signal to debt holders in the company

Some disadvantages
Some of the disadvantages include:
 there is a dilution of ownership
 the cost of equity is high (no tax benefit)
 the cost of issuing equity is usually higher than debt

Terms you should learn

There are some very important terms that are used in finance where shares are
concerned. It is important that you look these up in the textbook and understand
what they mean. This will also enable you to understand the financial newspapers
and financial new reports better.
 Issued shares
 Outstanding shares
 Authorised share capital
 Par value
 Paid in capital
 Retained earnings
 Book values and market values
 Ordinary shares and Preferred stock
 Residual claim on profits
 Limited liability
 Voting rights

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Valuing shares
A share is a financial asset. The value of a financial asset is the present value of
the benefits it promises in the future. In the previous modules, we valued an
investment as:

CF 1 CF 2 CF n
PV = 1
+ 2
+. .. .+
( 1+r ) (1+ r ) ( 1+ r )n

In a perfect market the present value is the price, that is, V = Po

We can apply the above to the evaluation of shares. A share’s value is the present
of its dividend. If we assume that a company is a going concern, then the
dividends will last forever.
There are a few evaluation models we can use depending on the assumption we
make about the dividend.

Constant dividend model

If we assume all profits paid out as dividends

0 1 2 3
Div Div Div 

If the company remains solvent forever with constant dividends then the above
becomes a perpetuity
From previous modules we know that the present value of a perpetuity is:
In equity evaluation, we use:
PMT
PV =
r
Where:
Div 1
Po =
RE
Div1 = Dividend in the first period
RE = Required Rate of Return appropriate to investment in shares.

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Activity 6.1
An investor is considering buying a share that promises a constant dividend of
$0.60 every year. If the investor calculates the cost of equity as 15%, what price
should he pay for this share?
The time line for the above is:

0 1 2 …

0.6 0.6 0.6

Div 1
Po =
RE
0.6
¿
0 . 15
¿ $4
The above evaluation assumes that the dividends are constant and do not grow
over time. What happens if the dividend has a growth factor attached to it.

Constant Growth Dividend Model

Not all companies pay the same dividend per period. It is possible to have a
company that has a constant growth dividend policy.
If the company expects the dividend growth (g) to be 10%, and if the last dividend
just paid Do = $1.20 then the cash flow an investor will get is as follows:

Notice that the growth goes on forever and the dollar value of the dividend
changes over time. Hence, we cannot use the perpetuity model that we looked at
earlier. We have to modify the above formula to include the growth factor.

This constant growth of dividends can be modelled as

Div 1
Po =
4 R E −g Equity
Or
Notice that both the formulas are the same. Div o is the dividend at time 0 and
Div1 is dividend at time 1. The formula specifies that the present value should be
based on dividend in time 1. Dividend in time 1 is dividend in time 0 plus the
Div 0 ( 1+ g )
Po =
R E −g
growth in dividend. That is:
Div 1 =Div 0 (1+g)

Activity 6.2
Over the last 20 years Smith and Williams Ltd have continued to grow, in terms
of earnings to shareholders, by about 14%. This growth is expected to continue
indefinitely and the current rate of return by investors is 18%. If the dividend to
shareholders last years was $0.95 calculate the current share price.
g = 14%, Re = 18%, Div0 = $0.95, Po = ?
The time line for the above will be:

0 1 2 …

0.95 1.08 1.2312

x (1.14) x (1.14)

You don’t need to go beyond year one as you only need the dividend in year 1 to
work out the answer:

Div 1
Po =
R E−g
1 .08
¿
0 . 18−0 . 14
27 . 07

Activity 6.3
Datafed Ltd will continue to grow at the same rate as last year, which was 12%
per annum. The share is currently priced at $15.00 and the dividend was $0.80.
Calculate the current required rate of return.
g =0.12 Po =15.0 Div0 =0.80 Re = ?

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Here we are asked to work out the return on equity. To do this we need to
manipulate the equation. First:
Div 1 =Div 0 (1+g )
¿ 0 . 80(1. 12)
¿ 0 . 896

Div 1
Po =
R E−g
0 .896
15=
R E −0 .12
0 . 896
R E−0 . 12=
15
0 . 896
R E= +0. 12
15
¿ 0 . 1797
The above calculation assumes that the dividend grows at a constant rate. What if
the growth rate fluctuates? Below is an example of how you can value a share
when the growth rate fluctuates.

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Activity 6.4
Global Netcom expects to grow at their current rate of 12% per annum for the
next three years and then at 8% per annum indefinitely thereafter. Assuming the
required rate of return on equity is 15% per annum and the last dividend was
$0.75 per share, calculate the current price.
You need to draw a time line for the above problem. This is because the growth
rate is changing and you need to pin point the cash flows on the time line.

0 1 2 3 4

0.75 0.84 0.94 1.0528 1.137…∞

x(1.12) x(1.12) x(1.12) x(1.08)

16.255

The first thing to do is to work out the dollar value of the dividends for each year.
When you reach year 4, the dividend grows at a constant rate forever, hence you
need to stop there and use the dividend growth model to calculate the value of the
dividends growing at 8% forever. The value of the dividends is:

Div 4
P3 =
R E−g
1 .137
¿
0 . 15−0 . 08
¿ 16 . 255

Notice that the value, 16.255 falls in year 3. (Remember – the present value falls
one period prior to the commencement of the cash flows). We need to then bring
it back to time zero along with the other dividends received. Hence the value is:
0 . 84 0 . 94 1. 0536+16 .255
P0 = + +
(1 . 15) (1. 15)2 (1 .15 )3
¿ $ 12. 83

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Cost of equity
The valuation formula allows us to calculate the value of the share based on a
required rate of return. If you are asked to find the required rate of return, you can
rearrange the formula to work it out. The required rate of return is the cost of
equity. What the investors require is the cost to the company.

Div 1
Po =
R E −g

Rearranging this:

Div 1
R E= +g
P0

You did an activity that used the formula above. ‘Re’ represents the required rate
of return to be achieved or exceeded when investing in equity. From the point of
view of firm Re represents the cost of equity to the firm.
Re is dependent on risk of this investment and the return from other investments
(opportunity).
Shareholder's wealth (return) is dependent upon:
- value received when selling share
- receipt of dividends.
We can calculate Re from the formula above or we can estimate Re using
historical estimates. An example on how we can work out Re is given in the next
activity.

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Activity 6.5
An investor sells a share today for $16. He bought the share $14 and received a
dividend of 50 cents just before he sold it. What is the return earned by the
investor?
Po = $14
P1 = $16
D1 = $0.50
Re = ?
Although the above looks complicated, it is a simple return calculation:
16+ 0. 50
R E= −1
14
¿ 0 . 1785
(What you sold it for, divided by what you bought it for plus the dividend – can
you think of what formula this is?)

The activity above shows you how you can calculate the return on holding a
share. If the investor held the share for a month, the above calculation would be a
monthly return. If it is a year, it would be a yearly return.
If you are trying to work out the return on equity for a new share, one way of
working it out would be to look at the returns shareholders are getting from
similar stocks in the same industry. Once you find the returns for some shares of
the same risk class, then you can calculate an average return. This could be a
good proxy for the return you need to evaluate your new share.
This leads us to calculating the returns on a stock index. It would be an
interesting exercise for you surf the internet and find out as much as you can
about a stock market index.
A stock market index comprises of a certain number of listed stocks (this varies
from market to market and index to index). It gives you an idea how the market
as a whole (aggregate) is performing. Everyday, you hear the news reader
reporting the closing stock index value. If the index goes up, it tells you that the
value of the companies in the economy on aggregate is up. The example below
illustrates how the index is calculated.

Price earnings ratio (P/E)

Our valuation model has used dividends to value shares. Analysts often use
company’s earnings to value shares. The ratio of the share price to the earnings
per share is the P/E ratio.

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Formulas used
Constant dividend model

Div 1
Po =
RE
Constant growth model

Div 1
Po =
R E −g

Return on equity

Div 1
R E= +g
P0

Reflecting on what you have learned

Write a short paragraph on the following:
How does the constant dividend model differ with the constant growth model?

How can you estimate the required rate of return of a new share that you are about
to issue?

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