Workshop Equity Securities STAFF

business.monash.
edu
BFF1001
Interactive Study:
Equity Securities
Please join the active FLUX session upon entering class.
1
Key Topic Aspects …
1. Finance using equity securities.
2. Types & characteristics of shares.
3. The share market & how to value shares.
4. Introducing Asset Pricing
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Risk of Residual Claim
Continuing from our Preload, let us further understand the risk of residual claim.
Possible reasons why no dividend/no fixed dividend is paid:
 Business earnings are poor and uncertain.
There is little or no residual cash flow available to shareholders after paying all creditors,
liabilities and obligations.
 Business earnings are good and there is ample residual cash flow.
Rather than pay a dividend, residual cash flow is reinvested by purchasing productive
assets that will increase future earnings growth.
 Business earnings are currently good but uncertain in the future.
Management is unwilling to commit to a fixed, high dividend payment now given the
uncertainty of sustaining it into the future. (Dividends provide a signalling effect)
Large, established (Blue chip) companies tend to aim for stable, progressive
dividend payments while young, growth companies tend not to pay dividends
but rather reinvest residual cash flow to maximise growth in future earnings. The
style of dividend payments is called the company’s dividend policy.
Historic Dividend
Yields
Share Valuation
Financial Math
What is Share Valuation?

 Share valuation is finding out how much a share is worth.
 We can then base our investment decision on the value.
• If Value > Price, then we should buy.
• If Value < Price, then we should sell.
Share Valuation
Financial Math
Methods of Share Valuation

 Relative Valuation
• Helps us to understand a share’s value relative to another share.
• Helps us to understand the growth potential of a share.
• Involves calculating the P/E ratio.
 Discounted Cash Flow (DCF) Valuation
• Helps us to determine the dollar value of a share.
• Helps us to make investment decisions (e.g. whether to buy a
share).
• Involves discounting the future cash flows (dividends) back to the
present time at an appropriate discount rate.
Relative Valuation
Critical Thinking: Cheap or Expensive?

Given
the uncertainty of dividend policy, the PE ratio is one of the most widely
used share valuation methods.
P/E Ratio =
(FLUX Q1)
FLUX 1

Which share is cheaper (by share price only)?
Share A: $0.10 price Share B: $100 price
A. Share A
B. Share B
C. Equal
D. Not enough information yet ….
Relative Valuation
FLUX 1 Solution

Which
share is cheaper (by share price only)?
Share A: $0.10 price Share B: $100 price

A. Share A
B. Share B
C. Equal
D. Not enough information yet ….
Additional Information:
Share A: $0.05 EPS Share B: $200 EPS
Using: P/E Ratio =
Share A: Share B:
PE Ratio = = 2 PE Ratio = = 0.5
Relative Valuation

A useful way of defining the PE ratio to aid our comprehension is as follows:
 With a PE ratio of 2, investors are paying $2 of market price for every $1 of
earnings for Share A.
 With a PE ratio of 0.5, investors are paying $0.5 of market price for every $1
of earnings for Share B.
Conclusion: Share A is more expensive. The PE ratio compares share

price by a common unit value.
  PE ratio, the more expensive the share.
  PE ratio, the cheaper the share.
Using the PE ratio for valuation, we do not need to forecast dividends to

obtain the value of the share; earnings per share is used as the
estimate of value.
Relative Valuation
Relative Valuation
Relative Valuation
Apple (APPL) vs. BHP (BHP)

Based on the PE ratio, Apple’s earnings are more than twice as expensive as
BHP’s earnings.
Does this mean that BHP is a better buy than Apple? Why or why not?
Growth vs. Value Shares

 Shares which have a high P/E ratio (e.g. Apple) are growth stocks.
Their P/E ratio is higher because they have more growth potential.
 Shares which have a low P/E ratio (e.g. BHP) are value stocks.
They tend to have steady earnings and are therefore, better value.
 Does not mean that we should invest in BHP over Apple, we need to
decide how important growth is to us.
(FLUX Q2)
FLUX 2
Given the following information about two companies, without calculating the PE
ratio, identify which is more expensive? Calculate out the PE ratio of both
companies to validate your earlier conclusion.
Monash Co. Melbourne Co.

Current Share Price $0.02 $0.01
Total Company Earnings $1,000 $0
Num. of Shares Outstanding 100,000 100,000
FLUX 2 Solution
Given the following information about two companies, without calculating the PE
ratio, identify which is more expensive? Calculate out the PE ratio of both
companies to validate your earlier conclusion.
ANSWER:
Without calculation, Melbourne Co. is more expensive because shareholders
are paying $0.01 share price for zero earnings. Compared to Monash
shareholders who pay $0.02 for $1,000 earnings.
With calculation: Monash Co. Melbourne Co.
Current Share Price $0.02 $0.01
Total Company Earnings $1,000 $0
Num. of Shares Outstanding 100,000 100,000
Earnings per Share (EPS) $1,000/100,000 = $0.01 $0/100,000 = $0
PE Ratio $0.02/$0.01 = 2 $0.01/$0 = ∞
Monash Co. has comparatively cheaper shares!
Share Valuation
Financial Math
Discounted
Cash Flow (DCF) Valuation
 DCF valuation discounts the future dividends of a share to the present time
to find the value of a share.
 One common valuation strategy is to assume that the future dividends grow
at a constant rate. Then we can use the growing perpetuity formula.
Next dividend
Growth rate
Discount rate
 Note the formula uses the NEXT dividend. If you are given the LAST
dividend paid, you must calculate the next dividend using:
Share Valuation
Financial Math
Discounted Cash Flow (DCF) Valuation

 Is constant dividend growth realistic?
 The following is for Apple stock:
Looks like constant growth!
(FLUX Q3 & 4)
FLUX 3 & 4
The next dividend Monash Co. is expected to pay is $1 which will grow at 5%
p.a. into perpetuity. What is the maximum price you would pay for Monash Co.
today if the expected return on Monash Co. shares is 12% p.a.? What is the
best price you can pay for Monash Co. shares?
You own shares in Monash Co. and expect the next dividend to be $1.20 which
grows at 5% p.a. into perpetuity. What is the minimum price you would accept to
sell your shares for today if the expected return on Monash Co. shares is 12%
p.a.? What is the best price you can sell Monash Co. shares for?
FLUX 3 & 4 Solution
 next dividend Monash Co. is expected to pay is $1 which will grow at 5%
The
p.a. into perpetuity. What is the maximum price you would pay for Monash Co.
today if the expected return on Monash Co. shares is 12% p.a.? What is the
best price you can pay for Monash Co. shares?
ANSWER: $14.28
The best price to pay is the lowest price that is acceptable to the seller.
You own shares in Monash Co. and expect the next dividend to be $1.20
which grows at 5% p.a. into perpetuity. What is the minimum price you would
accept to sell your shares for today if the expected return on Monash Co.
shares is 12% p.a.? What is the best price you can sell Monash Co. shares for?
ANSWER: $17.14
The best price to sell for is the highest price that a buyer is willing to pay.
Share Valuation
Financial Math
Understanding the Discount Rate

 The discount rate is affected by risk. The higher risk, the greater the return
you will need, thus the higher the discount rate. Vice versa.
 In general, people are risk averse. They need compensation to take on risk.
 Therefore, the riskier a share, the higher the discount rate.
 We usually use the standard deviation of a share’s returns to measure risk.
However, this does not take into account diversification benefits.
What is Diversification?
 When an investor holds multiple shares, sometimes the risks of those shares
can cancel out.
 Let’s have a look at the impact of COVID-19 on two shares – Qantas
Airways (QAN) and Zoom Video (ZOOM).
Share Valuation
Financial Math
What happened
after COVID-19?
Share Valuation
Financial Math
Diversification – What Happens if we buy Zoom and Qantas?

 Zoom and Qantas seem to “protect each other”.
 When Qantas goes down, Zoom tends to go up. When Zoom goes up,
Qantas tends to go down.
 Probably not surprising given Zoom benefits from people staying at home
and Qantas benefits from people travelling.
 If an investor holds both Qantas and Zoom, their capital growth will be much
smoother!
The Market Portfolio

 In general, holding more stocks means more diversification benefits.
 What if we held every single possible stock? Will this be riskless?
 Hard to do, but the ASX200 is an index of the 200 biggest stocks in Aus.
Share Valuation
Financial Math
The ASX200 Index

 In general, much smoother, i.e. less risky than individual stocks.
 However, it is still risky (can go up and down). This is because there are
certain risks that affect all stocks.
 This is called systematic risk. Diversification cannot reduce systematic risk.
Sources of Risk
There are two sources of risk:
Risks that cannot Risks that can be

be reduced by reduced by
diversification diversification
• Since all investors can diversify by holding more shares, when valuing shares,
we only take systematic risk into account.
• Systematic risks are risks which are common to all shares in the market.
Therefore, we can measure systematic risk by looking at the relationship
between a share’s price movements and the market’s movements.
Asset Pricing Models
Examples of Systematic and Unsystematic Risks

 Systematic risk is uncertainty which comes from factors that affect the entire
share market. For example, inflation, interest rates and taxes affect all
companies and would be systematic risk factors.
 Unsystematic risk factors are those which do not affect all companies but a
subset of the market. For example, the iron ore price would have an important
impact on BHP’s share price but would not affect Woolworths’s share price.
Asset Pricing Models

• Asset pricing models are a class of models which attempt to predict the
appropriate discount rate for a stock.
• The most basic is the Capital Asset Pricing Model (CAPM).
• The CAPM states that the appropriate discount rate depends ONLY on
systematic risk, measured by a quantity called (beta).
CAPM &
The size of beta provides an indication of volatility of share returns relative

to the market (systematic risk):
•  = 1, the share has the same systematic risk as the market
•  > 1, the share has the greater systematic risk than the market
•  < 1, the share has the less systematic than the market
CAPM
The CAPM states that the appropriate discount rate (or expected return) of a stock
depends ONLY on its .
In this equation,
• is the risk free rate (can be estimated by government debt securities such as
Treasury bonds and bills)
• is a measure of systematic risk
• is the expected return of the market (can be proxied using ASX200 or All Ordinaries
return)
Note that we often call the quantity the excess return of the market, where excess
refers to “on top of the risk-free rate”.
Note that there exist more complicated asset pricing models than the CAPM.
(FLUX Q5)
FLUX 5
The next dividend Monash Co. is expected to pay is $1 which will grow
at 5% p.a. into perpetuity. What is the maximum price you would pay for
Monash Co. today? The  of Monash shares is 1.3, government bonds
are yielding 4% while the All Ords is returning 12%.
FLUX 5 Solution
The next dividend Monash Co. is expected to pay is $1 which will grow
at 5% p.a. into perpetuity. What is the maximum price you would pay for
Monash Co. today? The  of Monash shares is 1.3, government bonds
are yielding 4% while the All Ords is returning 12%.
ANSWER: $10.64
business.monash.edu
BFF1001
PBL: Equity Securities
30
PBL 1
Sarah Co. is a fast-growing information technology company. The firm will pay its first
dividend of $2 one year from today and expects dividends to grow at a constant rate
of 2%. The appropriate discount rate is 9%.
a. Calculate the current valuation of the share.
b. Suppose that there have been some changes in the economy and Sarah Co.'s
future cash flows look more uncertain. Explain how this would affect the share
price and through what mechanism.
PBL 1 Solution
 Co. is a fast-growing information technology company. The firm will pay its first
Sarah
dividend of $2 one year from today and expects dividends to grow at a constant rate
of 2%. The appropriate discount rate is 9%.
a. Calculate the current valuation of the share.
ANSWER: $28.57
Use the formula for an ordinary perpetuity with growth;
b. Suppose that there have been some changes in the economy and Sarah Co.'s
future cash flows look more uncertain. Explain how this would affect the share price
and through what mechanism.
It is likely that the discount rate will increase, thereby reducing the value of Sarah
Co shares. Remember that riskier cash flows are worth less. Investors are willing
to pay less for riskier cash flows.
PBL 2
Jason Pty Ltd has recently posted earnings before tax of $14,285,715.00, all of which
will be distributed as dividends. It is believed that this performance will continue
indefinitely (as a perpetuity with zero growth).
The company has 1 million shares outstanding. You believe that the risk-free rate is
5%, the excess return of the market is 8%, and that Jason Pty Ltd has a beta (β) = 1.5.
Based on your assumptions above, calculate:

a. The cost of equity for Jason Pty Ltd
b. The market price of a share in Jason Pty Ltd
PBL 2 Solution
 Pty Ltd has recently posted earnings before tax of $14,285,715.00, all of which will be
Jason
distributed as dividends. It is believed that this performance will continue indefinitely (as a
perpetuity with zero growth).
The company has 1 million shares outstanding. You believe that the risk-free rate is 5%, the
excess return of the market is 8%, and that Jason Pty Ltd has a beta (β) = 1.5.
Based on your assumptions above, calculate:

a. The cost of equity for Jason Pty Ltd
ANSWER:
Therefore, the cost of equity is 17%.
b. The market price of a share in Jason Pty Ltd

ANSWER: The dividend per share is:
The share price is therefore (using the ordinary perpetuity formula):
PBL 3
Michael Ltd is a mining company based in Western Australia. After opening up a new
mine this year, its earnings are projected to increase at a rate of 8% per year. The
company has just paid a dividend of $3.00 per share. The required rate of return is
15%. Assume that the dividends will grow at the same rate as the company's
earnings.
a. What is the value of the share?
b. Explain how the price of Michael Ltd. would change if increased competition in the
mining sector led to a reduction in its earnings growth.
PBL 3 Solution

Michael Ltd is a mining company based in Western Australia. After opening up a new
mine this year, its earnings are projected to increase at a rate of 8% per year. The
company has just paid a dividend of $3.00 per share. The required rate of return is
15%. Assume that the dividends will grow at the same rate as the company's
earnings.
a. What is the value of the share?

ANSWER: $46.29
b. Explain how the price of Michael Ltd. would change if increased competition in the
mining sector led to a reduction in its earnings growth.
The price of Michael Pty Ltd. would decrease as this change would decrease the
growth rate of its dividends. Substituting in a lower growth rate, we can see that
the valuation of the share will be lower.
PBL 4
Anh Co. is an Australian pyjama designer. The company has recently come out with
an exciting new design which is allowing them to pay a dividend of $4 into perpetuity.
Anh Co.'s beta is estimated to be 0.60. Assume that the risk-free rate is 5% and the
return on the ASX200 is predicted to be 13%.
a. Calculate the expected return for Anh Co.
b. Suppose that Anh Co. is currently selling on the market for $41. Would you decide
to buy or sell stock in Anh Co.?
c. Tran Co. has emerged as a competitor to Anh Co. and is currently pursuing a
high-risk production strategy. Compared with Anh Co., would you expect Tran
Co.'s beta to be higher or lower?
d. If forecasts show that Anh Co. and Tran Co. will have identical earnings and
dividend policies, would you expect the share price of Tran Co. to be higher or
lower than that of Anh Co.?
PBL 4 Solution
 Co. is an Australian pyjama designer. The company has recently come out with
Anh
a. Calculate the expected return for Anh Co.
ANSWER: 9.8%
b. Suppose that Anh Co. is currently selling on the market for $41. Would you decide
to buy or sell stock in Anh Co.?
ANSWER: $40.82
Since value ($40.82) < price ($41), the stock of Anh Co. is overpriced and hence,
we should sell.
PBL 4 Solution
Anh Co. is an Australian pyjama designer. The company has recently come out with
c. Tran Co. has emerged as a competitor to Anh Co. and is currently pursuing a
high-risk production strategy. Compared with Anh Co., would you expect Tran
Co.'s beta to be higher or lower?
Since beta is a measure of (systematic) risk, and Anh Co. and Tran Co. are in
similar industries, if Tran Co. is riskier than Anh Co., then its beta will be higher.
d. If forecasts show that Anh Co. and Tran Co. will have identical earnings and
dividend policies, would you expect the share price of Tran Co. to be higher or
lower than that of Anh Co.?
The share price of Tran Co. will be lower. Higher risk means that we will discount
the future cash flows at a larger discount rate due to the uncertainty. Therefore,
this leads to a lower price.
PBL 5
Prior to the global financial crisis, you purchased a share in Sean & Sons. at $25.00,
which you still hold. You believed at the time that the share was fairly valued.
At the time, the market believed that this share would provide $1.50 of dividends one
year forward, and that the growth rate in dividends would be maintained at 6% per
annum in perpetuity. The market believed that the appropriate discount rate to be
applied to the dividends was 12% per annum.
a. Show your calculation to justify your belief that the share in Sean & Sons. was
fairly priced at $25.00.
PBL 5
At the time, the market believed that this share would provide $1.50 of dividends one year
forward, and that the growth rate in dividends would be maintained at 6% per annum in
perpetuity. The market believed that the appropriate discount rate to be applied to the dividends
was 12% per annum.
b. Suppose following the global financial crisis, you believe that the market is going through a
period of “correction.” In fact, the market believes that Sean & Sons. will issue a $1.50
dividend in one year, with a growth rate thereafter of only 2% per annum in perpetuity. The
discount rate applied to the dividends will be one of the following possibilities:
Possible Discount Rates (PDR)
12% (as before)
17% (due to increased uncertainty)
8% (due to more realistic expectations of the market)
Calculate your anticipated value for the share of Sean & Sons. under each of the above
assumptions for the discount rate (ie, with anticipated dividend one year forward as $1.50
and growth rate 2% per annum).
c. Ignoring any dividends you may have received, calculate your capital return (i.e. capital
gain) under each of the above possible discount rates (from your initial purchase price)
PBL 5 Solution

ANSWERS:
a. Show your calculation to justify your belief that the share in Sean & Sons. was
fairly priced at $25.00.
b & c. Answers are shown in this table:
PDR Share Price (part b) Percentage Return (part c)

12% $15.00 -40% (40% Loss)
17% $10.00 -60% (60% Loss)
8% Are shown
Workings $25.00
here: 0% (No Loss/Gain)
1.
2.
3.

Workshop Equity Securities STAFF

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business.monash.

1. Finance using equity securities.

2. Types & characteristics of shares.

3. The share market & how to value shares.

4. Introducing Asset Pricing

What is Share Valuation?

Methods of Share Valuation

Critical Thinking: Cheap or Expensive?

Critical Thinking: Cheap or Expensive?

Critical Thinking: Cheap or Expensive?

Share A: $0.10 price Share B: $100 price

Critical Thinking: Cheap or Expensive?

Conclusion: Share A is more expensive. The PE ratio compares share

Using the PE ratio for valuation, we do not need to forecast dividends to

Apple (APPL) vs. BHP (BHP)

Growth vs. Value Shares

Monash Co. Melbourne Co.

Monash Co. has comparatively cheaper shares!

Discounted Cash Flow (DCF) Valuation

Looks like constant growth!

Understanding the Discount Rate

Diversification – What Happens if we buy Zoom and Qantas?

The Market Portfolio

The ASX200 Index

There are two sources of risk:

Risks that cannot Risks that can be

Examples of Systematic and Unsystematic Risks

Asset Pricing Models

The size of beta provides an indication of volatility of share returns relative

PBL: Equity Securities

a. Calculate the current valuation of the share.

a. Calculate the current valuation of the share.

Based on your assumptions above, calculate:

Based on your assumptions above, calculate:

b. The market price of a share in Jason Pty Ltd

The share price is therefore (using the ordinary perpetuity formula):

a. What is the value of the share?

a. What is the value of the share?

a. Calculate the expected return for Anh Co.

a. Calculate the expected return for Anh Co.

b & c. Answers are shown in this table:

PDR Share Price (part b) Percentage Return (part c)

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