Lecture 7

LECTURE 7:VALUING EQUITY INSTRUMENTS
Learning Objectives
1. Describe the basics of ordinary shares, preference shares and share quotes.
2. Value a share as the present value of its expected future dividends.
3. Understand the trade-off between dividends and growth in share valuation.
4. Value a share as the present value of the company’s total payout.
Ordinary share: Ordinary share means that a share of ownership in the company gives its
owner rights to any ordinary dividends as well as the right to vote on the election of
directors, and on major events such as mergers.
Ticker symbol: A ticker symbol is a unique abbreviation assigned to a publicly traded
company and used when its trades are reported on the ticker (a real-time electronic display
of trading activity).
Ordinary shareholder rights:

Annual meeting: an event at which managers and directors answer questions from
shareholders, and shareholders vote on the election of directors and other proposals.
Proxy: an act through which shareholders direct that their shares be voted for them.
Proxy contest.
Preference shares:
Cumulative vs non-Cumulative preferred shares:
With cumulative preference shares, any unpaid dividends are carried forward. With non-
cumulative preference shares, missed dividends do not accumulate, and the firm can pay
current dividend payments first to preference and then to ordinary share shareholders.
Preference shares can be equity or debt.
We strive for precision, however, being exact is unnecessary because our aim is to buy a
security that is trading less than its intrinsic value. A good price to pay would be one that is
less than the intrinsic value, and provides a margin of safety (i.e., our assumptions have
errors. It would be similar to crossing a bridge while carrying the maximum allowable weight
– We wouldn’t want to buy a stock at exactly the intrinsic value, because our calculation is
unlikely to be exact.
This is because all methods are based on assumptions and in practise what we hope for is a
common range of values not an exact value.
We look at: dividend discount and total payout model, comparable, discounted cash flow
model(DCF).
Dividend discount model: one year investor is projected cash flows in one year: dividend
and sale of stock
Since cash flows are risky, discount them at equity cost of capital (rE) – the rate that
investors want for investments in that risk-class.
P0 = (Div1 + P1 )/(1+rE) and P1 = (Div1+t + P1+t )/(1+rE)
If current stock price were less than this amount, investors rush in and buy, driving up
stock’s price. If stock price exceed this amount, selling it would cause stock price to quickly
fall. Dividend and rE are estimates which makes price uncertain.
Dividend yield: percentage return investor expects to earn from dividend paid by share
Capital gain: difference between the expected sale price and original purchase price for the
share
Total return: sum of dividend yield and capital gain rate. Total return is expected return
investor will earn for a one-year investment in share. Total return = dividend yield + capital
gain rate. Total return = rE
The expected total return of the stock should equal the expected return of other
investments available in the market with equivalent risk.
Multi-year investor:
Three difference assumptions for dividends:
1. Dividends can remain constant over time
2. Have constant growth rate
3. Have mixed growth rate pattern
If ‘n’ is very large, present value of sale price (Pt ) will approach 0.
Constant dividend growth model:

g= expected capital gain rate. Expected growth rate of share price matches growth rate of
dividends.
Dividend payout ratio:

Divt=(earningst/shares outstanding(EPS)) * Dividend payout ratet
Retention rate = 1-payout ratio
Firm can increase dividends by:

1. Increase earnings,
2. Increase dividend payout rate
3. Decrease number of shares outstanding
Firm retains more of its earnings, it can use those earnings to invest in new projects and
increase future earnings and dividends or firm can release companies earnings to its
shareholders in form of dividends.
New investment: earnings * retention rate (i.e. how much money company keeps)
Change in earnings (i.e. what company will earn on its new investment): new
investment*return on new investment (ROE) or (Earnings * Retention Rate) * Return on
New Investment
Earnings growth rate (g) (i.e. how much will earnings grow based on new investment):
g= change in earnings/earnings=retention rate * return on new investment
ROE doesn’t = rE
Cutting firm’s dividend to increase investment will raise the stock price if and only if the new
investments have a positive NPV (r(new investment) > rE)
Dividend discount with changing growth rates:
Corporate boards typically set dividend payouts that are comfortably covered by earnings.
In good times: A greater amount of earnings is retained
In bad times: Dividends are often constant even if they exceed free cash flow.
Limitations of dividend-discount model:

There is a tremendous amount of uncertainty associated with forecasting a firm’s dividend
growth rate and future dividends. Small changes in the assumed dividend growth rate can
lead to large changes in the estimated stock price. Many companies do not pay dividends
for a very long time, thus the dividend-discount model must be modified.
Share repurchases: the firm uses excess cash to buy back its own share. Consequences: The
more cash the firm uses to repurchase shares, the less cash it has available to pay dividends.
By repurchasing shares, the firm decreases its share count, which increases its earnings and
dividends on a per-share basis.
In the dividend-discount model, a share is valued from the perspective of a single
shareholder, discounting the dividends the shareholder will receive.
P0=PV(future total dividends and net purchases)/shares outstanding0
How would an investor decide whether to buy or sell a share?

• They would value the share using their own expectations.
• If their expectations were substantially different, they might conclude that the share was
over- or under-priced.
• Based on that conclusion, they would buy or sell the share.
How could a share suddenly be worth more or less after an earnings announcement?
• As investors digest the news, they update their expectations and buying or selling pressure
would then drive the share price up or down until the buys and sells came into balance.
What should managers do to raise the share price further?

• The only way to raise the share price is to make value increasing decisions.
For repurchase: where CF1 is amount used to repurchase

P0=(Div1+CF1)/(rE-g)

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LECTURE 7:VALUING EQUITY INSTRUMENTS

Ordinary shareholder rights:

P0 = (Div1 + P1 )/(1+rE) and P1 = (Div1+t + P1+t )/(1+rE)

Constant dividend growth model:

Dividend payout ratio:

Firm can increase dividends by:

Dividend discount with changing growth rates:

Limitations of dividend-discount model:

P0=PV(future total dividends and net purchases)/shares outstanding0

How would an investor decide whether to buy or sell a share?

What should managers do to raise the share price further?

For repurchase: where CF1 is amount used to repurchase

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