1. 10 Chapter The Valuation and Characteristics of Shares Slides Developed by: Terry Fegarty Seneca College

2. © 2006 by Nelson, a division of Thomson Canada Limited 2 Chapter 10: Outline (1) Common Shares  The Return on an Investment in Common Shares  The Basis of Share Value  Comparison of Cash Flows from Shares and Bonds The Intrinsic (Calculated) value and Share Price Growth Models of Common Share Valuation  Developing Growth-Based Models  Working with Growth Rates  Dividend Valuation Models  Constant Normal Growth—The Gordon Model

3. © 2006 by Nelson, a division of Thomson Canada Limited 3 Chapter 10: Outline (2)  The Expected Return  Two-Stage Growth  Practical Limitations of Pricing Models Some Institutional Characteristics of Common Shares Preferred Shares  Valuation of Preferred Shares  Characteristics of Preferred Shares Securities Analysis

4. © 2006 by Nelson, a division of Thomson Canada Limited 4 Common Shares Common shares—evidence of ownership  Common shareholders own firm  Common shareholders elect Board of Directors Common shares—form of long-term equity financing for firm Common shares often called a residual security  Value represents whatever assets are left after all prior claims against assets have been settled.

5. © 2006 by Nelson, a division of Thomson Canada Limited 5 Common Shares Background  Common shareholders own corporation, but share ownership often spread among large number of people Most shareholders aren’t interested in role as owners  Most equity investors are only interested in how much money they will receive as shareholders

6. © 2006 by Nelson, a division of Thomson Canada Limited 6 The Return on an Investment in Common Shares Future cash flows from share ownership consist of  Dividends  Eventual selling price of shares If you buy a share for price P 0, hold it for one year during which time you receive a dividend of D 1, then sell it for a price P 1, your return, k, would be: A capital gain (loss) occurs if you sell the shares for a price greater (lower) than you paid for it.

7. © 2006 by Nelson, a division of Thomson Canada Limited 7 The Return on an Investment in Common Shares Solve previous equation for P 0, share’s price today: Return on our share investment is interest rate that equates present value of investment’s expected future cash flows to amount invested today, the price, P 0

8. © 2006 by Nelson, a division of Thomson Canada Limited 8 The Basis of Share Value Cash flows attributable to a common share accrue from:  Dividend stream (while owning the shares)  Sale price The market value of a common share is equal to the present value of its expected future cash flows!

9. © 2006 by Nelson, a division of Thomson Canada Limited 9 Comparison of Cash Flows from Shares and Bonds BondsShares Interest payments are guaranteedDividends on common shares are not guaranteed Interest payments are fixedDividends on common shares may increase, decrease or stop at discretion of management Maturity value is fixedShareholder sells shares at prevailing market price On maturity, investor receives par or face value from issuing company Shares are sold to another investor

10. © 2006 by Nelson, a division of Thomson Canada Limited 10 The Basis of Share Value Basis for share value is present value of expected cash inflows even though dividends and share prices are difficult to forecast  Must make assumptions about what future dividends and selling price will be Discount these assumptions at an appropriate interest rate

11. © 2006 by Nelson, a division of Thomson Canada Limited 11 Figure 10.1: Cash Flow Timeline for Share Valuation

12. © 2006 by Nelson, a division of Thomson Canada Limited 12 Example 10.1 : The Basis of Value Q: Joe Simmons is interested in the shares of Teltex Corp. Joe thinks the shares will pay a dividend of $2 next year and $3.50 the year after. By then he believes it will be selling for $75 a share, at which price he'll sell anything he buys now. People who have invested in shares like Teltex are currently earning returns of 12%. What is the most Joe should be willing to pay for a share of Teltex? Example

13. © 2006 by Nelson, a division of Thomson Canada Limited 13 Example 10.1: The Basis of Value A: Joe shouldn’t pay more than the present value of the cash flows he expects: $2 at the end of one year and $3.50 plus $75 at the end of two years. Example If the market price of Teltex is below about $64, Joe should buy; if not, he shouldn’t invest.

14. © 2006 by Nelson, a division of Thomson Canada Limited 14 The Intrinsic (Calculated) Value and Market Price Share’s intrinsic value is based on assumptions made by potential investor  Must estimate future expected cash flows Needs to perform fundamental analysis of firm and industry Different investors with different cash flow estimates will develop different intrinsic values Fundamental analysis: Developing intrinsic values and comparing them to market prices

15. © 2006 by Nelson, a division of Thomson Canada Limited 15 Growth Models of Common Share Valuation Realistically most people tend to forecast growth rates rather than cash flows  Because forecasting exact future prices and dividends is very difficult

16. © 2006 by Nelson, a division of Thomson Canada Limited 16 Working with Growth Rates Growth rates work like interest rates  If growth is expected to be 6% next year then $100 growing at 6% will increase by $6, ($100 x 1.06) to $106 Where: D 0 = Today’s dividend D i = Future dividend for year i g = growth rate

17. © 2006 by Nelson, a division of Thomson Canada Limited 17 Example 10.2: Growth Rates Example Q: Apex Corp. paid a dividend of $3.50 this year. What are its next 3 dividends if it is expected to grow at 7%? A: In this case D0 = $3.50 and g =.07, so (1 + g) = 1.07. Then D 1 = D 0 (1 + g) = $3.50(1.07) = $3.75 D 2 = D 1 (1 + g) = $3.75(1.07) = $4.01 D 3 = D 2 (1 + g) = $4.01(1.07) = $4.29

18. © 2006 by Nelson, a division of Thomson Canada Limited 18 Dividend Valuation Models Constant growth model Zero growth model Two-stage growth model

19. © 2006 by Nelson, a division of Thomson Canada Limited 19 Developing Growth-Based Models A person who buys shares at time n will hold it until period m and then sell it  Their valuation will look like this:  Repeating this process until infinity results in:  Conceptually it’s possible to replace the final selling price with an infinite series of dividends

20. © 2006 by Nelson, a division of Thomson Canada Limited 20 Constant Normal Growth—The Gordon Model k must be greater than g  Gordon model is simple expression for forecasting price of a share that’s expected to grow at a constant, normal rate D 1 = Dividend in Next Period [D 1 = D 0 x (1+g)] k = Required Rate of Return g = constant growth rate

21. © 2006 by Nelson, a division of Thomson Canada Limited 21 Example 10.3: Constant Normal Growth—The Gordon Model Q:Atlas Motors is expected to grow at a constant rate of 6% a year into the indefinite future. It recently paid a dividends of $2.25 a share. The rate of return on shares similar to Atlas is about 11%. What should a share of Atlas Motors sell for today? A: Example

22. © 2006 by Nelson, a division of Thomson Canada Limited 22 The Zero Growth Rate Case—A Constant Dividend If share is expected to pay constant, non- growing dividend, each dollar dividend is the same Gordon model simplifies to: Zero growth share is a perpetuity to the investor D = Dividend k = Required Rate of Return

23. © 2006 by Nelson, a division of Thomson Canada Limited 23 Zero Growth: Example Q. Firm ABC currently pays a dividend of $1.00 per share. This is expected to remain the same into the foreseeable future. If shareholders require a return of 20% to hold the shares, what is each share worth in the market? A. Example

24. © 2006 by Nelson, a division of Thomson Canada Limited 24 The Expected Return Can recast Gordon model to focus on return (k e ) implied by the constant growth assumption Expected return reflects investors’ knowledge of a company  If we know D 0 (most recent dividend paid) and P 0 (current actual share price), investors’ expectations are input via growth rate assumption

25. © 2006 by Nelson, a division of Thomson Canada Limited 25 Two-Stage Growth At times, we may expect that firm’s future growth will not be constant  For example, new product may lead to temporary high growth Two-stage growth model allows us to value share that is expected to grow at unusual rate for limited time 1.Use the Gordon model to value constant portion 2.Find the present value of non-constant growth periods

26. © 2006 by Nelson, a division of Thomson Canada Limited 26 Figure 10.2: Two-Stage Growth Model

27. © 2006 by Nelson, a division of Thomson Canada Limited 27 Q:Zylon Corporation’s shares are selling for $48. The firm will make an exciting new product announcement next week. We’ve concluded that this new product will support an overall company growth rate of 20% for about two years. After that, growth will level off at about 6%. The firm currently pays an annual dividend of $2.00, which can be expected to grow with the company. The rate of return on shares like Zylon is approximately 10%. Is Zylon a good buy at $48? A: We’ll estimate what we think Zylon should be worth given our expectations about growth. Example Example 10.5: Two-Stage Growth

28. © 2006 by Nelson, a division of Thomson Canada Limited 28 Example 10.5: Two-Stage Growth  First, draw a time line showing the expected cash flows. Each dividend must be calculated, using the growth rate for the period. 04321 ∞ $2.00 $2.40 $2.88 $3.05 20% 6% Example

29. © 2006 by Nelson, a division of Thomson Canada Limited 29 Example 10.5: Two-Stage Growth Next, we’ll develop a schedule of expected dividend payments: Next, we’ll use the Gordon model at the point in time where the growth rate changes and constant growth begins. That’s year 2, so: Example 6%$3.053 20%$2.882 20%$2.401 Growth Expected DividendYear

30. © 2006 by Nelson, a division of Thomson Canada Limited 30 Example 10.5: Two-Stage Growth Then we take the present value of D 1, D 2 and P 2 : Example Compare $67.57 to the listed price of $48.00. If we are correct in our assumptions, Zylon should be worth about $20 more than it is selling for in the market, so we should buy Zylon’s shares.

31. © 2006 by Nelson, a division of Thomson Canada Limited 31 Two-Stage Growth: Helpful Hints 1.Draw a timeline 2.Calculate each dividend on the timeline 3.During the period of non-constant growth, present value dividends back to time zero 4.Once growth has stabilized:  Calculate the present value of all dividends from that point forward out to infinity.  Calculated value must be brought back to time zero.

32. © 2006 by Nelson, a division of Thomson Canada Limited 32 Practical Limitations of Pricing Models Share valuation models give approximate results because inputs are approximations of reality  Bond valuation is precise because inputs are exact With bonds, future cash flows are contractually guaranteed in amount and time Actual growth rate and interest rate can be VERY different from predicted rates  Even if rates differ only slightly, it can make big difference in our decision  So, it’s best to allow margin for error in estimations

33. © 2006 by Nelson, a division of Thomson Canada Limited 33 Practical Limitations of Pricing Models Shares That Don’t Pay Dividends  Some firms don’t pay dividends even if they are profitable  Many companies claim they never intend to pay dividends These firms can still have a substantial share price  Firms of this type typically are growing and are using profits to finance growth However rapid growth won’t last forever When growth slows, the firm will begin paying dividends It’s these distant dividends that impart value

34. © 2006 by Nelson, a division of Thomson Canada Limited 34 Some Institutional Characteristics of Common Shares Common Shareholder Rights  Right to vote at shareholder meetings  Right to share in profits (either as a dividend or as reinvested profits)  Right to share in residual assets after all other stakeholder (i.e. governments, creditors, employees) claims are satisfied  Preemptive Rights: If a firm issues new shares, existing shareholders may have right to purchase pro rata share of new issue

35. © 2006 by Nelson, a division of Thomson Canada Limited 35 Some Institutional Characteristics of Common Shares Corporate Organization and Control  Controlled by Board of Directors (elected by shareholders)  Board appoints top management who then appoint middle/lower management  Board consists of: top management and outside members (major shareholders, top executives at other firms, former presidents, etc.)  In widely held corporations, top management is effectively in control of firm because no shareholder group has enough power to remove it

36. © 2006 by Nelson, a division of Thomson Canada Limited 36 Some Institutional Characteristics of Common Shares Voting Rights and Issues  Shareholders may assign their voting rights to someone else (proxy)  Management actively solicits proxies  Dissent shareholder group may try to solicit proxies to wrest control away from management  Proxy fight occurs if parties with conflicting interests solicit proxies at same time

37. © 2006 by Nelson, a division of Thomson Canada Limited 37 Some Institutional Characteristics of Common Shares Voting for the Board of Directors Majority voting  Each share carries one vote  Requires more than 50% of votes to elect a director  Gives control of the company to the larger group Cumulative voting  Each share carries as many votes as there are directors to be elected  Shareholders may cast all votes for one candidate  Gives minority interest a chance at some representation on the board

38. © 2006 by Nelson, a division of Thomson Canada Limited 38 Some Institutional Characteristics of Common Shares Shares With Different Voting Rights  Different classes of shares can be issued with different rights Some shares may be issued with limited or no voting rights

39. © 2006 by Nelson, a division of Thomson Canada Limited 39 Some Institutional Characteristics of Common Shares Shareholders’ Claim on Income And Assets  Common shareholders have a residual claim on the firm’s net income and assets Common shareholders are last in line to receive income or assets, after creditors and preferred shareholders Bear more risk than other investors However, residual interest is large when firm does well Residual income is paid out as dividends or retained (retained earnings) for investment in new projects Leads to future growth

40. © 2006 by Nelson, a division of Thomson Canada Limited 40 Preferred Shares Form of equity financing Intermediate position between common shares and long-term debt  No maturity date (like common shares)  Fixed dividend payment (similar to bond interest payment)

41. © 2006 by Nelson, a division of Thomson Canada Limited 41 Valuation of Preferred Shares Value of preferred share is present value of all its future expected dividends. No growth rate in preferred share dividends, so growth rate equals 0 Preferred shares are valued as a perpetuity D = Dividend k = Required Rate of Return

42. © 2006 by Nelson, a division of Thomson Canada Limited 42 Example 10.6: Preferred Shares Q:Roman Industries’ $6 preferred originally sold for $50. Interest rates on similar issues are now 9%. What should Roman’s preferred sell for today? A:Just substitute the new market interest rate into the preferred share valuation model to determine today’s price: Example

43. © 2006 by Nelson, a division of Thomson Canada Limited 43 Characteristics of Preferred Shares Cumulative Feature  Common dividends can’t be paid unless dividends on cumulative preferred are current

44. © 2006 by Nelson, a division of Thomson Canada Limited 44 Characteristics of Preferred Shares PreferredCommonBonds Payments to Investors Dividends are constant Dividends are discretionary Interest is constant Maturity and Return of Principal Issuing firm does not return principal. Holder must sell in market Issuing firm returns principal on maturity date Assurance of Payment Dividends can be passed but are cumulative Dividends can be passed indefinitely Interest must be paid or bondholders can put into bankruptcy

45. © 2006 by Nelson, a division of Thomson Canada Limited 45 Characteristics of Preferred Shares PreferredCommonBonds Priority in Bankruptcy Shareholders have claim on company assets after bondholders Shareholders have last claim on company assets Bondholders have first claim on company assets Voting RightsNoneRight to voteNone Tax Deductibility of Payments Dividends not deductible Interest payments are deductible Risk to InvestorMiddleHighestLowest

46. © 2006 by Nelson, a division of Thomson Canada Limited 46 Securities Analysis Securities analysis—the art and science of selecting investments Fundamental analysis looks at company and its business to forecast value Technical analysis bases value on pattern of past share prices and volumes Efficient Market Hypothesis says information moves so rapidly in financial markets that price changes occur immediately, so it is impossible to consistently beat the market to bargains