Chapter 4: Capital Markets (II)

Characteristics of Company Shares

Shares represents the ownership of a part of a company Two types of shares:
Common shares (ordinary shares or equities) Preferred shares

Characteristics of Company Shares

Shareholders have the right to vote to elect Board of Directors, to decide on matters of great importance Shareholders are entitled to share in profits generated by the firm
Firms may pay fixed proportion of their profits as dividends => dividends depend on profitability Firms may smooth the dividend payments by letting them grow steadily over time => dividends finally still depend on profitability

If the firm flourish and grow, value of shares will increase

Characteristics of Company Shares

Drawbacks of share ownership
Dividends depend on the firms earnings => can vary or even cease if the firm run into long-run difficulty If the firm goes bankrupt, shareholders will be paid after creditors (owners take risk of operation). If the firm is insolvent, shareholders equity = Assets Liabilities < 0 => shareholders get nothing

Bond versus Stock

Bonds
Bond owners are creditors Creditors generally do not have voting rights Interest payments are often fixed, not dependent on profitability Interest payments is tax deductable

Stocks
Stockholders are owners of the company Stockholders have voting rights Dividends are dependent on profitability Dividends are not tax deductable (from after tax profit)

If company cannot pay back debt, The same action is not possible for creditors can push for asset stockholders liquidation or reorganization

If the company go bankrupt, bond Equity is a residual claim (paid by owners will be paid first the remaining amount, after paying to all creditors)

Preferred Stocks
Preferred stocks: Pay fixed dividends and in that sense are like a bond. The dividends, however, may not be paid if the company incurs loss or low profits Preferred stockholders are owners and their dividends are not tax deductable Preferred stockholders rank behind bondholders but before common stockholders

Preferred Stocks
Cumulative preferred shares: Unpaid dividends are cumulated and become payable when earnings permit Convertible preferred shares: Carry rights to convert to ordinary shares on specified terms and at specified times

Understanding Share Price Data

Information on share price
Newspapers such as Financial Times and Wall Street Journal Stock exchanges websites Websites of investment banks, financial institutions

Understanding Share Price Data

2009 Telecommunications Price Cable and Wireless 142 Change -0.50 High Low 170 125.1 Yield 6.2 P/E Vol.000s 22 21,246

(1) Name of the firm (2) Latest price (in pence). In newspapers, this is previous days price (3) Price change from the previous days close price (4) Highest price so far during the year (5) Lowest price so far during the year (6) Dividend yield = Latest dividend/Current price (7) P/E = Price/EPS (8) Trading volume

Coca Cola Stock

Oil and Gas London Stock Exchange

Pricing of Company Shares

Fundamental analysis: The explanation of an assets value by reference to its potential earnings and risk Technical analysis: The explanation of an assets value by the study of past price movements

Fundamental Analysis
Fundamental theory of valuation: The value today of any financial asset equals the present value of all of its future cash flows, suitably discounted. Suitably discounted: Take into account both general level of interest rates and risk

Fundamental Analysis
Cash flows You buy a stock at price P0 and plan to sell it in 1 year. You predict that you can sell it for price P1 and receive a dividend of D1 at the end of the year. Discount future cash flows P1 and D1 to calculate current stock value (price):

D1 P 1 P0 1 K
K: Discount rate

Fundamental Analysis
Cash flows If the investor plans to hold the stock for H periods, receive a series of dividend D1, D2, DH and sell it after H periods for price PH.

D1 D2 DH PH P0 .... 2 H 1 K (1 K ) (1 K )

Fundamental Analysis
Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

Fundamental Analysis
Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

3.00 3.24 3.50 94.48 PV 1 2 3 (1.12 ) (1.12 ) (1.12 ) PV $75.00

Fundamental Analysis
Cash flows If the investor plans to hold the stock forever, he will receive a series of dividend D1, D2, D3..=> Discounted Dividend Model (DDM)

D3 D1 D2 P0 .... 2 3 1 K (1 K ) (1 K )

Fundamental Analysis
If we forecast no growth of dividends (D1 = D2 = D3 = ), and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.

D1 EPS Perpetuity P0 K K
Assume all earnings are paid to shareholders

Fundamental Analysis
Cooper, Inc. common stock currently pays a $1.00 dividend, which is expected to remain constant forever. If the required return on Cooper stock is 10%, what should the stock sell for today? Given no change in the variables, what will the stock be worth in one year?

Fundamental Analysis
P0 = $1/0.10 = $10 One year from now, the value of the stock, P1, must be equal to the present value of all remaining future dividends. Since the dividend is constant, D2 = D1 , and P1 = D2/K = $1/0.10 = $10. In other words, in the absence of any changes in expected cash flows (and given a constant discount rate), the price of a no-growth stock will never change.

Fundamental Analysis
Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate forever (Gordon Growth Model).

D1 P0 Kg
g: constant growth rate of dividends Given any combination of variables in the equation, you can solve for the unknown variable

Fundamental Analysis
We can use Gordon growth model to get the stock price at any point in time

Dt 1 Pt Kg
Notice that Pt = P0 x (1+g)t

Fundamental Analysis
Example What is the value of a stock that expects to pay a $3.00 dividend next year, and then increase the dividend at a rate of 8% per year, indefinitely? Assume a 12% expected return. What is the price of the stock in 5 years?

Fundamental Analysis
D1 $3.00 P0 $75.00 K g .12 .08

D6 D1.(1 g ) 3x(1 0.08) 4.408

5 5

D6 $4.408 P5 $110.2 K g .12 .08

P5 = P0.(1+g)5 = 75 x 1.085 = 110.2

Fundamental Analysis
Ex: Suppose a stock has just paid a $5 per share dividend. The dividend is projected to grow at 5% per year indefinitely. If the required return is 9%, then what is the stock price today?

Valuing Common Stocks

P0 = D1/(K - g)

=
=

$5 ( 1.05 )/( 0.09 - 0.05 )

$5.25/.04

$131.25 per share

Fundamental Analysis
Example- continued If the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends?

$3.00 $100 .12 g g .09

Answer The market is assuming the dividend will grow at 9% per year, indefinitely.

Fundamental Analysis
Ex: Suppose a stock has just paid a $5 per share dividend. The dividend is projected to grow at 5% per year indefinitely. If the stock sells today for $65.625, what is the required return?

Fundamental Analysis
P0 K = D1/(K - g)

(K - g) =
= = =

D1/P0
D1/P0 + g $5.25/$65.625 + .05 0.13 = 13%

Fundamental Analysis
Nonconstant growth: Dividends of the company grow at high rates over some finite length of time, and after that, grow at a constant rate forever

Fundamental Analysis

Required rate of return is 10%

Fundamental Analysis
P3 = D4/(K g) = D3 x (1 + g)/(K g) = 52.50

D3 P3 D1 D2 P0 2 3 3 1 K (1 K ) (1 K ) (1 K ) 1 2 2.5 52.5 43.88 2 3 3 1 0.1 (1 0.1) (1 0.1) (1 0.1)

Fundamental Analysis
If the dividend grows at constant rate after t periods, then the price can be written as:

Dt Pt D1 D2 P0 .... 2 t 1 K (1 K ) (1 K )
Dt 1 Pt Kg

Components of Required Return

The required return, r, can be written as the sum of two things: K = D1/P0 + g where
D1/P0 is the dividend yield g is the capital gains yield (capital appreciation) since growth rate in dividends is also the rate at which the stock price growth

In equilibrium, where the share price is stable and investors appear to be happy with the price, then K must be required rate of return

Fundamental Analysis
If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher.

Payout Ratio (p) - Fraction of earnings paid out as dividends Plowback (Retention) Ratio (q) - Fraction of earnings retained by the firm.

Fundamental Analysis
Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations.

g = return on equity X retention ratio

Fundamental Analysis
Ex: Suppose that earnings per share (EPS) next year is $10 and the firm retains 50% of earnings for reinvestment. Suppose that K = 0.2 and the productivity of the firms additional investment is also 0.2. What is the stock price? What is the stock price if retention ratio increases to 0.6?

Fundamental Analysis
If retention ratio = 0.5: D1 = (1 0.5) x 10 = 5; g = 0.2 x 0.5 = 0.1

0.5 x10 5 P0 50 0.2 0.1 0.1

If retention ratio = 0.6 D1 = (1 0.6) x 10 = 6; g = 0.2 x 0.6 = 0.12

0.4 x10 4 P0 50 0.2 0.12 0.08

Fundamental Analysis
Notice: Changing the payout/retention ratios have no effect on the share price: p.EPS p P0 k k .(1 p) 1 (1 p) 1 * p * .EPS p* P0 k k .(1 p*) 1 (1 p*) There is no change in price since the productivity of reinvestment, r, is equal to its cost of capital, K. This is a reasonable assumption since if the productivity exceeds the cost of capital, it pays the firm to increase its investment until productivity of the new capital just matches the cost.

Fundamental Analysis
Relative valuation models: Stock price are valued by comparing price multiples (P/E price/earnings, P/B price/book value, P/CF price/cash flow etc.) of similar assets based on one price principle
Assumption: Companies of the same industry usually have similar price multiples. The most popular price multiple is P/E which is telling us what we have to pay in order to obtain a share of a firms earnings A share with high P/E may indicate that it is expensive compare to other shares However, firms in the same sector with different characteristics may have different price multiples

Fundamental Analysis
The factors affecting share prices are:
Earnings - D1 Future growth - g Required return K - which is affected by the level of risk and general level of interest rates

Events that influence the factors will cause share price to change

Event

Acts on

A change in business activity

A startling new product Interest rates A profits surprise

Forecasts of economic boom/recession An increase in inflation

K, since this is likely to change the riskiness of the firm and thus the return required by shareholders G, since profits and dividends are likely to grow more rapidly K, since returns on alternative assets will have changed. Possibly g too D1, since this is likely to be different from what was expected and possibly also g depending on the reason for the surprise g, since we expect profits and dividends to growth more rapidly/slowly in a boom/recession K and maybe g, on the assumption that the central bank is inflation-adverse, this will create expectations of higher interest rates

Event

Acts on

Rumor of conflict amongst managers/directors

Depreciation of the currency A general change in public confidence about the future Rumors of a strike

K, since the future of the firm is more uncertain (riskier) and investors will want a higher return
g, since exporting firms will benefits (g increases) while firms producing for domestic market will face stiffer competition (g reduces) K, since this is likely to result in a changed attitude towards risk and risky assets If it goes ahead, this is likely to reduce this years profits and consequently D1. On the other hand, if it is a response to a management decision to cut costs or increase productivity in future, it may have little effect since there may be a compensating increase in g

Pricing New Shares

Price of new shares cannot exceed the price at which existing shares are trading.
Earnings per share will reduce since the firms earnings have to be spread across more shares Calculate price of new share by finding new dividend (earnings) per share, leaving all else unchanged

Pricing New Shares

Other factors affecting the price of new shares:
Perceived signal of the market about the firms future prospects after the issuance of new shares Reputational issues: The firm and the investment bank guaranteeing the issuance may sell new shares at a discount to sell the shares quickly

Technical Analysis
Technical analysis (chartism): The explanation of an assets value by the study of past price movements and trading volumes Visual study of recent patterns in the behavior of a shares price

Technical Analysis
Moving average: Moving average can be obtained by first taking the average of the first subset. The fixed subset size is then shifted forward, creating a new subset of numbers, which is averaged. This process is repeated over the entire data series. The plot line connecting all the (fixed) averages is the moving average. Moving average of stock prices smooths out the day-to-day fluctuations in price

Technical Analysis
A simple moving average (SMA): is the unweighted mean of the previous n data points An example of a simple unweighted running mean for a 10-day sample of closing price is the mean of the previous 10 days' closing prices. If those prices are pM, pM-1.pM-9 then the formula is

When calculating successive values, a new value comes into the sum and an old value drops out, meaning a full summation each time is unnecessary for this simple case,

Technical Analysis
Price P2

P1

t0

Time

Technical Analysis
Support level P1: The price range at which the technician would expect a substantial increase in the demand and price of the stock. In other words, stock price reaches the lowest point and begins to recover. Investors will be ready to buy as soon as the price approaches P1, especially those interested in capital growth

Technical Analysis
Resistance level P2: The price range at which the technician would expect an increase in the supply of the stock and a price reversal. If the price rises above P2, investors should be ready to sell the moment that the price starts to fall back

Technical Analysis

Technical Analysis
The last two assumptions are problematic: Technical analysts expect stock price to move in trends that persist for long periods because they believe that new information does not come to the market at one point in time (as assumed by fundamental analysts and efficient market supporters) but rather enters the market over a period of time.

Technical Analysis

Technical Analysis

Technical Analysis

Technical Analysis
EMH: Efficient Market Hypothesis (Next chapter) Self-fulfilling prophecies: For example, if many investors expect that stock price will increase and decide to buy, the stock price will actually increase because of high demand

Required Rate of Return

Required rate of return:
Incorporates the general level of interest rates and a risk premium Based on rate of return of similar assets

Measuring Risk of an Individual Asset

Variance - Average value of squared deviations from mean. A measure of volatility.
Standard Deviation - Average value of squared deviations from mean. A measure of volatility.

Measuring Risk of an Individual Asset

Expected rate of return:
e

K
Variance:

K
n
2

Var

(K

K ) n

e 2

Standard deviation:

Var

Risk of an Individual Asset

Deviation from Squared Year Rate of Return Average Return Deviation 1999 23.7 19.52 381.03 2000 (10.9) (15.08) 227.41 2001 (11.0) (15.18) 230.43 2002 (20.9) (25.08) 629.01 2003 31.6 27.42 751.86 2004 12.6 8.42 70.90 Total 25.1 2,290.63 Average rate of return = 25.1/6=4.18% Variance = average of squared deviations = 2290.63/6=381.77 Standard deviation = squared root of variance = 19.54%

Diversification
Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Unique Risk (Specific Risk) - Risk factors affecting only that firm. Also called diversifiable risk. Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called systematic risk. Portfolio: A collection of assets

Measuring Risk
Portfolio rate fraction of portfolio = x of return in first asset + fraction of portfolio x

( (

in second asset

)( )(

rate of return on first asset

rate of return

on second asset

) )

Diversification
Effects of diversification: When one asset receives a negative shock, there is a chance that another asset will experience a positive shock, thus stabilizing the return of the portfolio Because specific risks can be diversified, investors will accept only market risks Relevant risk that we consider in pricing an asset is not its total risks but its market risks

Diversification
Portfolio standard deviation

0 5 10 15 Number of Securities

Diversification
Portfolio standard deviation

Unique risk Market risk

0 5 10 15 Number of Securities

Market Risk
The risk of a well-diversified portfolio depends in the market risk of the securities included in the portfolio (no more unique risks) The sensitivity of an individual security to market movements (market risk) is called beta ()

Beta and Unique Risk

1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes Expected stock return beta +10% -10%

- 10% -10%

+10%

Expected market return

Copyright 1996 by The McGraw-Hill Companies, Inc

Beta and Unique Risk

Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stocks return to the return on the market portfolio.

Beta
Stocks with beta > 1: Tend to amplify the overall movements of the market Stocks with 0 < beta < 1: Tend to move in the same direction as the market but not as far Market portfolio of common stocks (ex: S&P 500) has average market risk with beta = 1

Beta
In a portfolio context, a securitys risk is measured by beta (its unique risk is diversified) A portfolio beta is a weighted average beta of the securities included in the portfolio P = x1 1 + x2 2 ++ xn n i = im/ m2 Where im is the covariance between stock is return and the market return, and m2 is the variance of the market return

Beta
Market risk: The return on the whole market portfolio, over and above the risk free rate Market risk premium = KM Krf Risk premium of asset Z = KZ Krf KM: Market return, Krf: Risk free rate, KZ: return of Z

Capital Asset Pricing Model

Capital Asset Pricing Model (CAPM): In a competitive market, the expected risk premium varies in direct proportion to beta

KZ - Krf = ( KM - Krf )

Security Market Line

Return

Market Return = KM Risk Free Return =

Krf
1.0 BETA

CAPM
All investment must plot along the security market line (SML)

Security Market Line

Return

.
Risk Free Return = rf Security Market Line (SML)

BETA

Security Market Line

Return

SML

Krf
1.0
BETA

SML Equation K = Krf + B ( KM - Krf )

Capital Asset Pricing Model

K = Krf + B ( KM - Krf )

CAPM
The market will price an asset such that its rate of return will equal to the risk free rate plus a risk premium which depends upon the market price of risk and the quantity of market risk contained within the asset

Capital Asset Pricing Model

Ex: Thornbury has a beta coefficient of 0.9. The risk free rate of interest rate is 3% while the return on the whole market portfolio is 14%. What is required rate of return on Thornburys stock? What is the price of Thornburys share if its last dividend is 6p per share and earnings have been growing steadily at 10% pa?

Capital Asset Pricing Model

KT = 0.03 + 0.9 (0.14 0.03) = 0.129

0.06(1.1) P 2.28 T 0.129 0.1

The Trading of Company Shares

Ultimate borrowers: Companies, usually large ones Ultimate lenders: Households
Directly Indirectly via financial intermediaries that manage pension or mutual funds or life insurance policies

The Trading of Company Shares

Quote-driven (price-driven) market: Market makers are ready to buy and sell shares at quoted prices (bid and ask prices)
Advantage: Buyers and sellers can be certain about the price at which the deal will take place Disadvantage: High transaction costs since market makers must cover their costs and earn a profit

The Trading of Company Shares

Order-driven market: All buy-and-sell orders are entered in a central order book. The exchange technology then tries to match the order with an opposing one so that shares are passing directly from buyer to seller without an intermediate market maker. If the order is not filled after a certain time it can be withdrawn
Advantage: Lower transaction costs Disadvantage: Buyers and sellers CANT BE CERTAIN about the price at which the deal will take place

The Trading of Company Shares

Secondary markets for shares have much bigger size than that of primary markets The London Equity Market, 2009
No. of listed companies 1,458 Market cap. bn (a) 3,252.3 Funds raised by new issues bn (b) 60.4 Turnover bn (b) 10,229.1 No. of trades, Mn (b) 144.8

(a): At end October 2009 (b): 1 January to 31 October 2009

The Trading of Company Shares

The new issues raising 60.4 billion in the ten months to the end of October 2009 while total transactions in the secondary market amounted to more than 10,000 billion
The consequence of portfolio adjustments investors selling one existing stock and buy another While stocks are irredeemable, they are highly liquid

The Trading of Company Shares

Exchange No. of listed companies (a)
2,382 2,999

Market Turnover capitalization US$bn (b) US$bn. (a)

10,312.7 2,579.5 30,214.8 13,618.6

No. of trades Mn (b)

3,476.5 1,826.6

NYSE NASDAQ

Hong Kong
Shanghai Euronext (exc NYSE) Deutsche Borse Tokyo
(a): At end October 2009

1,254
863 1,026 855 2,414

1,228.5
1,314.0 2,083.6 1,097.0 2,884.4

1,458.6
2,184.0 4,050.9 3,526.2 4,902.6

92.1
1,034.2 165.6 128.2 _

(b): 1 January to 31 October 2009

Pricing Instruments in a Supply and Demand Framework

Market for existing Thornbury plc. Shares (similar for primary market) Supply of the shares is fixed so supply curve is vertical Demand curve is downward-sloping because, other things equal, shares are more attractive at a lower price since their rate of return is higher

Pricing Instruments in a Supply and Demand Framework

Initially, the equilibrium price is 2.28 Suppose that Thornbury expands into a new line of riskier high class catering business instead of sticking to its tradition of manufacturing chocolate. 80% of the firm continues in chocolate making while 20% of the firm switches to luxury catering which has beta of 1.1

Pricing Instruments in a Supply and Demand Framework

T = 0.8 (0.9) + 0.2 (1.1) = 0.94 KT = 0.03 + 0.94 (0.14 0.03) = 0.1334

0.06(1.1) P 1.98 T 0.1334 0.1

The stocks price falls to 1.98 so demand curve shifts downward from D to D

Pricing Instruments in a Supply and Demand Framework

The switches (and thus increase in demand for the bond) will cease when the bonds yield equals to 3% as that of other instruments New equilibrium price of the bond is 105.66 at YTM of 3% => A change in market interest rates leads to change in asset prices in the opposite direction

Pricing Instruments in a Supply and Demand Framework

Market price Yield, % 0 = 2.28 12.9%

1.98
D D = 0

13.34%

Quantity of stocks