FINS1612 – SUMMARIES

Week 4 – Equity Markets 2 Investors in the Share Market

1/6 Share Market Investment:

Why buy shares? To received returns from dividends and capital gains (…or losses)

Other encouraging factors;

o Depth of the market – overall capitalisation of corporations listed on the SX

o Liquidity of the market – volume of trading relative to size of the market

o Efficient price discover – speed at which information enters the market and is absorbed into the current share price.

Risk;

Systematic Risk Market influences (economic growth, interest rate, exchange rate, politics)

o What cannot be diversified away is called ‘Beta’ – a measure of the sensitivity of the price of an asset relative to the market (positive or negative)

Unsystematic risk – Firm influences (deposition of CEO, board problems)

o Diversified portfolios contain a wide variety of securities and hence diversifies away most of the unsystematic risk of individual securities.

Investors receive no risk premium for unsystematic risk.

Expected return:

The weighted average of expected returns of each share

Portfolio variance ( = risk) is the correlation of pairs of securities within the portfolio.

Security types:

The wide variety listed on the SX are categorised into industry groups, allowing investors a choice from a range of economic sectors.

Investment approaches;

Active investment approach – Portfolio structure based on analysis, new information and risk-return preferences. High brokerage costs from continual portfolio changes.

Passive investment approach – Replication of a specific share-market index (by sector)

o Some managed funds are index funds (structured to fully/partly replicate a specific share-market index)

Asset allocation considerations;

o Risk vs. Return

o Investment time horizon

o Income vs. capital growth

o Domestic vs. International Shares

Note that asset allocation may be strategic (personal risk profile) or tactical (market risk and influence)

2/6 Buying and Selling Shares:

Direct investment in shares

o Investor buys and sells shares through a stockbroker.

Stockbroker can be discount broker (only provide intermediary service)

Full-service advisory broker (Fees considerably higher)

o Consideration is of liquidity, risk, return, (CHARGES), taxation, social security etc.

Indirect investment in shares

o Investor purchases units in a trust fund or managed fund (such as an equity trust).

o Fees are generally higher than direct investment

3/6 Taxation:

Prior to 1987 (PRE-dividend imputation system)

o Dividends were taxed twice – first at the company level (as profits) and then at the investor’s marginal rate

POST-Dividend imputation (1987);

o Removed the double taxation of dividends

o Investors now receive franking credits for the tax a company pays on a franked dividend.

Capital Gains Tax (CGT)

o Prior to 19-9-1985 it was tax free

o From 19th September 1985 to the 21st September 1999 the tax payers marginal tax rate was applied if held for less than 12 months.

The tax payers marginal rate applied to the indexed capital gain if held over 12 months.

o SINCE 1999;

There is a 50% discounted gain if held at least 12 months OR

Indexed capital gain OR 50% discounted gain if purchased between 1985 and 1999

4/6 Financial Performance Indicators:

Investors are concerned with the future level of a company’s performance because it affects both the profitability of the company and the variability of the cash flows.

The indicators include;

o Capital structure:

Proportion of company assets (funding) obtained through debt and equity.

¥ Usually measured by debt to equity ratio (D/E ratio)

o Higher debt increases financial risk of not being able to meet interest payments (accounting for industry norms though)

¥ Also measured by proprietorship ratio = ratio of shareholder’s funds to total assets.

o This indicates a firm’s longer term financial viability/stability. A higher ratio indicates less reliance on external funding.

o Liquidity;

Ability of a company to meet short term financial obligations

¥ Current ratio = Current assets (Maturing within one year) / Current liabilities (due within one year) – NOT the best indicator

¥ Liquid ratio

Current assets – inventory (stock on hand) / Current liabilities – bank overdraft.

o Debt servicing;

Ability to meet debt-related obligations i.e interest and repayment of debt.

Measured by debt to gross cash flow ratio

¥ Indicates number of years of cash flow required to repay total firm debt.

Also measured by interest coverage ratio.

¥ Earnings before finance lease charges, interest and tax / finance lease charges and interest. (generally should be 2 or above)

o Profitability;

Wide variation exists in the definition and measurement of profitability;

¥ EPS;

¥ EBIT to total funds ratio;

o EBIT/ Total funds employed (shareholder’s funds and borrowings)

¥ EBIT to long term funds ratio;

o EBIT/ Long-term-funds (total funds less short term debt)

¥ ROE (Return on equity);

o Net income / equity (shareholders’ funds)

o Share Price;

Represents investors’ view of the PV of the future net cash flows of a firm

Performance indicators of share price include;

¥ Price to Earnings (P/E) ratio (higher is more growth in future NCF)

o Share price divided by EPS

¥ Share price to net tangible assets ratio (P/NTA)

o Measures the theoretical premium or discount at which a firm’s share price is trading relative to its NTA

o Risk

Variability (uncertainty of the share price)

¥ Recall systematic vs. non-systematic risk

5/6 Pricing of Shares:

This is a function of the supply and demand for a share.

o This, in turn, is influenced by the information available about the share.

Therefore new information that changes investor’s expectations about any of the elements of the formula will result in a change in the share price.

o Hence the formula for the price of a share is;

Shares – Valuation (The maths)

As with bonds, the price of the stock is the present value of these expected cash flows

An example would be holding a share for 3 years in which the dividends are are 2, 2.10 and 2.205 and at the end of year 3 the share price is 15.435. R-ROR is 20% - what would you be willing to pay?

Shares – Valuation of Dividends (The maths)

Constant dividend (Zero Growth):

The firm will pay a constant dividend forever

Price is computed using the perpetuity formula;

o

Constant dividend growth ( Gordon’s Growth Model ):

The firm will increase the dividend by a constant percent every period

o Relationship between current and future dividends (D0 is original);

For example :

Share pays a constant dividend of $1 and has a R-ROR of 10% with semi-annual compounding.

1/0.05 = $20

Non-Constant dividend:

Dividend growth is consistent initially, but settles down to constant growth eventually

o Let us take an example of a share that is offering a dividend next year of $1.20 which is expected to grow at 20% for the next 2 years and then 5% thereafter. The R-ROR is 10%.

Solving for R:

Estimating the Growth Rate (g):One approach is to derive dividend growth from a firm’s earnings

o Payout Ratio (The percentage that dividends per share makes up of total earnings per share)

o Return on Equity (ROE) The rate that the retained profit is reinvested at.

This assumes

o The payout ratio is stable

o The estimated ROE is stable

How dividends are paid:

o

Declaration date – company managers meet and make announcement on how much regular dividends will be

Ex dividend date (Cum-dividend in between) – to avoid problems with changing ownership close to record date, 4 days before is set as the time which anyone buying shares before is entitled to the dividend.

Close of business on record date, list of shareholders is drawn up and all appearing on list will receive dividend

On payment date, actual dividend is sent (usually 2 months after ex-dividend date)

Alternatives to cash dividends?

Bonus Issue ‘Payment made by a firm to its shareholders in the form of additional shares’

¥ The effect of this is;

o Increase number of shares outstanding

o Decrease per-share price

o Decrease EPS

o Decrease dividends share price

Proportion of total shares each shareholder owns is not affected

For example, if someone owns 200 shares and a 1-for-20 share issue occurs, this holder will have a proportional increase, as will all other shareholders and so will still own the same proportion afterwards.

¥ Used to constrain a firm’s share price

o Because dividend increase is matched to firm’s earning increase over the same period.

Share Split‘Each share is split-up to create new shares’

¥ This increases the number of shares outstanding

o For example in a 3-for-1 stock split, each share in circulation becomes 3 shares.

Per share price decreases

EPS decreases

Shareholder wealth not affected

o 10 Shares at $10 is the same after a split to make 20 shares at $5 each.

¥ Typically used to reduce exorbitantly increasing share price

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Share splits and bonus issues can decrease liquidity – lower priced shares harder to sell, higher transaction costs (proportionally)

Share splits and bonus issues can increase liquidity – large numbers of shares can reduce transaction costs

Reverse Split‘Reverse of share split – numerous old shares combined for fewer new shares’

¥ For example, in a 1-for-2 reverse split, investors trade two old shares for one new share

o PPS increases

o EPS increases

Once again, total shareholder wealth not affected

¥ The reasons for this are;

o Reduce transaction costs

o Improve liquidity and marketability of stock as price is raised to popular trading range

o Improve firm respectability

o Comply with stock exchange listing requirements of minimum PPS

o To buy out any shareholders with small shareholdings and hence save on admin costs.

Pro-rata rights issue;

¥ This involves an increase in the company’s issued capital

¥ Typically issued at a discount to the market price

¥ The market price will fall by an amount dependent on the’

o Number of shares issued

o Size of the discount.

¥ A renounceable right is a right that can be sold before it is exercised.

o The value of this right is given by;

Share repurchase/ Buyback‘Firm uses cash to buy back own shares’ (Legal on ASX since 1989)

¥ Only shareholders willing to part with shares will received cash being offered by the firm.

¥ The effect of this is;

Reduce number of shares, Increase PPS, Increase EPS

¥ Can be done through;

o Open market (Normal course of trading on stock exchange)

o Tender offer to shareholders (written offer to existing shareholders)

o Targeted repurchase (Written offer to specific shareholders)

¥ Assuming a perfect capital market, share buybacks do not effect shareholder wealth.

o Shareholders should be indifferent between a cash dividend and a share repurchase.

o For example;

¥ Assume a company is seeking to distribute $800,000 excess cash to shareholders with the choices of a cash dividend or share buyback?

¥ Assume also that the earnings for distribution are 1,000,000 and the number of shares is 400,000 and the MV of equity is 20,000,000. EPS is 2.50, PPS is $50 and P/E ratio is 20.

¥ Option 1 would see a dividend per share of (800,000/400,000) = $2Ergo share price is (50-2)=$48 EPS is unchanged. P/E ratio is now (48/2.50) = 19.2

o Shareholder Wealth = $48 share + $2 dividend = $50

¥ Option 2 would see A buyback of (800,000/50) = 16,000 shares. Hence shares left is (400,000-16,000) = 384,000. Hence share price is equal to (20,000,000-800,000/384,000) = $50. EPS is now (1,000,000/384,000) = $2.60. P/E ratio is 50/2.6 = 19.2

o Shareholder Wealth = $50 share

Why?

¥ Advantages;

o Financial flexibility to respond if earnings change

o Shareholders have more choice

o Alter capital structure if too much equity, large changes quick and cheap.

o Signal to the market (implies shares are undervalued - strength)

o Taxes

¥ Disadvantages;

o Shareholders may have preference for cash dividends (clientele)

o May view as negative signal (forced by poor investment opportunities)

o If price needed to be bid up for purchase, firm may pay too much for own shares. This will decrease share price in long run and disadvantage remaining shareholders.

o Uninformed shareholders can be treated unfairly and may take legal recourse in the future.

6/6 Stock-market Indices and Published Share Information:

¥ Measures of the price performance of a share market or industry sector, eg;

o Performance Benchmark Index

Measures overall share-market performance and risk based on capitalisation and liquidity; typically around 75 to 90% of all the market.

o Tradeable benchmark index

A narrow index used as the basis for pricing certain derivative products. (stocks in this index are usually very stable)

o Market indicator index

Measure of overall share-market performance or a select group of stocks which indicate the measure of the market.

Price-weighted (Down Jones etc) – Weighting of a company proportional to its share price

Capitalisation-Weighted (S&P/ASX All Ords) – Weighting of a company proportional to market capitalisation.

o Research classification of FTSE, Nikkei 225, Hang Seng.

GICS (Global industry classification standard) comprises 10 standard international industry sector indices,e.g ENERGY, MATERIALS, INDUSTRIALS.

Published share information;

Newspapers and financial journals provide share-market information to varying degrees of detail

o Eg; Australian Financial Review.

Share-price index measures capital gains/losses from investing in an index-related portfolio

Whereas;

Accumulation index includes share price changes and reinvestment of dividends