PD Hahn 1

Principles of Finance
BS 2100
EQUITIES
Pete Hahn
Faculty of Finance
Room 5012
Cass Building
What is equity?
Is it?
1) Ownership?
2) Control?
3) What about the other providers of capital? (i.e.
Debt, Suppliers)?
4) ???
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Topics Covered
Review Bonds

How Common Stocks (also Ordinary Shares) are Traded

How Common Stocks are Valued

Estimating the Cost of Equity Capital

Stock Prices and EPS

Valuing a Business by Discounted Cash Flows
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Stocks & Stock Market
Auction Markets & Dealer Markets
Over-the-counter
Indices

Mutual Funds

Exchange Traded
Funds
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Listing of Shares
Firms initial listings (or offerings of shares) are often
completed (An IPO for example)
In a home market (same country offers familiarity)
In the market which offers new shareholders the greatest
liquidity
Some countries do not have developed equity markets
(with desired liquidity) and their companies may choose
other markets (e.g. London for metals, HK for luxuries)
Firms may also CROSS LIST their shares on additional
markets to increase their investor base (e.g. New York,
Tokyo, Singapore).
Make sure that you always study firms in their home market in
their reporting currency.
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Stocks & Stock Market
Common Stock - Ownership shares in a publicly held
corporation.

Secondary Market - market in which already issued
securities are traded by investors.

Dividend - Periodic cash distribution from the firm to the
shareholders.

P/E Ratio - Price per share divided by earnings per
share.
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Stocks & Stock Market
Book Value - Net worth of the firm according to the
balance sheet.

Liquidation Value - Net proceeds that would be realized
by selling the firms assets and paying off its creditors.

Market Value Balance Sheet - Financial statement that
uses market value of assets and liabilities.
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Preferred Shares
Preferred shares are a hybrid between debt
& equity

Pay a fixed dividend (which may be omitted)
Generally, dividends must be paid before ordinary
(or common) share dividends
Equity on the balance sheet
Dont vote like ordinary shares
Other specific factors.
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Valuing Common Stocks
Expected Return - The percentage yield that an
investor forecasts from a specific investment
over a set period of time. Sometimes called the
market capitalization rate.
Expected Return = =
+
r
Div P P
P
1 1 0
0
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*IMPORTANT*
The Expected Return of Investors is also known as

THE COST OF (Equity) CAPITAL
to the firm raising funds.

In this case it is the cost of equity capital. The Cost of
Capital to the firm can change through the use of debt.
You can study this in detail in Company Valuation next term.
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Valuing Common Stocks
Example: If Fledgling Electronics is selling for 100 per
share today and is expected to sell for 110 one year
from now, what is the expected return if the dividend one
year from now is forecasted to be 5.00?
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Valuing Common Stocks
Another Example: You purchase an ownership
share in Liverpool FC for 50,000, they were
almost relegated (bad). In one year you expect
Liverpool to return as cup champion and pay you
a dividend of 3,000. You think you will be able
to sell your share for 58,000 at that time. What
is your expected return?
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Valuing Common Stocks
The formula can be broken into two parts.

Dividend Yield + Capital Appreciation
Expected Return = = +

r
Div
P
P P
P
1
0
1 0
0
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0 P
=
1 Div
1
(1+r)
+
2 Div
2
(1+r)
+..... +
H Div
+
H P
H
(1+r)
Valuing Common Stocks
Dividend Discount Model Calculation of todays stock price which
states the share value equals the present value of all expected future
dividends and the eventual selling price.
H = time horizon of your investment
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Valuing Common Stocks
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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Valuing Common Stocks
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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Valuing Common Stocks
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Valuing Common Stocks
Return Measurements


0
1
P
Div
Yield Dividend =
Share y Per Book Equit
EPS
Equity on Return
=
=
ROE
ROE
g
P
Div
r
g r
Div
P
+ =

=
0
1
1
0
Restated
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Valuing Common Stocks
If we forecast no growth, and plan to hold our
stock indefinitely, we will then value the stock as
a PERPETUITY.
Perpetuity P
Div
r
or
EPS
r
= =
0
1 1
Assumes all earnings are
paid to shareholders.
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Valuing Common Stocks
Constant Growth DDM - A version of the dividend
growth model in which dividends grow at a
constant rate (Gordon Growth Model).




Is anything constant forever?

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Constant Growth

Dividend
_________________________
Expected (Equity) Return
Growth Rate
Price =
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Deriving the Growth Rate
.... given minor algebraic manipulation.



g
P
Div
r
g r
Div
P
+ = =

= =
0
1
1
0
Rate tion Capitaliza
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Valuing Common Stocks
Example
If a stock is selling for $100 in the stock market, what
might the market be assuming about the growth in
dividends? [Assume investors want 12% for their
return and a $3.00 dividend at end of the year]
$100
$3.
.
.
=

=
00
12
09
g
g
Answer
The market is assuming
the dividend will grow at
9% per year, indefinitely.
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Decisions &
Earnings
Increase
Dividend
Maintain
Dividend
Cut Dividend Non-Payers
First Time
Payers
Full Sample N 808 549 74 130 33 22
% 100.0% 67.9% 9.2% 16.1% 4.1% 2.7%
Earnings Increase 470 366 32 51 18 3
58.2% 45.3% 4.0% 6.3% 2.2% 0.4%
Earnings Decrease 325 183 42 79 15 6
40.2% 22.6% 5.2% 9.8% 1.9% 0.7%
No Earnings History 13 13
1.6% 1.6%
Net Losses N 93 31 14 28 15 5
% 100.0% 33.3% 15.1% 30.1% 16.1% 5.4%
Whilst 79.2% of listed US firms were shown not to pay regular dividends,
the equivalent in the UK was 25.5% (Benito and Young (2001)).
Culture, Reinvestment, Dividend Decisions? Growth?
Source: P.D.Hahn, Doctoral Dissertation 2008.
Are technology and growth companies welcome in the UK?
[Large UK Company Dividends 1998-2004]
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Valuing Common Stocks
If a firm elects to pay a lower dividend, and
reinvest the funds, the stock price may increase
because future dividends may be higher.
Why?

Payout Ratio - Fraction of earnings paid out as
dividends
Plowback Ratio - Fraction of earnings retained by
the firm. Also the reinvestment rate.
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Valuing Common Stocks
Growth can be derived from applying the
return on equity to the percentage of
earnings plowed back into operations.

g = return on equity X plowback ratio
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Valuing Common Stocks
Example
Our company forecasts to pay a $8.33 dividend
next year, which represents 100% of its
earnings. This will provide investors with a 15%
expected return. Instead, we decide to plow
back 40% of the earnings at the firms current
return on equity of 25%. What is the value of the
stock before and after the plowback decision?
Think: you want 15% and the firm can earn 25%, where should the cash go?

Can or how long will the firm grow if it pays out all earnings?
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Valuing Common Stocks
Example
Our company forecasts to pay a $8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with a
15% expected return. Instead, we decide to plow back 40% of the
earnings at the firms current return on equity of 25%. What is the
value of the stock before and after the plowback decision?
56 . 55 $
15 .
33 . 8
0
= = P
No Growth With Growth
00 . 100 $
10 . 15 .
00 . 5
10 . 40 . 25 .
0
=

=
= =
P
g
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Valuing Common Stocks
Example - continued
If the company did not plowback some earnings, the
stock price would remain at $55.56. With the
plowback, the price rose to $100.00.

The difference between these two numbers is called
the Present Value of Growth Opportunities (PVGO).
44 . 44 $ 56 . 55 00 . 100 = = PVGO
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Valuing Common Stocks
Present Value of Growth Opportunities
(PVGO) - Net present value of a firms
future investments.

Sustainable Growth Rate - Steady rate at
which a firm can grow: plowback ratio X
return on equity.
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Valuing a Business or Project
The value of a business or Project is usually
computed as the discounted value of FCF out
to a valuation horizon (H).

The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.
H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
) 1 ( ) 1 (
...
) 1 ( ) 1 (
2
2
1
1
+
+
+
+ +
+
+
+
=
FCF = free cash flow or the potential dividend
PD Hahn 32
Valuing a Business
Valuing a Business or Project

H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
) 1 ( ) 1 (
...
) 1 ( ) 1 (
2
2
1
1
+
+
+
+ +
+
+
+
=
PV (free cash flows) PV (horizon value)
PD Hahn 33
Valuing a Business
Example
Given the cash flows for Concatenator Manufacturing, calculate the
PV of near term cash flows, PV (horizon value), and the total value
of the firm. r=10% and g= 6%
[hint: horizon starts Y6+]
Year
1 2 3 4 5 6 7 8 9 10
Asset Value $ 10.00 12.00 14.40 17.28 20.74 23.43 26.48 28.07 29.75 31.54
Earnings $ 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.37 3.57 3.78
Investment $ 2.00 2.40 2.88 3.46 2.70 3.05 1.59 1.68 1.79 1.89
Free Cash Flow $ -0.80 -0.96 -1.15 -1.38 -0.21 -0.23 1.59 1.68 1.79 1.89
Earnings Growth 20% 20% 20% 20% 20% 13% 13% 6% 6% 6%
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Valuing a Business
Example - continued
Given the cash flows for Concatenator Manufacturing Division,
calculate the PV of near term cash flows, PV (horizon value), and
the total value of the firm. r=10% and g= 6%

( )
4 . 22
06 . 10 .
59 . 1
1.1
1
value) PV(horizon
6
=
|
.
|

\
|

=
( ) ( ) ( ) ( ) ( )
6 . 3
1 . 1
23 .
1 . 1
20 .
1 . 1
39 . 1
1 . 1
15 . 1
1 . 1
96 .
1.1
.80
- PV(FCF)
6 5 4 3 2
=
=
PD Hahn 35
Valuing a Business
Example - continued
Given the cash flows for Concatenator Manufacturing, calculate the
PV of near term cash flows, PV (horizon value), and the total value
of the firm. r=10% and g= 6%

$18.8
22.4 -3.6
value) PV(horizon PV(FCF) s) PV(busines
=
+ =
+ =
PD Hahn 36
Sources of Equity Finance
Varies By Country (e.g.)
USA was mostly retail (individuals) but now more
funds and institutional
UK traditionally mostly institutions (insurance and
pension), but now more foreign
We discussed public equity.
There are also sources of private equity
these investors do not value short-term liquidity
(specialist funds)
Sovereign Wealth Funds
Others
PD Hahn 37
Topics Covered

How Common Stocks are Traded
How Common Stocks are Valued
Estimating the Cost of Equity Capital
Stock Prices and EPS
Valuing a Business by Discounted Cash Flows
PD Hahn 38
The Big Question:
The UK rescued Royal Bank of Scotland and Lloyds Banking
Group through equity infusions (share purchases) in 2008 at
50.2p and 73.6p, respectively.

HM Treasury sees an opportunity for full repayment in late 2013 to
2014 if the shares reach the 50.2p and 73.6p levels. Can this be
correct?