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
