MAF203 5 Share valuation - StudentVIP

MAF 203 Topic 5 SHARE VALUATION

chapter 9

Valuation: Overview When we value any asset in finance, we follow 3 simple steps:

1) Estimate the future cash flows generated by the asset. 2) Find and appropriate required rate of return (See Topic 3) 3) Find the present value of each of the future cash flows using the appropriate required rate of return. 4) Add all the present values of all the future cash flows together.

Learning Objectives: Share Valuation 1. Describe the types of shares (equity securities) . 2. Describe how the general dividend discount model values a share . 3. Discuss the assumptions of the general dividend discount model . 4. Employ the general dividend discount model to value a company's ordinary shares. 5. Describe how the Price-Earnings model values a share. 6. Employ the Price-Earnings model to value ordinary's shares. 7. Discuss challenges in share valuation compared to bond valuation.

Valuation of Shares (Equity) Three Models of Share Valuation:

? Dividend Valuation Model ? Price-Earnings Model X Capital Asset Pricing Model (CAPM) (covered in Topic 3)

Types of equity securities

Share valuation with Dividend Valuation Model ? The periodic cash flows from an investment in shares are dividends. Assuming the dividends continue indefinitely, the value of the share (P0) is:

? This equation does not ignore the capital gains, as the price a share is sold for at time n should represent the discounted value of dividends beyond time n.

Share valuation with Dividend Valuation Model ? We estimate the value of a share using the same principles as any other asset. 1) Estimate the future cash flows (dividends) generated by the asset. 2) Find and appropriate required rate of return. 3) Find the present value of each of the future cash dividends and terminal value using the required rate of return. 4) Add all the present values of all the future cash flows together o The general expression for the value of a share: o Price of a share is present value of all expected future dividends (assuming share is a perpetuity) o The following formula (9.1 on p. 312) does not assume any specific pattern for future cash dividends, such as a constant growth rate

Share valuation: Three Models Three different assumptions can cover most growth patterns. The following models are based on alternative assumptions for the future cash flows. 1. Constant Dividend Model: Dividend payments are expected to remain constant over time forever. (e.g: The dividend payment is expected to be $5 forever).

2. Constant Growth: Dividends are expected to have constant growth rate forever. (e.g: Dividends are expected to grow at 5% each year forever).

3. Non-constant Growth: Dividends are expected grow at different growth rates during different time spans. (e.g 5% for the first 5 years and 2% after that).

For valuation purposes we also assume that shares are held forever by an investor. Further we assume that the required rate of return does not change for the duration we are

valuing the asset.

Constant dividend model/Zero Growth The dividend payment pattern remains constant over time: D1 = D2 = D3 = . . . = D

PRICE=P0

$5

$5

$5

$5

$5

$5

$5

$5

$5

0

1

2

3

4

5

6

7

8

Till Infinity

o In this case the dividend-discount model becomes:

P = D + D + D + D + ........... 0 (1+ R) (1+ R)2 (1+ R)2 (1+ R)3

the present value of a perpetuity with a constant cash flow is , where is the constant cash flow and is

the interest rate.

The valuation model for a zero growth share: (Formula 9.2 on p 314)

D P0 = R

P0 is the price of the share today, D is the constant dividend and R is the required rate of return or discount rate ().

This model can be used for irredeemable(Infinite life) preference shares with equal dividend payments! Look at tutorial questions.

Preference Shares

o Preference shares are similar to bonds in that preference shareholders receive a fixed dividend which must be paid before dividends can be paid on ordinary shares. o Dividend Valuation Model ? Zero Growth

o Preference shares have a constant dividend into perpetuity, with no growth in dividends. Therefore, the value of a preference share is found in the same way as the value of a perpetuity:

P0

=

D R

Constant growth dividend model

PRICE=P0 D0=5 D1=(1+g)

D2=(1+g)2

0

1

2

D2=(1+g)3

D2=(1+g)2

D2=(1+g)2

D2=(1+g)2

D2=(1+g)2

D2=(1+g)2

3

4

5

6

7

8

EACH YEAR THE DIVIDEND GROWS BY g%

Till Infinity

- Cash dividends do not remain constant but instead grow at some average rate `g' from one period to the next

and that growth rate remains constant forever

- Constant dividend growth may be an appropriate assumption for mature companies with a history of stable

growth

- Recall that equation for a growing perpetuity is: (Topic 2)

= 1/( - )

- How to value a constant growth share:

3

= 3(1 + ) = 7 - -

(9.3 9.4)

Constant growth dividend model: Example - X Limited has just paid a dividend of $0.25 per share and the dividends are expected to grow at a constant rate of 3% per annum. If the required rate of return is 9.5%, calculate the expected market price (in fact, `value') per share. - Always use the next dividend.

- If the current market price of the share is $4.25, what would be your conclusion and the decision?

Calculating future share values - The constant-growth dividend model can be modified to determine value of a share at any point in time - The following equation shows value of a share at any time t as follows: (Formula 9.5 on p. 318)

Pt = Dt + 1 (R - g)

Calculating Future Share Values: Example ? ABC Company has a current dividend of $2.50 per share. Investors require a 15% rate of return and the firm has forecasted dividends will grow at 5% p.a forever. ? What will the share price be in 5 years time? Step 1: Draw a timeline

STEP 2: Calculate D6 (Dt+1)

D6=D0(1+g)6=2.50(1+0.05)6=$3.35

STEP 3: Compute future value.

5 = B@CAD=3.7EF.CE3F.3F=$33.50

Share Price Sensitivity To The Dividend Growth Rate (g) ? The higher is the growth rate in dividends, g, the higher will be the share price. ? Why? 1. In terms of the constant growth in dividends pricing formula, the higher is g the lower will be the

denominator (R ? g) and, therefore, with a fixed numerator (D1) the result (P0,) must be higher:

P0

=

D1 (R - g)

2. It also makes intuitive sense. If g is higher then future dividends will be higher so, therefore, more investors will want the share in order to get hold of the higher future dividends. Therefore, demand for the share will go up, and with a fixed supply of the share, the price of the share must rise.

Share Price Sensitivity To The Required Rate of Return, R ? The higher is the required rate of return on equity, re, the lower will be the share price. ? Why? 1. In terms of the constant growth in dividends pricing formula, the higher is re the higher will be the

denominator (re ? g) and, therefore, with a fixed numerator (D1) the result (P0,) must be lower:

P0

=

D1 (R - g)

2. It also makes intuitive sense. If re is higher then investors require a higher rate of return on their investment. Therefore, holding other factors constant, to get a higher return they must pay a lower price (remember, there is an inverse relationship between the price of an asset and the rate of return on the asset: lower price -? higher return; higher price---? lower return).

Non-Constant (supernormal) growth dividend model - During the early part of their lives, very successful companies experience a supernormal rate of growth in

earnings. - To value a share of a company with supernormal dividend growth patterns, we can apply a combination of two

dividend models: - First, we discount the known dividends during the high growth period/s individually. - Second, we use the constant growth dividend model at the point in time the growth becomes constant and

stable.

Non-Constant (supernormal) growth dividend model: Example ? A company's dividends will grow at 5% per year for the first 3 years. Thereafter the dividends will grow at 3% per year forever. The required rate of return is 15% and a dividend of $1.00 was paid last year. ? STEP 1: DRAW TIMELINE

? STEP 2: CALCULATE THE VALUE OF DIVIDENDS DURING 1st GROWTH PHASE and 1 year after that. D0=$1.00 (From question)

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