Models for the Valuation of Shares
2 MODELS FOR THE VALUATION OF SHARES.
2.1 The concept of a cost of equity
The cost of equity is the cost to the company of providing equity holders with the return they require on their investment.
The primary financial objective is to maximize the return to equity shareholders. This return is as the future dividend yield and capital growth.
Until new shareholders become members of the company, the objective above is concerned with existing shareholders.
Company management will need to offer new shareholders the minimum acceptable future return on the funds they put into the company, thereby retaining as much benefit as possible for existing shareholders.
In practice, this return will be such as to provide new shareholders with the same future returns as existing shareholders expect to obtain on their investment at market values.
For example if the future return on ABC plc's shares is 15% and future return on new issue is 20% if this is viewed quite simplistically, investors would sell their existing shares and take up the new offer. The price of existing shares would fall, and as a result the percentage return would increase, until it matched the 20% of new shares. This would mean existing shareholders would suffer a capital loss as the price of their shares declined.
Thus, the object of management must be to offer the shares so as to provide a return identical to that of existing shares (in this case 15%). They could not offer less than 15% as it might then be difficult to find investors for the new issue.
Note: in all cases the relevant return is the future return anticipated by shareholders.
Thus, the problem of determining the cost of new equity becomes the problem of establishing the anticipated market return on existing equity.
The cost of equity ,equals the rate of return which investors expect to achieve on their equity holdings.
2.2 Anticipated rate of return on existing equity
The anticipated rate of return on a share acquired in
2.1 The concept of a cost of equity
The cost of equity is the cost to the company of providing equity holders with the return they require on their investment.
The primary financial objective is to maximize the return to equity shareholders. This return is as the future dividend yield and capital growth.
Until new shareholders become members of the company, the objective above is concerned with existing shareholders.
Company management will need to offer new shareholders the minimum acceptable future return on the funds they put into the company, thereby retaining as much benefit as possible for existing shareholders.
In practice, this return will be such as to provide new shareholders with the same future returns as existing shareholders expect to obtain on their investment at market values.
For example if the future return on ABC plc's shares is 15% and future return on new issue is 20% if this is viewed quite simplistically, investors would sell their existing shares and take up the new offer. The price of existing shares would fall, and as a result the percentage return would increase, until it matched the 20% of new shares. This would mean existing shareholders would suffer a capital loss as the price of their shares declined.
Thus, the object of management must be to offer the shares so as to provide a return identical to that of existing shares (in this case 15%). They could not offer less than 15% as it might then be difficult to find investors for the new issue.
Note: in all cases the relevant return is the future return anticipated by shareholders.
Thus, the problem of determining the cost of new equity becomes the problem of establishing the anticipated market return on existing equity.
The cost of equity ,equals the rate of return which investors expect to achieve on their equity holdings.
2.2 Anticipated rate of return on existing equity
The anticipated rate of return on a share acquired in