VALUATION OF SHARES AND DEBENTURES
Refer to your textbook, CHAPTER 8, pg. 164 – 180 Financial Management is South
Africa, 3rd Edition, J Marx, C de Swardt, M Beaumont Smith, P Erasmus.
1. THE VALUATION OF ORDINARY SHARES
When investing in shares, shareholders expect a return for the risk they
incur. They expect dividends and an increase in the share price.
To maximise wealth, investors are interested in buying undervalued
shares (economic value is greater than market price) and selling them
once they become overvalued. (market price is more than the economic
value). Because ordinary shares never mature (expire), today’s value is
the present value of an infinite (never-ending) stream of cash flows.
Ordinary shares are not annuities because the amount of the dividends
the shareholder receives are not fixed.
2. SELF-STUDY: PG 170 THE BELOW THEORY
It is important that any stock exchange be done as efficiently as
possible, since it is the buyers and sellers that determine the market
price of shares.
Market efficiency relates to the flow of information that affects share
prices. 3 types of market efficiency:
• Strong from of market efficiency – share price reflects all
information of every kind.
• Semi-strong form of market efficiency – share prices reflect all
public information.
• Weak form of market efficiency – current price of share reflects
its own past prices.
LET US KNOW LOOK AT THE 3 DIVIDEND MODELS TO VALUE
SHARES
3. THREE MODELS TO FIND THE PRESENT VALUE OF FUTURE
DIVIDENDS
NB: MOST RECENT DIVIDEND = D0, NEXT YEAR’S DIVIDEND = D1
A. Zero Growth
Assumes a constant dividend stream. No increase or decrease in
dividends.
D1
P0 = /ks
Where:
P0 = value of ordinary share at time period zero, today
D1 = dividend per share expected at the end of year 1
ks = required rate of return on ordinary shares
LET’S REFER TO EX. 8.4 ON PG. 171
B. Constant growth model (Gordon Model)
Assumes that dividends will grow at a constant rate, g.
Valuation Equation:
P0 = D1/ks-g
Where:
P0 = value of ordinary share at time period zero
D1 = the dividend payable at end of 1st year.
ks = the required rate of return
g = constant dividend growth rate
LET’S REFER TO EX. 8.5 ON PG. 171
C. Variable Growth
Allow for changes in dividend growth rate.
Follow the below steps:
1. Calculate the cash dividends at end of each year during the
initial growth phase. (Multiply the dividend by the growth rate).
2. Calculate the present values of the cash dividends in Step 1
and then add up the PVs for the initial growth phase.
3. Find the value of the share at the end of the initial growth phase
by applying the constant growth model to the next phase.
4. Add the values in Step 2 and 3 to get the total value of the
share.
LET’S REFER TO EX. 8.6 ON PG. 171
4. THREE OTHER APPROACHES TO VALUE ORDINARY
SHARES:
A. Use of the price/earnings (P/E) ratio
Value per share = normalised EPS x P/E ratio
See eg. Pg 175
B. Discounting dividends and the expected share price
Step 1:
Estimate the required return (ks) by using the Capital Asset
Pricing Model where:
Ks = Rf + B(km – Rf)
Where:
Ks = requires rate of return of an ordinary share
Rf = the risk-free rate of return (say on the RSA 150 stock)
B = beta is a measure of co-movement in the share price in
relation to other shares listed on the stock exchange.
Km = the market return
Step 2:
Discount future dividends to the present value using ks as the
discount rate.
Step 3:
Calculate the estimated selling price per share using the P/E
ratio method. Discount the estimated selling price to a present
value using ks as the discount rate.
Step 4:
Add Step 2 and Step 3 to determine the intrinsic value per
share.
C. Net Asset Value
total asset – total liabilities
NAV =
number of issued shares
If NAV is greater than MARKET price, shares are trading at a
discount.
If NAV is less than MARKET price, shares are trading at a
premium.
See eg pg. 175.
SELF-STUDY
5. PREFERENCE SHARES (not in text book)
Owners of preference shares receive a fixed income during the
investment period. The return comes in the form of dividends, not
interest.
Most preference shares are perpetuities (carries on indefinitely), like
ordinary shares. Because the preference dividend doesn’t grow, we
apply the zero-growth model.
VALUATION OF PREFERENCE SHARES
Following the same basic valuation model.
D
VP = /kp
Where:
VP = value of preference share at time period zero
D = annual dividend
Kp = required rate of return on preference shares
