FINC2011 Chap.5 Equity Markets and Share Valuation
Equity Markets and Share Valuation
This chapter separates primary capital raising from secondary trading and connects market price to expected shareholder cash flows. It calculates realised holding returns, values no-growth and constant-growth dividends, and builds multi-stage dividend discount models with a correctly dated terminal value.
It also links retention and return on new investment to growth, emphasising that reinvestment creates value only when projects earn an adequate return.
What this chapter covers
- 01
Primary issues and secondary trading
- 02
Price discovery and liquidity
- 03
Dividend yield and capital-gain yield
- 04
No-growth dividend valuation
- 05
Constant-growth Gordon model
- 06
Multi-stage dividend forecasts
- 07
Retention, new investment and growth
Worked example · free
Build a two-stage dividend value
- 1Forecast D1 = $1.188 and D2 = $1.28304 from the dividend just paid.
- 1Forecast D3 = $1.3215312 using the perpetual 3% growth rate.
- 2Place terminal value at Year 2: P2 = D3 divided by 0.09 minus 0.03, giving $22.02552.
- 1Discount D1, D2, and P2 to today at 9%.
- 1Report an estimated value of about $20.72 per share and state the growth assumptions.
Key terms
- Primary Market
- The market where newly issued securities raise capital for the issuing company.
- Secondary Market
- The market where investors trade existing securities with one another and establish current prices.
- Holding Period Return
- Dividend income plus price change over a holding period, divided by the initial share price.
- Terminal Value
- The value at a future date of cash flows expected to occur after an explicit forecast period.
Equity Markets and Share Valuation FAQ
Does the company receive cash from every share trade?
No. The company receives capital when it issues new shares in the primary market. Most later trades occur between investors in the secondary market. Those trades still matter because liquidity and price discovery influence investor confidence and future capital-raising terms.
Why does the Gordon model use the next dividend?
The current value is measured before the future stream begins, so the numerator must be the first dividend the buyer expects to receive. When the question gives a dividend just paid, grow D0 once to obtain D1 before dividing by required return minus growth.
Where should terminal value be placed?
Place terminal value one period before the first cash flow captured by the continuing formula. If constant growth begins with D4, the Gordon value is P3. Discounting that amount from Year 3 prevents an extra or missing period.
Exam move
Draw a model-choice tree with no growth, constant growth, and temporary high growth. For each branch, record the first dividend used and the date of the resulting value. Practise holding-period returns by separating dividend yield from capital-gain yield, then add them to reconcile total return. In multi-stage models, build a dated dividend schedule and highlight the first continuing dividend.
Perform a sensitivity check after each valuation: required return up means price down, while a higher credible dividend forecast raises value. Treat perpetual growth cautiously because small changes near required return can dominate the estimate. Begin market questions by following both cash and securities.
A primary issue sends investor funds to the company and increases issued claims, while a secondary trade transfers an existing claim between investors. Explain why liquidity and price discovery still influence the cost of future capital even though the company receives no proceeds from an ordinary secondary trade.
For valuation, label the most recent dividend D0 and forecast D1 explicitly before applying a constant-growth formula. In a staged model, write every forecast dividend on a timeline, locate terminal value one period before the first dividend it represents, and discount both the explicit cash flows and terminal value to today.
Calculate the percentage of estimated price supplied by terminal value; a dominant terminal component calls for sensitivity analysis. Reconcile the one-period identity by showing required return as dividend yield plus expected capital-gain yield. Then distinguish that expected relation from a realised holding-period return. Stress required return and perpetual growth separately so their economic roles are not blurred.
Check that required return exceeds perpetual growth and that the long-run rate is credible for a mature firm. Finish with an assumption map covering operating cash generation, payout policy, growth horizon, and risk. A market-price comparison is conditional on that map, not proof that the traded price must immediately converge to the model estimate. For spaced practice, alternate model-selection questions with calculations.
On selection rounds, explain why the rejected models do not fit the dividend path. On calculation rounds, estimate value and then recompute it after one controlled input change. Record which assumption causes the greatest movement and whether that sensitivity is economically plausible.
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