SHARE VALUATION MODELS

SHARE VALUATION MODELS PRESENTED BY: GEORGE TWUMASI

MODELS FOR THE VALUATION OF SHARES • There are several models used for the valuation of shares. Examples are: • Model based on streams of dividend expected (Dividend Valuation Model) • Models based on the anticipated earnings of the company over time. • Models based on the value of company’s assets and liabilities. • In each of these approaches the model utilises the discounted present value of these future cash flows.

DIVIDEND VALUATION MODEL • Assumptions of this theory are: • In the case of shares, these cash flows for the investor will be the dividends paid by the company. • Even when the shareholder sells his shares at some time in the future, the person who buys these shares will be purchasing the continuing stream of dividends. • Though the shareholder may benefit from the growth of the company through reinvestment of earnings, ultimately the earnings must generate dividends for the shareholders.

DIVIDEND VALUATION MODEL • This method is based on the assumption that it is possible to determine the dividend that will be paid by the company each year in the future. (Since the company does not have limited life, this stream of dividends continues, theoretically, to infinity.) • The generalised share valuation model based on anticipated future dividends can be expressed as: • Po = ( D1 / (1 + kc)1 + (D2 / (1 + kc)2 + (D3 / (1 + kc)3 + …. + D / (1 + kc) • Where P = the theoretical value of the share price • Dn = the dividend for each year in the future • Kc = the required rate of return (discount rate, or capitalisation rate).

DIVIDEND VALUATION MODEL • Limitations of the Model: • It is often difficult to estimate the dividends that a company will pay next year, much less the dividend to be paid in several years. • Further, each investor may well have his own unique required rate of return, or capitalisation rate, which he will apply to this stream of cash flows. • The basic dividend discount model is useful as a starting point for gaining an understanding of these methods, but should be used with an appreciation of its limitations.

Constant Amount of Dividend • Here the assumption is that the company pays the same amount as dividend every year. The value of the share is therefore the sum of the all the dividends discounted to their present values plus the discounted value of the price at the end of the period. The formula is therefore: Po=D/r

Illustration A Ltd has indicated that the annual dividend on its shares will be $1,500 and this amount in not expected to change. Investors require a return of 12%. Then the price of this share is: • Po=D/r • Po=1,500/0.12 • Po=$12,500.00

CONSTANT GROWTH DIVIDEND MODEL • With some companies it may be easier to predict a rate of growth in the dividends rather than a specific dividend for each year. • Many companies do, in fact, have a policy of raising their dividend each year at a rate, which will offset the erosion of purchasing power due to inflation. • If a constant rate of growth of the dividend can be assumed, the formula for the theoretical value of a share is given as follows:

CONSTANT GROWTH DIVIDEND MODEL • The constant dividend growth model can be shortened to: Po = D1 / (r - g) Where D1 = Do x (1 + g) • ILLUSTRATION • Company PDQ is currently paying a dividend of ¢50 per share. You believe that this company will maintain a steady growth rate for their dividend of 10% per year. You determine that a capitalisation rate of 20% is appropriate for this investment. • The theoretical value for one of PDQ’s shares is: Po = ((¢50 x (1 + 0.10)) / (0.20 – 0.10) = (¢55) / (0.10) = ¢550

Illustration 2 • Company Y currently pays an annual dividend of $100. The company mgt has indicated that it expects annual dividends to grow at 5% each year. Shareholders want a return of 12% on their investment. What is the value of the company’s shares? Po=D1/r-g, But D1=Do(1+g) • Therefore Po=100(1+0.05)/0.12-0.05 • =$1,500

Non Constant Dividend Growth (Multiple Growth) Model • In practice we know that companies go through periods of growth and decline. Maintaining a constant rate of growth of dividends may not be possible, or even part of the company’s objectives. Example: A Ltd is currently paying 150 cedis as dividend. This dividend will grow at the rate of 20% for the first three years and then grow at a steady rate of 5% forever. Compute the price you will pay for A Ltd’s share if investors require 15% return on the investment

Solution • Do=150 • D1=150(1.20)=180 • D2=180(1.20)=216 • D3=216(1.20)=259 • D4=259(1.05)=272 Compute the terminal value i.e. Price at year 3, P3=D4/r-g=272/0.15-0.05 P3=2,720

Solution Cont’d • P=D1/(1+r)1+D2/(1+r)2+D3/(1+r)3+P3/(1+r)3 • P=180/1.15+216/(1.15)2+259/(1.15)3+2,720/(1.15)3 • Therefore P=2,278

EARNINGS VALUATION MODELS • Some investors, rather than focusing on the dividends being paid or forecast to be paid, will look at the earnings of a company in determining the theoretical value of its shares. This might be most appropriate when a company does not pay a cash dividend, and does not expect to pay a dividend in the foreseeable future.

Basic Short Term Earnings Model • Some shareholders have a very short-term perspective on the market. They may feel uncertain as to their ability to forecast earnings or dividends years into the future. Rather, these investors would focus only on the current earnings per share (EPS) and determine an appropriate multiplier (price earnings ratio, or PE Ratio) to arrive at the theoretical value of the share. • Determining a price earnings multiple will involve both calculation and subjective judgement. Investors will often look at comparable companies to determine their price earnings ratios. A composite or average PE multiple might be determined, which would then be applied to the earnings for the company being analysed.

ILLUSTRATION • Company JKL operates several hotels in the major business centres in Ghana. The company has just reported EPS of ¢40 for the past year. Nana’s analysis of the PE ratios of comparable companies indicates that their shares are all priced at approximately 20 times current earnings per share. • Based on this assessment, the theoretical value of these shares would be ¢800).

Examples • Compute the price of a share with annual earnings per share of $7.50 with P/E ratio of 4 • A share with P/E ratio of 8 pays annual dividend of $4.25, 60% of most recent earnings per share. The share’s price is: • A company with total earnings of $50,000 with outstanding number of shares of 10,000 has a P/E ratio of 6, what is the value of its share? • A firm earned $400,000 before tax and it is in 40% tax bracket. If the number of issue shares is 5000 and P/E ratio of similar companies listed on the GSE is 10. What is the value of its share?

ASSET VALUATION MODELS • The liquidating value of the shares of a company (known also as the book value: • (tangible assets – liabilities) / # shares • is sometimes used as an estimate of the lowest value at which a share should be traded. The theory is that if the company were to wind up its business, this is the amount that would be realised by the owner of each share. • Certain types of companies are not well suited to this type of analysis. Companies normally carry assets on their books at cost. Certain types of assets, such as real estate and marketable securities, may have a fair market value well in excess (or well below) the cost.

REGULATION OF SECURITIES MARKETS PRESENTED BY: GEORGE TWUMASI

The Rationale for Regulation • For financial institutions such as stockbrokerage firms, the responsibility to maintain the highest standards of ethics and legality cannot be overemphasised. Ethics refers to agreed upon standards of behaviour or moral judgements of a community. However, legality is enshrined in legislation designed to achieve a wide range of objectives

The Rationale for Regulation • Regulation is driven by the need to: 1) Increase competition 2) Promote financial disclosure 3) Protect investors from insider abuse and fraud 4) Enforce fiduciary responsibilities of financial institutions 5) Promote safety and soundness

Increase Competition • One of the objectives of financial regulation is to promote competition. This ensures that existing and potential financial institutions are able to access the financial market on equal terms and under a uniform set of rules. The result of competition is a better quality of service to customers at a lower price.

Promoting Financial Disclosure • It is generally agreed that managers of companies who issue securities to the investing public are more informed about the affairs of the company than outsiders. • With the increasing complexity of financial instruments, regulations have to be put in place to promote disclosure as well as equal and fair access to information by all market participants.

Protect Investors From Fraud And Insider Abuse • There are laws that restrict the ability of a company’s management from buying and selling a company’s shares and bonds using information which they, because of their position, have access to. In addition, it is necessary to ensure that information is factual and timely so that insiders cannot give misleading signals to the investing public.

Enforce fiduciary responsibilities of financial institutions • In law, a fiduciary is a person who occupies a position of such power and confidence with regard to the property of another that the law requires him to act solely in the interest of the person who he represents. • A fiduciary is legally liable for the violation of his fiduciary duty. For example, brokers who control customer investment funds are sometimes accused of excessively trading a customer’s account to increase commissions.

The Duties of a Fiduciary • Refraining from profiting at the expense of the other person to whom he has a fiduciary obligation • Not competing with him without his consent • Not being unfair to him • Making a full disclosure of all facts when dealing with him • Refraining from delegating performance of his fiduciary responsibilities to a third person • Respecting the other person’s confidence and trust

Promote Safety and Soundness • The regulation of the safety and soundness of financial intermediaries is called prudential regulation • Among the fears that prudential regulation is intended to allay are: • Financial panics which disrupt economic activities and undermine public confidence • Loss of wealth of market participants resulting from failure of financial intermediaries.

The Structure of the Regulatory System in Ghana • The regulatory system in Ghana, much like the regulatory system in other countries, is a complex web of institutions and laws. Institutionally, we have the following statutory regulatory bodies: • Bank of Ghana • Securities and Exchange Commission • Registrar-General’s Department

The Structure of the Regulatory System in Ghana • The regulation of securities markets in Ghana is designed to simultaneously maximise investor protection and to enhance the intermediation role of financial institutions.

The Structure of the Regulatory System in Ghana • For securities markets, some of the most important laws are: • The Securities Industry Law, 1993 (P.N.D.C.L. 333) • The Companies Act, 1963 (Act 179) • The Banking Law, 1989 (P.N.D.C.L. 225) • The Financial Institutions (Non-Banking) Law, 1993 (P.N.D.C.L. 328)

The Securities Industry Law (SIL) • The broad objectives of the SIL are to regulate securities market institutions and to prevent inequitable and unfair practices in such markets. The Securities and Exchange Commission (SEC) is the primary agency responsible for administering securities laws in Ghana.

Functions of the SEC • to advise the Minister of Finance on all matters relating to the securities industry; • to maintain surveillance over activities in securities to ensure orderly, fair and equitable dealings in securities; • to register, license, authorise or regulate stock exchanges, investment advisers, unit trust schemes, mutual funds, securities dealers and their agents, and to control their activities with a view to maintaining proper standards of conduct and acceptable practices in the securities business; • to formulate principles for the guidance of the industry;

Functions of the SEC (con’t) • Protect the Integrity of the securities market. • To review, approve and regulate takeovers, mergers, acquisitions and all forms of business combinations • To institute measures to minimise and supervise any conflict of interest that may arise. • To create the necessary atmosphere for the growth and development of capital market

Enforcement of the Law • The methods available to the Commission for enforcing the law are: • Withdrawal of approval for a stock exchange • Prohibition of trading in a particular security • Approval of changes to the rules of a stock exchange or amend the rules of the exchange • Expulsion of a member of the exchange • Compelling observance or enforcement of the rules of a stock exchange by court order • Issuance of directives to a stock exchange in respect to the manner in which a stock exchange carries on its business

Standards of Conduct • Contract notes issued by dealers for trades must provide some minimal information on the dealer’s business including a disclosure of whether or not he is acting as a principal • Dealers or investment advisers should disclose their interest in securities that are recommended to a client • Advisers should have a reasonable basis for making a recommendation to a person who can be reasonably expected to rely on the recommendation. • In principal transactions with non-dealers, dealers are required to disclose that they are acting as principals

TRADING OFFENCES • False trading and fraudulent transactions. False trading occurs when transactions are designed to create a false or misleading appearance of active trading in a security. Such artificial market activity is usually designed to attract the public to a particular security. For example, a rising volume or price readily attracts the public which might rush to buy the stock.

TRADING OFFENCES • Stock market manipulation: Market manipulation is a series of transactions that are likely to have the effect of raising, lowering, maintaining or stabilising the price of a security, with the intention to induce other persons to sell or buy the security. Manipulation is an artificial control of security prices. It is an attempt to force securities to sell at prices either below or above those that would exist as a result of the normal operations of supply and demand.

TRADING OFFENCES • Dealings in securities by insiders: An important section of the SIL deals with trading by insiders. The SIL defines an insider as “ a person who is, or has at any time in the 6 months immediately prior to dealing in the securities of a corporate body been connected with that body corporate”. In practice, an insider is usually a director, an executive officer or a large shareholder.

Other Illegal Practices • False or misleading statements – This is the wilful dissemination of information calculated to induce the sale or purchase of securities by other persons or that is likely to have the effect of raising, lowering maintaining or stabilising the market price of securities. • Fraudulently inducing others to deal in securities: The publishing of statements that are false or deceptive and dishonest or concealment of material facts. • Employment of manipulative and deceptive devices

SHARE VALUATION MODELS