1. Chapter 2 What does the share price tell us?
Corporate Financial Strategy 4th edition
Dr Ruth Bender
Chapter 2 What does the share price tell us?

2. What does the share price tell us? Contents
Learning objectives
The share price reflects market expectations
Different variants of the P/E ratio
The P/E ratio and market perceptions of growth
The dividend growth model
The Ansoff matrix and growth strategies
Share prices, growth and steady state
Steady state
PVGO and strategies for achieving required growth
What does the share price mean?

3. Learning objectives
Understand how the P/E ratio should change with market expectations of growth and risk.
Distinguish between different versions of the P/E ratio and determine which is most relevant for your needs.
Appreciate how the theoretical construct of steady state is derived from the dividend growth model.
Calculate and interpret the present value of growth opportunities (PVGO) inherent in a company’s share price.
Calculate the expected eps growth built into a company’s share price.

4. The share price of a company reflects the market’s expectations of growth and risk

5. Different calculations for price/earnings ratio
P/E ratio = Share price ÷ eps
Basic eps
Actual earnings ÷ average shares in issue
This is the default figure to use
Diluted eps
Actual earnings ÷ increased shares in issue
Use if dilution is inevitable and already priced in
Adjusted eps
Adjusted earnings ÷ average (or diluted) shares in issue
Use if the adjustments are valid
Historic eps
Taken from the financial statements.
Useful because it is audited
Of less use as the year progresses
Prospective eps
Based on analysts’ consensus, or your own forecast
Use as the year progresses, as share prices are forward-looking

6. Figure 2.1 P/E ratio and market perceptions of growth
Earnings per share
High plc
Low plc
Current eps
Time
Assuming risk is the same, we can say that the market expects higher growth from High plc than from Low plc

7. Dividend growth model

8. Figure 2.2 The Ansoff matrix and growth strategies
Products
Existing
New
Existing
Market penetration
(1)
Product development
(2)
Markets
Market development
(3)
Diversification
(4)
New

9. Share prices, growth, and steady state
At steady state:
growth is zero
D1 = D2 = … Dn
full payout of earnings
Therefore: P/e = 1/Kess ; Kess = eps/P
(This is ONLY true at steady state)
Steady state value of share
= eps/Kess ; or eps x p/ess
Current price less SS value = PVGO

10. Steady state Present value of growth opportunities (PVGO)
Current eps E1
Perpetuity value of earnings
Time
Share price
eps

11. Figure 2.3 PVGO and strategies for achieving required growth
P1 = current share price
Eps growth based on Quadrants 2-4 of Ansoff matrix
Share price relating to successfully getting new customers/products
Share price relating to extending the current strategy
Eps growth based on Quadrant 1 of Ansoff matrix
Current eps E1
P0 = Value of share that relates to current eps
Time
Share price
eps

12. Why does the share price matter?
A high price is seen as a sign of success.
A high price is seen as a sign of the strength of the underlying business.
Share price is often used as a proxy for performance.
A high share price is the best protection against takeover.
Raising future capital becomes easier if the price is high, as fewer shares have to be issued, and the existing investors are well disposed to the company already.
Shareholders expect a growing share price.
Share price is often used as a metric for calculating management bonuses.
Management have share options, which only have value if the share price rises.
A high share price improves morale, particularly if employees own shares.
There is a strong correlation between power, influence, and company size.