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Chapter 4: Capital Markets (II)

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Characteristics of Company Shares

Shares represents the ownership of a partof a companyTwo types of shares:

Common shares (ordinary shares or equities)Preferred shares

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Shareholders have the right to vote to electBoard of Directors, to decide on matters of great importanceShareholders are entitled to share in profitsgenerated by the firm

Firms may pay fixed proportion of their profits asdividends => dividends depend on profitability

Firms may smooth the dividend payments byletting them grow steadily over time => dividendsfinally still depend on profitability

If the firm flourish and grow, value of shares

will increase

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Drawbacks of share ownershipDividends depend on the firms earnings => canvary or even cease if the firm run into long-rundifficultyIf the firm goes bankrupt, shareholders will bepaid after creditors (owners take risk of operation). If the firm is insolvent, shareholdersequity = Assets Liabilities < 0 => shareholdersget nothing

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Bond versus StockBonds StocksBond owners are creditors Stockholders are owners of the

companyCreditors generally do not havevoting rights

Stockholders have voting rights

Interest payments are often fixed,

not dependent on profitability

Dividends are dependent on

profitabilityInterest payments is taxdeductable

Dividends are not tax deductable(from after tax profit)

If company cannot pay back debt,

creditors can push for assetliquidation or reorganization

The same action is not possible for

stockholders

If the company go bankrupt, bondowners will be paid first

Equity is a residual claim (paid bythe remaining amount, after payingto all creditors)

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Preferred Stocks

Preferred stocks: Pay fixed dividends andin that sense are like a bond. Thedividends, however, may not be paid if the

company incurs loss or low profitsPreferred stockholders are owners andtheir dividends are not tax deductable

Preferred stockholders rank behindbondholders but before commonstockholders

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Preferred Stocks

Cumulative preferred shares: Unpaiddividends are cumulated and becomepayable when earnings permitConvertible preferred shares: Carry rightsto convert to ordinary shares on specifiedterms and at specified times

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Understanding Share Price Data

Information on share priceNewspapers such as Financial Times and WallStreet JournalStock exchanges websitesWebsites of investment banks, financialinstitutions

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Understanding Share Price Data

2009

Telecommunications Price Change High Low Yield P/E Vol.000s

Cable and Wireless 142 -0.50 170 125.1 6.2 22 21,246

(1) Name of the firm

(2) Latest price (in pence). In newspapers, this is previous days price

(3) Price change from the previous days close price

(4) Highest price so far during the year

(5) Lowest price so far during the year

(6) Dividend yield = Latest dividend/Current price

(7) P/E = Price/EPS

(8) Trading volume

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Coca Cola Stock

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Oil and Gas London Stock Exchange

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Pricing of Company Shares

Fundamental analysis: The explanation of an assets value by reference to itspotential earnings and riskTechnical analysis: The explanation of anassets value by the study of past pricemovements

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Fundamental Analysis

Fundamental theory of valuation:The value today of any financial asset

equals the present value of all of itsfuture cash flows, suitably discounted .Suitably discounted: Take into account

both general level of interest ratesand risk

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Cash flows You buy a stock at price P 0 and planto sell it in 1 year. You predict that you can sell itfor price P 1 and receive a dividend of D 1 at theend of the year. Discount future cash flows P 1and D 1 to calculate current stock value (price):

K P D

P 1110

K: Discount rate

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Cash flows If the investor plans to hold the stockfor H periods, receive a series of dividend D 1,D2, D H and sell it after H periods for price P H.

H H H

K

P D

K

D

K

DP

)1(....

)1(1 221

0

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Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next

three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

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Example Current forecasts are for XYZ Company to pay dividends of $3,$3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

PV

PV

3 00

1 12

3 24

1 12

350 94 48

1 1200

1 2 3

.

( . )

.

( . )

. .

( . )$75.

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Cash flows If the investor plans to hold the stockforever, he will receive a series of dividend D 1,D2, D3..=> Discounted Dividend Model (DDM)

....)1()1(1 3

32

210 K

D

K

D

K

DP

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If we forecast no growth of dividends (D 1 = D2 =D3 = ), and plan to hold out stock indefinitely,we will then value the stock as a PERPETUITY .

K

EPS

K

DPPerpetuity 10

Assume all earnings arepaid to shareholders

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Cooper, Inc. common stock currently paysa $1.00 dividend, which is expected toremain constant forever. If the requiredreturn on Cooper stock is 10%, whatshould the stock sell for today? Given nochange in the variables, what will the stock

be worth in one year?

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P 0 = $1/0.10 = $10One year from now, the value of the stock, P 1,must be equal to the present value of all

remaining future dividends.Since the dividend is constant, D 2 = D1 , andP 1 = D2/K = $1/0.10 = $10.

In other words, in the absence of any changes inexpected cash flows (and given a constantdiscount rate), the price of a no-growth stock will never change .

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Constant Growth DDM - A version of the dividendgrowth model in which dividends grow at aconstant rate forever (Gordon Growth Model) .

g: constant growth rate of dividends

Given any combination of variables in theequation, you can solve for the unknown variable

gK

DP

10

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We can use Gordon growth model to getthe stock price at any point in time

gK DP t t

1

Notice that P t = P 0 x (1+g) t

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Example What is the value of a stock that expects to pay a $3.00 dividend next year, and then increase

the dividend at a rate of 8% per year,indefinitely? Assume a 12% expected return.What is the price of the stock in 5 years?

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00.75$08.12.

00.3$10

gK

DP

2.110$08.12.

408.4$65 gK

DP

408.4)08.01(3)1.( 5516 xg D D

P 5 = P 0.(1+g) 5 = 75 x 1.08 5 = 110.2

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Ex: Suppose a stock has just paid a $5 per share dividend. The dividend is projectedto grow at 5% per year indefinitely. If therequired return is 9%, then what is thestock price today?

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Valuing Common Stocks

P 0 = D1/(K - g )

= $5 ( 1.05 )/( 0.09 - 0.05 )

= $5.25/.04= $131.25 per share

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Example- continued If the same stock is selling for $100 in the stock market, what might the market be assuming

about the growth in dividends?

$100$3.

..

00

1209

gg

Answer

The market isassuming the dividend will grow at 9% per

year, indefinitely.

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P 0 = D1/(K - g )(K - g ) = D1/P 0

K = D1/P 0 + g = $5.25/$65.625 + .05

= 0.13 = 13%

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Nonconstant growth: Dividends of thecompany grow at high rates over somefinite length of time, and after that, grow ata constant rate forever

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Required rate of return is 10%

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P 3 = D4/(K g) = D 3 x (1 + g)/(K g) = 52.50

88.43

)1.01(

5.52

)1.01(

5.2

)1.01(

2

1.01

1

)1()1()1(1

332

3

3

3

3

2

21

0 K

P

K

D

K

D

K

DP

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If the dividend grows at constant rate after t periods, then the price can be written as:

t t t

K P D

K D

K DP

)1(....

)1(1 221

0

gK

DP

t t

1

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Components of Required Return

The required return, r , can be written as the sum of two things:

K = D1/P 0 + g

whereD1/P 0 is the dividend yieldg is the capital gains yield (capital appreciation) since growth

rate in dividends is also the rate at which the stock pricegrowth

In equilibrium, where the share price is stable andinvestors appear to be happy with the price, then Kmust be required rate of return

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Ex: Suppose that earnings per share(EPS) next year is $10 and the firm retains50% of earnings for reinvestment.Suppose that K = 0.2 and the productivityof the firms additional investment is also0.2. What is the stock price?

What is the stock price if retention ratioincreases to 0.6?

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Fundamental AnalysisNotice: Changing the payout/retention ratios have no

effect on the share price:

1

*)1(1*

)1(1

*)1.(.*

)1.(.

*

0

0

p

p p

p

pk k

EPS p pk k

EPS p

P

P

There is no change in price since the productivity of reinvestment, r, is equal to its cost of capital, K. This isa reasonable assumption since if the productivityexceeds the cost of capital, it pays the firm to increaseits investment until productivity of the new capital just

matches the cost.

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Relative valuation models: Stock price arevalued by comparing price multiples (P/E price/earnings, P/B price/book value, P/CF price/cash flow etc.) of similar assets based onone price principle

Assumption: Companies of the same industry usuallyhave similar price multiples.The most popular price multiple is P/E which is telling uswhat we have to pay in order to obtain a share of a

firms earnings A share with high P/E may indicate that it is expensivecompare to other sharesHowever, firms in the same sector with differentcharacteristics may have different price multiples

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The factors affecting share prices are:Earnings - D 1Future growth - gRequired return K - which is affected by thelevel of risk and general level of interest rates

Events that influence the factors will cause

share price to change

Event Acts on

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Event Acts on A change inbusiness activity

K, since this is likely to change the riskinessof the firm and thus the return required byshareholders

A startling newproduct

G, since profits and dividends are likely togrow more rapidly

Interest rates K, since returns on alternative assets willhave changed. Possibly g too

A profits surprise D 1, since this is likely to be different fromwhat was expected and possibly also g depending on the reason for the surprise

Forecasts of economicboom/recession

g, since we expect profits and dividends togrowth more rapidly/slowly in aboom/recession

An increase ininflation

K and maybe g, on the assumption that thecentral bank is inflation-adverse, this willcreate expectations of higher interest rates

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Event Acts onRumor of conflictamongst

managers/directors

K, since the future of the firm is more uncertain(riskier) and investors will want a higher return

Depreciation of thecurrency

g, since exporting firms will benefits (g increases)while firms producing for domestic market willface stiffer competition (g reduces)

A general change inpublic confidenceabout the future

K, since this is likely to result in a changedattitude towards risk and risky assets

Rumors of a strike If it goes ahead, this is likely to reduce this yearsprofits and consequently D 1. On the other hand,if it is a response to a management decision tocut costs or increase productivity in future, it mayhave little effect since there may be acompensating increase in g

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Pricing New Shares

Price of new shares cannot exceed theprice at which existing shares are trading.

Earnings per share will reduce since the firms

earnings have to be spread across more sharesCalculate price of new share by finding newdividend (earnings) per share, leaving all elseunchanged

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Pricing New Shares

Other factors affecting the price of newshares:

Perceived signal of the market about the firms

future prospects after the issuance of newsharesReputational issues: The firm and theinvestment bank guaranteeing the issuancemay sell new shares at a discount to sell theshares quickly

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Technical Analysis

Technical analysis (chartism): Theexplanation of an assets value by thestudy of past price movements and tradingvolumesVisual study of recent patterns in thebehavior of a shares price

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Technical Analysis

Moving average: Moving average can beobtained by first taking the average of the firstsubset. The fixed subset size is then shifted

forward, creating a new subset of numbers,which is averaged. This process is repeatedover the entire data series. The plot lineconnecting all the (fixed) averages is the moving

average.Moving average of stock prices smooths outthe day-to-day fluctuations in price

Technical Analysis

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Technical Analysis A simple moving average (SMA): is the unweightedmean of the previous n data points

An example of a simple unweighted running mean for a 10-day sample of closing price is the mean of theprevious 10 days' closing prices. If those prices arep

M, p

M-1.p

M-9then the formula is

When calculating successive values, a new value

comes into the sum and an old value drops out,meaning a full summation each time is unnecessaryfor this simple case,
http://en.wikipedia.org/wiki/Arithmetic_meanhttp://en.wikipedia.org/wiki/Arithmetic_mean

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Technical Analysis

Support level P 1: The price range atwhich the technician would expect asubstantial increase in the demand and

price of the stock. In other words, stockprice reaches the lowest point and beginsto recover.Investors will be ready to buy as soon asthe price approaches P 1, especially thoseinterested in capital growth

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Technical Analysis

Resistance level P 2: The price range atwhich the technician would expect anincrease in the supply of the stock and aprice reversal.If the price rises above P 2, investorsshould be ready to sell the moment that

the price starts to fall back

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Technical Analysis

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Technical Analysis

The last two assumptions are problematic:Technical analysts expect stock price tomove in trends that persist for long periodsbecause they believe that new informationdoes not come to the market at one pointin time (as assumed by fundamental

analysts and efficient market supporters)but rather enters the market over a periodof time .

h l l

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Technical Analysis

T h i l A l i

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Technical Analysis

T h i l A l i

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Technical Analysis

T h i l A l i

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Technical Analysis

EMH: Efficient Market Hypothesis (Nextchapter)Self-fulfilling prophecies: For example, if many investors expect that stock price willincrease and decide to buy, the stock pricewill actually increase because of high

demand

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Required Rate of Return

Required rate of return:Incorporates the general level of interest ratesand a risk premium

Based on rate of return of similar assets

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Measuring Risk of an Individual Asset

Variance - Average value of squared deviationsfrom mean. A measure of volatility.

Standard Deviation - Average value of squared deviations from mean. A measure of volatility.

M i Ri k f I di id l A

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Measuring Risk of an Individual AssetExpected rate of return:

n

K K ie

Variance:

n

K K Var

ei

22 )(

Standard deviation:

Var

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Risk of an Individual Asset

Deviation from SquaredYear Rate of Return Average Return Deviation

1999 23.7 19.52 381.03 2000 (10.9) (15.08) 227.41

2001 (11.0) (15.18) 230.43 2002 (20.9) (25.08) 629.01 2003 31.6 27.42 751.86 2004 12.6 8.42 70.90

Total 25.1 2,290.63 Average rate of return = 25.1/6=4.18%Variance = average of squared deviations = 2290.63/6=381.77Standard deviation = squared root of variance = 19.54%

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Measuring Risk

Portfolio rate

of return=

fraction of portfolio

in first assetx

rate of return

on first asset

+fraction of portfolio

in second assetx

rate of return

on second asset

((

((

))

))

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Diversification

0

5 10 15

Number of Securities

P o r t

f o l i o s

t a n

d a r d

d e v

i a t i o n

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Diversification

0

5 10 15

Number of Securities

P o r t

f o l i o s

t a n

d a r d

d e v

i a t i o n

Market risk

Uniquerisk

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Market Risk

The risk of a well-diversified portfoliodepends in the market risk of thesecurities included in the portfolio (nomore unique risks)The sensitivity of an individual security tomarket movements (market risk) is called

beta ( )

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Beta and Unique Risk

beta

Expected

return

Expected

marketreturn

10%10%- +

-10%+10%

stock

Copyright 1996 by The McGraw-Hill Companies, Inc

-10%

1. Total risk =diversifiable risk +market risk2. Market risk ismeasured by beta,

the sensitivity tomarket changes

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Beta and Unique Risk

Market Portfolio - Portfolio of all assets in theeconomy. In practice a broad stock marketindex, such as the S&P Composite, is used

to represent the market.

Beta - Sensitivity of a stocks return to the

return on the market portfolio.

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Beta

Stocks with beta > 1: Tend to amplify theoverall movements of the marketStocks with 0 < beta < 1: Tend to move inthe same direction as the market but notas far Market portfolio of common stocks (ex:S&P 500) has average market risk withbeta = 1

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Beta

In a portfolio context, a securitys risk ismeasured by beta (its unique risk isdiversified)

A portfolio beta is a weighted average betaof the securities included in the portfolioP = x1 1 + x2 2 ++ x n n

i = im/ m2

Where im is the covariance between stockis return and the market return, and m2 isthe variance of the market return

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Beta

Market risk: The return on the wholemarket portfolio, over and above the riskfree rate

Market risk premium = K M Krf Risk premium of asset Z = K Z Krf KM: Market return, K rf : Risk free rate, K Z:return of Z

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Capital Asset Pricing Model

Capital Asset Pricing Model (CAPM): In acompetitive market, the expected riskpremium varies in direct proportion to beta

KZ - Krf = ( KM - Krf )

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Security Market LineReturn

.

KrfRisk Free

Return =

Market Return = K M

BETA1.0

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CAPM

All investment must plot along the securitymarket line (SML)

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.

r f

Risk Free

Return =

BETA

Security MarketLine (SML)

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BETA

Krf

1.0

SML

SML Equation K = K rf + B ( K M - Krf )

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K = K rf + B ( K M - Krf )

CAPMThe market will price an asset such that its rate of returnwill equal to the risk free rate plus a risk premium whichdepends upon the market price of risk and the quantityof market risk contained within the asset

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Ex: Thornbury has a beta coefficient of 0.9. The risk free rate of interest rate is 3%while the return on the whole market

portfolio is 14%. What is required rate of return on Thornburys stock? What is theprice of Thornburys share if its last

dividend is 6p per share and earningshave been growing steadily at 10% pa?

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KT = 0.03 + 0.9 (0.14 0.03) = 0.129

28.21.0129.0

)1.1(06.0T P

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The Trading of Company Shares

Ultimate borrowers: Companies, usuallylarge onesUltimate lenders: Households

DirectlyIndirectly via financial intermediaries thatmanage pension or mutual funds or life

insurance policies

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Quote-driven (price-driven) market: Marketmakers are ready to buy and sell shares atquoted prices (bid and ask prices)

Advantage: Buyers and sellers can be certain aboutthe price at which the deal will take placeDisadvantage: High transaction costs since marketmakers must cover their costs and earn a profit

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Order-driven market: All buy-and-sell orders areentered in a central order book. The exchangetechnology then tries to match the order with an

opposing one so that shares are passingdirectly from buyer to seller without anintermediate market maker. If the order is notfilled after a certain time it can be withdrawn

Advantage: Lower transaction costsDisadvantage: Buyers and sellers CANT BECERTAIN about the price at which the deal will takeplace

f

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Secondary markets for shares have much bigger size than that of primary markets

The London Equity Market, 2009No. of listed

companies

Market cap.bn (a)

Funds raised bynew issues

bn (b)

Turnover bn (b)

No. of trades,Mn (b)

1,458 3,252.3 60.4 10,229.1 144.8

(a): At end October 2009

(b): 1 January to 31 October 2009

h d f h

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The new issues raising 60.4 billion in theten months to the end of October 2009while total transactions in the secondary

market amounted to more than 10,000billionThe consequence of portfolio adjustments investors selling one existing stock and buy

another While stocks are irredeemable, they are highlyliquid


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Exchange No. of listedcompanies

(a)

Marketcapitalization

US$bn. (a)

Turnover US$bn (b)

No. of trades

Mn (b)NYSE 2,382 10,312.7 30,214.8 3,476.5

NASDAQ 2,999 2,579.5 13,618.6 1,826.6

Hong Kong 1,254 1,228.5 1,458.6 92.1

Shanghai 863 1,314.0 2,184.0 1,034.2

Euronext (exc NYSE) 1,026 2,083.6 4,050.9 165.6

Deutsche Borse 855 1,097.0 3,526.2 128.2

Tokyo 2,414 2,884.4 4,902.6 _

(a): At end October 2009

(b): 1 January to 31 October 2009

Pricing Instruments in a Supply and

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Pricing Instruments in a Supply andDemand Framework

Market for existing Thornbury plc. Shares(similar for primary market)Supply of the shares is fixed so supplycurve is verticalDemand curve is downward-slopingbecause, other things equal, shares aremore attractive at a lower price since their rate of return is higher


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Initially, the equilibrium price is 2.28Suppose that Thornbury expands into anew line of riskier high class cateringbusiness instead of sticking to its traditionof manufacturing chocolate. 80% of thefirm continues in chocolate making while

20% of the firm switches to luxury cateringwhich has beta of 1.1


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T = 0.8 (0.9) + 0.2 (1.1) = 0.94KT = 0.03 + 0.94 (0.14 0.03) = 0.1334

98.11.01334.0

)1.1(06.0T P

The stocks price falls to 1.98 sodemand curve shifts downward from Dto D


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The switches (and thus increase in demand for the bond) will cease when the bonds yieldequals to 3% as that of other instruments

New equilibrium price of the bond is 105.66 atYTM of 3%

=> A change in market interest rates leads tochange in asset prices in the opposite direction


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g pp yDemand Framework

D

D

13.34%

12.9%

Yield, %Market price

=

=

0

0

2.28

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Date post:	04-Apr-2018
Category:	Documents
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FM - Xuan Anh - Lec 4

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