Chapter 7 Equity Valuation Notes

7.1 Equity Securities

•equity securities ownership interests in an underlying entity, usually a corporation

•equities pay dividends from after-tax earnings, unlike interest payments, they don’t provide issuer with tax-deductible expense

•however, shareholders pay lower taxes on dividends received from Canadian corporations than they would on interest payments

•common share a certificate of ownership in a corporation; the most common type of equity security

•common shareholders represent the true “owners” of the corporation, and are the residual claimants of the corporation, which

means that they are entitled to income remaining only after all creditors and preferred shareholders have been paid

•preferred share the other major type of equity security, which gives the owner a claim to a fixed dividend rate that is

established when the shares are first issued; rarely have any voting rights

•traditionally, preferred shares had no maturity date, but over the past 30 years they have been increasingly issued with a fixed

maturity date, similar to a bond; however, unlike bonds, dividends are not a legal obligation until that declaration is made

Valuation of Equity Securities

•a commonly used method follows the discounted cash flow approach used to estimate the value of bonds

•the discount rate for equities will equal the risk-free rate of return plus a risk premium k = RF + Risk Premium

•the risk premium will be based on an estimate of the risk associated with the security; the higher the risk, the higher the risk

premium, because investors will require a higher return as compensation

•in addition to discount rate, investors must estimate size and timing of the expected cash flows associated with an equity security

7.2 Preferred Share Valuation

•because payments are essentially fixed when preferred shares are issued, such shares are referred to as fixed income investments

•P

ps

= D

p

/ k

p

, where P

ps

is the market price, D

p

is the dividend amount, and k

p

is the discount rate

•the amount of the dividend payments is usually based on stated par (or face) value and a stated dividend rate

•preferred shares will trade at par when the dividend rate equals the market rate, at a discount from par when market rates exceed

the dividend rate, and at a premium when market rates are less than the dividend rate

•the market prices of preferred shares increase when market rates decline, and vice versa

7.3 Common Share Valuation: The Dividend Discount Model (DDM)

The Basic Dividend Discount Model

•Dividend Discount Model (DDM) a model for valuing common shares that assumes they are valued according to the present

value of their expected future dividends or cash flows

•according to DDM, selling price at any point (time n) will equal PV of all expected future dividends from period n + 1 to infinity

•in other words, the price today is the present value of all future dividends to be received (i.e., from now to infinity)

The Constant Growth DDM

•Constant Growth DDM a version of the dividend discount model for valuing common shares, which assumes that dividends

grow at a constant rate indefinitely P

0

= D

1

/ k

c

– g

•this relationship only holds when k

c

is greater than g; only future estimated cash flows and estimate growth in these cash flows

are relevant; and the relationship holds only when growth in dividends is expected to occur at the same rate indefinitely

Estimating DDM Inputs

•several methods can be used to estimate the estimated annual growth rate in dividends (g)

•one of the most common approaches is to determine the company’s sustainable growth rate, which can be estimated by

multiplying the earnings retention ratio (b) by the return on equity g = b × ROE

Limitations of the DDM

•in particular, DDM is best suited for companies that (1) pay dividends based on a stable dividend payout history that they want to

maintain in the future, and (2) are growing at a steady and sustainable rate

•the DDM works reasonably well for large corporations in mature industries with stable profits and an established dividend policy

7.4 Using Multiples to Value Shares

The Basic Approach

•price-earnings (P/E) ratio the share price divided by the earnings per share; most commonly used relative valuation multiple

•the P/E approach is implemented by estimating the firm’s EPS and multiplying that figure by an appropriate P/E multiple

•the basic valuation equation can be then be expressed as P

0

= EPS

1

× P

0

/ E

1

•relative valuation valuing a firm relative to other comparable firms

•this means that if the comparable firms are all overvalued, then using the P/E approach will overvalue the firm in question

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## Document Summary

7. 2 preferred share valuation because payments are essentially fixed when preferred shares are issued, such shares are referred to as fixed income investments. 7. 3 common share valuation: the dividend discount model (ddm) Constant growth ddm a version of the dividend discount model for valuing common shares, which assumes that dividends grow at a constant rate indefinitely. Identify the basic characteristics of equity securities (i. e. , preferred shares and common shares) and describe the general framework for valuing equity securities. Equity securities are ownership interests in a company. Common shares have voting rights and pay a dividend (at the discretion of the board of directors). Preferred shares have no voting rights and pay a fixed, regular dividend. In the event of bankruptcy or liquidation, preferred shareholders are entitled to their par value before common shareholders are paid (if there is enough money to pay the par value after creditors are paid).