Convertible Bonds

A convertible bond gives the bondholder the right to convert the bond into a pre-specified number of common shares of the issuer.


Why may convertible bonds be attractive to investors?

Convertible bonds are attractive to investors as the conversion (to equity) option allows them to benefit from price appreciation of the issuer's stock.

On the other hand, if there is a decline in the issuer's share price (which causes a decline in the value of the embedded equity conversion/call option), the price of the convertible bond cannot fall below the price of an otherwise identical straight bond.


Why do issuers use convertible bonds rather than straight bonds?

Because of these attractive features, convertible bonds offer a lower yield and sell at higher prices than similar bonds without the conversion option.

Note however, that the coupon rate offered on convertible bonds is usually higher than the dividend yield on the underlying equity.



Some useful vocabulary

• The conversion price is the price per share at which the convertible bond can be converted into shares.
• The conversion ratio refers to the number of common shares that each bond can be converted into.  It is calculated as the par value divided by the conversion price.
• The conversion value is calculated as current share price multiplied by the conversion ratio.
• The conversion premium equals the difference between the convertible bond's price and the conversion value.
• Conversion parity occurs if the conversion value equals the convertible bond's price.

Why issuers often embed a call option alongside the conversion option in the convertible bond?

Although it is common for convertible bonds to reach conversion parity before they mature, bondholders rarely exercise the conversion option, choosing to retain their bonds and receive (higher) coupon payments instead of (lower) dividend payments.

As a result, issuers often embed a call option alongside the conversion option in the convertible bond, making them callable convertible bonds.






An example:   Proposed ICUL of Aeon Credit

http://www.bursamalaysia.com/market/listed-companies/company-announcements/5374537

Summary of proposed ICUL (Convertible Bond) of Aeon Credit

1.  Proposed right issue to raise RM432,000,000, represented by the 432,000,000 ICULS to be issued.

2.  The coupon rate for the ICULS will be a minimum of 3.5% per annum, payable on an annual basis (“ICULS Coupon Rate”).

3.  The ICULS holders can convert their ICULS held into new ACSM Shares anytime from and including the date of issuance of the ICULS (“Issue Date”) up to its maturity date, which is the third (3rd) anniversary of the Issue Date (“Maturity Date”). 

4.  Any ICULS which are not converted would be mandatorily converted into new ACSM Shares on the Maturity Date.

5.  The conversion price for the ICULS has not been fixed.

6.  The Board shall determine the ICULS conversion price, taking into consideration the following: 

(i) the theoretical ex-all price (“TEAP”) per ACSM Share taking into account the Proposals, calculated based on the 5-market day volume weighted average market price (“VWAMP”) up to the date immediately preceding the Price Fixing Date;

(ii) the then prevailing market conditions; and

(iii) the final ICULS Coupon Rate and pricing for rights issue exercises. 

7.  In any event, the ICULS conversion price shall be determined at a minimum of 15.0% discount to the TEAP as calculated in (i) above.

[Comments:

Benefits for the issuer:

• Using ICULS, the company, Aeon Credit, would be able to raise fund by paying a lower coupon rate of 3.5% per annum.  
• The issuer also embed a call option along side the conversion option in the ICULS; any ICULS that are not converted before the Maturity Date would be mandatorily converted into new ACSM shares on the Maturity Date.

Benefits for the investors:

• The company has proposed that the ICULS conversion price shall be determined at a minimum of 155 discount to the TEAP (theoretical ex-all price) as calculated in (i) above.  Thus, the investors benefit by buying with a discount to the prevailing mother share price.
• The investors of the ICULS hope to benefit from price appreciation of the issuer's stock.]

MULTIPLE PROPOSALS AEON CREDIT SERVICE (M) BERHAD ("ACSM" OR THE "COMPANY") I) PROPOSED BONUS ISSUE; AND II) PROPOSED RIGHTS ISSUE (COLLECTIVELY REFERRED TO AS THE "PROPOSALS").

AEON CREDIT SERVICE (M) BERHAD

Type	Announcement
Subject	MULTIPLE PROPOSALS
Description	AEON CREDIT SERVICE (M) BERHAD ("ACSM" OR THE "COMPANY") I) PROPOSED BONUS ISSUE; AND II) PROPOSED RIGHTS ISSUE (COLLECTIVELY REFERRED TO AS THE "PROPOSALS").
On behalf of the Board of Directors of ACSM, CIMB Investment Bank Berhad wishes to announce that the Company proposes to undertake the following: (i)  Proposed bonus issue of 72,000,000 new ordinary shares in ACSM (“Bonus Shares”) at an issue price of RM0.50 each on the basis of 1 bonus share for every 2 existing ACSM ordinary shares (“ACSM Shares”) held (“Proposed Bonus Issue”); and (ii)  Proposed renounceable rights issue of 3-year minimum 3.5% irredeemable convertible unsecured loan stocks (“ICULS”) on the basis of 2 ICULS for every 1 existing ACSM Share held to raise RM432,000,000 in cash (“Proposed Rights Issue”). (collectively referred to as the “Proposals”) Please refer to the attachment for the full text on the announcement of the Proposals. This announcement is dated 23 March 2017. AEON CREDIT SERVICE (M) BERHAD (“ACSM” OR “COMPANY”) (I) PROPOSED BONUS ISSUE OF 72,000,000 NEW ORDINARY SHARES IN ACSM (“BONUS SHARES”) AT AN ISSUE PRICE OF RM0.50 EACH TO BE CAPITALISED FROM THE COMPANY’S RETAINED EARNINGS ON THE BASIS OF 1 BONUS SHARE FOR EVERY 2 EXISTING ACSM ORDINARY SHARES (“ACSM SHARES”) HELD (“PROPOSED BONUS ISSUE”); AND (II) PROPOSED RENOUNCEABLE RIGHTS ISSUE OF 3-YEAR MINIMUM 3.5% IRREDEEMABLE CONVERTIBLE UNSECURED LOAN STOCKS (“ICULS”) ON THE BASIS OF 2 ICULS FOR EVERY 1 EXISTING ACSM SHARE HELD TO RAISE RM432,000,000 IN CASH (“PROPOSED RIGHTS ISSUE”) Proposed Rights Issue 2.2.1 Details The Proposed Rights Issue will be undertaken after the completion of the Proposed Bonus Issue. As mentioned in Section 2.1.1 of this announcement, the Proposed Rights Issue is not conditional upon the Proposed Bonus Issue, and in the event that the Proposed Bonus Issue is not completed for whatsoever reason, subject to obtaining all relevant approvals, the Proposed Rights Issue will be implemented. The Proposed Rights Issue, to be undertaken on a renounceable basis, involves the issuance of 432,000,000 ICULS at 100% of its nominal value of RM1.00 each in cash on the basis of 2 ICULS for every 1 existing ACSM Share held by the Company’s shareholders (“Entitled Shareholders”) whose names appear in ACSM’s ROD as at the close of business on an entitlement date to be determined by the Board and announced later (“ICULS Entitlement Date”) after the completion of the Proposed Bonus Issue. In the event that the Proposed Bonus Issue is not completed for whatsoever reason, the Proposed Rights Issue shall be undertaken on the basis of 3 ICULS for every 1 existing ACSM Share held. The Proposed Rights Issue will raise RM432,000,000 for the Company from the issuance of a total of 432,000,000 ICULS under the Proposed Rights Issue. The Proposed Rights Issue is renounceable in full or in part. This means that the Entitled Shareholders can subscribe for or renounce their entitlements to the ICULS in full or in part. Any ICULS not subscribed or not validly subscribed for shall be made available for excess applications by the Entitled Shareholders or their renouncee(s)/transferee(s).The Board intends to allocate such excess ICULS in a fair and equitable manner on a basis to be determined later by the Board. The ICULS will be provisionally allotted to the Entitled Shareholders on the ICULS Entitlement Date. Any fractional entitlements of ICULS under the Proposed Rights Issue will be disregarded and shall be dealt with in the Board’s absolute discretion in such manner as it deem fits and in the best interests of ACSM. The coupon rate for the ICULS will be a minimum of 3.5% per annum, payable on an annual basis (“ICULS Coupon Rate”). The final ICULS Coupon Rate shall be reflected in the circular to the Company’s shareholders seeking their approval for the Proposed Rights Issue at an extraordinary general meeting to be convened (“EGM”). The ICULS will be constituted by a trust deed to be executed between ACSM and an appointed trustee for the benefit of the ICULS holders. The indicative principal terms and conditions of the ICULS are set out in Appendix I of this announcement. 2.2.2 Basis of determining and justification for the ICULS issue price and ICULS conversion price The ICULS will be issued at its nominal value of RM1.00 each. The nominal value was fixed after taking into account the aggregate proceeds of RM432,000,000 to be raised from the Proposed Rights Issue, represented by the 432,000,000 ICULS to be issued. Due to the timeframe to implement the Proposed Rights Issue and the potential share price movement of the ACSM Shares during this period, the conversion price for the ICULS has not been fixed. The ICULS conversion price will be determined on the price-fixing date to be announced at a later date (“Price Fixing Date”) after receipt of all relevant approvals but prior to the ICULS Entitlement Date. The Board shall determine the ICULS conversion price, taking into consideration the following: (i) the theoretical ex-all price (“TEAP”) per ACSM Share taking into account the Proposals, calculated based on the 5-market day volume weighted average market price (“VWAMP”) up to the date immediately preceding the Price Fixing Date; (ii) the then prevailing market conditions; and (iii) the final ICULS Coupon Rate and pricing for rights issue exercises. In any event, the ICULS conversion price shall be determined at a minimum of 15.0% discount to the TEAP as calculated in (i) above. For illustration purposes only and taking into account the 5-market day VWAMP per ACSM Share up to 22 March 2017, being the market day immediately preceding the date of this announcement of RM16.24 resulting in a TEAP of RM10.48 and assuming a discount to TEAP of 15.0%, the illustrative conversion price of the ICULS is RM8.91 per new ACSM Share after taking into account the completion of the Proposed Bonus Issue (“Illustrative ICULS Conversion Price”). Using the Illustrative ICULS Conversion Price and for illustration purposes only, a total of 48,484,848 new ACSM Shares will be issued upon full conversion of the ICULS. This represents 18.3% of the Company’s enlarged share capital after the completion of the Proposals. 2.2.3 Ranking of the new ACSM Shares arising from the conversion of ICULS The new ACSM Shares to be issued arising from the conversion of the ICULS shall, upon allotment and issuance, rank equally in all respects with the existing ACSM Shares, save and except that they will not be entitled to any dividends, rights, allotments and/or any other distributions that may be declared, made or paid where the entitlement date is before the allotment date of the new ACSM Shares. Based on the terms of the ICULS, the ICULS holders can convert their ICULS held into new ACSM Shares anytime from and including the date of issuance of the ICULS (“Issue Date”) up to its maturity date, which is the third (3rd) anniversary of the Issue Date (“Maturity Date”). Any ICULS which are not converted would be mandatorily converted into new ACSM Shares on the Maturity Date. 2.2.4 Status of ICULS The ICULS shall constitute direct, unconditional, unsecured and unsubordinated obligations of ACSM and subject to the provisions contained in the trust deed, at all times rank equally, without discrimination, preference or priority between themselves and all present and future direct, unconditional, unsecured and unsubordinated debts and obligations of ACSM except those which are preferred by law.

Calculating Intrinsic Value

Free Cash Flow of Firm

FCFF = CFO - Capex
Enterprise Value = FCFF / WACC
Enterprise Value = Equity Value + Net Debt
Equity Value = Enterprise Value - Net Debt


Free Cash Flow of Equity

FCFE = CFO - Capex + Net Debt
Equity Value = FCFE / Required rate of return on equity


Equity Value = Intrinsic Value


Investors compare this Equity Value to the Market Value in their investing.

Market Value > Equity Value = Overvalued
Market Value = Equity Value = Fair Value
Market Value < Equity Value = Undervalued



Additional Notes:

Assuming there is no preferred stock outstanding:

Interest*(1–t) is the firm's after-tax interest expense

If company has zero debt, its FCFF = FCFE

Using Free Cash Flow to Equity to derive the Equity or Intrinsic Value of a Stock

Free cash flow to equity

From Wikipedia, the free encyclopedia

In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders.^[1][2] The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is also called the levered free cash flow.

Contents

  [hide] 

• 1Basic formulae
• 2FCFF vs. FCFE
• 3Negative FCFE
• 4Use
• 5References
• 6External links

Basic formulae[edit]

Assuming there is no preferred stock outstanding:

${\displaystyle FCFE=FCFF+Net\ Borrowing-Interest*(1-t)}$

where:

• FCFF is the free cash flow to firm;
• Net Borrowing is the difference between debt principals paid and raised;
• Interest*(1–t) is the firm's after-tax interest expense.^[3]

or

${\displaystyle FCFE=NI+D\&A-Capex-\Delta WC+Net\ Borrowing}$

where:

• NI is the firm's net income;
• D&A is the depreciation and amortisation;
• Capex is the capital expenditure;
• ΔWC is the change in working capital;
• Net Borrowing is the difference between debt principals paid and raised;
• In this case, it is important not to include interest expense, as this is already figured into net income.^[4]

FCFF vs. FCFE[edit]

• Free cash flow to firm (FCFF) is the cash flow available to all the firm’s providers of capital once the firm pays all operating expenses (including taxes) and expenditures needed to support the firm’s productive capacity. The providers of capital include common stockholders, bondholders, preferred stockholders, and other claimholders.
• Free cash flow to equity (FCFE) is the cash flow available to the firm’s common stockholders only.
• If the firm is all-equity financed, its FCFF is equal to FCFE.

Negative FCFE[edit]

Like FCFF, the free cash flow to equity can be negative. If FCFE is negative, it is a sign that the firm will need to raise or earn new equity, not necessarily immediately. Some examples include:

• Large negative net income may result in the negative FCFE;
• Reinvestment needs, such as large capex, may overwhelm net income, which is often the case for growth companies, especially early in the life cycle.
• Large debt repayments coming due that have to be funded with equity cash flows can cause negative FCFE; highly levered firms that are trying to bring their debt ratios down can go through years of negative FCFE.
• The waves of the reinvestment process, when firms invest large amounts of cash in some years and nothing in others, can cause the FCFE to be negative in the big reinvestment years and positive in others;^[5]
• FCFF is a preferred metric for valuation when FCFE is negative or when the firm's capital structure is unstable.

Use[edit]

There are two ways to estimate the equity value using free cash flows:

• Discounting free cash flows to firm (FCFF) at the weighted average cost of capital (WACC) yields the enterprise value. The firm’s net debt and the value of other claims are then subtracted from EV to calculate the equity value.

Enterprise Value EV = FCFF/WACC

Enterprise Value EV = Equity Value + net Debt

Equity Value = Enterprise Value EV - net Debt

• If only the free cash flows to equity (FCFE) are discounted, then the relevant discount rate should be the required return on equity. This provides a more direct way of estimating equity value.

Equity Value = FCFE/required return on equity

• In theory, both approaches should yield the same equity value if the inputs are consistent.

Notes:

Equity Value = Intrinsic Value of the Company

FCFF / WACC = Enterprise Value
Enterprise Value = Equity Value + Net Debts
Equity Value = Intrinsic Value of the stock = Enterprise Value - Net Debts

FCFE = CFO - Capex + Net Debts
Equity Value = Intrinsic Value of the stock = FCFE/required rate of return on equity
Equity Value < Market Value = Overvalued

Equity Value = Market Value = Fair Value
Equity Value > Market Value = Undervalued

https://en.wikipedia.org/wiki/Free_cash_flow_to_equity

The Free-Cash-Flow to-Equity (FCFE) Model

Many analysts assert that a company's dividend-paying capacity should be reflected in its cash flow estimates instead of estimated future dividends.

FCFE is a measure of dividend paying capacity.

It can also be used to value companies that currently do not make any dividend payments.

FCF can be calculated as:

FCFE = CFO - FC Inv + Net borrowing


Analysts may calculate the intrinsic value of the company's stock by discounting their projections of future FCFE at the required rate of return on equity.




Reference:

https://en.wikipedia.org/wiki/Free_cash_flow_to_equity

Valuation of Common Stock with Temporary Supernormal Growth

The correct valuation model to value such "supernormal growth" companies is the multi-stage dividend discount model that combines

• the multi-period and 
• infinite-period dividend discount models (Gordon Growth Model).

Value
= Multi-period DDM + Infinite Period (constant growth) DDM
= D1/(1+k)^1 + D2/(1+k)^2 + ..... + Dn/(1+k)^n + Pn/(1+k)^n


Dn = Last dividend of the supernormal growth period
Dn+1 = First dividend of the constant growth period.
Pn = Dn+1 / (k-g) = PV at time n+1 of Dn at a Constant rate of Growth.

Applying Present Value Models

1.  Where Gordon Growth Model is highly appropriate

The Gordon Growth Model is highly appropriate for valuing dividend-paying stocks that are relatively immune to the business cycle and are relatively mature (e.g., utilities).

It is also useful for valuing companies that have historically been raising their dividends at a stable rate.



2.  Where DDM or Gordon Growth Model is difficult to use

Applying the DDM is relatively difficult if the company is not currently paying out a dividend.  

A company may not pay out a dividend because:

• It has a lot of lucrative investment opportunities available and it wants to retain profits to reinvest them in the business.
• It does not have sufficient excess cash flow to pay out a dividend.

Even though the Gordon Growth Model can be used for valuing such companies, the forecasts used are generally quite uncertain.

Therefore, analysts use one of the other valuation models to value such companies and may use the DDM model as a supplement.

3.  Multi-stage DDM can be employed 

The DDM can be extended to numerous stages.  For example:

A.   A three-stage DDM is used to value fairly young companies that are just entering the growth phase.  Their development falls into three stages - 

• growth (with very high growth rates), 
• transition (with decent growth rates) and 
• maturity (with a lower growth into perpetuity).

B.  A two-stage DDM can be used to value a company 

• currently undergoing moderate growth, but 
• whose growth rate is expected to improve (rise) to its long term growth rate.

Return on Share Investment = Dividend Yield + Growth over Time (Gordon Growth Model)

Rearranging the Dividend Discount Model (DDM) formula:

PV = D1 / (k-g)

k = (D1/PV) + g
   = Dividend yield + growth over time.

This expression for the cost of equity (required rate of return) tells us that the return on an equity investment has two components:

• The dividend yield (D1/PV at year 0)
• Growth over time (g)

Return on share investment = Dividend Yield + Growth over Time:

Dividend Discount Model

Dividend Discount Model

Where:

V = the value

D₁ = the dividend next period

r = the required rate of return

1.  One year holding period

If our holding period is just one year, the value that we will place on the stock today is the present value of the dividends that we will receive over the year plus the present value of the price that we expect to sell the stock for at the end of the holding period.

Present Value of the dividends that we will receive over one year 
= Dividend to be received/(1+r)^1

Present value of the price we expect to sell the stock for at the end of the holding period
= Year-end price / (1+k)^1


Value 
= PV of dividends receive over 1 year + PV of price we expect to sell at end of 1 year
= [Dividend to be received/(1+k)^1]  +  [Year-end price /(1+k)^1]

k = cost of equity or required rate of return



2.  Multiple-Year Holding Period DDM

We apply the same discounting principles for valuing common stock over multiple holding periods.

In order to estimate the intrinsic value of the stock, we first estimate the dividends that will be received every year that the stock is held and the price that the stock will sell for at the end of the holding period.

Then we simply discount these expected cash flows at the cost of equity (required return).

PV of Dividends received in Year 1 = D1/(1+k)^1
PV of Dividends received in Year 2 = D2/(1+k)^2
PV of Dividends received in Year .. =
PV of Dividends received in Year n= Dn/(1+k)^n
Price of stock sold at end of holding period n = Pn / (1+k)^n

Value
= PV of D1 + PV of D2 + PV of D3 +.................. PV of Dn + PV of Holding-Period Price
= [D1/(1+k)^1]  + [D2/(1+k)^2]  + .[D3/(1+k)^3]..........[.Dn/(1+k)^n]  + [Pn / (1+k)^n]




3.  Infinite Period DDM (Gordon Growth Model)

Assumptions of the Infinite Period DDM (Gordon Growth Model):

• The infinite period dividend discount model assumes that a company will continue to pay dividends for an infinite number of periods.
• It also assumes that the dividend stream will grow at a constant rate (g) over the infinite period.

In this case, the intrinsic value of the stock is calculated as:

Value = PV of D1 + PV of D2 + PV of D3 + ...........PV of Dn....... + PV of Dinfinity


PV of Dividends received in Year 1 = D1/(1+k)^1 = D0(1+g)^1/(1+k)^1
PV of Dividends received in Year 2 = D2/(1+k)^2 = D0(1+g)^2/(1+k)^2
PV of Dividends received in Year .. =
PV of Dividends received in Year n= Dn/(1+k)^n = DO(1+g)^infinity / (1+k)^infinity

D0 = Dividends received at year 0

This equation simplifies to:

PV at year 0
= D0(1+g)^1/(k-g)^1
= D1/(k-g)






The critical relationship between k and g in the infinite-period DDM (Gordon Growth Model)

The relation between k and g is critical:

• As (k-g) increases, the intrinsic value of the stock falls.
• As (k-g) narrows, the intrinsic value of the stock rises.
• Small changes in either k or g, can cause large changes in the value of the stock.

For the infinite-period DDM model to work, the following assumptions must hold:

• Dividend grows at a rate, g, which is not expected to change (constant growth).
• k must be greater than g; otherwise the model breaks down because of the denominator being negative.

(k-g) = difference between k and g or difference between cost of equity or required rate of return and growth rate.







Additional notes:

Return on investment = Dividend Yield + Growth over Time:

Rearranging the DDM formula:

PV = D1 / (k-g)

k = (D1/PV) + g
   = Dividend yield + growth over time.

This expression for the cost of equity (required rate of return) tells us that the return on an equity investment has two components:

• The dividend yield (D1/PV at year 0)
• Growth over time (g)

Intrinsic Value of Preferred Stock

1.  When preferred stock is non-callable, non-convertible, has no maturity date and pays dividends at a fixed rate, the value of the preferred stock can be calculated using the perpetuity formula:

V = D/r

V = value
D = dividend
r = required rate of return




2.  For a non-callable, non-convertible preferred stock with maturity at time, n, the value of the stock can be calculated using another formula.

Value
= PV of Dividends received + PV of Final Selling Price of Preferred Stock
= D1/(1+r)^1 + D2/(1+r)^2 + ....... + F/(1+r)^n




http://www.investopedia.com/articles/fundamental-analysis/11/valuation-prefered-stock.asp

Multiples based on Comparables

This method compares relative values estimated using multiples to determine whether an asset is 

• undervalued, 
• overvalued or 
• fairly valued.  

The benchmark multiple can be any of:

• A multiple of a closely matched individual stock.
• The average or median multiple of a peer group or the firm's industry.
• The average multiple derived from trend or time-series analysis.

Analyst should be careful to select only those companies that have similar size, product lines, and growth prospects to the company being valued as comparables.

Price to cash flow ratio 

P/CF = Market price of share / Cash flow per share

Price to sales ratio

P/S = Market price per share / Net sales per share

P/S = Market value of equity / Total net sales

Price to Book Value ratio

P/BV = Current market price of share / Book value per share

P/BV = Market vale of common shareholders' equity / Book value of common shareholders' equity

where:

Book value of common shareholders' equity 

= (Total assets - Total liabilities) - Preferred stock

Multiples based on Fundamentals - the Justified P/E ratio

A price multiple may be related to fundamentals through a dividend discount model such as the Gordon growth model.

The expressions developed in such an exercise are interpreted as the justified (or based on fundamental) values for a multiple.


The justified P/E Ratio:

P/E = D/E/(r-g)

r = required rate of return
g = growth


Gordon Growth Model

r = D/P + g
D/P = r-g
P= D/(r-g)
P/E = D/E(r-g)
P/E = Dividend Payout Ratio / (r-g)



Inference

The P/E ratio is inversely related to the required rate of return.
The P/E ratio is positively related to the growth rate.
The P/E ratio appears to be positively related to the dividend payout ratio.

• However, this relationship may not always hold because a higher dividend payout ratio implies that the company's earnings retention ratio is lower.  
• A lower earnings retention ratio translates into a lower growth rate.  
• This is known as the "dividend displacement" of earnings.

Notes:

Higher the growth rate (g), higher the P/E.
Higher the required rate of return (r), lower the P/E.
Higher the DPO ratio, higher the P/E.
Also, higher the DPO ratio, lower the retained earnings,  leading to lower growth rate (g), thus lower P/E. ("dividend displacement" of earnings)

Price Multiples - Relative Valuation

Price multiples are ratios that compare the price of a stock to some sort of value.

Price multiples allow an analyst to evaluate the relative worth of a company's stock.

Popular multiples used in relative valuation include:

• price-to-earnings,
• price-to-sales,
• price-to-book, and
• price-to-cash flow.

Enterprise Value Multiples

Enterprise value (EV) is calculated as the market value of the company's common stock plus the market value of outstanding preferred stock if any, plus the market value of debt, less cash and short term investment (cash equivalent).

EV
= market value of company's common stock
+ market value of outstanding preferred stock
+ market value of debt
- cash and short term investment (cash equivalent)

It can be thought of as the cost of taking over a company.



EV/EBITDA multiple

The most widely used EV multiple is the EV/EBITDA multiple.

EBITDA measures a company's income before payments to any providers of capital are made.

The EV/EBITDA multiple is often used when comparing two companies with different capital structures.


Loss-making companies usually have a positive EBITDA

Loss-making companies usually have a positive EBITDA, which allow analysts to use the EV/EBITDA multiple to value them.  

The P/E ratio is meaningless (negative) for a loss making company as its earnings are negative.

Asset-Based Valuation

Asset-Based Valuation uses market values of a company's assets and liabilities to determine the value of the company as a whole.

Asset based valuation works well for:

• Companies that do not have a significant number of intangible or "off-the-book" assets, and have a higher proportion of current assets and liabilities.
• Private companies, especially if applied together with multiplier models.
• Financial companies, natural resource companies and companies that are been liquidated.

Asset-based valuation may not be appropriate when:

• Market values of assets and liabilities cannot be easily determined.
• The company has a significant amount of intangible assets.
• Asset values are difficult to determine (e.g., in periods of very high inflation).
• Market values of assets and liabilities significantly differ from their carrying values.

Dividend Discount Model

Present Value Models

Dividend Discount Model


1.  If a company pays regular dividends

The dividend discount model (DDM) values a share of common stock as the present value of its expected future cash flows (dividends).

When an investor sells a share of common stock, the value that the purchaser will pay equals the present value of the future stream of cash flows (i.e. the remaining dividend stream).

Therefore, the value of the stock at any point in time is still determined by its expected future dividends.

When this value is discounted to the present, we are back at the original dividend discount model.



2.  If a company pays no dividends currently

If a company pays no dividends currently, it does not mean that its stock will be worthless.

There is an expectation that after a certain period of time the firm will start making dividend payments.

Currently, the company is reinvesting all its earnings in its business with the expectation that its earnings and dividends will be larger and will grow faster in the future.



3.  If the company is making losses

If the company does not make positive earnings going forward, there will still be an expectation of a liquidating dividend.  

The amount of this dividend will be discounted at the required rate of return to compute the stock's current price.




Additional notes:

The required rate of return on equity is usually estimated using the CAPM.

Another approach for calculating the required return on equity simply adds a risk premium to the before-tax cost of debt of the company.

Competitive Strategies

1.  Cost Leadership

Companies pursuing this strategy strive to cut down their costs to become the lowest cost producers in an industry so that they can gain market share by charging lower prices.

Pricing may be

• defensive (to protect market positions when competition is low) or 
• aggressive (to increase market share when competition is intense.)

2.  Product/Service Differentiation

Companies pursuing this strategy strive to differentiate their products from those of competitors in terms of quality, type, or means of distribution.

These companies are then able to charge a premium price for their products.

This strategy is successful only if the price premium is greater than the cost of differentiation and the source of differentiation appeals to customers and is sustainable over time.

Price Competition

1.  Highly competitive industry (commodity products)

• Industries in which price is the most significant consideration in customers' purchase decisions tend to be highly competitive.
• A slight increase in price may cause customers to switch to substitute products if they are widely available.

2.  Franchise industry (franchise products)

• Price is not as important if companies in an industry are able to effectively differentiate their products in terms of quality and performance.  
• Customers may not focus on price as much if product reliability is more important to them.

Factors Affecting Industry Growth, Profitability and Risk

• Macroeconomic influences
• Technological influences
• Demographic influences
• Government influences
• Social influences

Elements that should be Considered in a Company Analysis

A thorough company analysis should:

• Provide an overview of the company.
• Explain relevant industry characteristics.
• Analyze the demand for the company's products and services.
• Analyze the supply of products and services including an analysis of costs.
• Explain the company's pricing environment.
• Present and interpret relevant financial ratios, including comparisons over time and comparisons with competitors.

Industry Life-Cycle Analysis

Stages of Life-Cycle of Business / Industry

• Embryonic
• Growth
• Shakeout
• Mature
• Decline

Embryonic

Industries in this stage are just beginning to develop.

They are characterised by:

• Slow growth as customers are still unfamiliar with the product.
• High prices as volumes are too low to achieve significant economies of scale.
• Significant initial investment.
• High risk of failure.

Companies focus on raising product awareness and developing distribution channels during this stage.

Growth

Once the new product starts gaining acceptance in the market, the industry experiences rapid growth.

The growth stage is characterised by:

• New customers entering the market, which increases demand.
• Improved profitability as sales grow rapidly.
• Lower prices as econmies of scale are achieved.
• Relatively low competition among companies in the industry as the overall market size is growing rapidly.  Firms do no need to wrestle market share away from competitors to grow.
• High threat of new competitors entering the market due to low barriers to entry.

During this stage, companies focus on building customer loyalty and reinvest heavily in the business.

Shakeout

The period of rapid growth is followed by a period of slower growth.

The shakeout stage is characterised by:

• Slower demand growth as fewer new customers are left to enter the industry.
• Intense competition as growth becomes dependent on market share growth.
• Excess industry capacity, which leads to price reductions and declining profitability.

During this stage, companies focus on reducing their costs and building brand loyalty.

Some firms may fail or merge with others.

Mature

Eventually demand stops growing and the industry matures.

Characteristics of this stage are:

• Little or no growth in demand as the market is completely saturated.
• Companies move towards consolidation.  They recognize that they are interdependent so they stay away from price wars  However, price wars may occur during downturns.
• High barriers to entry in the form of brand loyalty and relatively efficient cost structures.

During this stage, companies are likely to be pursuing replacement demand rather than new buyers and should focus on extending successful product lines rather than introducing revolutionary new products.

Companies have limited opportunities to reinvest and often have strong cash flows.  

As a result, they are more likely to pay dividends.

Decline

Technological substitution, social changes or global competition may eventually cause an industry to decline.

The decline stage is characterised by:

• Negative growth
• Excess capacity due to diminishing demand.
• Price competition due to excess capacity.
• Weaker firms leaving the industry.

Limitations of Industry Life-Cycle Analysis

The following factors may

• change the shape of the industry life cycle, 
• cause some stages to be longer or shorter than expected, or 
• even result in certain stages being skipped altogether.

These factors are:

• Technological changes
• Regulatory changes
• Social changes
• Demographics

Industry life-cycles analysis is most useful in analyzing industries during periods of relative stability.

It is not as useful in analyzing industries experiencing rapid change.

Not all companies in an industry display similar performance.

Cost of Equity and Investors' Required Rates of Return

You should think about the cost of equity as the minimum expected rate of return that a company must offer investors to purchase its shares in the primary market and to maintain its share price in the secondary market.

If the required rate of return is not maintained, the price of the security in the secondary market will adjust to reflect the minimum rate of return required by investors.

If investors require a higher return than the company's cost of equity, they will sell the company's shares and invest elsewhere, which would bring down the company's stock price.

This decline in the stock price will lead to an increase in the expected return on equity and bring it in line with the (higher) required rate of return.

Investors' Minimum Required Rates of Return, Cost of Debt and Cost of Equity

A company may raise capital by issuing

• debt or 
• equity, 

Both of which have associated costs.



Investors' Minimum Required Rates of Return

Investors' minimum required rates of return refer to the return they require for providing funds to the company.



Cost of Debts

A company's cost of debt is easy to estimate as it is reflected in the interest payments that the company is contractually obligated to make to debt holders.

For investors who provide debt capital to the company, their minimum required rate of return is the periodic interest rate they charge the company for using their funds.

All providers of debt capital receive the same interest rate.

Therefore, the company's cost of debt and investor's minimum required rate of return on debt are the same.



Cost of Equity

Estimating cost of equity is difficult because the company is not contractually obligated to make any payments to common shareholders.

For investors who provide equity capital tot he company, the future cash flows that they expect to receive are uncertain (in both timing and amount), so their minimum required rate of return must be estimated.

Further, each investor may have different expectations regarding future cash flows.

Therefore, the company's cost of equity may be different from investors' minimum required rate of return on equity.





Additional notes:

The company's cost of equity can be estimated using the dividend discount model (DDM) and capital asset pricing model (CAPM).

The costs of debt and equity are used to estimate a company's weighted average cost of capital (WACC), which represents the minimum required rate of return that the company must earn on its investments.

Importance of Equities in Global Financial Markets

In 2008, on a global level, the equity market capitalization to GDP ratio was close to 100% (more than twice the long run average of 50%)

During 1900 - 2008, government bonds and bills earned annualized real returns of 1% to 2% on average, which is in line with the inflation rate.   Equity markets earned real returns in excess of 4% per year in most markets.

In most developed countries, equity ownership as a percentage of the population was between 20% and 50%.

Equity Securities and Company Value (Intrinsic Value of a company)

Book values and ROE do help analysts evaluate companies, but they cannot be used as the primary means to determine a company's intrinsic value.

Intrinsic value refers to the present value of the company's expected future cash flows.

Intrinsic value can only be estimated as it is impossible to accurately predict the amount and timing of a company's future cash flows.

Astute investors aim to profit from differences between market prices and intrinsic values.

Accounting Return on Equity

Return on Equity (ROE) measures the rate of return earned by a company on its equity capital.

It indicates how efficient a firm is in generating profits from every dollar of net assets.


The ROE is computed as net income available to ordinary shareholders (after preference dividends have been paid) divided by the average total book value of equity.

ROE
= Net Income / Average Book Value of Equity
= Net Income /[ (Book Value of Equity FY1 + Book Value of Equity FY2)/2]


An increase in ROE might not always be a positive sign for the company.

• The increase in ROE may be the result of net income decreasing at a slower rate than shareholders' equity.  A declining net income is a source of concern for investors.
• The increase in ROE may be the result of debt issuance proceeds being used to repurchase shares.  This would increase the company's financial leverage (risk).

Primary aim of management is to increase the book value and the market value of the company.

The primary aim of management is to increase

• the book value and 
• market value of the company.

Book Value

Book value (shareholders' equity on the company's balance sheet) is calculated as total assets less total liabilities.

It reflects the historical operating and financing decisions made by the company.

Management can directly influence book value (e.g., by retaining net income).


Market Value

However, management can only indirectly influence a company's market value.

Market value of a company is primarily determined by investors' expectations about the about, timing and uncertainty of the company's future cash flows

A company may increase its book value by retaining net income, but it will only have a positive effect on the company's market value if investors expect the company to invest its retained earnings in profitable growth opportunities.

If investors believe that the company has a significant number of cash flow generating investment opportunities coming through, the market value of the company's equity will exceed its book value.



Price to book ratio (market to book ratio)

A useful ratio to evaluate investor's expectations about a company is the price to book ratio.

If a company has a price to book ratio that is greater than industry average, it suggests that investors believe that the company has more significant future growth opportunities than its industry peers.

It may not be appropriate to compare price to book ratios of companies in different industries because the ratio also reflects investors' growth outlook for the industry itself.


Accounting Return on Equity

An important measure used by investors to evaluate the effectiveness of management in increasing the company's book value is accounting return on equity.

Risks of Equity Securities

Preference shares are less risky than common shares.

Putable common shares are less risky than callable or non-callable common shares.

Callable common and callable preference shares are more risky than their non-callable counterparts.

Cumulative preference shares are less risky than non-cumulative preference shares as they accrue unpaid dividends.



Risks (> = more risky than)

Common shares  >  Preference shares

Callable or non-callable common shares > Putable common shares

Callable common stocks > Non-callable common stocks

Callable preference shares > Non-callable preference shares

 Non-cumulative preference shares > Cumulative preference shares

Convertible Preference Shares or Preferred Stock

Preference shares can be classified into the following categories:

• Cumulative
• Non-cumulative
• Participating 
• Non-participating
• Convertible

Convertible Preference Shares

These are convertible into a specified number of common shares based on a conversion ratio that is determined at issuance.

They have the following advantages:

• They allow investors to earn a higher dividend than if they had invested in the company's common shares.
• They offer investors the opportunity to share the profits of the company.
• They allow investors to benefit from a rise in the price of common shares through the conversion option.
• Their price is less volatile than the underlying common shares because their dividend payments are known and more stable.

Convertible preference shares are becoming increasingly common in venture capital and private equity transactions.

Return Characteristics of Equity Securities

The two main sources of an equity security's total return are:

• Capital gains from price appreciation
• Dividend income

The total return on non-dividend paying stocks only consists of capital gains.

Investors in depository receipts and foreign shares also incur foreign exchange gains (or losses).

Another source of return arises from the compounding effects of reinvested dividends.

Psychological Biases

Loss Aversion

Behavioural finance asserts that investors exhibit loss aversion, that is, they dislike losses more than they like comparable gains.

This results in a strong preference for avoiding losses as opposed to achieving gains.

Advocates of this bias argue that loss aversion is more important to investors than risk aversion,, which is why the "overreaction" anomaly is observed.

While loss aversion can explain the overreaction anomaly, studies have shown that under reactions are just as common as overreactions, which counters the assertions of this bias.



Herding

Herding behaviour is a behavioural bias that explains both under reactions and overreactions in financial markets.

Herding occurs when investors ignore their own analysis, and instead make investment decisions in line with the direction of the market.



Overconfidence

Overconfdence bias asserts investors have an inflated view of their ability to process new information appropriately.

Overconfident investors are inaccurate when it comes to valuing securities given new information, and therefore stocks will be mispriced if there is an adequate number of such investors in the market.

Evidence has suggested that overconfidence has led to mispricing in most major markets around the world, but the bias has been observed predominantly in higher-growth companies, whose prices are slow to factor in any new information.

Another aspect of this bias is that overconfident investors tend to maintain portfolios that are less-than-optimally diversified because they tend to overestimate their stock-picking abilities.




Information Cascades

An information cascade refers to the transfer of information from market participants who are the first to take investment action upon the release of new information, and whose decisions influence the decisions of others.

Studies have shown that information cascades tend to be greater for stocks when reliable and relevant information about the underlying company is not easily available.




Representativeness

Investors assess probabilities of future outcomes based on how similar they are to the current state.



Mental Accounting

Investors tend to keep track of gains and losses from different investments in separate mental accounts.



Conservatism

Investors are slow to react to changes and continue to maintain their initial views.



Narrow framing

Investors focus on issues in isolation

Behavioural Finance

Behavioural finance looks at investor behaviour to explain 

• why individuals make the decisions that they do, 
• whether these decisions are rational or irrational.

It is based on the premise that individuals, due to the presence of behavioural biases:

• do not always make "efficient" investment decisions, or 
• do they always act "rationally" 

These behavioural biases include:

• Loss Aversion
• Herding
• Overconfidence
• Information Cascades
• Representativeness
• Mental Accounting
• Conservatism
• Narrow Framing

Whether investor behaviour can explain market anomalies is a subject open to debate.

• If investors must be rational for the market to be efficient, then markets cannot be efficient.
• If markets are defined as being efficient, investors cannot earn superior risk-adjusted profits consistently. 

Momentum and Overreaction Anomalies

Overreaction

Investors tend to inflate (depress) stock prices of companies that have released good (bad) news.

Studies have shown that "losers" (stocks that have witnessed a recent price decline due to the release of bad news) have outperformed the market in subsequent periods, while winners have underperformed in subsequent periods.


Momentum

Other studies have also shown that securities that have outperformed in the short term continue to generate high returns in subsequent periods (carrying on price momentum).



Note:  The overreaction and momentum anomalies go against the assertions of weak-form efficiency in markets.

Earnings Surprises

Several studies have shown that although earnings surprises are quickly reflected in stock prices most of the time, this is not always the case.

Investors may be able to earn abnormal returns using publicly available earnings information by purchasing stocks of companies that have announced positive earnings surprises.

However, recent evidence has suggested that abnormal returns observed after earnings surprises do not control for transaction costs and risk.

Closed-End Investment Fund Discounts

Several studies have shown that closed-end funds tend to trade at a discount (sometimes exceeding 50%) to their per share NAVs.

Theoretically, investors could purchase all the shares in the fund, liquidate the fund, and make a profit by selling the constituent securities at their market prices.

However, after accounting for management fees, unrealized capital gain taxes, liquidity and transactions costs, any profit potential is eliminated.