How do you value Ordinary Share?
The market value of a share is the present value of all expected net cash flows to be received from the share, discounted at a rate of return that reflects the riskiness of those cash flows.
The expected net cash flows to be received from a share are all future dividends.
Dividend growth is an important aspect of share valuation.
Share valuation is more difficult than bond or debenture valuation for a number of reasons:
- uncertainty of promised cash flows
- shares have no maturity
- observing the market return (to determine the discount rate) is not easy
What are the 2 models to value shares?
1. Dividend valuation model
Market price =PV of all expected of shares future cash flows (dividends)
Note:
Even if you sell your shares at period t, the selling price at that point in time is the PV to the buyer of all expected future cash flows - dividends.
Consequently, we can ignore the receipt of cash at the point of sale and treat the price of shares simply as the PV of all expected dividends.
A share can have no growth (perpetuity or commonly known as preference share), constant growth (growing perpetuity) or uneven growth
Price of share can be calculated by:
A) No Growth:
P0 = d / r
where d is your dividend and r is the required rate of return
B) Constant Growth:
P0 = d1/ (re-g)
where d1 is the expected dividend per share for the next disbursement, re is the required rate of return for equity and g is the constant growth
What happens if g > re?If g > re, get negative stock price, which is not possible.
We can’t use model unless (1) g < re (2) g is expected to be constant forever.
Because g must be a long-term growth rate, it cannot be > re
C) Uneven growth
contact us if you have difficulty
2) Price earnings model
A technique used to estimate the firm’s share value
Calculated by multiplying firm’s expected earnings per share by the P/E ratio (often the average P/E for the industry)
P/E ratio reflects amount investors are willing to pay for each dollar of earnings (mkt price/EPS)
share value = expected earnings x P/E
Practice Questions:
1) M. Ltd is expected to retain 40% of its expected earnings per share of $1. If dividends are expected to grow at 10% p.a. and the required rate of return is 20%, what is:
a) the P/E ratio?
b) the price per share?
2) The directors of Bishop Ltd have provided you with the following information:
Expected earnings per share next year - $1.50
Shareholders required return - 22%
Proportion of expected earnings per share that is to be retained in the firm - 6%
Growth rate in earnings per share - 6%
Required:
(a) Compute Bishop Ltd’s price/earnings ratio.
In simple terms, what does this ratio tell you?
In simple terms, what does this ratio tell you?
(b) Compute Bishop Ltd’s share value using the price/earnings ratio calculated in (a)
hi
ReplyDelete