Session 5: Share Markets and Share Valuation Learning Objective - Introducing the learners to the share market.
- Explain various methods used in share valuation.
Important Terms - Factoring
- Invoice discounting
- Bank overdraft
- Forfeiting
Stocks are regarded as having high risk to investors because of uncertainty in income flows. The value of a stock is determined using the time value of money concept. Stockholder will rank last in earnings distribution but also in sharing proceeds from liquidation. Classification of Stocks (a) Common stocks - holders are the owners of the firm and have voting rights and other privileges but they are subordinate to preference stock holders in ranking for dividend and liquidation proceeds. (b) Preference stocks - holders are entitled a fixed return ahead of common stockholders but have no voting rights. (c) Founders stocks - stocks with voting rights held by the promoters of the firm but will be entitled to dividend after common stocks. Legal Rights of Common Stocks (a) PROXY A document giving one person the authority to act for another, typically the power to vote shares of common stocks. The common stock holders have rights to appoint proxies on represent them over firm’s matters. (b) PRE-EMPTIVE RIGHTS A provision in the corporate charter that gives common holders right to purchase on a pro-rata basis new issue of common stocks. In most cases the price paid will be slightly lower than active market value and is undertaken to avoid dilution of holder’s control. Stock Market Stock exchange markets are establishments where government and industry can raise long-term capital and investors can buy and sell securities. Globalisation has led to integration of capital markets through out the world resulting in large volumes of foreign equity trading. Importance of Stock Markets - Firms have access to finance at low cost
- Assist in allocation of capital within the economy
- Flexibility and speedy in transfer of stocks
- Enhance public profile of the firm
- Mergers can be facilitated better by a quotation
- Improves corporate behaviour
Valuation of Stocks 
(c) Firms with supernormal growth - A firm’s life cycle duration whereby its growth rate exceed the average economy growth rate.
- The firm should calculate the expected dividend for each year of supernormal profit.
- The price of stock is the PV of dividends from time to infinity
- The market value of stocks will be present value of dividend during supernormal growth period plus the PV of stocks value at the end of supernormal period.
Security Market Line The set of risk – return combinations available by combining the market portfolio with risk free borrowing and lending shows the relationship between risk and return from stocks. 
Efficient Market Hypothesis (EMH) EMH is concerned with information processing efficiency in stock markets.
An efficient market is one in which - Information is widely available to all investors at low cost
- All the available relevant information is reflected in short prices
Forms of EMH - Weak form - stock price reflects all past information on price movements
- Semi –strong - stock price reflects all other publicly available information
- Strong - strong price reflects all pertinent information publicly available or privately held.
Dividend Policy The determination of the proportion of profits paid to the stockholder periodically. Optimal dividend policy should strike a balance between current dividend and the future growth that will maximize the firms’ stocks price.
A Company’s directors will have a policy for - What portion of profits to pay out as dividends and what proportion of profits to retain for reinvestments
- What rate of dividend growth to aim for, with the help of reinvestment retained profits.
Their choice of policy might affect their firm’s stock price - A high dividend payout gives stock holders more current income ( on which individual stock holders pay income tax)
- A high retention ratio should provide for future earnings and dividend growth, which ought to improve the current stock price and so give the stock holder a capital gain ( which will be subjected to capital gains tax upon sale of stocks)
Theories on Dividend Policy Irrelevancy proportion theory:
Value of the firms stocks depends on the availability of projects with positive net present value and the pattern of dividend payment makes no difference to firm’s stock prices.
Assumptions: No bankruptcy cost
No taxes
No transaction costs
All investors have access to free information Dividend as residual value
Dividend is distributed to stockholders only after cash has been utilised on the best projects with positive NPV due to cost of finance.
The firm’s primary objective is regarded as maximizing shareholders funds and all cash in the firms after funding projects should be returned o the owners i.e. stockholders. Other policies
Birds in hand
Stock holders requirement for current consumption
Tax preference theory.
Stock repurchases
A transaction, in which the firm buys back share of its own stocks, thereby decreases its stockholding. Methods of stock purchase
Tender – A formal offer to all stockholders wishing to place the stocks for sale to the company.
The firm in an open market as any investor acquires optional market – Stocks and the firm will incur blockarage costs. Advantages of repurchase scheme - Viewed as a positive signal by the investors.
- There is choice to the stockholders to sell or not sell stocks.
- Repurchase can remove large block of stocks overhanging in the market
- Used as a means of utilizing surplus cash flow.
- Can assist in setting the dividend payment policy.
- Reduce large-scale changes in capital structure.
Disadvantages - Stock holders indifference as to hold or sell stocks
- Holders may not be presented with enough information on the present and future prospects of the firm.
- Prices may be too high.
Managerial considerations in determining a dividend pay out ratio - Need for funds- Current financial commitments the firm has apart from dividend payment.
- Liquidity – how comfortable with the present cash balance the firm has to pay the proposed dividend.
- Ability to borrow – If the firm has lesser sources of finance the dividend will be the optimal source of finance.
- Assessment of the industrial trend in dividend payout ratios.
- Nature of stockholders – In a closely held firm management may be able to know the preference of its stock holders thereby able to design a policy that will suit the needs of stockholders.
- Indenture in bond – Restrictions to make further borrowings by bond indenture will force the company to rely on retained profit as the only means for funding thereby resulting in low dividend payout ratio.
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