INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment

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Financial Management MGT201

Lesson 16

INTRODUCTION TO STOCKS AND STOCK VALUATION

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following

topics

· Introduction to Stocks

· Stock Valuation

In previous lectures, we have discussed about one kind of direct claim security which is bonds.

Bonds are long term debt instruments. Now, we will take in detail about another kind of security which

is known as Stocks or Shares.

Stocks:

These are equity paper representing ownership. Shareholders are part owners of the company. If

you look at the balance sheet when the company issues shares to raise money such shares should be

shown on the liability side of the balance sheet of the company. Shareholders are called owners of the

company these are shown under the equity section .However, the shares that are purchased by the

company are shown on the asset side of the company under the head of marketable securities .Generally,

when we are talking about the issuance of the shares we refer to shares as liability. Basically, the share

is a legal contractual piece of paper it shows the name of the company. It shows the par or face value of

the share and it also assures that the shareholder is the part owner of the company.

Remember that Shares are distinguished from the bonds because shares represent the

ownership whereas the bond is a debt instrument. Another thing about the shares is to remember that par

value is the value when they are issued the market value of the shares changes with investor's

perception about the company's future and supply and demand situation. So, do not confuse the par

value with the Market value of the shares .par value is printed on that share certificate. As we have

studied that Value of Direct Claim Security is directly tied to the value of the underlying Real Asset.

Why raise money through Equity (i.e. Shares or Stocks) rather than Debt (i.e. Bonds or

Loan)?

What are the advantages of raising money through equity?

Equity financing gives the flexibility that you do not have to made regular payments. In case of debt or

bond you have under taken a promise to pay a fixed rate of return .but in case of shares o fixed rate of

interest is paid only dividend is paid on net income according to the decisions of the board of directors

and management. You have no obligations to pay fixed dividend to common shareholders. But, if the

Company raises money using Bonds, then it will have to pay a fixed amount of interest (or mark-up)

regularly for 2 Years. If the Company does NOT pay on time, you are declared Defaulter and your

business can be closed and the Lenders (Bondholders) can sell the company's assets to recover their

money.

The value of direct claim security because derived from underlying real asset. It can be thought

of as a piece of paper that generates a certain cash flow over the period of time. Share certificate is a

piece of paper that represents some other real assets and it generates future cash flows.

1. Dividend you are received as shareholder.

2. Capital gain

For example, if there is a textile company which need to raise the amount of Rs1 million to

invest in looms. Company can raise this amount either by equity or bonds.

In case the company decides to raise it through equity. Then it issues the share certificate amounting to

Rs 1 million and sells them to various interested investors and receives the capital in the form of equity.

Why do these share certificates carry value?

This investment for the share holders will generate the cash flow in form of income and the cash

flows in the form of capital gains .These cash flows are generated through the under lying real

assets .what are these real assets .the real assets in this example are the textile weaving looms and fabric

prepared by these looms. The cash flows are generated from the sale of this fabric. From these cash

flows the company is paying dividend (See diagram)

Financial Management MGT201

Share Value & Cash Flows

from Underlying Real Assets

COMPANY'S REAL WORKING ASSETS

that has issued the Share ie: Weaving Looms

Capital

Budgeting NPV

Criteria

COMPANY'S OPERATING CASH FLOWS

& INCOME ie. Revenue from sale of Fabric

(Company Value)

DIVIDEND & CAPITAL GAIN CASHFLOWS

Securities Valuation

i.e. Cash pay out to Shareholders (Share Value)

or Share Pricing

Share Concept:

A Limited Company can raise money by Issuing (or selling) Equity in the form of Shares. In

Pakistan, the Par Value (or Face Value) of each share is generally Rs 10. But by in large public listed

companies' issues shares with par value of Rs.10each .keep in mind that par value of the share is value

when it was issued when it has gone into market it has different value. The Life of a Share is considered

Perpetual (or never-ending "going concern") unless of course the company closes down or goes

bankrupt.

As the financial health (cash flows and income) of the company changes with time, the Market

Value (or Price) of the Share changes (even though it's Par Value is fixed). Market Prices also change

depending on the Supply-Demand for the share and also speculation or satta.

Shares of Listed Public Limited Companies are traded in the Stock Exchange like KSE (Karachi

Stock Exchange), LSE (Lahore), ISE (Islamabad). You can buy / sell shares over the phone &/or

computer through your Broker whose agents / Jobbers are trading at the exchange. You make payments

to your Broker through a Brokerage Account at one of the banks in the Stock Exchange or through cash

soon after the trade is made.

Shares of Private Limited Companies (which are not listed) can also be bought and sold

privately and the Corporate Law Authority and Registrar Joint Stock Companies need to be informed.

Types of Equity:

There are two types of equity

1. Common Stock

2. Preferred Stock

Common Stock:

It is the most common kind of equity as compared to preferred stock. Common Shareholders are

Owners who have Voting Rights in management decisions. Common Shareholders are owners who

receive a Dividend (share of the Profit or Net Income proportionate to their shareholding) which varies

depending on the Net Income for that year and the decision of the Board of Directors regarding how

much to Retain and Reinvest. Cash flows associated with common shares will be used to calculate the

expected price of share then we compare it market value of stock. There are 2 kinds of cash flow

associated with the stocks

1. Dividend you received as shareholder: In case of common stocks, these are unpredictable

and changing as to bond valuation where the coupon receipts are generally constant and

regular in time interval. Therefore we can use annuity formula. But when we are talking

about common shares dividends are not fixed. That's make the valuation of common stock

different from bond valuation

2. Capital gains

Preferred Stock:

This kind of Equity is rare. Preferred Shareholders get a preference (or priority) over the

Common Shareholders in recovering their money if the company goes bankrupt. Although

Preferred Shareholders are owners, they may not get voting rights. It is also known as Hybrid

Financial Management MGT201

Equity. As it is a Mix of Bond and Share. Preferred Shareholders receive a Fixed Regular

Dividend (similar to the Coupon for a Bondholder).

Share Price Valuation - Preferred Stock:

Perpetual Investment with Fixed Regular Dividends:

Perpetual Investment means you are considering buying this Stock and keeping it forever!

PV = Po* = DIV 1 / r PE

Where r PE = Minimum Required Rate of Return on Preferred Stock Equity for the individual investor,

PV = Present Market Value (or Estimated Present Price) which depends on DIV 1 = Forecasted Future

Dividend in the next period (ie. Year 1 and all other years since DIV 1=DIV2= DIV3=...) Basically, it

is a Perpetuity Formula.

Finite Investment:

Finite Investment means you plan to buy this Stock and then sell it in a few days or years (n). Formula

similar to Bond.

PV = Po* =

DIVt / (1+ rPE) t + Pn / (1+ rPE) n .

t=year. Sum from t = 1 to n. Pn = Final Expected Selling Price

PV (Share Price) = Dividend Value + Capital Gain /Loss.

The Dividend Value derived from Dividend Cash Stream and Capital Gain /Loss from Difference

between Buying & Selling Price.

Example:

Company ABC Preferred Stock is traded in the Lahore Stock Exchange and has a Market Price of

Rs 13. The Company has fixed the Dividend to be Rs 2 per share. The Par Value of each share is

Rs 10. You expect the Price to be Rs 13 after 2 years. As the investor, you expect a Minimum

Required Return of 10% because you can earn that much from a bank deposit account almost risk

free. BUT, Stocks are generally more risky investments than bank deposits SO you will only invest

in risky stock IF the expected return is higher than 10% - lets say 15%. Calculate the Fair (or

Expected) Price of the Preferred Stock.

NOTE: We will discuss RISK in detail later in course

Perpetual Investment in Preferred Stock

PV = DIV 1 / r PE = Rs 2 / 15% = 2 / 0.15 = Rs 13.33

The Fair (or Intrinsic Value) of the Share to You is Rs 13.33. The Market Value is Rs 13. So, the Share

is worth more to You than its price in the market. It is undervalued and you will gain value by buying it.

Finite Investment in Preferred Stock:

PV =

DIVt / (1+ rPE) t + Pn / (1+ rPE) n. n = 2 years

= 2 / (1.15) + 2 / (1.15)2 + 13 / (1.15)2 = Rs 13.08

In this example, Perpetual Investment in Preferred Stock is worth more than Finite Investment in

Preferred Stock because Present Value of the Infinite Stream of Rs 2 Dividends is more than the Present

Value of the expected future Selling Price (Rs 13).

Share Price Valuation - Common Stock

Finite (Limited Life) Investment in Common Stock

It is more common. Need to account for Cash Flows from Variable Dividends and Estimated

Selling Price (Pn).

Note that Pn depends on DIVn+1. Price at any point in time will always depend on Dividend in the

following year! Formula is similar to Bond Valuation Equation.

Perpetual Investment in Common Stock:

PV = DIV1/(1+rCE) +DIV2/(1+rCE)2 +..+ DIVn/(1+rCE)n + Pn/(1+rCE)n

PV = Po* = Expected or Fair Price = Present Value of Share, DIV1= Forecasted Future Dividend at

end of Year 1, DIV 2 = Expected Future Dividend at end of Year 2, ..., Pn = Expected Future Selling

Price, rCE = Minimum Required Rate of Return for Investment in the Common Stock for you (the

investor). Note that Dividends are uncertain and n = infinity

PV (Share Price) = Dividend Value + Capital Gain.

Dividend Value is derived from Dividend Cash Stream and Capital Gain / Loss from Difference

between Buying & Selling Price.

Perpetual Investment in Common Stock:

It is an idealized Case. The Final Cash Flow term (containing Pn) in the equation takes place at

Year n = infinity The last term (containing Pn) has a Present Value almost equal to Zero because the

Financial Management MGT201

Discount Factor (1+rE)n in the denominator becomes very large when n=infinity. So, you can ignore

the Last Cash Flow terms taking place at Year n.

Simplified Formula (Pn term removed from the equation for large investment durations i.e. n =

infinity):

PV = DIV1/ (1+rE) + DIV2/ (1+rE) 2 + ... DIVn/(1+rE)n

= DIVt / (1+ rE) t. t = year. Sum from t =1 to n

This Equation is still impractical because need to forecast Dividends for every year forever!!

Example:

The Common Stock of Company ABC is being traded in the Islamabad Stock Market. Its

Market Price is Rs.13. You study Company ABC's Annual Report, Balance Sheet, Income Statement,

and Cash Flow Statement and you forecast the future Dividends to be Rs 2 in the first year and Rs 4 in

the second year. You forecast the Market Price to be Rs 13 after 2 years. The Par Value of each share is

Rs 10. The Risk Free Return is 10% pa. Your expected Minimum Required Return from the high-risk

Common Stock of ABC is 20%. Calculate the Fair (or Expected) Price of the Common Stock

Common Stock Valuation (Risky Investment: rCE= 20%)

1st year will be Rs.2 and dividend in 2nd year will be Rs.4 assume risk free rate of return is 10% and high

rate of return to be required is 20%again this 20% is higher than 10% in a country .and this 20%

minimum required rate of return is higher than the preferred stock required by that company is

15 % .this is because common stock is considered more risky than preferred stock and bank deposit in a

country .let's calculate the value of common stock for company ABC we will use our old present value

formula for finite investment :

PV=2/12+4/(1.2)2+1.3/(1.2)2

Finite Investment for 2 Years: PV = 2/1.2 + 4 / (1.2)2 + 13 / (1.2)2 = Rs 13.47

This is estimated price for 2nd year investment based on forecasted dividend let's see the long term

investment use present value formula about which we talked earlier on

Perpetual Investment: PV =??

We can not determine it because we don't have Dividend forecast data for every year forever!! We need

to use Models for approximating future Dividends Cash Flow Stream:

Zero Growth Model

Constant Growth Model

We will discuss about these in the next lecture.

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