Pricing Shares A Caggia M Armanini Financial Investments

Pricing Shares A. Caggia, M. Armanini Financial Investments & Pricing 2015/2016 1

Stocks(Shares) n n n Stocks or shares represent the participation of an individual in the activities of a company in the role of share-holder, involving some «risk capital» . ¨ Nominal value ¨ Book value ¨ Market value The cash flow generated by the assets of a company pay debt obligations and tax first and the remaining goes to equity. Residual Claim characteristic. 2

Ordinary Shares n Ordinary shares are the most commonly traded shares, and they give you a vote in company matters. n They earn a dividend as long as the company is earning money, and this dividend directly corresponds to the profit made by the company. High profits mean high dividends for you. n Ordinary shares have no special rights or restrictions. Whilst they have the highest risk, they also have the potential to bring the biggest financial gains. 3

Preferred Shares n n In direct contrast to common shares, these shares are given preference when it comes to dividend payments. More importantly, if a company goes bankrupt, these shares are paid back before common shares. The shareholders of preference shares, however, do not enjoy normal voting rights. Dividends of preference shares have a fixed rate, and therefore provide more security, but this means that if the profits of the business increase, the value of preference shares remains the same. Low risk but only moderate returns. 4

Share valuation (I) n In order to determine the value today of a share, just like in any other financial instrument, we must estimate the PV of its future cashflows n Shares involve two possible cashflows. . . 1. Dividends: received by share-holders at regular intervals 2. Market price: received at the time the share-holder decides to sell its share in the company 5

Share valuation (II) n n n A share is a financial instrument without a predefined maturity (perpetual) Its price therefore must be calculated from the infinite series of future dividends or cash flows to equity However, the exact value of these future dividends is unknown. Some simplifications are thus used: (a) constant dividends (b) constant interest rates 6

Dividend Discount Models: General Model V 0 = Value of Stock Dt = Dividend k = required return 7

Dividend Discount Models: No Growth Model Stocks that have earnings and dividends that are expected to remain constant Preferred Stock 8

Dividend Discount Models: No Growth Model (Example) E 1 = D 1 = $5. 00 k =. 15 V 0 = $5. 00 /. 15 = $33. 33 9

Dividend Discount Models: Constant Growth Model g = constant perpetual growth rate 10

CAPM: a way to calculate K (Re) n n Assumption: the return of a single stock is related to the return of the market index The relationship according to CAPM is K=Rf+Beta*(Rm-Rf)=Re ¨ Where ¨ K or Re expected return of the single stock (equity) Rf risk free rate Beta correlation coefficient Rm expected return of the market index ¨ ¨ ¨ 11

Security Market Line n Slope rm-rf

Look for Alfa

Beta as a function of Risk Premia n Beta=(Re-Rf)/(Rm-Rf)

Share Valuation (III) n n n The value of the equity of a company could be calculated as the difference between the total value of the company and its debt. This methodology implies an estimate of the future cash flows generated by the business of the company This cash flows are then discounted at weighted average cost of capital The value of the debt is then subctracted and the resulting number represent the value of equity This methodology is considered the most accurate and needs a deep understanding of the company in order to model its business 15

Stockmarkets 16

Stockmarkets n n n The primary market is the market where securities are created The secondary market is one in which they are traded among investors. Knowing how the primary and secondary markets work is key to understanding how stocks trade. 17

Primary market n n n The primary market is the one in which a security is first issued Companies use the primary market to raise capital If a company decides to issue securities in order to raise short- or long-term capital, it enters the money or capital market as an issuer Companies can issue different kinds of securities: shares, bonds, debt securities, warrants etc The proceeds from issuing shares constitute or increase the company's equity capital. Issuing a bond constitutes or increases its debt capital 18

Primary market n n n In a first step, securities such as shares and bonds are placed directly with investors or indirectly via banks If trading on a stock exchange is desired (secondary market), among other things, this involves the duty to publish a prospectus, the subscription period and the lodging of a listing application with the stock exchange When a joint-stock company goes public, the first share issue is called the Initial Public Offering (IPO) 19

Secondary market n n The secondary market is the market in which securities are traded on the stock market In the secondary market, companies are not in search of capital You as an investor deal with other buyers and sellers of securities This is where actual stock-exchange trading takes place. All traded securities are public and available to everyone. 20

Secondary market n n In order for a security to be traded on the Exchange, the company has to successfully complete the issuing process and meet various requirements set out in the Listing Rules In order to remain listed, issuers have to carry out certain duties such as publication of pricesensitive data. This is why news about listed companies is published in the media on an almost daily basis 21

Secondary market n n n The national exchanges are secondary markets and includes the New York Stock Exchange (NYSE), Nasdaq and all major exchanges around the world A market where investors purchase securities or assets from other investors, rather than from issuing companies themselves If you go to buy IBM stock, you are dealing only with another investor who owns shares in IBM (the company) is in no way involved with the transaction 22

Auction vs Dealer Markets n n The secondary market can be further broken down into two specialized categories: Auction Market and Dealer Market The difference between these two market systems lies in what is displayed in the market in terms of orders and bid and ask prices The Auction Market is an “Order Driven” market and displays all of the bids and asks The Dealer Market is a “Quote Driven” market and focuses only on the bids and asks of market makers and other designated parties 23

Quote Driven Market n n n Participants are joined through electronic networks The dealers hold an inventory of the security in which they “make a market” The dealers then stand ready to buy or sell with market participants These dealers earn profits through the spread between the prices at which they buy and sell securities Nasdaq is a dealer market: here the dealers (market makers) provide firm bid and ask prices at which they are willing to buy and sell a security The theory is that competition between dealers will provide the best possible price for investors 24

Order Driven Market n n n In the auction market, all individuals and institutions that want to trade securities announce the prices at which they are willing to buy and sell These are referred to as bid and ask prices An efficient market should prevail by bringing together all parties and having them publicly declare their prices The best price of a good need not be sought out because the convergence of buyers and sellers will cause mutuallyagreeable prices to emerge The biggest advantage is its transparency: it clearly shows all of the market orders and what price people are willing to buy at or sell for NYSE is an auction market 25

Market Order Book n n n An order book is the list of orders (manual or electronic) that a trading venue (in particular stock exchanges) uses to record the interest of buyers and sellers in a particular financial instrument A matching engine uses the book to determine which orders can be fulfilled i. e. what trades can be made Market orders: ¨ At market ¨ Limit order (create the order book) ¨ Stop loss / Take profit order ¨ Vwap order … 26

Market Order Book 27

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Extraordinary Events n n A company could increase its capital by: 1. Free capital increase 2. Paid capital increase (with or without prehemption rights) 3. A mixture of the two Listed stocks could be subject to takeover offers 1. There are strict stockmarkets rules in case of takeover offers aimed at protecting minority shareholders 2. The price of shares might be strongly influenced by takeover activities 30

Teoretical Ex Right Price n 31