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Topic 8– ACFI1003

Investors in
the Share Market
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Company
3. Non-Bank
Projects Financials
2. Banks
1. Financial 4. & 5. Financial
6. The Securities System Mathematics
Exchange
7. Equity Debt 9. Long Term

10. Short-Term
8. Investors
11. Derivatives
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Learning Objectives
• Consider the role of an investor in the share market and
examine the range of investment choices available to the
investor
• Explore the process of buying and selling shares, the risks
involved, and the importance of taxation when investing
• Describe and use indicators of financial performance

• Demonstrate share pricing methods

• Consider the importance of share-market indices and

published share information
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Chapter Organisation
8.1 Share-market investment
8.2 Financial performance indicators
8.3 Pricing of shares
8.4 Stock-market indices and published share
information
8.5 Summary
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Share-Market Investment
• Investors buy shares to receive returns from dividends
and capital gains (capital losses)
• Other factors encouraging investment in securities quoted
on a stock exchange (SX)
o Depth of the market
− Overall capitalisation of corporations listed on a stock exchange
(number of shares x price of each share)

o Liquidity of the market

− Volume of trading relative to the size of the market
o Efficient price discovery
− Speed and efficiency with which new information is reflected in the
current share price
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Share-market investment (cont.)

• The stock exchange offers a wide range of security types
to the investor
• Securities listed on the stock exchange are categorised
into industry groups, allowing investors a choice from a
range of economic sectors
• Two types of risk impact on security returns
o Systematic risk
− Factors that generally impact on share prices in the market, e.g.
economic growth, and changes in interest rates and exchange rates
o Unsystematic risk
− Factors that specifically impact on the share price of a corporation, e.g.
resignation of the CEO, technology failure, board problems
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Share-Market Investment (cont.)

• Diversified investment portfolio
o A portfolio containing a wide range of securities
o Diversifies most of the unsystematic risk of the individual securities
− Investors will not receive higher returns for unnecessarily bearing
unsystematic risk
o The remaining risk is systematic risk, which is measured by beta
− Beta is a measure of the sensitivity of the price of an asset relative to
the market
o Expected portfolio return is the weighted average of expected
returns of each share
o Portfolio variance (risk) is the variability of the portfolio’s returns
over time
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Share-Market Investment (cont.)

• Investors may take one of two approaches
o Active investment approach
− Portfolio structure is based on share analysis, new information and risk-
return preferences
o Passive investment approach
− Portfolio structure is based on the replication of a specific share-market
index, e.g. industrial or telecommunications sector index

• Some managed funds are index funds

o Portfolios are structured to fully or partially replicate a specific
share-market index
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“Monkeydex” ranked 22nd out of 6000 managed funds in the

USA in 1999.
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Share-Market Investment (cont.)

• Investors need to consider asset allocation within a
share portfolio
o Risk versus return
o Investment time horizon
o Income versus capital growth
o Domestic and international shares
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Share-market investment (cont.)

• The recent global financial crisis has caused much
concern, particularly among those in or approaching
retirement
• A large amount of retirement savings is invested in the
share market
• For those nearing retirement the investment horizon is
shorter, particularly if money will be withdrawn from the
share market upon retirement
• When market prices fall sharply, these individuals are
adversely affected. Importantly, they have the least time to
recover their losses (before retirement)
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Buying and Selling Shares

• Direct investment in shares
o Investor buys and sells shares through a stockbroker
− Discount broker, i.e. phone and Internet
− Full-service advisory broker
o Consideration of liquidity, risk, return, charges, taxation, social
security etc.

• Indirect investment in shares

o Investor purchases units in a unit trust or managed fund, e.g.
equity trust
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Taxation
• The return on a share is realised by investors through
dividends whilst the shares are owned and a capital gain
when the shares are sold. Both the dividend and capital
gain is subject to taxation.
• Pre-dividend imputation (prior to 1987)
o Dividends were taxed twice—first at company level (as profits) and
then at the investor’s marginal rate

• Dividend imputation (since 1987)

o Removed the double taxation of dividends
o Investors receive franking credit for the tax a company pays on a
franked dividend
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Taxation (cont.)
• Capital gains tax on shares purchased
o Prior to 19/9/1985 tax free
o 19/9/1985–21/9/1999
− Taxpayer’s marginal tax rate applied if held less than 12 months
− Taxpayer’s marginal tax rate applied to indexed capital gain if held over
12 months
o Since 21/9/1999
− 50% discounted gain if held at least 12 months; or
− indexed capital gain or 50% discounted gain if purchased 19/9/1985–
21/9/1999
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Chapter Organisation
8.1 Share-market investment
8.2 Financial performance indicators
8.3 Pricing of shares
8.4 Stock-market indices and published share
information
8.5 Summary
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Financial Performance Indicators

• Potential investors are concerned with the future level of a company’s
performance
• Company’s performance affects both the profitability of the company and
the variability of the cash flows
• Note – if you were to need a financial performance indicator formula in an
assessment it will be provided to you.
• Indicators of company performance

o Capital structure

o Liquidity

o Debt servicing

o Profitability

o Share price

o Risk
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Financial Performance Indicators (cont.)

Capital structure (measure of risk and long-term
solvency or stability)
• Proportion of company assets (funding) obtained through
debt and equity
o Usually measured by debt to equity ratio (D/E)
− There are slightly different definitions but we define the debt-to-equity
ratio as total liabilities/total shareholders’ equity.
− Higher debt levels increase financial risk, i.e. firm may not be able to
meet interest payments

Equity
Debt
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Financial performance indicators (cont.)

Capital structure (cont.)

• Proportion of company assets (funding) obtained through
debt and equity (cont.)
o Also measured by proprietorship ratio, which is the ratio of
shareholders’ funds to total assets
− Indicates firm’s longer term financial viability/stability; a higher ratio
indicates less reliance on external funding
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Financial Performance Indicators (cont.)

Liquidity
• The ability of a company to meet its short-term financial
obligations
• Measured by current ratio
o Fails to consider the not very liquid nature of certain current assets
like inventory

Current ratio  current assets (maturing within one year)

current liabilitie s (due within one year)
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Financial Performance Indicators (cont.)

Liquidity (cont.)
• Measured by liquid ratio

• The higher the current and liquid ratios, the better the
liquidity position of a firm

Liquid ratio  current assets - inventory stock (on hand)

current liabilities - bank overdraft
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Financial Performance Indicators (cont.)

Debt servicing
• Ability to meet debt-related obligations, i.e. interest and
repayment of debt
• Measured by debt to gross cash flow ratio
• Indicates number of years of cash flow required to repay total firm
debt
• Measured by interest coverage ratio

Interest cover  earnings before finance lease charges, interest and tax
finance lease charges and interest
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Financial Performance Indicators (cont.)

Profitability
• Wide variation in the measurement of profitability
o Earnings before interest and tax (EBIT)

o Earnings per share (EPS)

 Net Profit
Number of ordinary shares

o EBIT to total funds ratio

 EBIT
total funds employed
where total funds employed is shareholders’ funds and borrowings
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Financial performance indicators (cont.)

Profitability (cont.)
• Wide variation in the measurement of profitability (cont.)
o EBIT to long-term funds ratio

 EBIT
long- term funds (i.e. total funds less short - term debt)

o Return on equity (net income/equity)

 Net Income
Equity (sharehold ers' funds)
o Higher ratios indicate greater profitability
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Financial performance indicators (cont.)

Share price
• Represents investors’ view of the present value of future
net cash flows of a firm
• Share price performance indicators
o Price to earnings ratio (P/E)
− Share price divided by earnings (use net profit figure) per share
− A higher P/E indicates more growth in future net cash flows
o Share price to net tangible assets ratio (P/NTA)
− Measures the theoretical premium or discount at which a firm’s share
price is trading relative to its NTA
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Chapter Organisation
8.1 Share-market investment
8.2 Financial performance indicators
8.3 Pricing of shares
8.4 Stock-market indices and published share
information
8.5 Summary
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Pricing of Shares

• Share price is mainly a function of supply and demand for

a share
o Supply and demand are influenced mainly by information
o Share price is considered to be the present value of future dividend
payments to shareholders
o New information that changes investors’ expectations about future
dividends will result in a change in the share price
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Pricing of Shares (cont.)

• Dividend Valuation Models
o Assume the share price is a function of future dividend payments

$Div $Div $Div $Div $Div $Div

Share
Value
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Pricing of shares (cont.)

• Estimating the price of a share
o General dividend valuation model


D t

t 1
P
1rs t
0

Where: P  current share price

0

D  expected dividend per share in period t

t

r  required rate of return

s
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Pricing of Shares (cont.)

• Estimating the price of a share (cont.)

o Valuing a share with a constant dividend (D 0) and required rate of

return (rs)
 D
P0
0

rs

o Valuing a share with constant dividend growth (g)

1g
 
 
 
 

P D
 
 
0 0

r g


 s





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Pricing of Shares (cont.)

Sydney Ltd just paid a dividend of $0.50 per share. This
dividend is expected to stay constant forever. If the required rate
of return is 10% per annum, calculate the expected share price.

 D
P 0
0

rs
0.5
P 0.1  $5.00

0
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Pricing of Shares (cont.)

Newcastle Ltd just paid a dividend of $0.50 per share. This
dividend is expected to grow by 5%p.a. forever. If the required
rate of return is 10% per annum, calculate the expected share
price.

1g
 
 
 
 

P D
 
 
0 0

r g



s




 0.50
1 0.05
0.10  0.05
 $10.50
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Pricing of Shares (cont.)

• Cum-dividend and ex-dividend Share Price
o Dividends are payments made to shareholders, expressed as
cents per share
o Dividends are declared at one date and paid at a later specified
date
o During the period between the cum-dividend date and the ex-
dividend date, the shares have the future dividend entitlement
attached, i.e. cum-dividend
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Pricing of Shares (cont.)

• Cum-dividend and ex-dividend (cont.)
o When a share is trading cum-dividend, the buyer of the share will
also receive the next dividend payment
o At a specified date, the share begins to trade ex-dividend and the
seller of the share not the buyer, will receive the dividend when the
payment is finally made by the company
o Theoretically, the share price will fall on the ex-dividend date by the
size of the dividend

Example:
Share price cum-dividend $1.00
Dividend to be paid 0.07
Theoretical ex-dividend price 0.93
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Pricing of Shares (cont.)

• Bonus share issues
o Where a company has accumulated reserves, it may distribute
these to existing shareholders by making a bonus issue of
additional shares
o As with dividends, there will be a downward adjustment in share
price when shares go ex-bonus
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Pricing of Shares (cont.)

• Bonus share issues (cont.)
o As no new capital is raised, there is no change in the assets or
expected earnings of the company

Example—if a bonus 1:4 issue is made

Cum-bonus price $5.00
Market value of 4 cum-bonus shares $20.00
Theoretical value of 5 ex-bonus shares $20.00
Theoretical value of 1 ex-bonus share $4.00
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Pricing of Shares (cont.)

• Share splits
o Involves division of the number of shares on issue
o Involves no fundamental change in the structure or asset value of
the company
o Theoretically the share price will fall in the proportion of the split

Example—5 for 1 split

Pre-split share price $50.00
Theoretical ex-split share price $10.00
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Pricing of Shares (cont.)

• Pro-rata rights issue
o Involves an increase in the company’s issued capital
o Typically issued at a discount to market price

o Theoretically, the market price will fall by an amount dependent on

− The number of shares issued
− The size of the discount
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Pricing of Shares (cont.)

• Pro-rata rights issue (cont.)

• Example—market price cum-rights $1.00, with 1:5 rights issue

priced at $0.88

Cum-rights share price $1.00

Market value of 5 cum-rights shares $5.00
Plus new cash from 1:5 issue $0.88
Market value of 6 ex-rights shares $5.88
Theoretical ex-rights share price $0.98
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Pricing of Shares (cont.)

• The ex-rights share price can also be calculated
using the following formula (although, I don’t use
the formula as I use the approach on the previous
slide based on intuition):

X = (N*CumRights Market Price)+Subscription Price

N+1

Where N is the number of shares required to obtain

one share on rights issue
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Pricing of Shares (cont.)

• Pro-rata rights issue (cont.)
o A renounceable right is a right that can be sold before it is
exercised. As such, it has a value which can be calculated as:

Value of right  N (cum rights price - subscripti on price)

N 1
o Where N is the no of shares required to obtain the rights issue
share and the subscription price is the discounted price of the
additional share
o Note I do not use this formula in practice either, I use intuition. You
can calculate the value of the right as the difference between the
ex-rights share price and the subscription price.
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Pricing of Shares (cont.)

• Using the formula and previous example calculate the Ex-
Rights Share Price and the Value of the Right:

From previous example: Market price prior to the rights offer

was $1.00, with 1:5 rights issue priced at $0.88.

Ex-Rights Share Price Value of Right

X = (5x1) + 0.88 R = 5 x (1 - 0.88)
(5 + 1) (5 + 1)

X = $0.98 R = $0.10
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Chapter Organisation
8.1 Share-market investment
8.2 Financial performance indicators
8.3 Pricing of shares
8.4 Stock-market indices and published share
information
8.5 Summary
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Stock-market indices and published share

information
• Stock-market indices
o Measure of the price performance of a share
market or industry sector; e.g. market indicator
indices which measure overall share market
performance
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Stock-market indices and published share

information (cont.)

• Market indicator indices

o Price-weighted, e.g. Dow Jones
− Weighting of a company proportional to its share price
o Capitalisation-weighted, e.g. S&P/ASX All Ords
− Weighting of a company proportional to market capitalisation
o Share-price index measures capital gains/losses from investing in
an index-related portfolio
o Accumulation index includes share price changes and
reinvestment of dividends
o Global industry classification standard (GICS) comprises 10
standard international industry sector indices; e.g. energy,
materials, industrials
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Stock-market indices and published share

information

• Published share information

o Newspapers and financial journals provide share-market
information to varying degrees of detail;
o e.g. The Australian Financial Review
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Chapter Organisation
8.1 Share-market investment
8.2 Financial performance indicators
8.3 Pricing of shares
8.4 Stock-market indices and published share
information
8.5 Summary
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Summary

• Factors a share investor should consider

o Diversification, portfolio return and risk
o Active or passive investment

o Direct or indirect investment

o Taxation
o Company financial performance indicators
− Capital structure, liquidity, debt servicing, profitability, share price, risk
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Summary (cont.)

• Factors that influence a company’s share price

o Expected future dividends
o Bonus shares issues

o Share splits

o Pro-rata rights issues

• Various share-market indices exist that provide a

measure of the price performance of a sector or of the
market overall