Compare and contrast preference share and equity share? Briefly explain the techniques for valuation of equity shares?

Compare and contrast preference share and equity share?  Briefly explain the techniques for valuation of equity shares?
Equity shares are the ordinary shares of the company. The holder of the equity shares are the real owners of the company, i.e. the amount of shares held by them is the portion of their ownership in the company.Equity shareholders have some privileges like they get voting rights at the general meeting, they can appoint or remove the directors and auditors of the company. Apart from that, they have the right to get the profits of the company, i.e. the more the profit, the more is their dividend and vice versa. Therefore, the amount of dividends is not fixed. This does not mean that they will get the whole profit, but the residual profit, which remains after paying all expenses and liabilities on the company.
Preference Shares, as its name suggests, gets precedence over equity shares on the matters like distribution of dividend at a fixed rate and repayment of capital in the event of liquidation of the company.The preference shareholders are also the part owners of the company like equity shareholders, but in general, they do not have voting rights. However, they get right to vote on the matters which directly affect their rights like the resolution of winding up of the company, or in the case of the reduction of capital.
Comparison of Equity and Preference shares
BASIS FOR COMPARISON
EQUITY SHARES
PREFERENCE SHARES
Meaning
Equity shares are the ordinary shares of the company representing the part ownership of the shareholder in the company.
Preference shares are the shares that
carry preferential rights on the matters of
payment of dividend and repayment of capital.
Payment of dividend
The dividend is paid after the payment of all liabilities.
Priority in payment of dividend over equity shareholders.
Repayment of capital
In the event of winding up of the company, equity shares are repaid at the end.
In the event of winding up of the company, preference
 shares are repaid before equity shares.
Rate of dividend
Fluctuating
Fixed
Redemption
No
Yes
Voting rights
Equity shares carry voting rights.
Normally, preference shares do not carry voting rights.
 However, in special circumstances, they get voting rights.
Convertibility
Equity shares can never be converted.
Preference shares can be converted into equity shares.
Arrears of Dividend
Equity shareholders have no rights to get arrears of the dividend for the previous years.
Preference shareholders generally get the arrears of
dividend along with the present year's dividend, if not
paid in the last previous year, except in the case of
 non-cumulative preference shares.


Key Differences Between Equity Shares and Preference Shares

1.    Equity shares cannot be converted into preference shares. However, Preference shares could be converted into equity shares.
2.    Equity shares are irredeemable, but preference shares are redeemable.
3.    The next major difference is the ‘right to vote’. In general, equity shares carry the right to vote, although preference shares do not carry voting rights.
4.    If in a financial year, dividend on equity shares is not declared and paid, then the dividend for that year lapses. On the other hand, in the same situation, the preference shares dividend gets accumulated which is paid in the next financial year except in the case of non-cumulative preference shares.
5.    The rate of dividend is consistent for preference shares, while the rate of equity dividend depends on the amount of profit earned by the company in the financial year. Thus it goes on changing.
Valuation of Equity shares
Equity shares can be described more easily than the fixed income securities. However they are more difficult to analyze. Fixed income securities typically have a limited life and a welldefined cash flow stream but equity shares have neither of these. While the basic principles of valuation are same for fixed income securities as well as equity shares, the factors for growth and risk create greater complexity in case of equity shares. As our discussion in market efficiency suggested that identifying mispriced securities is not easy. Yet there are enough chinks in the efficient market hypothesis and hence the search for mispriced securities cannot be dismissed out of hand. Moreover, it is the ongoing search for mispriced securities by equity analysts that contributes to a high degree of market efficiency. Equity analysts employ two kinds of analysis – Fundamental analysis & Technical analysis. Fundamental analysts assess the fair market value of equity shares by examining the assets, earnings prospects, cash flow projections and dividend potential. Fundamental analysts differ from technical analysts, who essentially rely on price and volume trends and other market indicators to identify trading opportunities.T Equity shares can be described more easily than the fixed income securities. However they are more difficult to analyze. Fixed income securities typically have a limited life and a welldefined cash flow stream but equity shares have neither of these. While the basic principles of valuation are same for fixed income securities as well as equity shares, the factors for growth and risk create greater complexity in case of equity shares. As our discussion in market efficiency suggested that identifying mispriced securities is not easy. Yet there are enough chinks in the efficient market hypothesis and hence the search for mispriced securities cannot be dismissed out of hand. Moreover, it is the ongoing search for mispriced securities by equity analysts that contributes to a high degree of market efficiency. Equity analysts employ two kinds of analysis – Fundamental analysis & Technical analysis. Fundamental analysts assess the fair market value of equity shares by examining the assets, earnings prospects, cash flow projections and dividend potential. Fundamental analysts differ from technical analysts, who essentially rely on price and volume trends and other market indicators to identify trading opportunities.
A Philosophical Basis for Valuation
 • There have always been investors in financial markets who have argued that market prices are determined by the perceptions (and misperceptions) of buyers and sellers, and not by anything as prosaic as cash flows or earnings.
 • Perceptions matter, but they cannot be all the matter.
 • Asset prices cannot be justified by merely using the “bigger fool” theory.
Approaches to Valuation 1. Balance Sheet Valuation 2. Dividend Discount Model 3. Earning Multipliers Approach
Balance Sheet Valuation Analysts often look at the balance sheet of the firm to get a handle on some valuation measures. Three measures derive from the balance sheet are book value, liquidation value and replacement cost.
Book Value - The book value per share is simply the net worth of the company, which is equal to the paid up equity capital plus reserves plus surplus, divided by the number of outstanding equity shares. For example, if the net worth of Zenith Ltd is Rs 37 million and the number of outstanding shares of Zenith is 2 million, the book value per share works out to be Rs 18.50 (Rs 37 million divided by 2 million). How relevant and useful is the book value per share as a measure of investment value? The book value per share is firmly rooted in financial accounting and hence can be established relatively easily. Due to this, its proponents argue that it represents an ‘objective’ measure of value. A closer examination, however, quickly revels that what is regarded as objective is based on accounting conventions and policies, which are characterized, by a great deal of subjectivity and arbitrariness. An allied and more powerful criticism against the book value measures, is that historical balance sheet figures on which it is based are often are very divergent from current economic value. Balance sheet figure rarely reflect earning power and hence the book value per share cannot be regarded as a good proxy for true investment value.
Liquidation Value - The liquidation value per share is equal to: (Value realized from liquidating all the assets of the firm — Amount to be paid to all the creditors and preference shareholders) Number of outstanding equity shares To illustrate, assume that Pioneer Industries would realize Rs 45 million from the liquidation of its assets and pay Rs 18 million to its creditors and preference shareholders in full settlement of their claims. If the number of outstanding equity shares of Pioneer is 1.5 million, the liquidation value per share works out to be: (Rs 45 million/  Rs 18 million)  = Rs 18 1.5 Million
While the liquidation value appears more realistic than the book value, there are two serious problems in applying it. First, it is very difficult to estimate that what amounts would be realized from liquidation of various assets. Second, the liquidation value does not reflect earning capacity. Given these problems, the measure of liquidation value seems to make sense only for firms, which are ‘better dead and alive’ – such firms are not viable and economic values cannot be established for them.
 Replacement Cost - Another balance sheet measure considered by analysts in valuing a firm is the replacement cost of its assets less liabilities. The use of this measure is based on the premise that the market value of a firm cannot deviate too much from its replacement cost. If it did so, competitive pressure will tend to align the two. This idea seems to be popular among economists. The ratio of market price to replacement cost is called Tobin q. the proponents of replacement cost believe that in the long run Tobin’s q will tend to 1. The empirical evidence, however, is that this ratio can depart significantly from 1 to long periods of time. The major limitation of the replacement cost concept is that organizational capital, a very valuable asset, is not shown on the balance sheet. Organizational capital is the value created by bringing together employees, customers, suppliers, managers and others in a mutually beneficial and productive relationship. An important characteristic of organizational capital is that it cannot be easily separated from the firm as a going entity. Although balance sheet analysis may provide useful information about book value, liquidation value or replacement cost, the analyst must focus on expected future dividends, earnings and cash flows to estimate the value of a firm as a going entity.
Capitalization of Income Method of Valuation
There are many ways to implement the fundamental analysis approach to identifying mispriced securities. A number of them are either directly or indirectly related to what is sometimes referred to as the capitalization of income method of valuation. This method states that the true or intrinsic value of any asset is based on the cash flow that the investor expects to receive in the future from owning the asset. Because these cash flows are expected in the future, they are adjusted by a discount rate to reflect not only the time value of money but also the riskiness of the cash flows. Algebraically, the intrinsic value of the asset V is equal to the sum of the present values of the expected cash flows:

where Ct denotes the expected cash flow associated with the asset at time t and k is the appropriate discount rate for cash flows of this degree of risk. In this equa-tion the discount rate is assumed to be the same for all periods. Because the sym-bol ¥ above the summation sign in the equation denotes infinity, all expected cash flows, from immediately after making the investment until infinity, will be discounted at the same rate in determining V 2.
Net Present Value - For the sake of convenience, let the current moment in time be denoted as zero, or t = 0. If the cost of purchasing an asset at t = 0 is P, then its net present value (NPV) is equal to the difference between its intrinsic value and cost, or: NPV = V – P


The NPV calculation shown here is conceptually the same as the NPV calcula-tion made for capital budgeting decisions. Capital budgeting decisions involve deciding whether or not a given investment project should be undertaken. (For example, should a new machine be purchased?) In making this decision, the focal point is the NPV of the project. Specifically, an investment project is viewed favorably if its NPV is posi-tive, and unfavorably if its NPV is negative. For a simple project involving cash outflow now (at t = 0) and expected cash inflows in the future, a positive NPV means that the present value of all the expected cash inflows is greater than the cost of making the investment. Conversely, a negative NPV means that the present value of all the expected cash inflows is less than the cost of making the investment. The same views about NPV apply when financial assets (such as a share of common stock), instead of real assets such as a new machine), are being consid-ered for purchase. That is, a financial asset is viewed favorably and said to be un-derpriced (or undervalued) if NPV > 0. Conversely, a financial asset is viewed unfavorably and said to be overpriced or (overvalued) if NPV < 0. From Equation (2), this is equivalent to stating that a financial asset is underpriced if V > P:




Internal Rate of Return- Another way of making capital budgeting decisions in a manner that is similar to the NPV method involves calculating the internal rate of return (IRR) associated with the investment project. With IRR, NPV in Equation (2) is set equal to zero and the discount rate becomes the unknown that must be calculated. That is, the IRR for a given investment is the discount rate that makes the NPV of the investment equal to zero. Algebraically, the procedure involves solving the fol-lowing equation for the internal rate of return k*:

The decision rule for IRR involves comparing the project’s IRR (denoted by k*) with the required rate of return for an investment of similar risk (denoted by k). Specifically, the investment is viewed favorably if k* > k, and unfavorably if k*< k. As with NPV, the same decision rule applies if either a real asset or a fi-nancial asset is being c

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