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PD Hahn 1

Principles of FinanceBS 2100

EQUITIES

Pete HahnFaculty of Finance

Room 5012

Cass Building

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What is equity?

Is it?1) Ownership?

2) Control?

3) What about the other providers of capital? (i.e.Debt, Suppliers)?

4) ???

PD Hahn 2

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Topics Covered

Review Bonds

• How Common Stocks (also “Ordinary Shares”) are Traded 

• How Common Stocks are Valued

• Estimating the Cost of Equity Capital

• Stock Prices and EPS

• Valuing a Business by Discounted Cash Flows

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PD Hahn 4

Stocks & Stock Market

 Auction Markets & Dealer Markets

Over-the-counter

Indices

Mutual Funds

Exchange Traded

Funds

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Listing of Shares

• Firms initial listings (or offerings of shares) are often

completed… (An IPO for example)» In a home market (same country – offers familiarity)

» In the market which offers new shareholders the greatest

liquidity» Some countries do not have developed equity markets

(with desired liquidity ) and their companies may choose

other markets (e.g. London for metals, HK for luxuries)

• Firms may also CROSS LIST their shares on additional

markets to increase their investor base (e.g. New York,Tokyo, Singapore).

» Make sure that you always study firms in their home market intheir reporting currency.

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Stocks & Stock Market

• Common Stock - Ownership shares in a publicly heldcorporation.

• Secondary Market - market in which already issued

securities are traded by investors.

• Dividend - Periodic cash distribution from the firm to theshareholders.

• P/E Ratio - Price per share divided by earnings pershare.

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Stocks & Stock Market

• Book Value - Net worth of the firm according to the

balance sheet.

• Liquidation Value - Net proceeds that would be realizedby selling the firm’s assets and paying off its creditors. 

• Market Value Balance Sheet - Financial statement that

uses market value of assets and liabilities.

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PD Hahn

Preferred Shares

Preferred shares are a hybrid between debt

& equity

• Pay a fixed dividend (which may be omitted)

• Generally, dividends must be paid before ordinary

(or common) share dividends

• Equity on the balance sheet• Don’t vote like ordinary shares 

• Other specific factors.

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PD Hahn 9

Valuing Common Stocks

Expected Return - The percentage yield that an

investor forecasts from a specific investment

over a set period of time. Sometimes called the

market capital izat ion rate . 

Expected Return    r    Div P P   P 

1 1 0

0

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*IMPORTANT*

The Expected Return of Investors is also known as

 THE COST OF (Equity) CAPITAL

to the firm raising funds.

In this case it is the cost of equity capital. The Cost ofCapital to the firm can change through the use of debt.

You can study this in detail in Company Valuation next term. 

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Valuing Common Stocks

Example: If Fledgling Electronics is selling for €100 per

share today and is expected to sell for €110 one year

from now, what is the expected return if the dividend one

year from now is forecasted to be €5.00?

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Valuing Common Stocks

 Another Example: You purchase an ownership

share in Liverpool FC for £50,000, they were

almost relegated (bad).  In one year you expect

Liverpool to return as cup champion and pay youa dividend of £3,000. You think you will be able

to sell your share for £58,000 at that time. What

is your expected return?

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Valuing Common Stocks

The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

Expected Return   

r   Div

 P 

 P P 

 P 

1

0

1 0

0

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0 P   =  1 Div

1

(1+r )+

  2 Div2

(1+r )+.....+   H  Div   +

 H  P  H 

(1+r )

Valuing Common Stocks

Dividend Discount Model – Calculation of today’s stock price which

states the share value equals the present value of all expected future

dividends and the eventual selling price.

 H = time horizon of your investment 

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Valuing Common Stocks

Example

Current forecasts are for XYZ Company to paydiv idends  of $3, $3.24 , and $3.50  over the next

three years, respectively. At the end of threeyears you anticipate selling your stock at amarket price of $94.48 . What is the price of thestock given a 12% expected return ?

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PD Hahn 16

Valuing Common Stocks

Example

Current forecasts are for XYZ Company to pay dividends of $3,$3.24, and $3.50 over the next three years, respectively. At the endof three years you anticipate selling your stock at a market price of$94.48. What is the price of the stock given a 12% expected return? 

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PD Hahn 17

Valuing Common Stocks

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Valuing Common Stocks

Return Measurements

0

1

P

Div YieldDividend  

Sharey PerBook Equit

EPS

 EquityonReturn

 ROE 

 ROE 

 g  P  Divr 

 g r 

 Div P 

0

1

1

0 Restated

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Valuing Common Stocks

If we forecast no growth, and plan to hold our

stock indefinitely, we will then value the stock as

a PERPETUITY.

 Perpetuity P   Div

r or 

 EPS 

r  0

1 1

Assumes all earnings are

 paid to shareholders.

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PD Hahn 20

Valuing Common Stocks

Constant Growth DDM - A version of the dividend

growth model in which dividends grow at a

constant rate (Gordon Growth Model).

Is anyth ing constant forever?

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Deriving the Growth Rate

….... given minor algebraic manipulation. 

 g  P 

 Divr 

 g r 

 Div P 

0

1

10RatetionCapitaliza

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Valuing Common Stocks

Example  If a stock is selling for $100 in the stock market, whatmight the market be assuming about the growth individends? [Assume investors want 12% for their

return and a $3.00 dividend at end of the year]

$100  $3.

..

00

1209

 g  g 

 Answer

The market is assuming

the dividend will grow at9% per year, indefinitely.

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PD Hahn

Decisions &Earnings IncreaseDividend MaintainDividend Cut Dividend Non-Payers First TimePayers

  Full Sample   N  808 549 74 130 33 22

% 100.0% 67.9% 9.2% 16.1% 4.1% 2.7%

  Earnings Increase 470 366 32 51 18 3

58.2% 45.3% 4.0% 6.3% 2.2% 0.4%

  Earnings Decrease 325 183 42 79 15 6

40.2% 22.6% 5.2% 9.8% 1.9% 0.7%  No Earnings History 13 13

1.6% 1.6%

  Net Losses   N  93 31 14 28 15 5

% 100.0% 33.3% 15.1% 30.1% 16.1% 5.4%

“Whilst 79.2% of listed US firms were shown not to pay regular dividends,

the equivalent in the UK was 25.5% (Benito and Young (2001)).”  

Culture, Reinvestment, Dividend Decisions? Growth?

Source: P.D.Hahn, Doctoral Dissertation 2008.

Are techno logy and grow th companies welcome in the UK?

[Large UK Company Dividends 1998-2004] 

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PD Hahn 25

Valuing Common Stocks

If a firm elects to pay a lower dividend, and

reinvest the funds, the stock price may increase

because future dividends may be higher.

Why?

Payout Ratio - Fraction of earnings paid out as

dividendsPlowback Ratio - Fraction of earnings retained by

the firm. Also the reinvestment rate.

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PD Hahn 26

Valuing Common Stocks

Growth can be derived from applying the

return on equity to the percentage of

earnings plowed back into operations.

g = return on equity X plowback ratio

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Valuing Common Stocks

ExampleOur company forecasts to pay a $8.33 dividendnext year, which represents 100% of itsearnings. This will provide investors with a 15%

expected return. Instead , we decide to plowback 40% of the earnings at the firm’s  currentreturn on equity of 25%. What is the value of thestock before and after the plowback decision?

Think: you w ant 15% and the f i rm can earn 25%, wh ere should the cash go?

Can or how lon g w i l l the f irm g row i f i t pays out al l earnings ?

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PD Hahn 28

Valuing Common Stocks

Example

Our company forecasts to pay a $8.33 dividend next year, whichrepresents 100% of its earnings. This will provide investors with a15% expected return. Instead, we decide to plow back 40% of theearnings at the firm’s current return on equity of 25%. What is the

value of the stock before and after the plowback decision?

56.55$15.

33.80    P 

 No Growth With Growth

00.100$10.15.

00.510.40.25.

0  

 P 

 g 

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Valuing Common Stocks

Example - continuedIf the company did not plowback some earnings, thestock price would remain at $55.56. With the

 plowback, the price rose to $100.00.

The difference between these two numbers is calledthe Present Value of Growth Opportunities (PVGO).

44.44$56.5500.100    PVGO

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Valuing a Business or Project

The value of a business or Project is usually

computed as the discounted value of FCF outto a valuat ion ho rizon (H).

The valuat ion ho r izon is sometimes called theterminal value and is calculated like PVGO.

 H 

 H 

 H 

 H 

r 

 PV 

r 

 FCF 

r 

 FCF 

r 

 FCF 

 PV  )1()1(...)1()1(   2

2

1

1

FCF = free cash flow or the potential dividend

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Valuing a Business

Valuing a Bus iness o r Project  

 H 

 H 

 H 

 H 

r 

 PV 

r 

 FCF 

r 

 FCF 

r 

 FCF  PV 

)1()1(...

)1()1(   2

2

1

1

PV (free cash flows) PV (horizon value)

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PD Hahn 33

Valuing a Business

Example  

Given the cash flows for Concatenator Manufacturing, calculate the

PV of near term cash flows, PV (horizon value), and the total valueof the firm. r=10% and g= 6% 

[hint: horizon starts Y6+]  

Year

1 2 3 4 5 6 7 8 9 10

Asset Value $ 10.00 12.00 14.40 17.28 20.74 23.43 26.48 28.07 29.75 31.54

Earnings $ 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.37 3.57 3.78Investment $ 2.00 2.40 2.88 3.46 2.70 3.05 1.59 1.68 1.79 1.89

Free Cash Flow $ -0.80 -0.96 -1.15 -1.38 -0.21 -0.23 1.59 1.68 1.79 1.89

Earnings Growth 20% 20% 20% 20% 20% 13% 13% 6% 6% 6%

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Valuing a Business

Examp le - continued  Given the cash flows for Concatenator Manufacturing Division,calculate the PV of near term cash flows, PV (horizon value), andthe total value of the firm. r=10% and g= 6% 

  4.2206.10.

59.1

1.1

1 value)PV(horizon

6 

  

  

6.3

1.123.

1.120.

1.139.1

1.115.1

1.196.

1.1.80-PV(FCF)

65432

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Valuing a Business

Examp le - continued  Given the cash flows for Concatenator Manufacturing, calculate thePV of near term cash flows, PV (horizon value), and the total valueof the firm. r=10% and g= 6% 

$18.822.4-3.6

 value)PV(horizonPV(FCF)s)PV(busines

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Sources of Equity Finance

• Varies By Country (e.g.)• USA – was mostly retail (individuals) but now more

funds and institutional

• UK – traditionally mostly institutions (insurance andpension), but now more foreign

• We discussed public equity…. 

• There are also sources of private equity… 

 – these investors do not value short-term liquidity(specialist funds)

 – Sovereign Wealth Funds

 – Others

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Topics Covered

• How Common Stocks are Traded

• How Common Stocks are Valued

• Estimating the Cost of Equity Capital

• Stock Prices and EPS

• Valuing a Business by Discounted Cash Flows

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The Big Quest ion:

The UK rescued Royal Bank of Scot land and Lloyds Banking

Group throug h equi ty infusion s (share purchases) in 2008 at

50.2p and 73.6p, respectively.

HM Treasur y sees an opp ortu nity fo r ful l repayment in late 2013 to

2014 if the shares reach the 50.2p and 73.6p levels. Can thi s be

correct?