EQUITY

SECURITIES
MARKET
(Part 3)
Presented by Group 11
 Constant Growth Model

The constant growth model or the Gordon

growth model (named her Myren Gordon)
is the most widely known model used in
share valuation.
Assumptions:

A. Dividends are assumed to grow at a constant rate forever (or at an

extended period of time).
B. Growth rate is always assumed to be lower than the required return.
C. The first dividend is assumed to be received right away and the next
dividend will be received after a year.
D. Reasonableness of expectations of investors regarding future
profitability of the firm and future dividends is important to determine
right share valuation.
The Constant Growth Model Formula is shown below:
Illustration 3:

Investor TLC is looking at

investing and buying shares
from Nutela Company, a
publicly listed company.
Based on publicly available
information, Investor TLC
was able to compile the
following dividend data for
the last 6 years.
The Compound Annual Growth Rate
formula is shown below:
 Compound Annual Growth Rate
The Compound Annual Growth Rate formula is shown below:
Assuming that the growth rate will continue based
on the historical trend, value of the common stock
can be computed as follows:
The dividend of P3 is used as the numerator since this is the
expected dividend to be received in the next period.

Computed simply [Latest dividend x (1+growth rate)].

 Variable Growth Model

An inherent limitation associated with the zero-

growth and constant growth model is it does not
allow flexibility in terms growth rate
expectations. It also developed to incorporate
changes in growth rate in the valuation.
Four steps involved in the variable growth model:
Illustration 4: Vic Company is contemplating whether to buy shares in Vin Company.
Vin Company recently paid dividends P3 per share. After carefully studying the
business of Vin Company, Vic came up with the estimate that dividends may grow 5%
annual rate in the next 3 years. At the end of 3 years, Vic expected that the market will
mature, and organic growth will only lead to a constant 3% dividend growth in the
foreseeable future. Vic uses 12% required return in evaluating his investment.
2. Present value of dividends expected to be received for each
year using required return of 12%
4. Combine the present value of the expected dividends during the initial
growth period and the value of the stock (which considered future
expected dividends growing at a constant rate) at the end of the initial
growth period.
 Other Approaches to Share Valuation

Free Cash Flow

An alternative to using dividend-based share valuation
techniques is the use of free cash flow. Free cash flow refers
to the cash flow that are available for debt creditors and
shareholders after satisfying all other operating obligations.
Free cash valuation is useful when computing the value of
startup companies, companies without any dividend history or
the operating division of a large company.
The free cash flow valuation model estimates the value of the entire company as a
whole. Since it is the value of the entire company, it is necessary to isolate only
the value of ordinary shares. To do that, the market value of the debt and
preference shares should be deducted from the entire company value.

This can be in the form of below formula:

Free cash flow valuation also faces the same
limitation as the dividend growth model i.e it is
difficult to forecast cash flow for an extended period
of time. For this reason, methodologically, PV of free
cash flow can be computed for the first five years and
value from Year 6 onwards will be computed using the
constant dividend growth model. This is the same
method of computation as the variable growth model.
 Book Value per Share
Book value per share refers to the amount per share that will be
received if all of the company's assets are sold based on its exact book
or accounting values and whose proceeds will go to ordinary
shareholders after satisfying claims from creditors and preference
shareholders. Book value per share is very easy to compute since book
value can easily be derived from the accounting records.
Formula:
Book Value per share =

Illustration.
At the end of 2018, the balance sheet of Jamar Company showed total assets
of P3,000,000, total liabilities of P2,000,000, preference shares of 500,000
and 100,000 outstanding shares. Book value can be computed using above
formula
 Liquidation Value per Share
Liquidation value per share pertains to the actual amount per share that
will be received if all assets are sold based on their current market
value and all liabilities (including preferred shares) are fully paid and
the proceeds are divided between remaining shareholders. Liquidation
value is a more realistic approach compared to book value since this
approximates that assets will be sold based on its market value.
==

Illustration:
Upon further evaluation, Jamar Company found out that the assets can only be
realized for P2.7 million, lower than its book value of 3 million.

Liquidation value per share = 27000000−2000000−500000

100000

200000
Book value per share = 100000

Liquidation value per share = P2 per share

 Price Earning Multiples
The P/E multiples method uses the price-earnings ratio
to compute for the share price. The price/earnings ratio shows the
amount that investors are willing to pay for each peso of earnings.
Investors can use the average P/E ratio of a particular industry as
reference point to determine a company's value. This is under the
assumption that Investors compute for the value of a firm through the
same methodology assuming the average firm in the industry is valued.
The P/E multiples is a very popular approach in estimating
how much the shares of a firm are value. The P/E multiples is
computed by multiplying the expected EPS of the company by
the average P/E ratio for the industry where the company is
similar. The average P/E ratios for the industry can be
researched from publicly available information .
A high than average P/E ratio may mean two things:

 Market is expecting company earnings to increase in the

future which will pull down P/E to the normal level or

 Market feels that company earnings has low risk and

investors are willing to pay premium for them.
 Limitations of Share Valuation

Changes in Expected Dividends

- Increase in expected dividends brought upon by positive management actions will
increase the firm's value under the assumption that associated risk is unchanged.

Changes in Risks/Required Return

- Actions taken by management that will increase risk will cause share value to decline.
Problems with Growth Estimations
- Estimating future growth using historical data may fail to account for present changes in the
company or economy that might influence the growth rate.

Problems with Risk Estimations

- Since share price is highly dependent on required return, any minute error in risk
estimations may result in a different share price.

Problems with Dividend Forecasting

- Many factors can influence dividend payout such as future growth opportunities and
management's concern regarding future cash flows. Investors may find it difficult to accurately
forecast dividends as declaration is highly dependent on the decision of board of directors.
 Relevance of Share Valuation to Investors

In the stock market, share prices are usually set by the buyer who are willing to pay
the highest price. This price doesn't necessarily mean that it is true price of the asset but is
incrementally greater than prices from other buyers. Market prices are set by buyers who
can take advantage of the asset if buyers think that they can do more with the investment,
they are willing to pay for it even if they push the price higher. Lastly, information plays a
significant role how securities are priced in the stock market. Superior or more
information regarding an asset may increase its value by mitigating associated risks.
investors who do not have background knowledge will tend to put a higher discount on
securities because of the associated uncertainties.
 Market Efficiency
Setting of share prices in the market through the interactions of
many buyers and sellers can be further explained through market
efficiency. The market price of shares signifies he collective actions
that sellers and buyers undertake based on currently available
information.
The efficient market hypothesis (EMH) theory-developed by John Muth - describes
the behavior of a perfect market. The EMH theory says that:

1.Securities are typically in equilibrium, which means that they are fairly priced and
that their expected returns equal their required returns.
2.At any point in time, security prices fully reflect all information available about the
firm and its securities, and these prices react swiftly to new information.
3.Because stocks are fully and fairly priced, investors need not waste their time
trying to find mispriced securities.
 The expectation of investors regarding future profitability of companies
significantly influence determination of share price in the market. Adaptive
expectations, which assumes that people forecast future values based on past
values, became the norm during the early studies of expectations.

One emerging trend regarding expectations is the rational expectations.

Rational expectations assume that people make forecasts using all available
information, thus, they are acting rationally to achieve the goal of preparing a better
forecast.
 Hybrid and Derivative Securities

Aside from shares, there are other securities that can be traded in the
capital markets with the intention of mitigating potential risk.
 Hybrid Securities

Hybrid Securities are financial instruments that carry characteristics of

both debt(i.e. fixed contractual payment) and equity (ownership
features) instruments. Examples of hybrid securities are stock warrants,
convertible bonds and convertible preference shares.
Stock Purchase Warrants
- Stock purchase warrants are instruments that grant their holders right to
buy a specific number of shares of the issuer at a specified price for a
given period of time.

Convertible Securities
- Convertible Bonds are bonds that can be converted into specified
number of ordinary shares.
Motives for the use of convertible financing include:
• Deferred ordinary shares financing
—Deferring the issuance of new ordinary shares up until such time that the market
price of the shares has increased means that, fewer shares will have to be issued,
which reduces the dilution of both ownership and earnings.
• Sweetener for Financing
–Because of the conversion feature, convertible securities can be sold at a lower
interest rate benefitting issuing companies
• Source of temporary , cheap funds
- Through convertible bonds, firms temporarily rase debit which is cheaper to
funds project.
 Derivative Securities
Derivative securities are securities that are not debt nor equity but
derives as value on an underlying asset which is another security. The
most popular type of derivative securities is options.
 OPTION
Options are financial instruments that grants the holder a chance
to sell or buy a specific asset at a set price on or before an expiration
date .
2 Types of Option:

Call option
- is an option to buy a specified number of shares on or before a specific date at
a stated strike price.

Put Option
- is an option to sell a specified number of shares on or before a specific date at
stated strike price.
Quiz Time