FINS1612 SUMMARIES

Week 4 Equity Markets 2

Investors in the Share Market
1/6 Share Market Investment:
Why buy shares? To received returns from dividends and capital gains (or
losses)

Other encouraging factors;

o Depth of the market overall capitalisation of corporations listed on
the SX
o Liquidity of the market volume of trading relative to size of the
market
o Efficient price discover speed at which information enters the
market and is absorbed into the current share price.

Risk;

Systematic Risk Market influences (economic growth, interest rate,

exchange rate, politics)
o What cannot be diversified away is called Beta a measure of the
sensitivity of the price of an asset relative to the market (positive or
negative)

Unsystematic risk Firm influences (deposition of CEO, board problems)

o Diversified portfolios contain a wide variety of securities and hence
diversifies away most of the unsystematic risk of individual securities.

Investors receive no risk premium for unsystematic risk.

Expected return:

The weighted average of expected returns of each share

Portfolio variance ( = risk) is the correlation of pairs of securities within

the portfolio.

Security types:

The wide variety listed on the SX are categorised into industry groups,
allowing investors a choice from a range of economic sectors.

Investment approaches;

Active investment approach Portfolio structure based on analysis, new

information and risk-return preferences. High brokerage costs from
continual portfolio changes.

Passive investment approach Replication of a specific share-market index

(by sector)
o Some managed funds are index funds (structured to fully/partly
replicate a specific share-market index)

Asset allocation considerations;

o Risk vs. Return
o Investment time horizon
o Income vs. capital growth
o Domestic vs. International Shares

Note that asset allocation may be strategic (personal risk

profile) or tactical (market risk and influence)

2/6 Buying and Selling Shares:

Direct investment in shares

o Investor buys and sells shares through a stockbroker.

Stockbroker can be discount broker (only provide intermediary

service)

Full-service advisory broker (Fees considerably higher)

o Consideration is of liquidity, risk, return, (CHARGES), taxation, social

security etc.

Indirect investment in shares

o Investor purchases units in a trust fund or managed fund (such as an
equity trust).
o Fees are generally higher than direct investment

3/6 Taxation:

Prior to 1987 (PRE-dividend imputation system)

o Dividends were taxed twice first at the company level (as profits)
and then at the investors marginal rate

POST-Dividend imputation (1987);

o Removed the double taxation of dividends

o Investors now receive franking credits for the tax a company pays
on a franked dividend.

Capital Gains Tax (CGT)

o Prior to 19-9-1985 it was tax free
o From 19th September 1985 to the 21st September 1999 the tax payers
marginal tax rate was applied if held for less than 12 months.

The tax payers marginal rate applied to the indexed capital gain
if held over 12 months.

o SINCE 1999;

There is a 50% discounted gain if held at least 12 months

OR

Indexed capital gain OR 50% discounted gain if purchased

between 1985 and 1999

4/6 Financial Performance Indicators:

Investors are concerned with the future level of a companys performance

because it affects both the profitability of the company and the variability
of the cash flows.

The indicators include;

o Capital structure:

Proportion of company assets (funding) obtained through debt

and equity.
Usually measured by debt to equity ratio (D/E ratio)
o Higher debt increases financial risk of not being
able to meet interest payments (accounting for
industry norms though)
Also measured by proprietorship ratio = ratio of
shareholders funds to total assets.

o This indicates a firms longer term financial

viability/stability. A higher ratio indicates less
reliance on external funding.
o Liquidity;

Ability of a company to meet short term financial obligations

Current ratio = Current assets (Maturing within one
year) / Current liabilities (due within one year) NOT the
best indicator
Liquid ratio

Current assets inventory (stock on hand) / Current liabilities bank overdraft.

o Debt servicing;

Ability to meet debt-related obligations i.e interest and

repayment of debt.

Measured by debt to gross cash flow ratio

Indicates number of years of cash flow required to
repay total firm debt.

Also measured by interest coverage ratio.

Earnings before finance lease charges, interest and
tax / finance lease charges and interest. (generally
should be 2 or above)

o Profitability;

Wide variation exists in the definition and measurement of

profitability;
EPS;
EBIT to total funds ratio;
o EBIT/ Total funds employed (shareholders
funds and borrowings)
EBIT to long term funds ratio;
o EBIT/ Long-term-funds (total funds less short
term debt)
ROE (Return on equity);

o Net income / equity (shareholders funds)

o Share Price;

Represents investors view of the PV of the future net cash flows

of a firm

Performance indicators of share price include;

Price to Earnings (P/E) ratio (higher is more growth in
future NCF)
o Share price divided by EPS
Share price to net tangible assets ratio (P/NTA)
o Measures the theoretical premium or discount at
which a firms share price is trading relative to its
NTA

o Risk

Variability (uncertainty of the share price)

Recall systematic vs. non-systematic risk

5/6 Pricing of Shares:

This is a function of the supply and demand for a share.

o This, in turn, is influenced by the information available about the
share.

Therefore new information that changes investors expectations

about any of the elements of the formula will result in a change
in the share price.

o Hence the formula for the price of a share is;

Shares Valuation (The maths)

As with bonds, the price of the stock is the present value of these
expected cash flows

An example would be holding a share for 3 years in which the dividends

are are 2, 2.10 and 2.205 and at the end of year 3 the share price is
15.435. R-ROR is 20%
- what would you be willing to pay?

Shares Valuation of Dividends (The maths)

Constant dividend (Zero Growth):

The firm will pay a constant dividend forever

Price is computed using the perpetuity formula;

For example:

Share pays a
constant dividend
of $1 and has a RROR of 10% with
semi-annual
compounding.
1/0.05 = $20

Constant dividend growth (Gordons Growth Model):

The firm will increase the dividend by a constant percent every period

o Relationship between current and future dividends (D0 is original);

Non-Constant dividend:

Dividend growth is consistent initially, but settles down to constant growth

eventually

o Let us take an example of a share that is offering a dividend next year

of $1.20 which is expected to grow at 20% for the next 2 years and
then 5% thereafter. The R-ROR is 10%.

Solving for R:

Estimating the Growth Rate (g):

One approach is to derive dividend growth from a firms earnings

o Payout Ratio (The percentage that dividends per share makes up of
total earnings per share)
o Return on Equity (ROE) The rate that the retained profit is
reinvested at.

This assumes
o The payout ratio is stable
o The estimated ROE is stable

How dividends are paid:

Declaration date company managers meet and make announcement on

how much regular dividends will be

Ex dividend date (Cum-dividend in between) to avoid problems with

changing ownership close to record date, 4 days before is set as the time
which anyone buying shares before is entitled to the dividend.

Close of business on record date, list of shareholders is drawn up and all

appearing on list will receive dividend

On payment date, actual dividend is sent (usually 2 months after exdividend date)

Alternatives to cash dividends?

Bonus Issue
Payment made by a firm to its shareholders in the form of additional
shares

The effect of this is;

o Increase number of shares outstanding
o Decrease per-share price
o Decrease EPS
o Decrease dividends share price

Proportion of total shares each shareholder owns is not

affected

For example, if someone owns 200 shares and a 1-for-20

share issue occurs, this holder will have a proportional
increase, as will all other shareholders and so will still own
the same proportion afterwards.

Used to constrain a firms share price

o Because dividend increase is matched to firms earning increase over
the same period.

Share Split
Each share is split-up to create new shares
This increases the number of shares outstanding
o For example in a 3-for-1 stock split, each share in circulation becomes
3 shares.

Per share price decreases

EPS decreases

Shareholder wealth not affected

o 10 Shares at $10 is the same after a split to make
20 shares at $5 each.

Typically used to reduce exorbitantly increasing share price

Share splits and bonus issues can decrease liquidity lower priced shares harder
to sell, higher transaction costs (proportionally)
Share splits and bonus issues can increase liquidity large numbers of shares
can reduce transaction costs

Reverse Split

Reverse of share split numerous old shares combined for fewer new
shares
For example, in a 1-for-2 reverse split, investors trade two old shares for
one new share
o

PPS increases

o EPS increases

Once again, total shareholder wealth not affected

The reasons for this are;

o Reduce transaction costs
o Improve liquidity and marketability of stock as price is raised to
popular trading range
o Improve firm respectability
o Comply with stock exchange listing requirements of minimum
PPS
o To buy out any shareholders with small shareholdings and hence save
on admin costs.

Pro-rata rights issue;

This involves an increase in the companys issued capital
Typically issued at a discount to the market price
The market price will fall by an amount dependent on the
o Number of shares issued
o Size of the discount.
A renounceable right is a right that can be sold before it is exercised.
o The value of this right is given by;

Share repurchase/ Buyback

Firm uses cash to buy back own shares (Legal on ASX since 1989)

Only shareholders willing to part with shares will received cash being
offered by the firm.

The effect of this is;

Reduce number of shares, Increase PPS, Increase EPS

Can be done through;

o Open market (Normal course of trading on stock exchange)
o Tender offer to shareholders (written offer to existing
shareholders)
o Targeted repurchase (Written offer to specific shareholders)
Assuming a perfect capital market, share buybacks do not effect
shareholder wealth.
o Shareholders should be indifferent between a cash dividend and a
share repurchase.
o For example;
Assume a company is seeking to distribute $800,000 excess cash to
shareholders with the choices of a cash dividend or share buyback?
Assume also that the earnings for distribution are 1,000,000 and the
number of shares is 400,000 and the MV of equity is 20,000,000. EPS is
2.50, PPS is $50 and P/E ratio is 20.
Option 1 would see
a dividend per share of (800,000/400,000) = $2
Ergo share price is (50-2)=$48
EPS is unchanged.
P/E ratio is now (48/2.50) = 19.2
o Shareholder Wealth = $48 share + $2 dividend = $50
Option 2 would see
A buyback of (800,000/50) = 16,000 shares.
Hence shares left is (400,000-16,000) = 384,000.
Hence share price is equal to (20,000,000-800,000/384,000) = $50. EPS is
now (1,000,000/384,000) = $2.60.
P/E ratio is 50/2.6 = 19.2
o Shareholder Wealth = $50 share

Why?
Advantages;
o Financial flexibility to respond if earnings change
o Shareholders have more choice
o Alter capital structure if too much equity, large changes quick and
cheap.
o Signal to the market (implies shares are undervalued - strength)
o Taxes
Disadvantages;
o Shareholders may have preference for cash dividends (clientele)
o May view as negative signal (forced by poor investment
opportunities)
o If price needed to be bid up for purchase, firm may pay too much for
own shares. This will decrease share price in long run and
disadvantage remaining shareholders.
o Uninformed shareholders can be treated unfairly and may take legal
recourse in the future.

6/6 Stock-market Indices and Published Share

Information:

Measures of the price performance of a share market or industry sector,

eg;
o

Performance Benchmark Index

Tradeable benchmark index

Measures overall share-market performance and risk based on

capitalisation and liquidity; typically around 75 to 90% of all the
market.

A narrow index used as the basis for pricing certain derivative

products. (stocks in this index are usually very stable)

Market indicator index

Measure of overall share-market performance or a select group

of stocks which indicate the measure of the market.

Price-weighted (Down Jones etc) Weighting of a

company proportional to its share price

Capitalisation-Weighted (S&P/ASX All Ords) Weighting

of a company proportional to market capitalisation.
o

Research classification of FTSE, Nikkei 225, Hang Seng.

Share-price index measures capital

gains/losses from investing in an indexrelated portfolio
Whereas;
Accumulation index includes share price
changes and reinvestment of dividends

GICS (Global industry classification standard) comprises 10

standard international industry sector indices,
e.g ENERGY, MATERIALS, INDUSTRIALS.

Published share information;

Newspapers and financial journals provide share-market

information to varying degrees of detail
o

Eg; Australian Financial Review.