Investors in The Share Market

Chapter 6
Investors in
the share market
Websites:
www.ato.gov.au
www.asx.com.au
Copyright  2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 6-1
Slides prepared by Peter Phillips
Learning objectives
• Consider the role of an investor in the share market
and appreciate the range of investment choices
available to the investor
• Understand the process of buying and selling shares,
the risks involved, and the importance of taxation when
investing
• Describe indicators of financial performance
• Demonstrate share pricing methods
• Consider the importance of share-market indices and
published share information

Chapter organisation
6.1 Share-market investment

6.2 Buying and selling shares
6.3 Taxation
6.4 Financial performance indicators
6.5 Pricing of shares
6.6 Stock-market indices and published share
information
6.7 Summary

• Investors buy shares to receive returns from dividends
and capital gains (losses)
• Other factors encouraging investment in securities

quoted on a stock exchange (SX)
– Depth of the market
▪ Overall capitalisation of corporations listed on an SX
– Liquidity of the market
▪ Volume of trading relative to the size of the market
– Efficient price discovery
▪ Speed and efficiency with which new information is reflected in
the current share price
(cont.)
6.1 Share-market investment (cont.)
• The SX offers a wide range of security types to the

investor
• Securities listed on the SX are categorised into industry

groups, allowing investors a choice from a range of
economic sectors
(cont.)
• Two types of risk impact on security returns
1. Systematic risk
▪ Factors that generally impact on share prices in the market;
e.g. economic growth, and changes in interest rates and
exchange rates
2. Unsystematic risk
▪ Factors that impact specifically on the share price of a
corporation; e.g. resignation of the CEO, technology failure,
board problems
(cont.)
• Diversified investment portfolio
– A portfolio containing a wide range of securities
– Diversifies most of the unsystematic risk of the individual

securities
▪ Investors will not receive higher returns for unnecessarily
bearing unsystematic risk
– The remaining risk is systematic risk, which is measured by

beta
▪ Beta is a measure of the sensitivity of the price of an asset
relative to the market
(cont.)
• Diversified investment portfolio (cont.)
– Expected portfolio return is the weighted average of

expected returns of each share
– Portfolio variance (risk) is the correlation of pairs of

securities within the portfolio
(cont.)
• Investors may take one of two approaches
– 1. Active investment approach
▪ Portfolio structure is based on share analysis, new information
and risk-return preferences
– 2. Passive investment approach
▪ Portfolio structure is based on the replication of a specific
share-market index, e.g. industrial or telecommunications
sector index
• Some managed funds are index funds

– Portfolios are structured to fully or partially replicate a
specific share-market index
(cont.)
• Investors need to consider asset allocation within a
share portfolio
▪ Risk versus return
▪ Investment time horizon
▪ Income versus capital growth
▪ Domestic and international shares
• Asset allocation may be:

▪ strategic
▪ tactical
(cont.)
• The recent global financial crisis has caused much
concern, particularly among those in or approaching
retirement
• A large amount of retirement savings is invested in the
share market
• For those nearing retirement the investment horizon is
shorter, particularly if money will be withdrawn from the
share market upon retirement
• When market prices fall sharply, these individuals are
adversely affected. Importantly, they have the least
time to recover their losses (before retirement)


6.3 Taxation
information
6.7 Summary

• Direct investment in shares
– Investor buys and sells shares through a stockbroker
▪ Discount broker, i.e. phone and Internet
▪ Full-service advisory broker
– Consideration of liquidity, risk, return, charges, taxation,

social security, etc.
• Indirect investment in shares

– Investor purchases units in a unit trust or managed fund,
e.g. equity trusts


6.3 Taxation
information
6.7 Summary

6.3 Taxation
• Pre-dividend imputation (prior to 1987)
– Dividends were taxed twice—first at company level (as
profits) and then at the investor’s marginal rate
• Dividend imputation (since 1987)

– Removed the double taxation of dividends
– Investors receive franking credit for the tax a company pays
on a franked dividend (cổ tức đã hoàn thành nghĩa vụ
thuế)
(cont.)
6.3 Taxation (cont.)
(cont.)
6.3 Taxation (cont.)
• Capital gains tax on shares purchased
– Prior to 19/9/1985 tax free
– 19/9/1985–21/9/1999
▪ Taxpayer’s marginal tax rate applied if held less than 12
months
▪ Taxpayer’s marginal tax rate applied to indexed capital gain if
held over 12 months
– Since 21/9/1999
▪ 50% discounted gain if held at least 12 months; or
▪ indexed capital gain or 50% discounted gain if purchased
19/9/1985–21/9/1999


6.3 Taxation
information
6.7 Summary

• Potential investors are concerned with the future level
of a company’s performance
• Company’s performance affects both the profitability of

the company and the variability of the cash flows
• Indicators of company performance

– Capital structure
– Liquidity
– Debt servicing
– Profitability
– Share price
– Risk (cont.)
6.4 Financial performance indicators (cont.)
Capital structure
• Proportion of company assets (funding) obtained

through debt and equity
– Usually measured by debt to equity ratio (D/E)

▪ Higher debt levels increase financial risk; i.e. firm may not be
able to meet interest payments
(cont.)
Capital structure (cont.)
• Proportion of company assets (funding) obtained

through debt and equity (cont.)
– Also measured by proprietorship ratio, which is the ratio of

shareholders’ funds to total assets
▪ Indicates firm’s longer term financial viability/stability; a higher
ratio indicates less reliance on external funding
(cont.)
Liquidity
• The ability of a company to meet its short-term financial
obligations
• Measured by current ratio

– Fails to consider the not very liquid nature of certain current
assets, such as inventory
Current ratio  current assets (maturing within one year)

current liabilities (due within one year)
(cont.)
Liquidity (cont.)
• Measured by liquid ratio
• The higher the current and liquid ratios, the better the
liquidity position of a firm
Liquid ratio  current assets - inventory (stock on hand)

current liabilities - bank overdraft
(cont.)
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
(cont.)
Debt servicing (cont.)
• Measured by interest coverage ratio
Interest cover  earnings before finance lease charges, interest and tax
finance lease charges and interest
(cont.)
Profitability
• Wide variation in the measurement of profitability

– Earnings before interest and tax (EBIT) to total funds ratio
– Earnings per share (EPS)
EBIT to total funds ratio
 EBIT
total funds employed (shareholders' funds and borrowings )
(cont.)
Profitability (cont.)

(cont.)
– EBIT to long-term funds ratio
EBIT to long - term funds ratio 
EBIT
long - term funds (i.e. total funds less short - term debt)
(cont.)
Profitability (cont.)

(cont.)
– Return on equity (net income/equity)
– Higher ratios indicate greater profitability
Return on equity  net income

equity (shareholders' funds)
(cont.)
Share price
• Represents investors’ view of the present value of
future net cash flows of a firm
• Share price performance indicators
– Price to earnings ratio (P/E)

▪ Share price divided by earnings per share
▪ A higher P/E indicates more growth in future net cash flows
– Share price to net tangible assets ratio (P/NTA)

▪ Measures the theoretical premium or discount at which a firm’s
share price is trading relative to its NTA
(cont.)
Risk
• Variability (uncertainty) of the share price
• Two components
1. Systematic risk (often referred to as beta)

▪ Arises from factors affecting the whole market, e.g. state of the
domestic economy and world economy
2. Non-systematic risk
▪ Arises from firm-specific factors, e.g. management
competence, labour productivity, financial and operational risks
▪ Can be eliminated in a well-diversified portfolio

6.1 Share-market Investment

6.2 Buying and Selling Shares
6.3 Taxation
6.4 Financial Performance Indicators
6.5 Pricing of Shares
6.6 Stock-market Indices and Published Share
Information
6.7 Summary

• Share price is mainly a function of supply and demand
for a share
– Supply and demand are influenced mainly by information
– Share price is considered to be the present value of future

dividend payments to shareholders
– New information that changes investors’ expectations about

future dividends will result in a change in the share price
(cont.)
6.5 Pricing of shares (cont.)
• Estimating the price of a share
– General dividend valuation model

D t
t1
P
1rs t
0
Where: P  current share price

0
D  expected dividend per share in period t

t
r  required rate of return

s
(cont.)
• Estimating the price of a share (cont.)
– Valuing a share with a constant dividend (D0)
D
P
0
0
rs
– Valuing a share with constant dividend growth (g)

1g
 
 
 
 
P D
 
 
0 0



r g s



(cont.)
• Cum-dividend and ex-dividend
– Dividends are payments made to shareholders, expressed

as cents per share
– Dividends are declared at one date and paid at a later,

specified date
– During the period between the two dates, the shares have
the future dividend entitlement attached, i.e. cum-dividend
(cont.)
• Cum-dividend and ex-dividend (cont.)
– Once the dividend is paid the shares are traded ex-dividend
– Theoretically, the share price will fall on the ex-dividend date

by the size of the dividend
▪ Example:
Share price cum-dividend $1.00
Dividend paid 0.07
Theoretical ex-dividend price 0.93
(cont.)
• Bonus share issues
– Where a company has accumulated reserves, it may

distribute these to existing shareholders by making a bonus
issue of additional shares
– As with dividends, there will be a downward adjustment in

share price when shares go ex-bonus
(cont.)
• Bonus share issues (cont.)
– As no new capital is raised, there is no change in the assets

or expected earnings of the company
▪ Example—If a bonus 1:4 issue is made:

Cum-bonus price $5.00
Market value of 4 cum-bonus shares $20.00
Theoretical value of 5 ex-bonus shares $20.00
Theoretical value of 1 ex-bonus share $4.00
(cont.)
• Share splits
– Involves division of the number of shares on issue
– Involves no fundamental change in the structure or asset

value of the company
– Theoretically, the share price will fall in the proportion of the

split
▪ Example—5 for 1 split:
Pre-split share price $50.00
Theoretical ex-split share price $10.00
(cont.)
• Pro-rata rights issue
– Involves an increase in the company’s issued capital
– Typically issued at a discount to market price
– Theoretically, the market price will fall by an amount

dependent on the:
▪ number of shares issued
▪ size of the discount
(cont.)
• Pro-rata rights issue (cont.)
– Example—market price cum-rights $1.00, with 1:5 rights

issue priced at $0.88:
Cum-rights share price $1.00

Market value of 5 cum-rights shares 5.00
Plus new funds from 1:5 issue 0.88
Market value of 6 ex-rights shares 5.88
Theoretical ex-rights share price (5.88/6) 0.98
(cont.)
• Pro-rata rights issue (cont.)
– A renounceable right is a right that can be sold before it is

exercised
▪ The value of the right is determined by Equation 6.12
Value of right  N (cum rights price - subscription price)

N 1
Where N is the number of shares required
to obtain the rights issue share, and the subscription
price is the discounted price of the additional share.


6.3 Taxation
information
6.7 Summary

information
• Stock-market indices
– Measure of the price performance of a share market or

industry sector; e.g.:
▪ Performance benchmark index
• Measures overall share-market performance based on
capitalisation and liquidity
▪ Tradeable benchmark index
• A narrow index used as the basis for pricing certain derivative
products
▪ Market indicator index
• Measure of overall share-market performance
(cont.)
information (cont.)
• Market indicator indices
– Price-weighted, e.g. Dow Jones
▪ Weighting of a company proportional to its share price
– Capitalisation-weighted, e.g. S&P/ASX All Ords

▪ Weighting of a company proportional to market capitalisation
– Share-price index measures capital gains/losses from

investing in an index-related portfolio
– Accumulation index includes share price changes and

reinvestment of dividends
(cont.)
information (cont.)
• Market indicator indices (cont.)
– Global industry classification standard (GICS) 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; e.g. Australian
Financial Review


6.3 Taxation
information
6.7 Summary

6.7 Summary
• Factors a share investor should consider

– Diversification, portfolio return and risk
– Active or passive investment
– Direct or indirect investment
– Taxation
– Company financial performance indicators
▪ Capital structure, liquidity, debt servicing, profitability, share
price, risk
(cont.)
6.7 Summary (cont.)
• Factors that influence a company’s share price

– Expected future dividends
– Bonus shares issues
– Share splits
– Pro-rata rights issues
• Various share-market indices exist that provide a

measure of the price performance of a sector or of the
market overall


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Chapter 6

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

6.1 Share-market investment

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Other factors encouraging investment in securities

• The SX offers a wide range of security types to the

• Securities listed on the SX are categorised into industry

• Two types of risk impact on security returns

– A portfolio containing a wide range of securities

– Diversifies most of the unsystematic risk of the individual

– The remaining risk is systematic risk, which is measured by

• Diversified investment portfolio (cont.)

– Expected portfolio return is the weighted average of

– Portfolio variance (risk) is the correlation of pairs of

• Some managed funds are index funds

• Asset allocation may be:

Copyright  2012 McGraw-Hill Australia Pty Ltd

6.1 Share-market investment

Copyright  2012 McGraw-Hill Australia Pty Ltd

– Consideration of liquidity, risk, return, charges, taxation,

• Indirect investment in shares

Copyright  2012 McGraw-Hill Australia Pty Ltd

6.1 Share-market investment

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Dividend imputation (since 1987)

– Prior to 19/9/1985 tax free

Copyright  2012 McGraw-Hill Australia Pty Ltd

6.1 Share-market investment

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Company’s performance affects both the profitability of

• Indicators of company performance

• Proportion of company assets (funding) obtained

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

• Proportion of company assets (funding) obtained

– Also measured by proprietorship ratio, which is the ratio of

• Measured by current ratio

Current ratio  current assets (maturing within one year)

Liquid ratio  current assets - inventory (stock on hand)

• Ability to meet debt-related obligations, i.e. interest and

• Measured by debt to gross cash flow ratio

• Measured by interest coverage ratio

• Wide variation in the measurement of profitability

EBIT to total funds ratio

• Wide variation in the measurement of profitability

EBIT to long - term funds ratio 

• Wide variation in the measurement of profitability

Return on equity  net income

• Share price performance indicators

– Price to earnings ratio (P/E)

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

1. Systematic risk (often referred to as beta)

Copyright  2012 McGraw-Hill Australia Pty Ltd

6.1 Share-market Investment

Copyright  2012 McGraw-Hill Australia Pty Ltd

– Supply and demand are influenced mainly by information

– Share price is considered to be the present value of future

– New information that changes investors’ expectations about

– General dividend valuation model

Where: P  current share price

D  expected dividend per share in period t

r  required rate of return

– Valuing a share with a constant dividend (D0)