Valuation of Ordinary Shares
Any shares that are not preferred shares and do not have any predetermined dividend amounts. An ordinary share makes up equity ownership in a company and ennobles the owner to a vote in matters put in front shareholders in ratio to their percentage ownership in the company.
Ordinary shareholders are ennobled to get dividends if any are available after dividends on preferable shares are paid. They are to a very great extent entitled to their share of the residual economic value of the company should the business unwind, on the other hand, they are last in line after bond holders and preferable shareholders for getting business proceeds. As such, ordinary shareholders are regarded unsecured creditors. To a very great extent known as "common stock".
A company's shares may be classified as
(a) Ordinary or Equity shares and
(b) Preference shares.
The returns these shareholders get are called dividends. Preference shareholders bring forth a preferential treatment as to the payment of dividend and repayment of capital in the upshot of winding up. Such holders are entitled for a fixed rate of dividends.
Some important attributes of preference and equity shares.
Dividends:
Rate is fixed for preference shareholders. They can be given cumulative rights, that is, the dividend can be compensated off after accumulation. The dividend rate is not fixed for equity shareholders. They alter with an increase or decrease in profits. During years of big profits, the management may announce a high dividend. The dividends are not accumulative for equity shareholders, that is, they cannot be accumulated and distributed in later years. Dividends are not taxable.
Claims:
In the consequence of the business closing down, the preference shareholders have a prior claim on the assets of the company. Their claims shall be decided first and the balance if any will be paid off to equity shareholders. Equity shareholders are remainder applicants to the income and assets of the company.
Redemption:
Preference shares have a maturity date on which day the company pays off the face value of the share to the holders. Preference shares can be of two
types - irredeemable and redeemable. Irredeemable preference shares are perpetual. Equity shareholders have no maturity date.
Conversion:
A company can issue convertible preference shares. After a specific period as remarked in the share certificate, the preference shares can be changed over into ordinary shares.
People hold common stocks for two reasons - to obtain dividends in a timely mode and to get a higher sum of money when sold. in general, shares are not held in perpetuity. An investor purchases the shares,holds them for some time during which he acquires dividend and finally sells it off to acquire capital gains. The value of a share which an investor is willing to pay is linked with the cash inflows countered and risks associated with these inflows. Intrinsic value of a share is linked with the earnings and profitability of the company, dividends compensated and countered and future definite prospects of the company. It is the economical assessment of a company regarding its nature of business, investment environment and characteristics.
Dividend Capitalization Model
When a shareholder purchases a share, he is actually buying the stream of future dividends. thus the value of an ordinary share is decided by capitalizing the future dividend stream at an set aside rate of interest. To a very great extent under the dividend capitalization approach, the value of an equity share is the discounted present value of dividends experienced plus the present value of the marketing price countered when the share is cast away. Two presumptions are made to apply this approach:
Dividends are compensated annually. First payment of dividend is brought in after one year the equity share is purchased.
Single period valuation model
This model accommodates well when an investor holds an equity share for one year. The cost of such shares will be:
P0= D1 + P1
(1+Ke) (1+Ke)
Where P0=Current market price of the share
D1=countered dividend after one year
P1=countered price of the share after one year
Ke=requisite rate of return on the equity share
instance : The share of Gammon India Ltd. is countered to touch Rs. 500 one year from now. The company is countered to declare a dividend of Rs. 30 per share.
P0=D1/(1+Ke) + P1/(1+Ke)
{30/(1+0.15)} + {500/(1+0.15)}
=26.09 + 434.78
=Rs. 460.87 is the price he is willing to pay today
Multiple Period Valuation Model:
An equity share can be held for an vague period as it has no maturity date, in case the rating of a price at time zero is:
P0=D1/(1+Ke) 1 + D2/(1+Ke)2 + D3/(1+Ke) 3
+.................+ D∞/(1+Ke) ∞
Or P0=∑ ∞ t=1 Dn {(1+Ke) n }
Where P0=Current market price of the share
D1=countered dividend after one year
P1=countered price of the share after one year
D∞=countered dividend at infinite duration
Ke=requisite rate of return on the equity share.
The above equation can also be altered to find the value of an equity share for a finite period.
P0=D1/(1+Ke) 1 + D2/(1+Ke) 2 + D3/(1+Ke) 3 +...........+ D∞/(1+Ke) ∞
+ Pn/(1+Ke) n = P0=∑ ∞ t=1 Dn/{(1+Ke) n } + Pn/(1+Ke) n
We can come across three instances of dividends in companies:
- Changing growth rates of dividends.
- Constant growth of dividends
- Constant dividends
Valuation with constant dividends:
If constant dividends are compensated year after year, then
P0=D1/(1+Ke) 1 + D2/(1+Ke) 2 + D3/(1+Ke) 3 +...........+ D∞/(1+Ke) ∞
Simplifying this we obtain P=D/Ke
Valuation with variable growth in dividends:
Some business firms may not have a constant growth rate of dividends indefinitely. There are periods during which the dividends may grow super normally, that is, the growth rate is higher when the demand for the products of company is very high. After a certain period of time, the growth rate may fall to normal levels when the returns fall due to fall in demand for products (with competition setting in or due to availability of substitutes). The cost of the equity share of such a firm is determined in the following manner:
Step 1. Expected dividend flows during periods of super normal growth is to be believed and present value of this is to be computed with the following equation:
P0=∑
∞
t=1 Dn/(1+Ke)
n
Value of the share at the end of the initial growth period is computed as:
Pn=(Dn+1)/(Kegn) (constant growth model). This is discounted to the present value and we have received:
(Dn+1)/(Kegn)*1 / (1+Ke)
n
Add both the present value composites to find the value P0 of the share, that is, P0=∑
∞
t=1
Dn/(1+Ke)
n
+ (Dn+1)/(Kegn)*1/(1+Ke)
n
Step III: P0=∑
∞
t=1 Dn/(1+Ke)
n
+ (Dn+1)/(Kegn)*1/(1+Ke)
n
There are different approaches to valuation of shares based on the Ratio Approach.
Book value approach:
The book value per share is the net worth of the company divided by the number of outstanding equity shares. Net worth is represented by the sum total of compensatedup equity shares, reserves and surplus. Alternatively, this can also be computed as the amount per share on the assets sale of the firm at their exact book value minus all liabilities letting in preference shares.
Price Earnings Ratio (PE):
The price earnings ratio indicates the amount capitalists are reluctant to pay for each one rupee of earnings.
Expected EPS = (Expected PAT) - (Preference dividend) / No. of
outstanding shares.
Expected PAT is based on number of elements like sales, gross profit margin, depreciation and interest and tax rate. The P/E ratio is also to consider factors like stability of earnings, growth rate, company management team, dividend payout ratio and company size.
P/E ratio = (1-b) / r-(ROE*b)
Where 1-b is dividend pay out ratio
r is requisite rate of return
ROE*b is countered growth rate.
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