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*:
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