Chapter 2 What does the share price tell us? Corporate Financial Strategy 4th edition Dr Ruth Bender Chapter 2 What does the share price tell us?

What does the share price tell us? Contents Learning objectives The share price reflects market expectations Different variants of the P/E ratio The P/E ratio and market perceptions of growth The dividend growth model The Ansoff matrix and growth strategies Share prices, growth and steady state Steady state PVGO and strategies for achieving required growth What does the share price mean?

Learning objectives Understand how the P/E ratio should change with market expectations of growth and risk. Distinguish between different versions of the P/E ratio and determine which is most relevant for your needs. Appreciate how the theoretical construct of steady state is derived from the dividend growth model. Calculate and interpret the present value of growth opportunities (PVGO) inherent in a company’s share price. Calculate the expected eps growth built into a company’s share price.

The share price of a company reflects the market’s expectations of growth and risk

Different calculations for price/earnings ratio P/E ratio = Share price ÷ eps Basic eps Actual earnings ÷ average shares in issue This is the default figure to use Diluted eps Actual earnings ÷ increased shares in issue Use if dilution is inevitable and already priced in Adjusted eps Adjusted earnings ÷ average (or diluted) shares in issue Use if the adjustments are valid Historic eps Taken from the financial statements. Useful because it is audited Of less use as the year progresses Prospective eps Based on analysts’ consensus, or your own forecast Use as the year progresses, as share prices are forward-looking

Figure 2.1 P/E ratio and market perceptions of growth Earnings per share High plc Low plc Current eps Time Assuming risk is the same, we can say that the market expects higher growth from High plc than from Low plc

Dividend growth model

Figure 2.2 The Ansoff matrix and growth strategies Products Existing New Existing Market penetration (1) Product development (2) Markets Market development (3) Diversification (4) New

Share prices, growth, and steady state At steady state: growth is zero D1 = D2 = … Dn full payout of earnings Therefore: P/e = 1/Kess ; Kess = eps/P (This is ONLY true at steady state) Steady state value of share = eps/Kess ; or eps x p/ess Current price less SS value = PVGO

Steady state Present value of growth opportunities (PVGO) Current eps E1 Perpetuity value of earnings Time Share price eps

Figure 2.3 PVGO and strategies for achieving required growth P1 = current share price Eps growth based on Quadrants 2-4 of Ansoff matrix Share price relating to successfully getting new customers/products Share price relating to extending the current strategy Eps growth based on Quadrant 1 of Ansoff matrix Current eps E1 P0 = Value of share that relates to current eps Time Share price eps

Why does the share price matter? A high price is seen as a sign of success. A high price is seen as a sign of the strength of the underlying business. Share price is often used as a proxy for performance. A high share price is the best protection against takeover. Raising future capital becomes easier if the price is high, as fewer shares have to be issued, and the existing investors are well disposed to the company already. Shareholders expect a growing share price. Share price is often used as a metric for calculating management bonuses. Management have share options, which only have value if the share price rises. A high share price improves morale, particularly if employees own shares. There is a strong correlation between power, influence, and company size.