Topic 4 – Valuation Of Equity
Introduction
CHARACTERISTICS OF COMMON STOCK
Common shareholders receive returns in the form of dividends. However, a dividend is only paid to common shareholders after interest payments to bond holders and dividend payments to preferred shareholders have been met. The dividend rate paid to common shareholders can fluctuate according to the profits earned by the firm.
Besides the dividend, investors of common stock may enjoy capital gain if the market price of the share is higher than the purchase price. On the other hand, investors would incur capital loss if the market price of the share is lower than the purchase price. However, if the share is not sold, the loss is only considered as a “paper loss”.
Common shareholders are regarded as owners of the company. However, they do not manage the company directly but can be indirectly involved by exercising their voting rights at annual general meetings or AGMs – meetings by companies to provide information and make known the company’s past performance and future plans to shareholders. If there are urgent important issues to be discussed, an emergency general meeting or EGM among the shareholders may be called. If the shareholder cannot attend the meeting personally, he or she can appoint a proxy – that is, a representative to vote on his or her behalf.
TERMS ASSOCIATED WITH COMMON STOCKS
(a) Par Value
The par value is the issue price per share of the common stock.
(b) Prospectus
A prospectus is a brochure that is distributed to would-be investors. It provides information on the company such as the activities of the firm, the board of directors, past year financial statements, summary of material risk factors, utilisation of proceeds, and financial impact from utilisation of proceeds etc.
(c) Board Lots
Shares are traded on the stock exchange in units of board lots. Previously one board lot traded in the Bursa Malaysia is equivalent to 1,000 units of shares but in the year 2003, the Bursa Malaysia implemented the standardisation of board lots at 100 shares per lot. The exercise was carried out in four stages; starting with the Second Board counters in April 2003 and followed by the Main Board counters which concluded in June 2003. With the standardisation of board lots at 100 shares per lot instead of 1,000 shares, it is anticipated that there would be greater stock market participation and activity, thus enhancing liquidity in the stock market.
(d)Dividends
Earnings of a company are distributed to shareholders in the form of dividends and the dividend can be paid in the form of cash or additional stocks allotted to existing shareholders.
ADVANTAGES AND DISADVANTAGES OF COMMON STOCKS TO ISSUING FIRMS
Advantages of Common Stock to Issuing Firms
(a) Payment of dividend is not compulsory
Unlike that of bond financing it is not legally binding for a firm to pay dividends to its common shareholders . If interest payments on bonds are not made, the bondholders have the right to sue the company but in the case of common stocks, it is not compulsory for the company to pay dividends. If the performance of the firm is poor in a particular year, it may not pay dividends to its common shareholders. This provides greater flexibility to the issuing firm in terms of financing.
(b) Issuance of common stock provides a favourable option especially if the firm already has a high leverage ratio or gearing ratio.
Disadvantages of Common Stock to Issuing Firms(
a) If a company issues and sells its shares to the public, there is the possibility that the founder of the firm may lose control over the business. Even though common shareholders are not involved directly in the management of the company, they can indirectly influence management through their voting rights.
(b) Besides being subjected to the scrutiny of the investing public, a company that issues shares
to the public also has to abide by several rules and regulations such as the Companies Act 1965, Securities Industry Act 1983, Securities Commission Act 1993, rules of the Bursa Malaysia etc. Compliance with these rules and regulations would result in higher costs to
ADVANTAGES AND DISADVANTAGES OF COMMON STOCKS TO INVESTORSAdvantages of Common Stock to Investors
(a) Common stocks issued by public listed companies are traded on the stock exchange. This provides liquidity to the investment because investors can easily dispose of the stock in the stock market.
(b) Common stockholders face higher risk compared to other investors such as bondholders
or preferred stockholders. However, taking into account the trade-off between risk and return, it can be generalised that common shareholders would be rewarded with higher returns especially over the long-term based on the belief that the market does reward risk-takers.
(c) Investment in common stocks offers variable dividends and returns in the form of capital
gains which may help investors to beat or keep up with inflation which erodes purchasingpower.
Disadvantages of Common Stock to Investors
(a) Common stockholders face higher risk as compared to other investors such as bondholders and preferred stockholders. If a firm is forced to liquidate or becomes bankrupt, bondholders and other creditors have prior claims on the assets of the firm, followed by preferred stockholders. There is the possibility that the common shareholder may lose all of his or her investments in the event of liquidation of the firm.
(b) Separation of ownership and management
Even though common shareholders are the owners of the firm, they are not involved directly in the management of the business. Instead, the company is managed by paid managers and employees, together with the board of directors who oversee the management of the firm. Due to the separation of ownership and management, the activities of the business may not be in the best interest of the minority shareholders
VALUATION
4.1 Balance Sheet Valuation Methods
• Book value
• Replacement value
• Liquidation value
4.1.1 Book Value
It uses the book value of the Net tangible asset Backing (NTA) or Net Asset Value can be defined as :-
NTA = (issued capital + reserves ) / (total number of issued shares)
NTA/share = (shareholders’ funds) / (total number of issued shares)
NTA/share provides an indication of the asset value of the company shares. This value compared with the market price of the company’s share to determine buy/sell decisions.
The weakness of NTA per share :-
• Calculated from the historical accounting data. It may not truly reflect the current value of the company’s assets.
• Does not take into consideration the quality of the company’s assets. It may be over or under stated in the balance sheet.
• Does not reflect any contingent liabilities that may have been incurred.
4.1.2 Replacement value
Using the same method as NTA but the accounts-derived NTA may be adjusted to reflect the replacement value of key assets like land and buildings, machinery etc.
4.1.3 Liquidation Value
Using the same concept as NTA but the accounts-derived NTA be adjusted to reflect the liquidation value of the company’s key assets especially machinery.
4.2 The Dividend Discount Model (DDM)• Dividends are the foundation of valuation for common stocks.
• To value common stock. i.e the cash flows are the dividends expected to be paid in each future period.
• Investors must be carefully study the future prospects for a company and estimate the likely dividends to be paid.
• Estimate an appropriate required rate of return or discount rate based on the risk foreseen in the dividends.
• Discount to the present value of the future dividends to be expected.
Definition – DDM is the estimated price of a stock by discounting all future dividends.
Formula :-
Pcs = D1/(1 + Kcs)1 + D2/(1+ Kcs)2 + D3/(1 + Kcs)3 ….. + D∞ / (1 + Kcs) ∞
∞
= ∑Dt /(1 + K)t
t=1
Where:-
Pcs = the intrinsic value of the stock today.
D1, D2 … D∞ = the dividends expected to be received in each future period.
Kcs = the discount rate applicable for an investment.
Types of DDM:-
1. The Zero-Growth Model (The fixed dollar dividend model).
• Assuming a constant dollar dividend (no growth model).
Formula :-
Po = Do/Kcs
where:-
Do is the constant dollar dividend expected for all future time periods.
Kcs is the opportunity cost or required rate of return for this particular common share.
2. The Constant –Growth Model
Dividends are expected to grow at a constant rate over time.
Formula:-
Po = Do(1 + g)1 /(1 + Kcs)1 + Do(1 + g )2 /(1 + Kcs)2 + Do(1 + g)3/(1 + Kcs)3 + …. Do(1 + g) ∞ / (1 + Kcs) ∞
Where :-
Do = the current dividend being paid.
g = constant growing rate.
Kcs = discount rate.
Simplified equation :-
Po = D1 / (K – g)
Where :-
D1 = the dividend expected to be received at the end of year 1.
3. The Multiple-Growth Model
Where the expected future growth in dividends must be described using two or more growth rates.
Formula:-
t=n
Po = ∑ Do(1 + g1)t / (1 + K)t + [Dn(1 + gc)/(K – g) x 1/(1 + K)n ]
t=1
Where:-
Po = the intrinsic value of the stock today.
Do = the current dividend.
g1 = the supernormal growth rate for dividends.
gc = the constant- growth rate for dividends.
K = the required rate of return.
n = the number of periods of supernormal growth.
Dn= the dividend at the end of the abnormal growth period.
Pn = D(n + 1) / (K – gc)
Pn = the expected price of the stock derived from the constant-growth model.
Example :-
Do = RM 1.00
g1 = 12% (for 5 years0
gc = 6% (forever)
K = 10%
Po (for the 1st five years)
Year Dividend received PVIF 10%, t Present value
1 1.00(1.12) = 1.12 0.909 1.02
2. 1.12(1.12) = 1.25 0.826 1.03
3. (1.12)3 = 1.40 0.751 1.05
4. (1.12)4 = 1.57 0.683 1.07
5. (1.12)5 = 1.76 0.621 1.09
Po(D1 – D5) 5.26
Pn = D6 /(K – gc)
= D5(1.06) / (0.10 – 0.06)
= 1.76 (1.06) /(0.10 – 0.06)
= RM 46.64
Po(D6 - D∞) = 46.64(0.621)
= 28.96
Po(D1 - D∞) = 5.26 + 28.96
= RM 34.22
4.3 P/E Ratio Model (Earnings Multiplier)
• More common used by security analysts.
• Easier to use.
• Very simplicity.
• Can lead to forget the need of estimation of the uncertain future. (Every valuation model requires estimates of the uncertain future).
• Consistent with the present value analysis. i.e intrinsic value.
•
Definition - P/E ratio is calculated by dividing the current market price of the stock by the latest 12-month earnings (EPS).
Po = estimated earnings x justified P/E ratio.
Po = E1 x P/E ratio
Example
E1 = Rm 3.00
P/E ratio = 15
Po = RM 45.00
Determinants of P/E ratio :-
P/E ratio can be derived from DDM (based on constant growth model).
PE = D1 /(k-g)
Devide by E1 (both sides)
PE / E1 = (D1/E1) /(k – g)
Factors that affect P/E ratio:-
• The dividend payout ratio (D/E)
• The required rate of return (k)
• The expected growth rate of dividends (g)
The relationship between the P/E ratio and the related factors :-
• When the payout ratio rise; the P/E ratio rise. i.e direct relationship.
• When the value of g rise ; the P/E ratio rise . i.e direct relationship.
• When the value of k rise; the P/E ratio declines. i.e inverse relationship.
Example
Assume that the payout ratio is 60% . Calculate the P/E ratio and the price of the share if the expected earning for next year is RM 3 . The following data are related.
i. k = 0.15 ; g = 0.07
ii. k= 0.16 ; g = 0.06
iii. k=0.14 ; g = 0.08
i. P/E = (D/E) / (k – g)
= 0.60 / (0.15 – 0.07 )
= 7.5 x
Po = 7.5 x 3 = RM 22.50
ii. P/E = 0.60/ (0.16 – 0.06)
= 6x
Po = 6 x 3
= RM 18.00
iv. P/E = 0.60 / (0.14 – 0.08)
= 10 x
Po = 10 x 3
= RM 30.00
4.4 Problems arise in the valuation of equity :-
The Problems Occurred With DDM :_
1. The equation indicates the investors are dealing with infinity. Investors must value a stream of dividends may be paid forever since common share has no maturity date.
2. The dividend stream is uncertain. There is no specified number of dividends. Dividends must be declared periodically by the firm’s board of directors . Dividends for most firms are expected to grow over time.
How To solve These Problems:-
1. The infinite number of periods and dividends can be solved by using a reasonable high discount rates such as 12 %, 145 etc. Today’s value for dividends to be received in 50/60 years in the future are worth very little. E.g The present value of RM 1 to be received 50 years from now; if discount rate is 15% is RM 0.0009.
2. Due to uncertainty. The solution is to make some assumptions about the expected growth rate of dividends over time.
4.5 Key factors in the valuation of equity
i. Dividends
It is as the foundation of valuation of common stocks because dividends are the only cash payment a stockholder receives directly from a firm.
ii. The required rate of return
Investors must estimate an appropriate required rate of return.
iii. Intrinsic value
It is obtained through the present value analysis (DDM). It is specify the relationship between intrinsic value (IV) and the current market price (CMP).
If IV > CMP – the asset is under-valued and should be purchased or held if already hold.
If IV < CMP – the asset is over-valued and should be avoided or sold if held or sold short.
If IV = CMP – implies an equilibrium that asset is correctly valued.
IV may differ among investors due to different estimations of future benefits and discount or required rate of return.
Therefore a particular asset on a particular day, some investors are willing to buy and some are willing to sell.
4.6 Other Factors That Affect The Share Price.
i. Interest Rates
It has inverse relationship with the share price. When the interest rates increase ; the share prices decrease.
ii. Changes In Money Supply
The relationship between changes in money supply and the share price is direct.
iii. Composite Indexes
Generally the composite indexes are moving in line with stock prices (direct relationship).
