VALUING SHARES

Chapter 5
 WHAT COMPANIES DO
Qantas shares fall on news of losses
• On 12 June 2012, Qantas reported its first annual loss since it
was privatised in 1995.
• A Qantas shares sell-off wiped out $1.1 billion of its market value.
• This in turn fuelled speculation of assets sell-offs, such as stakes
in Australian Air Express.
• Bad news such as reports of unusual losses may make
shareholders become concerned about a decline.
• Assessing whether a company’s ordinary shares are correctly
valued is a difficult task.
This chapter introduces methods of valuing an entire company
and/or determining if a company’s share is priced correctly.
 THE ESSENTIAL FEATURES OF
PREFERRED AND ORDINARY SHARES
Ordinary shareholders are residual claimants.
• No claim to earnings or assets until all senior claims are paid
in full.
• High risk but historically also high return.

Shareholders have voting rights on important

company decisions.

Debt and equity have substantially different marginal

benefits and marginal costs.
 PREFERRED SHARES
Preferred shares have some features similar to debt
and other features similar to equity.
• Claim on assets and cash flow rank senior to ordinary shares.
• Dividend payments are not tax-deductible.
• Preferred shares are held mostly by corporations.

Promises a fixed annual dividend payment, though this

is not legally enforceable.

Preferred shareholders usually do not have voting

rights.
 PREFERRED SHARE VALUATION
A preferred share is an equity security that is expected to
pay a fixed annual dividend indefinitely.

Using the formula for valuing a perpetuity:

Dp • PS0 = Preferred share market price
PS 0 = • Dp = Next period’s dividend payment
rp • rp = Discount rate

An example: Investors require an 11% return on a preferred share that pays a

$2.30 annual dividend.  What is the price?
Dp $2.30
PS 0 = = = $20.90 / share
rp 0.11
 SHARE VALUATION:
ORDINARY SHARES
• Suppose that an investor buys a share today for price
P0 , receives a dividend equal to D1 at the end of one
year, and immediately sells the shares for price P1.

Return on D1  P1  P0
investment
r
P0
Value of a D1  P1
share of P0 
ordinary shares (1  r )1
 SHARE VALUATION:
ORDINARY SHARES
• How is P1 determined?
– PV of expected share price P2 plus dividends
– P2 is the PV of P3 plus dividends etc …
D1 D2 D3 D4 D5
P0  1
 2
 3
 4
 5
 .... ( Eq.4.5)
(1  r ) (1  r ) (1  r ) (1  r ) (1  r )

Repeating this logic over and over, you will find that today’s
price equals the PV of the entire dividend stream that the
share will pay in the future.
ZERO GROWTH VALUATION MODEL
The zero growth model is the simplest approach to
share valuation. It assumes a constant, non-growing
dividend stream.
D1 = D2 = ... = D
• With the constant value D for each dividend
payment, the ordinary share valuation formula
reduces to the simple equation for a perpetuity:
D1
P0 
r
 CONSTANT GROWTH
VALUATION MODEL
• Assumes dividends will grow at a constant rate
(g) that is less than the required return (r)
• If dividends grow at a constant rate forever, you
can value the share as a growing perpetuity,
denoting next year’s dividend as D1:
D1
P0  Eq.4.6
rg

Commonly called the Gordon growth model

 AN EXAMPLE
Hewlett-Packard (HP) pays a quarterly dividend of $0.08 from
1998 to 2011.  If investors expect that dividend to remain
constant forever, and they require a 10% return on HP shares,
what is the share worth?

D1 $0.32
P0    $3.20
r 0.1
What is the stock worth if investors expect HP’s dividends to
grow at 3% per year?

D1 $0.32
P0    $4.57
r  g 0.10  0.03
 VARIABLE GROWTH
VALUATION MODEL
• The variable growth model assumes that the
dividend growth rate will vary during different
periods of time.
 SHARE VALUATION
• How to estimate growth.
– Growth rate g = retention rate × ROE
– Historical data

• What if there are no dividends?

 THE FREE CASH FLOW APPROACH TO
ORDINARY SHARE VALUATION

• The net amount of cash flow remaining after

Free cash flow the company has met all operating needs and
(FCF) paid for investments, both long-term and
short-term.
• Represents the cash amount that a company
could distribute to investors after meeting all
its other obligations.

Weighted • The after-tax, weighted average required

return on all types of securities issued by a
average cost of company, where the weights equal the
capital (WACC) percentage of each type of financing in a
company’s overall capital structure.
 THE FREE CASH FLOW APPROACH TO
ORDINARY SHARE VALUATION

Steps:
1. Estimate the free cash flow that the company will generate
over time.
2. Discount the free cash flow at the company’s weighted
average cost of capital to derive the total value of the firm, VF .
3. Subtract the values of the company’s debt, VD , and preferred
shares, VP , from VF to obtain the value of the company’s
shares, VS .
4. Divide VS by the number of shares outstanding to calculate the
value per share, P0 .
 OTHER APPROACHES TO ORDINARY
SHARE VALUATION
• The value of a company’s equity as
Book value recorded on the company’s balance
sheet.

Liquidation • The amount of cash that remains if

the company’s assets are sold and
value all liabilities paid.

• The amount investors are willing to

Comparable pay for each dollar of earnings.
multiples • P/E ratios differ between and
within industries.
THE INVESTMENT BANKING FUNCTIONS
AND THE PRIMARY MARKET
Trading
Key investment
banking activities Asset management

Corporate finance

Investment banks assist companies with the process of raising

long-term debt and equity in capital markets.
Initial public offering • The first public sale of company shares to
(IPO) outside investors.
Seasoned equity • An equity issue by a company that already
offering has ordinary shares outstanding.
 THE INVESTMENT BANKER’S ROLE IN
EQUITY ISSUES
Companies can choose an investment bank through:

a negotiated offer a competitively bid offer

The contract to sell equity can be:

• The bank promises its best effort to sell the
best effort company’s securities. If the demand is
insufficient, the issue will be withdrawn.

• The bank underwrites the securities.

firm • Underwrite: purchasing shares from the company
commitment and reselling them to investors.
 SECONDARY MARKETS FOR
EQUITY SECURITIES
• Conducts its operations entirely by computer
Australian using the Stock Exchange Automated Trading
Securities System (SEATS). A satisfied deal is cleared
Exchange (ASX) through the Clearing House Electronic Sub-
register System (CHESS).

Over-the- • Company shares can also be traded OTC in

counter (OTC) smaller, unlisted securities.