CHAPTER 9 SHARE VALUATION 1

Chapter outline Introduction Ordinary shares and preference shares The development of stock exchanges Defining value Share valuation Expected return and required return Market efficiency Conclusion

Learning outcomes By the end of this chapter, you should be able to: differentiate between ordinary shares and preference shares distinguish between par value, book value, market value and economic (intrinsic) value explain the importance of share valuation determine the intrinsic value of a share using discounted cash flow techniques calculate and interpret four prominent financial ratios used to determine the relative value of a share differentiate between the expected and required rate of return explain what is meant by an efficient market.

Introduction Concept of an acceptable return and other important topics Primary goal of financial management is to maximise shareholder’s wealth Shares represent investors’ ownership of the productive assets of businesses

Ordinary shares and preference shares Ordinary shareholders become owners of productive assets Have the right to elect a board of directors Have a pre-emptive right to purchase additional shares Preference shares No voting rights at AGM Receive preferential treatment when it comes to distribution of profits and assets in liquidation Normally offer a fixed annual rate of dividend

Preference shares Cumulative Non-cumulative Participating Convertible Dividends that have not been paid in a particular period will accrue Non-cumulative Do not entitle shareholders to missed dividends Participating Allows higher dividend if company performs better then expected Convertible Allows shares to be converted into a predetermined amount of ordinary shares Redeemable Shares can be called back by issuing company at stated maturity date

Defining value Value is defined differently by different users of financial information Par value the arbitrarily assigned value of a share the value at which a share is issued in the primary market Market value the current price of a share established by means of demand and supply in the financial markets

Defining value Book value Economic (intrinsic) value the value of a share as reflected in the financial statements of the company it usually differs from market value Economic (intrinsic) value determined by discounting future cash flows (dividends) using an appropriate discount rate

Discounted cash flow techniques Intrinsic value of a share can be calculated: Where: = intrinsic value of a share D1 = the expected dividend paid at the end of period 1 D2 = the expected dividend paid at the end of period 2 Dn = the expected dividend paid at the end of period n rs = required rate of return

Discounted cash flow techniques Formula can be simplified depending on the expected growth rate in dividends Variables are estimated based on the basis of a fundamental analysis of macro, market and micro factors Three scenarios can be considered in this regard: zero dividend growth constant dividend growth variable dividend growth

Zero dividend growth This dividend pattern is typical of preference shares where D0 = D1 = D2 = …= D D0 is the most recent dividend paid and D1 represents the expected dividend in the next period The intrinsic value of a share can now be calculated:

Example 9.2 The Chatterbox Company has issued 7% preference shares with a par value of R100 each. If investors require an 11% return, what is the intrinsic value of these preference shares? Note: required return = discount rate

Constant dividend growth Due to the signaling effect associated with the payment of dividends, some companies prefer to offer investors steadily increasing dividends In this case dividends are expected to grow at a constant rate There are two ways in which to compute future dividends: D1 = D0(1+g)1; D2 = D1(1+g)1; D3 = D2(1+g)1 OR: D1 = D0(1+g)1; D2 = D0(1+g)2; D3 = D0(1+g)3

Constant dividend growth Based on the assumption of constant dividend growth, we can find the intrinsic value of a share:

Constant dividend growth Constant growth model often called the Gordon model after its developer Benefit of this technique is the expected price of a share can be determined at any future point: The value at any future point is simply the NEXT dividend divided by (rs – g): Two important assumptions when using this DCF technique is that D1 > 0 and g < rs

Example 9.3 The PrePaid Technologies Company has just paid an ordinary dividend of R1,15 and dividends are expected to grow at a constant growth rate of 8% indefinitely. Investors require a rate of 13,4% on investments of similar risk. What is the intrinsic value of this company’s shares?

Variable dividend growth The Gordon model is not suitable in cases where dividends fluctuate widely or where dividends are not paid for a few years (which is often the case for start up companies) In this situation we need to use the variable dividend growth technique which consists of two or more dividend growth periods

Variable dividend growth The process of finding the intrinsic value can be broken down into five steps Calculate the dividends during the supernormal growth period. Calculate the present value (PV) of supernormal growth dividends. Determine the value of all the constant dividends that will occur after the supernormal growth period. Determine the PV of the constant dividends after the supernormal growth period. Get the sum of all the PVs (i.e. those calculated in steps 2 and 4).

Example 9.5 The Konia Company has just paid a dividend of R5 per share. Investors anticipate that dividends will grow at 30% for the next three years because of the successful launch of a new cellular product. Thereafter, dividend growth will decrease to 10% forever. If investors required a 20% rate of return, how much would they be willing to pay for one Konia share (i.e. what is the intrinsic value of the share?)

Example 9.5 Identification of the variables: Current dividend (D0) = R5 Supernormal growth rate (g1) = 30% for three years Constant growth rate (g2) = 10% per year forever thereafter Required rate of return (rs) = 20%

Example 9.5 - solution

Example 9.5 - solution Step 1: Calculate the dividends during the supernormal growth period Year 1: D1 = D0(1 + g1) = 5 × (1 + 0,3) = 6,50 Year 2: D2 = D1(1 + g1) = 6,50 × (1 + 0,3) = 8,45 Year 3: D3 = D2(1 + g1) = 8,45 × (1 + 0,3) = 10,99

Example 9.5 - solution Step 2: Calculate the PV of supernormal growth dividends FV = 6,50; n = 1; i = 20; compute PV = 5,42 FV = 8,45; n = 2; i = 20; compute PV = 5,87 FV = 10,99; n = 3; i = 20; compute PV= 6,36 Total PV of supernormal dividends: 17,65  

Example 9.5 - solution Step 3: Determine the value of all the constant dividends that will occur after the supernormal growth period In this case, the supernormal period ends after three years and constant growth starts in year 4. Therefore, we need to find P3 

Example 9.5 - solution Step 4: Determine the PV of the constant dividends after the supernormal growth period PV of what you calculated in step 3 FV = 120,89; n = 3; i = 20; compute PV = 69,96 Step 5: Get the sum of all the PVs (i.e. those calculated in steps 2 and 4) 17,65 + 69,96 = R87,61

Example 9.5 - answer Would prospective investors be interested in purchasing shares in the Konia Company if the market price per share is R89? No! Based on their estimates of future dividends and the riskiness of the company, Konia shares are only worth R87,61 each. Konia’s shares are overvalued 

Relative valuation techniques In addition to DCF techniques, investors can also use financial ratios These evaluate the market value of a share relative to some accounting measures, such as earnings per share, cash flow, sales or book value The most important include the Price : Earnings ratio Price : Book ratio

Price : Earnings ratio Shows how much investors are willing to pay per rand of reported earnings Although this technique has some flaws, it is widely used to compare companies to competitors in the same sector A higher P:E ratio is generally favoured

Example 9.6 Calculate and interpret the P:E ratio for the Wireless Communication Company: Net profit after tax = R117 000 000 Number of shares issued = 50m Current market price = R23 EPS = 117 000 000 ÷ 50 000 000 = 2,33 P:E ratio = 9,83 times Interpretation: Current market price per share of the company is 9,83 times larger than the company’s last reported EPS. Investors are thus willing to pay R9,83 for every R1 of reported earnings.

Price : Book ratio This ratio is calculated as follows: For healthy companies the P:B should exceed one

Example 9.8 Calculate and interpret the P:B ratio for the Wireless Communication Company: Ordinary shareholders’ equity = R936 000 000 Number of shares issued = 50m Current market price = R23 Book value per share = 18,72 P:B ratio = 1,23 times Interpretation: The current market price per ordinary share is 1,23 times larger than the book value per ordinary share.

Expected return and required return The Gordon Model can be rearranged to find the expected rate of return on a share: Expected return = dividend yield plus capital gains yield

Example 9.9 Investors are interested in purchasing ordinary shares in the Cell P Company. Shares are currently priced at R80. The last dividend paid by the company was R2 per share and dividends are expected to grow at a constant rate of 5% per year. What is the return that investors expect to earn should they invest in these shares?

Example 9.9 - answer If investors require an 8% return on these shares to compensate them for the investment risk they are taking on, should they invest? No! The expected return earned on Cell P’s shares (7,63%) is less than the required rate of return (8%). So they are not adequately compensated for taking on investment risk.

Expected return and required return – decision rules If expected return > required return, intrinsic value > market value, which implies that investors should buy the share, as it is undervalued If expected return < required return, intrinsic value < market value, which implies that investors should not buy the share (or sell it if you own it), as the share is overvalued

Market efficiency In an efficient market share prices react quickly to new information prices are in equilibrium: market values = intrinsic values expected rates of return = required rates of return no gains can be made by investors who engage in fundamental and/or technical analysis

Market efficiency (cont.) Empirical tests have been undertaken to establish if market are: Weak form efficient Semi-strong form efficient Strong form efficient Most financial markets, including the JSE, is weak form efficient Implications for fundamental analysts? Technical analysts?

Conclusion Ordinary and preference shares are the main types of financial securities traded on the JSE. Although both types of shares represent equity capital, they have distinct characteristics. The main differences between ordinary and preference shares relate to the voting powers of shareholders, as well as their claims on the assets and profits of the company. Stock markets originated in the Middle Ages and have become very sophisticated markets that facilitate the transfer of funds between borrowers and lenders.

Conclusion (cont.) There are several definitions of value. We have concentrated on par value, market value, book value and economic (intrinsic) value. Various models can be used by financial mangers, shareholders, prospective investors and other stakeholders to determine the intrinsic value of a share. The two main approaches are the discounted cash flow approach and the relative valuation approach.

Conclusion (cont.) When using the discounted cash flow approach analysts need to estimate future dividends and may use one of three techniques to find the intrinsic value of the share. These include the zero dividend growth, constant dividend growth and variable dividend growth techniques. When using the relative valuation approach analysts generally evaluate financial ratios, which compare the market value of a share relative to certain accounting measures, such as earning, cash flow, sales or book value.

Conclusion (cont.) Investors should only purchase the shares of a company when the expected return exceeds the share’s required return. If the expected return is less than the required return, the share is overvalued and should not be purchased. In efficient markets the expected returns of companies equal the required returns and change very quickly when new information about a company is made public.