CORPORATE FINANCE & FINANCIAL STRATEGIES

Week 4: Equity Markets and Stock Valuation

Instructor: Dr. Sanjukta Brahma
Institution: Glasgow Caledonian University (GCU)
Focus: University for the Common Good

Topics Covered

1. UK Capital Market & Listing Requirements

2. Dividend Discount Model (DDM)

3. Determinants of Share Value & Underlying Assumptions

4. Valuation by Comparables: P/E Multiple

5. Contribution of Growth to Firm Value

6. Market Efficiency & Random Walk Theory

Additional Reading

• Brealey, R.A., Myers, C.A., & Marcus, A.J. (2020). Fundamentals of Corporate Finance. 10th ed. New York: McGraw-Hill – Chapter 7

• Bodie, Z., Kane, A., & Marcus, A.J. (2011). Investments and Portfolio Management. 9th edition, New York: McGraw-Hill. – Chapter 22

• Hillier, D., Clacher, I., Ross, S., Westerfield, R., & Jordan, B. (2017). Fundamentals of Corporate Finance. 3rd edition, New York: McGraw-Hill. – Chapter 7

Funding Across Company Life Cycle

• Start-up Phase:

  • Sources include savings, funds from friends and relatives, angel investors, venture capital, private sales of shares, and local banks.

• Growth Phase 1 & 2:

  • Funding from venture capital, asset-based loans or leases.

  • Initial Public Offering (IPO) can be used.

• Maturity Phase:

  • Funding through money-center banks, asset-based loans and leases, commercial paper, bond issues, and follow-on share issues.

Types of Equity

1. Ordinary Shares (Common Stock)

   • Entitled to dividends and share of net asset value post creditor payments.

   • Carry voting rights and can influence company management changes.

   • Dual-class shares are available, offering varying voting rights.

2. Preference Stocks (preffered stocks)

   • These shares provide a fixed dividend before ordinary shares receive any dividends.

   • Holders do not have voting rights and have a priority over ordinary shareholders but lower than debt holders.

UK Listing Requirements

• Financial Conduct Authority (FCA) Requirements:

  1. Published audited accounts for at least three years.

  2. Expected market value of securities listed should be at least £30 million for both premium and standard listing segments on the Main market.

  3. A minimum of 10% of shares must be made available to the public.

• Alternative Investment Market (AIM):

  • Designed for smaller, growing firms that do not meet all the aforementioned listing criteria.

Distribution of Companies by Equity Market Value (London Stock Exchange, Sep 2022)

• Market Value Range (GBP):

  • £0-25 million: 263 companies

  • £25-100 million: 364

  • £100-250 million: 125

  • £250-500 million: 252

  • £500-1000 million: 180

  • £1-2 billion: 117

  • £2-5 billion: 132

  • £5-10 billion: 54

  • £10-50 billion: 84

  • Over £50 billion: 26

Dividend Discount Model (DDM)

• Core Principle:

  • The value of a share is the present value of expected future cash flows (dividends).

  • The equation:
    P0 = rac{D1}{1 + r} + rac{P_1}{(1 + r)}
    Where:

  • P_0 = intrinsic value of the share

  • r = required rate of return (discount rate)

  • D_1 = expected dividend at year-end

  • P_1 = expected share price at year-end.

Holding Period Return

• The yield from holding the stock over a period (1 year baseline in this discussion) is given by the holding period return (HPR).

• Rearranged form of DDM can provide the value of the holding period return formula:
  HPR = rac{D + P1 - P0}{P_0}

Dividend Discount Model - Example

• A share is expected to pay £2 in dividends next year, with an expected price of £53.

• Given a required rate of return of 10%, determine:

  1. Fair (intrinsic) value of the share

  2. Holding Period Return

• If market price is £49, is the share underpriced or overpriced?

  • Conclusion: Share is underpriced since Market Price < Intrinsic Value.

  • Holding period return exceeds the required return indicating a profitable investment opportunity.

Dividend Discount Model for Multiple Periods

1. Specific Investment Period:
   P0 = rac{D1}{(1 + r)} + … + rac{DN + PN}{(1 + r)^N}
   Where N is the time period of the investment.

2. Infinite Investment Period:

   • Later dividends contribute relatively less to the share value as per the discounting principle.

Gordon Constant Growth Model

• Assumptions:

  1. All investments are financed entirely from retentions (i.e., no external borrowing).

  2. The retention ratio (b) is constant.

  3. The rate of return on firm investments (i = ROE) remains constant.

  4. Cash flows from investments yield constant perpetuation.

  5. The rate of return on existing assets does not change over time.

Example using the Gordon Constant Growth Model

• For ABC plc with an expected EPS of £4 and a dividend payout of 50%, if the required rate of return is 14% and the dividend growth rate is 6%, calculate the intrinsic value. - Using the formula: P_0 = rac{DPS}{r - g} where:

  • DPS is the Dividend per Share

  • g is the growth rate

  • Ensure: g < r for appropriate evaluation.

Multistage Dividend Growth Model Illustration

• Growth rate transitions from a high temporary growth to a lower sustainable growth:

  • Short-term fast growth, logical for the initial years followed by a transition to a sustainable growth rate.

  • Project dividends and discount them back to present value.

Two-Stage Growth Model Example

• Example of Rivendell plc with dividends growing at 10% for 5 years followed by 3% indefinitely.

• Required rate of return is 12%.

• Calculation approach involves determining present values for each dividend segment separately and adding them together to yield total share value.

Valuation by Comparables: Price-Earnings Ratio

• Analysts commonly use multiples like P/E to estimate firm value.

• The P/E ratio calculated as:
  P/E = rac{ ext{Price}}{ ext{Earnings per Share (EPS)}}

• This ratio can be applied to firms with similar risk/growth characteristics or derived from major competitors.

P/E Ratio Example

• Given PepsiCo's stock price of $72.62 & EPS of $3.80, derive Coca-Cola's share value using its EPS of $1.65.

P/E Ratio and Growth Opportunities

1. Realization: Growth adds value only if i > r, where i is return on investments and r is the cost of capital.

2. Significant effects observed when altering retention ratios (b) and ROE on P/E and share price.

   • A higher retention ratio can lead to increased P/E and hence higher share price, while reduced ROE negatively impacts both metrics.

Stock Valuation vs. Efficient Market Hypothesis (EMH)

• Investors use valuation models to identify mispriced stocks for potential advantage.

• EMH posits that all available information is reflected in market prices, asserting a generally efficient market condition where one cannot consistently achieve superior returns.

Efficient Market Theory

1. Weak Form Efficiency: Prices reflect all historical info, discouraging technical analysis.

2. Semi-Strong Form Efficiency: Prices encompass all publicly available information, discounting fundamental analysis.

3. Strong Form Efficiency: Prices reflect all information, public and private, effectively negating insider trading.

Random Walk Simulation

• Coin toss or random events model can be analogously plotted against stock index movements to demonstrate the unpredictability of stock price movements.

Conclusion

• Understanding equity market operations, valuation methodologies, and the implications of growth and risk is pivotal in corporate finance practices.

• Concepts like DDM, comparables, and market efficiency offer foundational knowledge for assessing stock investments.