1. CHAPTER 9
SHARE VALUATION 1

2. Chapter outline Introduction Ordinary shares and preference shares
The development of stock exchanges
Defining value
Share valuation
Expected return and required return
Market efficiency
Conclusion

3. Learning outcomes By the end of this chapter, you should be able to:
differentiate between ordinary shares and preference shares
distinguish between par value, book value, market value and economic (intrinsic) value
explain the importance of share valuation
determine the intrinsic value of a share using discounted cash flow techniques
calculate and interpret four prominent financial ratios used to determine the relative value of a share
differentiate between the expected and required rate of return
explain what is meant by an efficient market.

4. Introduction
Concept of an acceptable return and other important topics
Primary goal of financial management is to maximise shareholder’s wealth
Shares represent investors’ ownership of the productive assets of businesses

5. Ordinary shares and preference shares
Ordinary shareholders become owners of productive assets
Have the right to elect a board of directors
Have a pre-emptive right to purchase additional shares
Preference shares
No voting rights at AGM
Receive preferential treatment when it comes to distribution of profits and assets in liquidation
Normally offer a fixed annual rate of dividend

6. Preference shares Cumulative Non-cumulative Participating Convertible
Dividends that have not been paid in a particular period will accrue
Non-cumulative
Do not entitle shareholders to missed dividends
Participating
Allows higher dividend if company performs better then expected
Convertible
Allows shares to be converted into a predetermined amount of ordinary shares
Redeemable
Shares can be called back by issuing company at stated maturity date

7. Defining value
Value is defined differently by different users of financial information
Par value
the arbitrarily assigned value of a share
the value at which a share is issued in the primary market
Market value
the current price of a share
established by means of demand and supply in the financial markets

8. Defining value Book value Economic (intrinsic) value
the value of a share as reflected in the financial statements of the company
it usually differs from market value
Economic (intrinsic) value
determined by discounting future cash flows (dividends) using an appropriate discount rate

9. Discounted cash flow techniques
Intrinsic value of a share can be calculated:
Where:
= intrinsic value of a share
D1 = the expected dividend paid at the end of period 1
D2 = the expected dividend paid at the end of period 2
Dn = the expected dividend paid at the end of period n
rs = required rate of return

10. Discounted cash flow techniques
Formula can be simplified depending on the expected growth rate in dividends
Variables are estimated based on the basis of a fundamental analysis of macro, market and micro factors
Three scenarios can be considered in this regard:
zero dividend growth
constant dividend growth
variable dividend growth

11. Zero dividend growth
This dividend pattern is typical of preference shares where D0 = D1 = D2 = …= D
D0 is the most recent dividend paid and D1 represents the expected dividend in the next period
The intrinsic value of a share can now be calculated:

12. Example 9.2
The Chatterbox Company has issued 7% preference shares with a par value of R100 each. If investors require an 11% return, what is the intrinsic value of these preference shares?
Note: required return = discount rate

13. Constant dividend growth
Due to the signaling effect associated with the payment of dividends, some companies prefer to offer investors steadily increasing dividends
In this case dividends are expected to grow at a constant rate
There are two ways in which to compute future dividends:
D1 = D0(1+g)1; D2 = D1(1+g)1; D3 = D2(1+g)1
OR: D1 = D0(1+g)1; D2 = D0(1+g)2; D3 = D0(1+g)3

14. Constant dividend growth
Based on the assumption of constant dividend growth, we can find the intrinsic value of a share:

15. Constant dividend growth
Constant growth model often called the Gordon model after its developer
Benefit of this technique is the expected price of a share can be determined at any future point:
The value at any future point is simply the NEXT dividend divided by (rs – g):
Two important assumptions when using this DCF technique is that D1 > 0 and g < rs

16. Example 9.3
The PrePaid Technologies Company has just paid an ordinary dividend of R1,15 and dividends are expected to grow at a constant growth rate of 8% indefinitely. Investors require a rate of 13,4% on investments of similar risk. What is the intrinsic value of this company’s shares?

17. Variable dividend growth
The Gordon model is not suitable in cases where dividends fluctuate widely or where dividends are not paid for a few years (which is often the case for start up companies)
In this situation we need to use the variable dividend growth technique which consists of two or more dividend growth periods

18. Variable dividend growth
The process of finding the intrinsic value can be broken down into five steps
Calculate the dividends during the supernormal growth period.
Calculate the present value (PV) of supernormal growth dividends.
Determine the value of all the constant dividends that will occur after the supernormal growth period.
Determine the PV of the constant dividends after the supernormal growth period.
Get the sum of all the PVs (i.e. those calculated in steps 2 and 4).

19. Example 9.5
The Konia Company has just paid a dividend of R5 per share. Investors anticipate that dividends will grow at 30% for the next three years because of the successful launch of a new cellular product. Thereafter, dividend growth will decrease to 10% forever. If investors required a 20% rate of return, how much would they be willing to pay for one Konia share (i.e. what is the intrinsic value of the share?)

20. Example 9.5 Identification of the variables:
Current dividend (D0) = R5
Supernormal growth rate (g1) = 30% for three years
Constant growth rate (g2) = 10% per year forever thereafter
Required rate of return (rs) = 20%

21. Example solution

22. Example solution
Step 1: Calculate the dividends during the supernormal growth period
Year 1: D1 = D0(1 + g1) = 5 × (1 + 0,3) = 6,50
Year 2: D2 = D1(1 + g1) = 6,50 × (1 + 0,3) = 8,45
Year 3: D3 = D2(1 + g1) = 8,45 × (1 + 0,3) = 10,99

23. Example solution
Step 2: Calculate the PV of supernormal growth dividends
FV = 6,50; n = 1; i = 20; compute PV = 5,42
FV = 8,45; n = 2; i = 20; compute PV = 5,87
FV = 10,99; n = 3; i = 20; compute PV= 6,36
Total PV of supernormal dividends: 17,65

24. Example solution
Step 3: Determine the value of all the constant dividends that will occur after the supernormal growth period
In this case, the supernormal period ends after three years and constant growth starts in year 4. Therefore, we need to find P3 

25. Example solution
Step 4: Determine the PV of the constant dividends after the supernormal growth period
PV of what you calculated in step 3
FV = 120,89; n = 3; i = 20; compute PV = 69,96
Step 5: Get the sum of all the PVs (i.e. those calculated in steps 2 and 4)
17, ,96 = R87,61

26. Example answer
Would prospective investors be interested in purchasing shares in the Konia Company if the market price per share is R89?
No! Based on their estimates of future dividends and the riskiness of the company, Konia shares are only worth R87,61 each.
Konia’s shares are overvalued 

27. Relative valuation techniques
In addition to DCF techniques, investors can also use financial ratios
These evaluate the market value of a share relative to some accounting measures, such as earnings per share, cash flow, sales or book value
The most important include the
Price : Earnings ratio
Price : Book ratio

28. Price : Earnings ratio
Shows how much investors are willing to pay per rand of reported earnings
Although this technique has some flaws, it is widely used to compare companies to competitors in the same sector
A higher P:E ratio is generally favoured

29. Example 9.6
Calculate and interpret the P:E ratio for the Wireless Communication Company:
Net profit after tax = R
Number of shares issued = 50m
Current market price = R23
EPS = ÷ = 2,33
P:E ratio = 9,83 times
Interpretation: Current market price per share of the company is 9,83 times larger than the company’s last reported EPS. Investors are thus willing to pay R9,83 for every R1 of reported earnings.

30. Price : Book ratio This ratio is calculated as follows:
For healthy companies the P:B should exceed one

31. Example 9.8
Calculate and interpret the P:B ratio for the Wireless Communication Company:
Ordinary shareholders’ equity = R
Number of shares issued = 50m
Current market price = R23
Book value per share = 18,72
P:B ratio = 1,23 times
Interpretation: The current market price per ordinary share is 1,23 times larger than the book value per ordinary share.

32. Expected return and required return
The Gordon Model can be rearranged to find the expected rate of return on a share:
Expected return = dividend yield plus capital gains yield

33. Example 9.9
Investors are interested in purchasing ordinary shares in the Cell P Company. Shares are currently priced at R80. The last dividend paid by the company was R2 per share and dividends are expected to grow at a constant rate of 5% per year. What is the return that investors expect to earn should they invest in these shares?

34. Example answer
If investors require an 8% return on these shares to compensate them for the investment risk they are taking on, should they invest?
No! The expected return earned on Cell P’s shares (7,63%) is less than the required rate of return (8%). So they are not adequately compensated for taking on investment risk.

35. Expected return and required return – decision rules
If expected return > required return, intrinsic value > market value, which implies that investors should buy the share, as it is undervalued
If expected return < required return, intrinsic value < market value, which implies that investors should not buy the share (or sell it if you own it), as the share is overvalued

36. Market efficiency In an efficient market
share prices react quickly to new information
prices are in equilibrium:
market values = intrinsic values
expected rates of return = required rates of return
no gains can be made by investors who engage in fundamental and/or technical analysis

37. Market efficiency (cont.)
Empirical tests have been undertaken to establish if market are:
Weak form efficient
Semi-strong form efficient
Strong form efficient
Most financial markets, including the JSE, is weak form efficient
Implications for fundamental analysts?
Technical analysts?

38. Conclusion
Ordinary and preference shares are the main types of financial securities traded on the JSE. Although both types of shares represent equity capital, they have distinct characteristics.
The main differences between ordinary and preference shares relate to the voting powers of shareholders, as well as their claims on the assets and profits of the company.
Stock markets originated in the Middle Ages and have become very sophisticated markets that facilitate the transfer of funds between borrowers and lenders.

39. Conclusion (cont.)
There are several definitions of value. We have concentrated on par value, market value, book value and economic (intrinsic) value.
Various models can be used by financial mangers, shareholders, prospective investors and other stakeholders to determine the intrinsic value of a share. The two main approaches are the discounted cash flow approach and the relative valuation approach.

40. Conclusion (cont.)
When using the discounted cash flow approach analysts need to estimate future dividends and may use one of three techniques to find the intrinsic value of the share. These include the zero dividend growth, constant dividend growth and variable dividend growth techniques.
When using the relative valuation approach analysts generally evaluate financial ratios, which compare the market value of a share relative to certain accounting measures, such as earning, cash flow, sales or book value.

41. Conclusion (cont.)
Investors should only purchase the shares of a company when the expected return exceeds the share’s required return. If the expected return is less than the required return, the share is overvalued and should not be purchased.
In efficient markets the expected returns of companies equal the required returns and change very quickly when new information about a company is made public.