Home Accounting Corporate Valuation and Takeover: Exercises

## II: Share Valuation Theories## How to Value a Share## IntroductionThe key to understanding how markets work and the basic measures used by investors to analyse their performance (price, dividend yield, cover, and the P/E ratio) requires a theoretical appreciation of the relationship between a share's price, its return (dividend or earnings) and growth prospects using various models based on discounted revenue theory. Chapter Two of share price using discounted techniques to define current price in a ex-div of ways. Each depends on a definition of future periodic income (either a dividend or earnings stream) under growth or non-growth conditions discounted at an appropriate cost of equity (either a dividend or earnings yield) also termed the equity capitalisation rate, within a time continuum.variety For example, given a forecast of periodic future dividends (Dt) and a shareholder's desired rate of return (Ke) based on current dividend yields for similar companies of equivalent risk, we defined the The present number of years (n) should equal the discounted sum of future dividends (Dt) plus its eventual given sale price (Pn) using the current dividend yield (Ke) as a capitalisation rate.ex-div Expressed algebraically, using the Equation numbering from the Likewise, given a forecast for periodic future earnings (Et) and a desired return (Ke) based on current earnings yields of equivalent risk, we defined the The present number of years (n) should equal the discounted sum of future earnings (Et) plus its eventual given sale price (Pn) using the current earnings yield (Ke) as a capitalisation rate.ex-div We eventually focused on a far simpler model using the price can be expressed using the ex div as follows:constant dividend valuation model Next year's dividend (Dj) and those thereafter are represented by the latest reported dividend indefinitely.maintainable Turning to published earnings data we observed that: Next year's earnings (Ej) and those thereafter are represented by the latest reported profit indefinitely.maintainable Because a company's shares cannot sell for different prices at a particular point in time we then noted that: If management pursue a policy of full distribution (whereby But if a company retains a proportion of earnings for reinvestment (Dj< E1) the dividend yield will be lower than the earnings yield: For example, if a company's, latest reported dividend and earnings per share are £1.00 and £1.60 respectively, trading at a current price of £8.00 then because earnings This difference in yields is not a problem for investors who know what they are looking for. Some prefer their return as current income (dividends and perhaps the sale of shares). Some look to earnings that incorporate retentions (future dividends plus capital gains). So, their respective returns will differ according to their consumption preferences and the risk-return profile of their portfolio of investments. This is why share price listings in the newspapers focus on dividends between the two measured by dividend cover.interrelationship However, you will recall that to avoid any confusion between dividend and earnings yields when analysing a company's performance, published listings adopt a universal namely a reciprocal, the price-earnings (P/E) ratio.valuation multiplier: ## Exercise 2: The Dividend Yield, Cover and the P/E RatioUnlike the dividend yield and the earnings yield, which are number that analyses price as a real of earnings. On the assumption that a firm's current post-tax profits are maintainable indefinitely, the ratio therefore provides an alternative method whereby a company's distributable earnings can be capitalised to establish a share's value. However, it does not stand alone when we analyse a company's performance. With information on dividend yield, or dividend cover it is possible to construct a comprehensive investment profile for the basis of analysis.multiple Consider the following data relating to four companies whose dividends are covered twice by earnings.
1. Tabulate the earnings yield and corresponding P/E ratio for each company. 2. Comment on the mathematical relationship between these two measures and its utility.
1. The corresponding earnings yields and P/E ratios for each company can be tabulated as follows: 2. The Mathematical Relationship Because the two measures are reciprocals of one another, whose product always equals one, there is always a The interpretation of the P/E is that the the earnings yield and higher Because investors are dealing with an vice versa. P/E value and not a absolute yield, there is no possibility of confusing a share's dividend and earnings performance when reading share price listings, articles or commentaries from the press, media, analyst reports, or internet downloads.percentage ## Summary and ConclusionsNot only is the previous exercise useful for future reference throughout this text once we begin to interpret the interrelationships between price, dividend yield and the P/E ratio in Part Three. But in the interim your regular reading of the financial press as a guide to further study outlined in Chapter One should also fall into place. However, before we analyse this practical methodology for analysing corporate, stock market performance, we need to consider its theoretical limitations with answers to the following questions. What happens to current share prices listed in the financial press if the latest reported dividends, or earnings, are not constant in perpetuity? For the purpose of equity valuation, are dividends (yields) more important than earnings (P/E ratios) or To understand the debate, I suggest that you do some preparation by reading the remainder of ## Selected ReferenceHill, R.A., |

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