25556 Chap.14 Equity Securities and Share Valuation
Equity Securities and Share Valuation
Topic 7 moves from debt to equity, the funds a business receives from its owners. Because payments to shareholders are not a binding commitment and come last in the queue, equity is riskier than debt and costs the firm more.
The topic follows equity through a company's life, from business angels and venture capital funds backing a young firm to the ordinary and preference shares traded once it is listed.
This chapter compares the two classes of share and explains where shareholder returns and risks come from.
It then sets out the fundamental valuation toolkit the workshop uses: the price-earnings ratio and a P/E-based price forecast, the perpetuity and Gordon dividend growth models, the compound growth rate of dividends and the capital asset pricing model for the required return.
It shows how sensitive a dividend valuation is to the growth input and closes with the top-down, bottom-up and technical approaches to reading a share.
What this chapter covers
- 01
Venture capital, business angels and investment readiness
- 02
Ordinary shares versus preference shares
- 03
Sources of return and risk for shareholders
- 04
P/E ratio and P/E-based price forecasts
- 05
Gordon's dividend growth model and the CAPM
- 06
Technical analysis and moving-average signals
Worked example · free
Work out the dividend growth rate a share price implies on the Gordon value curve
- 1Rearrange: P0 times (ir minus g) = D0 times (1 + g), so g = (ir times P0 minus D0) divided by (P0 + D0).
- 1At $23.85: g = (0.10 times 23.85 minus 0.90) divided by (23.85 + 0.90) = 1.485 divided by 24.75 = 0.06, or 6%.
- 1At $15.60: g = (1.56 minus 0.90) divided by (15.60 + 0.90) = 0.66 divided by 16.50 = 0.04, or 4%.
- 1Reading: a price fall of about 35% corresponds to the market cutting its growth expectation by only two percentage points, because the value is so sensitive to the gap between the required return and growth.
Key terms
- Venture capital
- Equity invested by patient, risk-taking investors in young businesses that aim to grow into large companies.
- Business angel
- A wealthy individual who invests in an emerging firm and takes part in running it during its early development.
- Preference share
- A class of share whose promised dividend ranks ahead of ordinary dividends but which usually carries limited voting rights.
- Price to earnings ratio
- A share's market price divided by its earnings per share, read as a gauge of expected earnings growth.
- Beta
- A measure of how risky a share is relative to the overall market, capturing its systematic risk in the CAPM.
Equity Securities and Share Valuation FAQ
What is the difference between ordinary and preference shares?
Ordinary shares give a residual claim on profits, full voting rights and unlimited potential for capital gains. Preference shares pay a promised dividend that ranks ahead of ordinary dividends but usually have restricted votes, and they may be cumulative, convertible or redeemable. Both represent ownership of the company.
How do I use the P/E ratio to forecast a share price?
Divide the current price by earnings per share to get the P/E. If you expect the ratio to stay stable, multiply it by your forecast of next year's earnings per share to estimate the future price. A P/E above the industry average signals that the market expects faster earnings growth than its peers.
What inputs does Gordon's dividend growth model need?
It needs the dividend just paid, a constant annual growth rate for dividends and the required return on equity, which must exceed the growth rate. Growth is often estimated from past dividends with a compound rate formula, and the required return usually comes from the CAPM.
How does the CAPM give a required return?
Start from the risk-free rate and add a premium equal to the share's beta times the market risk premium, which is the expected market return minus the risk-free rate. A beta above one means the share moves more than the market, so investors demand a higher return.
Why do venture capital funds invest in several businesses?
Investing in young firms is high risk, and any one of them can fail completely. Spreading money across a number of new businesses reduces the chance of losing everything, while the few successes can be sold later, often through a public float once the firm is investment ready.
Exam move
Make a one-page sheet with the five valuation formulas and, next to each, the inputs it needs and where they come from. Then practise chaining them on your own numbers, but also run each model backwards, solving for growth or the required return from a price, because that shows whether you understand the structure rather than the order of keystrokes.
Draw the ordinary versus preference comparison from memory and check the features against the lecture list. Finally, practise explaining in two sentences why a small change in the growth estimate can swing a dividend valuation, since that judgement is what distinguishes a reasoned answer from a calculation. Check every valuation you produce for a growth rate that exceeds the required return, which the model cannot handle.
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