 Valuation of Preference shares

 Valuation of equity shares with constant dividend

 Valuation of equity shares with variable dividends
 Summary
  A company may issue two types of shares:
◦ ordinary shares and
◦ preference shares
 Features of Preference and Ordinary Shares
◦ Claims
◦ Dividend
◦ Redemption
◦ Conversion

3
 Claims: Preference is given at the time of
asset or dividend claims
 Dividend: Fixed, sometimes cumulative
 Redemption: specific maturity period
 Conversion: Convertible preference shares
can be converted into equity shares after a
stated period.
 Preference shares are differentiated from
equity share with following points
◦ In case of preference share owners are given
preference while giving dividends
◦ Given preference repayment of capital at the time of
company winding up
◦ The holders get dividend at a fixed rate
 With regard to maturity:
◦ Redeemable – fixed maturity
◦ Irredeemable (Not allowed in India) – No Maturity

 With regard to Dividends:

◦ Cumulative – Unpaid dividends are cumulated to
next period
◦ Non-Cumulative – Dividends in arrear does not
accumulate
 PDIV1 PDIV2 PDIV3 PDIVn Pn
P0 = 1 + 2 + 3 + ..... + n +
(1+k) (1+k) (1+k) (1+k) (1+k)n

Or PDIVt Pn
P0 = +
(1+k) (1+k)n
t

Where, P0 = Value of the Pref. Share

PDIV = Dividend of the Pref. share
Pn = Maturity value of the Pref. share
k = Required rate of return
 P0 = PDIV
k

Where P0 = Value of the Preference Share

PDIV = Dividend
k = Required rate of return
 The valuation of ordinary or equity shares is
relatively more difficult.
◦ The rate of dividend on equity shares is not known;
also, the payment of equity dividend is
discretionary.
◦ The earnings and dividends on equity shares are
generally expected to grow, unlike the interest on
bonds and preference dividend.
 Present value of the cash flows expected in
the future.
 Cash inflows consists of dividends that the
owner expects to receive while holding the
share and the price, which the owner is
expected to obtain when the share is sold.
• Single Period Valuation: (When the
investor expects to hold the share
for 1 year)
DIV1  P1
P0 
1  ke
– If the share price is expected to grow at g per
cent, then P1:
P1  P0 (1  g )
– If we simplify the above formula by putting
the value of P1 = P0(1+g)
DIV1
P0 
ke  g
 If the final period is n, we can write the general
formula for share value as follows:
n
DIVt Pn
P0   
t 1 (1  ke ) (1  ke ) n
t

 Growth in Dividends
Growth = Retention ratio  Return on equity
g  b  ROE
◦ Normal Growth DIV1
P0 
ke  g
◦ Super-normal Growth
Share value  PV of dividends during finite super-normal growth period
 PV of dividends during indefinite normal growth period
 Under two cases, the value of the share
can be determined by capitalising the
expected earnings:
◦ When the firm pays out 100 per cent
dividends; that is, it does not retain any
earnings.
◦ When the firm’s return on equity (ROE) is equal
to its opportunity cost of capital.
 For firms for which dividends are expected
to grow at a constant rate indefinitely and
the current market price is given

DIV1
ke  g
P0
 Estimation errors
 Unsustainable high current growth
 Errors in forecasting dividends
 P/E ratio is calculated as the price of a share
divided by earning per share.
 Some people use P/E multiplier to value the
shares of companies.
 Alternatively, you could find the share value
by dividing EPS by E/P ratio, which is the
reciprocal of P/E ratio.
 The share price is also given by the following
formula:
EPS1
P0   Vg
ke
 The earnings price ratio can be derived as
follows:
EPS1  Vg 
 ke 1  
Po  Po 
 Cautions:

◦ E/P ratio will be equal to the capitalisation rate only

if the value of growth opportunities is zero.
◦ A high P/E ratio is considered good but it could be
high not because the share price is high but because
the earnings per share are quite low.
◦ The interpretation of P/E ratio becomes meaningless
because of the measurement problems of EPS.
 Value of preference share
 Value of equity share
◦ Dividend Capitalisation Model
 Single Period
 Multi-Period (No-Growth, Constant growth & variable
growth)
◦ Earning capitalisation
 P/E ratio