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Objectives and learning outcomes from this module Explain the characteristics of equity securities. Understand some financial ratios. Understand how equity securities are valued. Identify the expected return on equity securities.
Introduction to and characteristics of equity securities Equity is a claim on the residual assets of the issuer.
Initial public offerings (IPO) is when a company (that has been privately owned) sell shares to the public for the first time. Transactions that occur prior to the IPO may not be efficient.
Introduction to and characteristics of equity securities Book value: original cost accumulated depreciation. of the asset minus
Liquidation value: minimum value of the asset (when the company is liquidated). It does not capture the going-concern value of the business. Intangible value: impounded into market price. While it is valuable for the going-concern purpose, it may have no value in a forced liquidation.
DPS 1.26 Dividend payout ratio 70%; EPS 1.79 Plowback ratio 1 Dividend payout ratio 30%
return on equity
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In general, the value (price) of an asset is the present value of the expected future cash flows on the asset.
Dividends have zero growth; Dividends have a constant growth; and Dividends have non-constant growth.
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P0
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Suppose all shareholders of ANZ hold preferred shares, with annual dividend of $1.79 per share. Further assume a cost of equity of 7.71%. How much should ANZs share be trading in such a case?
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DDM: Dividends have constant growth Suppose that ANZs earnings (and accordingly its dividends) are growing at a constant, stable rate of g% p.a. How to calculate g? Use the following equation: g = ROE from investment x retention rate
where ROE = return on equity from (new) investment or project; retention rate = reinvestment or plowback rate.
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DDM: Dividends have constant growth The ROE of ANZs new investment is 13% (From previously calculated). Current dividend (D0) is $1.26. Current EPS0 = $1.79. Thus, current dividend payout ratio = D0/EPS0 70%. That is, retention rate = 1 dividend payout ratio = 30%. Hence, g = 0.13 x 0.3 = 3.9% p.a.
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D3 = D2(1+g) =1.41
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DDM: Dividends have constant growth Using Gordon Growth Model (i.e. growing perpetuity formula), we can compute the current share price of P0. The GGM is given by
P0 D (1 g ) D1 0 , where re g re g re g
Assume re = 9.5%.
Implication: ??
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Growth in dividend
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P0
P0
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DDM: Dividends have constant growth For example, suppose the ROE of ANZs new investment is 7% instead of 13%.
Thus, g = ROE x retention rate = 0.07 x 0.30 = 2.1%.
1.26(1.021) P0 $17.38 $18.84 PVGO $1.46 0.095 0.021
No reinvestment Firm reinvests in projects with ROE = 7%
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DDM: Dividends have non-constant growth Therefore, ANZ has two stages of growth. Suppose, in the first stage (from year 2010 to 2013), g1 = 3.9% and dividend payout ratio = 70%. In the second stage (from year 2013 onwards), g2 = 2% and dividend payout ratio = 80%.
g1 = 3.9%, payout ratio = 70% 2010 2011 2012 g2 =2%, payout ratio = 80% 2013 2014
D1=1.31
D2=1.36
D3=1.41
D4 = 1.64..
D4 = EPS4 x dividend payout ratio = EPS3 (1+g2) x 0.80 = EPS0 (1+g1)3 (1+g2) x 0.80 = 1.79(1.039)3(1.02) x 0.80 = 1.64
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