Valuation Of Shares

X.A. What are shares? A share is a financial instrument that provides the holder with partial ownership of a company.

A share is also commonly referred to as a share of common stock, ordinary share, equity share or simply equity. These terms are used interchangeably.

Example ABC Co issues 10,000 shares to raise capital. Mrs. A. Bloomberg buys 100 of those shares. How much of the company does Mrs. Bloomberg own?

Answer: 100 shares/10,000 shares = 0.01 or 1%

Mrs. A. Bloomberg owns 1% of ABC Co.

X.B. Methods to value shares There are two common methods used to value shares as follows: 1. Dividend Growth Model 2. Capital Asset Pricing Model

In this chapter, we cover the first method.

X.C. Dividend Growth Model Using this model, the share price is the discounted value of the future dividends that the share earns over its life.

Example DEF Plc pays annual dividend of 10 pence per share. The shareholders of DEF Plc demand 9% return on their invested capital. The company is expected to remain in business for the foreseeable future and there are no plans to increase the dividend per share. Using the Dividend Growth Model, estimate the value of one share of DEF Plc.

We need to define a few terminologies first. P0 is the current value of the share. D1 is next year's dividend per share. R is the required rate of return. G is the growth rate in dividend.

Based on the Dividend Growth Model, P0 = D1/(R - g)

Applying the formula, P0 = 10 pence / (9% - 0%) = 111.11 pence or £1.11

X.D. Dividend Growth In the previous example, the dividend per share stayed constant every year. If that's not the case, then we have to figure out what D1 will be. Investors usually assume a constant growth rate, g. Then, D1 = D0 * (1 + g), where D0 is the current dividend per share.

Example GHI Plc just paid a dividend of £0.25 per share. The growth rate in annual dividend has averaged 2% over the years. The company's shareholders demand 10% as return on their investment. Using the Dividend Growth Model, estimate the current value of one share of common stock in GHI Plc.

The formulas using the Dividend Growth Model are P0 = D1/(R - g) and D1 = D0 * (1 + g).

Based on the information provided, we know that D0 = £0.25, R = 10% and g = 2%.

Thus, D1 = £0.25 * (1 + 2%) = £0.255 and P0 = £0.255/(0.10 - 0.02) = £3.1875

The estimate of the current value per share is £3.19 (rounded to 2 decimal places).

X.E. Other uses of the Dividend Growth Model The formula P0 = D1/(R - g) can be used to figure out other parameters of interest to investors. For instance, upon rearranging the formula, we end up with one for the return on equity, i.e., R = (D1/P0) + g.

D1/P0 refers to the dividend yield and g refers to the growth rate in dividend, which is the same as the growth rate in the stock price. Note that the price is the current value of all dividends the share expects to earn throughout its life. Thus, the growth rate in dividend is also the growth rate in the share price. We also refer to g as the capital gains yield, i.e., the growth rate in the share price.

The Dividend Growth Model suggests that the expected return on share investment is the sum of the dividend yield and the capital gains yield. This makes perfect sense, as there are only two possible avenues for returns available to investors in shares. The first is the dividend received and the second is the increase in the share price post purchase.

X.F. Limitations of the Dividend Growth Model To use the formula, investors need to assume a growth rate in dividend. This is not unreasonable though we need to realize that forecasts of growth rates are approximations that can be far from what transpires over time.

The growth rate is not the only uncertain element in the formula. R, i.e., the required rate of return is also an estimate. The point is: the estimated value of a share derived from the formula is only as good as the forecasted values of g and R.

Next, two third of all listed companies on the major stock exchanges, for instance, the New York Stock Exchange, do not pay dividend. As a result, the Dividend Growth Model won't work to estimate share values for these companies.