Chapter 9 Equities and Equity Valuation Keith Pilbeam

Chapter 9 Equities and Equity Valuation Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Learning Objectives Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

10 Largest US Companies by Market Capitalization

Debt or Equity Finance? � A company’s Primary Gearing is it’s debt to equity ratio D/E � Over time, a firm must expect to pay more for equity finance than debt finance since equity holders require a premium to compensate for their exposure to the additional capital risk and greater uncertainty over future payments. � With equity finance the firm is not obliged to make any payments. This can make equity finance quite attractive for dynamic fast-expanding companies that prefer to pay no or low dividends in their early growth years. � Debt finance can prove to be an attractive way of raising finance, particularly as it is generally easier to obtain than equity finance for a lot of companies. Many small to medium-sized enterprises are also not listed on a stock exchange and so do not have easy recourse to equity finance Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Debt or Equity Finance? continued � Some firms may be reluctant to seek a listing because of the disclosure requirements or their trading record may be too short, or the owners may be reluctant to give up the degree of control in their company which a public listing entails. � There is a need to distinguish between short-term, medium-term and long -term debt when considering its attractiveness. � Short-term debt usually involves bank overdraft facilities or the sale of commercial bills. most companies do not like to become too reliant on short-term finance because they could be placed in severe difficulty if the finance facility is not renewed. � Medium-term debt includes the use of bank loans, often secured against assets of the firm and the use of medium-term bond finance. � Long-term finance is usually obtained by the sale of corporate bonds, typically with 10 to 20 years until maturity, at fixed rates of interest. However, on average, long-term finance is more costly than short-term finance because of the need to pay investors a liquidity premium. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Different Types of Equity � Ordinary Shares (Common Stock) Owners are entitled to dividends and share of the net asset value of the company once creditors have been paid. Owners have voting rights and the power to change the management of the company. Owners have the first right to buy new stock issued by the company. � Preference Shares o o o Owners are entitled to a fixed dividend payment before any dividends are distributed to ordinary shareholders. They have priority over ordinary shareholders They do not confer ownership of the firm or voting privileges on their holders. They are entitled to a share of the assets if the firm goes into liquidation. They have lower priority than debt holders. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

What is equity capital? • Ordinary shares – Ordinary shares represent the equity share capital of the firm – Share in the rising prosperity of a company – Owners of the firm – The right to exercise control over the company – Vote at shareholder meetings – A right to receive a share of dividends distributed – Each shareholder entitled to a copy of the annual report – – No agreement between ordinary shareholders and the company that the investor will receive back the original capital invested What ordinary shareholders receive depends on how well the company is managed Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Advantages and disadvantages of share issues • Advantages – 1 Usually there is no obligation to pay dividends – 2 The capital does not have to be repaid • Disadvantages – 1 High cost – Direct costs of issue – The return required to satisfy shareholders – 2 Loss of control – 3 Dividends cannot be used to reduce taxable profit Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Preference shares � Preference shares usually offer their owners a fixed rate of dividend each year � However if the firm has insufficient profits the amount paid would be reduced, sometimes to zero � The dividend on preference shares is paid before anything is paid out to ordinary shareholders � Preference shares are part of shareholders’ funds but are not equity share capital Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Advantages and disadvantages to the firm of preference share capital • Advantages: – 1 Dividend ‘optional’ – 2 Influence over management – 3 Extraordinary profits – 4 Financial gearing considerations • Disadvantages: – 1 High cost of capital – 2 Dividends are not tax deductible Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Types of Preference Shares � Cumulative Preference Shares: The holder is entitled to any missed dividends if earnings recover sufficiently before any dividends are made to ordinary shareholders. � Convertible Preference Shares: Holders have the right to convert their preference shares into ordinary ones. � Redeemable Preference Shares: The company can buy back the shares at their original price at some time in the future. � Participating Preference Shares: It allows for even greater dividend in the event that profits are above certain levels. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Initial Public Offerings �Definition: A company’s first equity issue made available to the public. �This issue occurs when a privately held company decides to go public �Also called an “unseasoned new issue. ” Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Why do companies go public? � New capital Almost all companies go public primarily because they need money to expand the business � Future capital Once public, firms have greater and easier access to capital in the future � Mergers and acquisitions Its easier for other companies to notice and evaluate a public firm for potential synergies IPOs are often used to finance acquisitions Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Disadvantages of the IPO � Expensive A typical firm may spend about 15 -25% of the money raised on direct expenses � Reporting responsibilities Public companies must continuously file reports with the SEC and the stock exchange they list on � Loss of control Ownership is transferred to outsiders who can take control and even fire the entrepreneur Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Is it a good time to do an IPO? � There are clear “windows of opportunity” that open and close for IPO issuers � Determinants of suitability: The general stock market condition The industry market condition The frequency and size of all IPO’s in the financial cycle Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Outline of the IPO process: 1. 2. 3. 4. 5. 6. Select an underwriter Register IPO with the SEC (Securities Exchange Commission) Print prospectus Present roadshow Price the securities Sell the securities Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

1. Select an underwriter � An underwriter is an investment firm that acts as an intermediary between a company selling securities and the investing public � The underwriter is the principal player in the IPO � Typically, the underwriter buys the securities for less than the offering price and accepts the risk of not being able to sell them Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Types of underwriting � Firm commitment underwriting: The underwriter buys the entire issue, assuming full financial responsibility for any unsold shares Most prevalent type of underwriting in the U. S. � Best efforts underwriting: The underwriter sells as much of the issue as possible, but can return any unsold shares to the issuer without financial responsibility Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

2. Register IPO with SEC �The firm must prepare a registration statement and file it with the SEC �The registration statement discloses all material information concerning the corporation making a public offering Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

3. Print prospectus �The prospectus is a legal document describing details of the issuing corporation and the proposed offering to potential investors �Contains much of the information in the registration statement �The preliminary prospectus is sometimes called a “red herring” Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

4. Present road-show �The road-show is presented to institutional investors around the country �The road-show allows firms to raise interest in the company and thus the price �Allows the firm and its underwriters to gather information from potential purchasers Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

5. Price the securities � How much to charge for giving away a part of the firm is very important to the issuers � The securities are priced based on the value of the company and expected demand for the securities � Examples of valuation methods: Net Present Value Earnings/Price ratios

6. Sell the securities � A full-fledged selling effort gets under way on the effective date of the registration statement � A final prospectus must accompany the delivery of securities Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

IPOs and the “dot com” bubble � One of the most spectacular times for IPOs was 1998– 2001 when hundreds of internet firms came to market. � This period is known as the ‘dot com bubble’ � Two of the leading investment banks involved in the IPOs were Merrill Lynch, with its lead analyst Henry Blodget Morgan Stanley Dean Witter whose lead analyst, Mary Meeker, briefly acquired the title of ‘Queen of the Internet’. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

IPOs and the “dot com” bubble � Double. Click. com came to the market at $8. 50 a share on 20 February 1998 and rose to $85. 63 a share by 25 May 1999, giving it a market capitalization of $6. 73 billion based on revenue of $156 million and losses of $21 million! � etoys. com came to the market at $20 a share and peaked at $85 a share, giving it a market capitalization of $8. 4 billion based on sales of $24 million and losses of $53 million! � Webvan. com raised $375 million in its IPO, had a market valuation of $1. 2 billion at its peak but went out of business in July 2001. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

IPOs and the “dot com” bubble � netj. com, raised $3 million from its IPO and its share price rose from $0. 50 to $7 giving it a market capitalization of $47 million despite its IPO filing specifically stating: ‘The company is not currently engaged in any substantial business activity and has no plans to engage in any such activity in the foreseeable future’. � In plain English this means: ‘We do nothing and we intend to continue to do nothing!’

The Buying and Selling of Shares � Short Selling: The process of borrowing a security and selling it in the hope of buying it back at a lower price. � The ability to sell short is important to the pricing of shares as it affords investors who feel a share is overvalued the opportunity to profit from that viewpoint. � If such investors were excluded from the market then there would be an upward bias in share prices, because shares would only be held by people who were optimistic about the share. � There a number of ways in which a share can be sold short – one is when an investor requests his broker to borrow the shares from an existing holder and the stock is then on-sold to a buyer. � The seller subsequently ‘covers’ his position by purchasing the shares at some future date (hopefully at a lower price) for delivery to the party that lent the stock. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Buying and Selling of Shares Example: Mr. A believes that shares in company XYZ are currently overvalued at £ 10. He seeks to take advantage of an expected price fall. He instructs his borrower to short sell 2000 shares at £ 10 on his behalf. The broker will borrow 2000 shares from Mr. B to deliver to the buyer of the shares and the broker receives £ 20, 000 on Mr. A’s account. When the price falls to £ 8, Mr. A can advise his broker to buy 2000 shares for £ 16, 000 on his behalf and he makes £ 4, 000 profit (less commission and fees). Obviously if Mr. A is wrong, and share price rises, he will incur a loss. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

A Rights Issue � The issuance of new shares by an existing listed company to raise new finance. � The shares are offered to current shareholders first in proportion to the number of shares that they own. � Shareholders can transfer their rights to a third party. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Figure 9. 2 The pricing of the rights issue Current Price is: P 1 Firm issues new stock: S moves to S 2 New Price: P 2, which is below P 1. Tendency to sell new issues at a price below the equilibrium price, say at P 3 Underpricing: all of the issue is taken up and thus the risk to underwriters is minimized (and this should be reflected in lower underwriting fees). Overpricing: some of the stock is likely to remain with the underwriters, fall in the share price, adverse effect on the company, making it harder to raise additional capital in the future.

Does the Performance of the Stock market matter? � If the firm is seen to be inefficient and its profitability is low, its share price will be depressed and it will a potential takeover. � Takeover: A situation in which an acquiring company makes a bid for a target company. � A hostile takeover ensues if the acquired company resists the takeover. � A friendly takeover occurs if the target company welcomes the bid. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Pricing of Equities � Holders of ordinary shares /common stock expect to make a return from their investment in two ways. A stream of dividends during the holding period An increase in the value of shares (capital appreciation) during the holding period � There are different approaches to valuing equities which will be explained in the following slides. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Dividend Pricing Approach � The value of future income streams, in this case dividends, are discounted to yield the formula for equity prices. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Dividend Pricing Approach � If dividend payments and the discount rate are fixed: Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Gordon Growth Model � Gordon(1962) assumes that dividends will grow by a certain growth rate of g percent per annum. Difficult(? ) mathematical proof Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Gordon Growth Model � According to Gordon Growth Model, there are three factors that are crucial to the price of equities. The previous dividend payment made by the firm, or the forthcoming dividend The expected growth rate of dividend made by the firm The required rate of return demanded by the market In the special case, when g=0, Gordon model reduces to: Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Example � Current share price: 140 pence � The last dividend: 10 pence � Dividend growth rate: 8 % (g=0. 08) � Required rate of return on the share : 15% (R=0. 15) � As the current share price is 140 pence, the share seems to be undervalued and it is recommended for a purchase. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Non-constant Growth Model � Example: The last year dividend: 10 pence � Dividend growth rate for the next three years 12%, and 7% for the following two years. � Thereafter dividend growth is assumed to slow for the foreseeable future to a 3%. � Current share price: 125 pence � Should they be recommended for purchase? � The relevant dividend growth formula: Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Non-constant Growth Model � The relevant dividend growth formula: Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Non-constant Growth Model Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Dividend Irrelevance Theorem � According to the Dividend Pricing Approach, an increase in the current dividend or the next period dividend lead to an increase in the share price. � A firm can reduce its dividend but use the retained earnings for investment, which mean higher dividend growth in the future (a higher g). � Modigliani and Miller (1958, 1961) show that under certain assumptions, reductions in dividends lead to systemically higher values of g, leaving share prices unaffected. � Hence, the required rate of return and dividend growth rate are the fundamental determinants of a share price. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Measurement of the Required Rate of Return � Judgmental Risk Premium Basis R=Real Interest Rate + Expected Inflation Rate + Risk Premium R=Nominal Rate of Interest + Risk Premium � The Gordon Growth Model Estimate of R Required rate of return can be derived using the Gordon growth model � The Capital Asset Pricing Model Estimate of R The required rate of return [R] is equal to the risk-free rate of interest [R*] plus a multiple of the market risk premium as represented by the share’s beta coefficient: Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Forecasting Future Dividends Business Risk: Profits are more volatile than sales. The risk that company profits will fall by more than sales. Example A company has fixed costs of £ 1 million (regardless of whether any sales are generated) and variable costs of £ 10 for each unit produced and sold at £ 20, . It will break even on sales of 100, 000 units when the sales revenue equals £ 2 million. If the sales revenue rises by 10 per cent to £ 2. 2 million, profits become £ 100, 000. If the sales revenue rises a further 10 per cent to £ 2. 42 million profits more than double to £ 210, 000. Small percentage rises or falls in sales lead to much bigger percentage changes in profits. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Primary Gearing Effect: � Primary gearing is the ratio of a company’s debt to its equity. � The greater the debt-to-equity ratio of a firm, the more of a firm’s earnings to be devoted to debt payment, the less money is available for stock holders. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Effect of Primary Gearings on Net Earnings � Two companies have similar outstanding liabilities. � Company B has a higher gearing than company A. � Each company has to pay 10% interest on its debt from its earnings before interest. � Net Earnings=Earnings before Interest-Interest Payments on Debt � Maximum dividend with the more highly geared company B are more variable (0 to 20 pence) than for the lower-geared company A (2. 5 to 17. 5 pence). Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Table 9. 2 The effect of primary gearing on net earnings Highly geared companies have more volatile dividends Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Effect of Primary Gearings on Net Earnings � The relation between the expected return on equity and a company’s gearing: � p: Expected rate of profit � r: Interest rate payable on debt � D: Outstanding debt � E: Value of equity with (p > r) the expected rate of return on equity varies positively with the company’s gearing (D/E) Thus, highly geared companies will tend to offer a higher rate of return However, the higher gearing implies a greater volatility of expected return and a greater risk of bankruptcy. � Standard deviation of the expected rate of return on equity – � Standard deviation of rate of profit: Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Table 9. 3 The effect of primary gearing on equity returns The rate of return on equity is less variable for different rates of profit the lower the level of primary gearing. Although higher gearing increases the return on equity with good profitability, it also has the effect of increasing losses on equity if the rate of profitability is low. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Effect of Primary Gearings on Net Earnings � The relevant formula for the proportion of profits absorbed by interest is: � Using the formula above, and assuming initial rate of profit as 15%, it is seen that as the level of gearing rises, the proportion of profit taken up by interest payments rises. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The effect of interest rates and primary gearing on profits Highly-geared companies are more vulnerable to interest-rate rises than lower-geared companies. As the level of gearing rises, then so too does the proportion of profit taken up by interest payments. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Financial Ratios Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Table 9. 5 Analysing a company’s financial performance Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Example for Financial Ratios Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Example for Financial Ratios Earnings per share/return on equity: The advantage of this measure is that companies with high- and low-dividend policies are on a more equal footing; low-dividend payers tend to have higher share prices and high payers tend to have lower share prices; the earnings per share figure is unaffected by the dividend policy. Return on capital employed (ROCE): This is a commonly used ratio looking at the percentage return on total capital used by the firm. A firm that is earning less than, say, the risk-free rate of interest would be regarded as a very poor performing company since it would do better to exit the industry and invest its capital in Treasury bonds. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Example for Financial Ratios Dividend yield: it is viewed as important since it shows the income accruing to the investor during the holding period. Dividend yields are normally reported before income tax is applied so that the investor can make comparisons with the yield on alternative investments such as government bonds. Disadvantages The major problem with the dividend yield is that it ignores the capital gain accruing to the investor as a result of any price rise in the share. Another factor that has to be borne in mind is that dividend yields are very much a function of the dividend policy pursued by the company’s management; some companies pay out a higher ratio of dividends as a proportion of earnings than others. Also, the dividend yield reported in the Financial Times is based on the last year’s dividend, whereas investors are generally more interested in prospective dividends and yields. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Example for Financial Ratios Price–earnings ratio (P/E): it shows the degree to which investors value a company as a multiple of last years’ earnings. A price–earnings ratio of 10 means that anyone contemplating a takeover would have to pay at least 10 times the last reported earnings. A high ratio in relation to other companies in the sector means that the firm is being highly valued by the market for some reason other than its current earnings, possibly strong future earnings growth is expected, making its shares popular. Conversely, a low price–earnings ratio in relation to other companies in the sector means that the firm is relatively cheap, possibly because its future earnings performance is expected to be relatively poor. Such a company may be vulnerable to a takeover bid. Disadvantages It can be calculated in various ways; for instance it can be based on the last 12 months’ data or calculated on an average basis over, say, 5 years. Great caution has to be taken in using price–earnings ratios to compare companies, especially those in different sectors of the economy. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The PEG ratio Superior to PE ratio ? � Price–Earnings to Growth ratio (PEG): � This corrects the PE ratio for a company’s growth rate � Say we have two companies with PE ratios of 10 � Company A is growing at 5% whereas Company B is growing at 20% � Company has a PEG ratio of 10/5 = 2 which is expensive � Company B has a PEG ratio 10/20 = 0. 5 which is cheap � In general companies with a PEG below 1 are thought of as relatively good value whereas companies with PEG ratio above 1 are relatively cheap and worth buying. � In this case Company B seems better value than Company A even though both have the same PE ratio Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Risk Ratios The higher the ratio the lower the financial risk facing the firm. A firm with a high ratio has more chance of meeting its obligations with respect to financing debt than a firm with a low ratio. Often called debt coverage. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Other Comparative Valuation Ratios Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Usefulness for Financial Ratios Useful for comparative assessments between firms. Such comparisons tend to be more useful between firms in the same industry. Provide a useful summary of key financial data and enable comparisons with the industry average. Can be used as an additional tool along with formal pricing models of shares to determine if a company’s stock is over- or undervalued. Problems: Different companies use different methodologies to calculate their net profits and have different reporting years, making valid comparisons quite difficult. Some allowance also needs to be made for firm size; it can be unreasonable to expect firms of differing sizes to conform to similar financial ratios. No scientific weighting system exists to suggest which are the most important in determining the likely success or failure of a company. Many analysts tend to focus more on trends in a company’s financial ratios than its current financial ratios. The past is not necessarily a guide to the future. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Chartism and Technical Analysis Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Conclusions � Stockmarket an important role in matching risk taking companies with risk taking investors. � Firms have to decide the optimal level of debt to equity finance. The advantage of equity is that you do not have to pay dividends. But the investors have to be compensated for the risk of non payment with a higher expected rate of return. � There is no scientific formula that gives you an appropriate price of the share of a company. But fundamental determinants are expected rate of return, earnings growth, dividends and required rate of return. � Financial analysis can be a useful tool, however, it is an art rather than a science and can prove a useful supplement to dividend discount type models. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition