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6 Example: Valuation of convertible debt

6 Example: Valuation of convertible debt

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Chapter Roundup


There are a number of different ways of putting a value on a business, or on shares in an unquoted
company. It makes sense to use several methods of valuation, and to compare the values they produce.



The net assets valuation method can be used as one of many valuation methods, or to provide a lower
limit for the value of a company. By itself it is unlikely to produce the most realistic value.



P/E ratios may be used to value equity shares when a large block of shares, or a whole business, is being
valued. This method can be problematic when P/E ratios for quoted companies are used to value unquoted
companies.



Cash flow based valuation models include the dividend valuation model, the dividend growth model and
valuation on a discounted cash flow basis.



For irredeemable debt:
Market price, ex interest (P0)

=

I
Kd

=

i (1  T) with tax
K dnet

For redeemable debt, the market value is the discounted present value of future interest receivable, up
to the year of redemption, plus the discounted present value of the redemption payment.

Quick Quiz
1

Give four circumstances in which the shares of an unquoted company might need to be valued.

2

How is the P/E ratio related to EPS?

3

What is meant by 'multiples' in the context of share valuation?

4

Suggest two circumstances in which net assets might be used as a basis for valuation of a company.

5

Cum interest prices should always be used in calculations involving debt. True/False?

6

Fill in the blanks. For redeemable bonds:
Market value = ........................................ + ........................................

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17: Business valuations  Part F Business valuations

Answers to Quick Quiz
1

(a)
(b)
(c)
(d)

Setting an issue price if the company is floating its shares
When shares are sold
For tax purposes
When shares are pledged as collateral for a loan

2

P/E ratio = Share price/EPS

3

The P/E ratio: the multiple of earnings at which a company's shares are traded

4

(a)
(b)

5

False. Ex-interest prices should be used.

6

Market value

As a measure of asset backing
For comparison, in a scheme of merger

= Discounted present value of future interest receivable up to year of redemption
+ Discounted present value of redemption payment

Now try the questions below from the Practice Question Bank
Number

Level

Marks

Approximate time

Section A Q29

Examination

2

4 mins

Section B Q11-15

Examination

10

20 mins

Section B Q16-20

Examination

10

20 mins

Section C Q20

Introductory

N/A

39 mins

Section C Q21

Introductory

N/A

39 mins

Part F Business valuations  17: Business valuations

359

360

17: Business valuations  Part F Business valuations

Market efficiency

Topic list
1 The efficient market hypothesis
2 The valuation of shares

Syllabus reference
F4 (a)
F4 (b), (c)

Introduction
This chapter deals with the determination of share prices. As we shall see, there
are various theories which seek to provide a rationale for share price
movement. The most important of these is the efficient market hypothesis,
which provides theoretical underpinning for how markets take into account new
information.
The chapter also looks at practical issues that may affect the market valuation
of shares.

361

Study guide
Intellectual level
F4

Efficient market hypothesis (EMH) and practical considerations in the
valuation of shares

(a)

Distinguish between and discuss weak form efficiency, semi-strong form
efficiency and strong form efficiency.

2

(b)

Discuss practical considerations in the valuation of shares and businesses,
including:

2

(i)

Marketability and liquidity of shares

(ii)

Availability and sources of information

(iii)

Market imperfections and pricing anomalies

(iv)

Market capitalisation

(c)

Describe the significance of investor speculation and the explanations of
investor decisions offered by behavioural finance.

1

Exam guide
Market efficiency may need to be discussed as part of a business valuation question.

1 The efficient market hypothesis
FAST FORWARD

The theory behind share price movements can be explained by the three forms of the efficient market
hypothesis.




Key term

12/07, 6/08, 12/10, 6/14

Weak form efficiency implies that prices reflect all relevant information about past price
movements and their implications.
Semi-strong form efficiency implies that prices reflect past price movements and publicly available
knowledge.
Strong form efficiency implies that prices reflect past price movements, publicly available
knowledge and inside knowledge.

The efficient market hypothesis provides a rationale for explaining how share prices react to new
information about a company, and when any such change in share price occurs. Stock market reaction to
new information depends on the strength of the stock market efficiency.

1.1 Definition of market efficiency
Different types of efficiency can be distinguished in the context of the operation of financial markets.
(a)

Allocative efficiency
If financial markets allow funds to be directed towards firms which make the most productive use
of them, then there is allocative efficiency in these markets.

(b)

Operational efficiency
Transaction costs are incurred by participants in financial markets, for example commissions on
share transactions, margins between interest rates for lending and for borrowing, and loan
arrangement fees. Financial markets have operational efficiency if transaction costs are kept as
low as possible. Transaction costs are kept low where there is open competition between brokers
and other market participants.

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18: Market efficiency  Part F Business valuations

(c)

Information processing efficiency
The information processing efficiency of a stock market means the ability of a stock market to
price stocks and shares fairly and quickly. An efficient market in this sense is one in which the
market prices of all securities reflect all the available information.

The efficient markets hypothesis is concerned with the information processing efficiency of stock markets.

1.2 Varying degrees of efficiency
There are three degrees or 'forms' of stock market efficiency: weak form, semi-strong form and strong
form.

1.2.1 Weak form efficiency
If a stock market has weak form efficiency, it is not efficient at responding to events that affect companies
and should affect share prices. It does not react to much of the information that is available about a
company. Instead, when stock market efficiency is weak, share prices respond to all available historical
published information and information about past changes in the share price.

1.2.2 Semi-strong form efficiency
If a stock market displays semi-strong efficiency, current share prices reflect:



All relevant information about past price movements and their implications
All publicly available knowledge about companies and market returns

Share prices respond quickly to new information as it becomes available.
This means that individuals cannot 'beat the market' by reading the newspapers or annual reports, since
the information contained in these will already be reflected in share prices.
Tests to prove semi-strong efficiency have concentrated on the speed and accuracy of stock market
response to information and on the ability of the market to anticipate share price changes before new
information is formally announced. For example, if two companies plan a merger, share prices of the two
companies will inevitably change once the merger plans are formally announced. The market would show
semi-strong efficiency, however, if it were able to anticipate such an announcement, so that share prices
of the companies concerned would change in advance of the merger plans being confirmed.
Research in both the UK and the US has suggested that market prices anticipate mergers several months
before they are formally announced, and the conclusion drawn is that the stock markets in these countries
do exhibit semi-strong efficiency.

1.2.3 Strong form efficiency
If a stock market displays a strong form of efficiency, share prices reflect all information, whether it is
publicly available or not:




From past price changes
From public knowledge or anticipation
From specialists' or experts' insider knowledge (eg the inside knowledge of investment managers
about unpublished facts)

If a stock market has strong form efficiency, share prices will respond to new developments and events
before they even become public knowledge.

1.3 Features of efficient markets
Stock markets that are efficient (or semi-efficient) are therefore markets in which:
(a)

The prices of securities bought and sold reflect all the relevant information available to the buyers
and sellers, and share prices change quickly to reflect all new information about future prospects.

Part F Business valuations  18: Market efficiency

363

(b)

No individual dominates the market.

(c)

Transaction costs of buying and selling are not so high as to discourage trading significantly.

(d)

Investors are rational and so make rational buying and selling decisions, and value shares in a
rational way.

(e)

There are low, or no, costs of acquiring information.

1.4 Impact of efficiency on share prices
If the stock market is efficient, share prices should vary in a rational way.
(a)

If a company makes an investment with a positive net present value (NPV), shareholders will get
to know about it and the market price of its shares will rise in anticipation of future dividend
increases.

(b)

If a company makes a bad investment, shareholders will find out and so the price of its shares
will fall.

(c)

If interest rates rise, shareholders will want a higher return from their investments, so market
prices will fall.

1.5 Implications of efficient market hypothesis for the financial
manager
If the markets are quite strongly efficient, the main consequence for financial managers will be that they
simply need to concentrate on maximising the net present value of the company's investments in order
to maximise the wealth of shareholders. Managers need not worry, for example, about the effect on share
prices of financial results in the published accounts because investors will make allowances for low
profits or dividends in the current year if higher profits or dividends are expected in the future.
If the market is strongly efficient, there is little point in financial managers attempting strategies that will
attempt to mislead the markets.
(a)

There is no point for example in trying to identify a correct date when shares should be issued,
since share prices will always reflect the true worth of the company.

(b)

The market will identify any attempts to window dress the accounts and put an optimistic spin on
the figures.

(c)

The market will decide what level of return it requires for the risk involved in making an investment
in the company. It is pointless for the company to try to change the market's view by issuing
different types of capital instruments.

Similarly, if the company is looking to expand, the directors will be wasting their time if they seek as
takeover targets companies whose shares are undervalued, since the market will fairly value all
companies' shares.
Only if the market is semi-strongly efficient, and the financial managers possess inside information that
would significantly alter the price of the company's shares if released to the market, could they perhaps
gain an advantage. However, attempts to take account of this inside information may breach insider
dealing laws.
The different characteristics of a semi-strong form and a strong form efficient market thus affect the
timing of share price movements, in cases where the relevant information becomes available to the
market eventually. The difference between the two forms of market efficiency concerns when the share
prices change, not by how much prices eventually change.

Exam focus
point

364

The point that share prices may depend to some extent on the efficiency of the markets is important when
you discuss company valuations.

18: Market efficiency  Part F Business valuations

2 The valuation of shares
FAST FORWARD

Fundamental analysis is based on the theory that share prices can be derived from a rational analysis of
future dividends.
Technical analysts or chartists work on the basis that past price patterns will be repeated, therefore
future price movements can be predicted from historical patterns of share price movements in the past,
and there are some patterns that continually reappear.
Random walk theory is based on the idea that share prices will alter when new information becomes
available.
Share prices are also affected by marketability and liquidity of shares, availability and sources of
information, market imperfections and pricing anomalies, market capitalisation and investor speculation.

2.1 The fundamental theory of share values
We discussed the fundamental theory of share values in the last chapter. Remember that it is based on the
theory that the realistic market price of a share can be derived from a valuation of estimated future
dividends. The value of a share will be the discounted present value of all future expected dividends on the
shares, discounted at the shareholders' cost of capital. The theory therefore supports the view that
'realistic' share prices can be determined by valuation models, such as the dividend growth model.
If the fundamental analysis theory of share values is correct, the price of any share will be predictable,
provided that all investors have the same information about a company's expected future profits and
dividends, and a known cost of capital.

Question

Share valuation

The management of Crocus is trying to decide on the dividend policy of the company.
There are two options that are being considered.
(a)
(b)

The company could pay a constant annual dividend of 8c per share.
The company could pay a dividend of 6c per share this year, and use the retained earnings to
achieve an annual growth of 3% in dividends for each year after that.

The shareholders' cost of capital is thought to be 10%. Which dividend policy would maximise the wealth
of shareholders, by maximising the share price?

Answer
(a)

With a constant annual dividend
Share price =

(b)

8
= 80c
0.1

With dividend growth
Share price 

6(1.03)
6.18

 88c
(0.1 0.03) 0.07

The dividend of 6c per share with 3% annual growth would be preferred.

2.2 Charting or technical analysis
Chartists or 'technical analysts' attempt to predict share price movements by assuming that past price
patterns will be repeated. There is no real theoretical justification for this approach, but it can at times be

Part F Business valuations  18: Market efficiency

365

spectacularly successful. Studies have suggested that the degree of success is greater than could be
expected merely from chance.
Chartists do not attempt to predict every price change. They are primarily interested in trend reversals, for
example when the price of a share has been rising for several months but suddenly starts to fall.
Moving averages help the chartist to examine overall trends. For example, they may calculate and plot
moving averages of share prices for 20 days, 60 days and 240 days. The 20 day figures will give a
reasonable representation of the actual movement in share prices after eliminating day to day fluctuations.
The other two moving averages give a good idea of longer-term trends.
One of the main problems with chartism is that it is often difficult to see a new trend until after it has
happened. By the time the chartist has detected a signal, other chartists will have as well, and the
resulting mass movement to buy or sell will push the price so as to eliminate any advantage.
With the use of sophisticated computer programs to simulate the work of a chartist, academic studies
have found that the results obtained were no better or worse than those obtained from a simple 'buy and
hold' strategy of a well-diversified portfolio of shares.
This may be explained by research that has found that there are no regular patterns or cycles in share
price movements over time – they follow a random walk.

2.3 Random walk theory
Random walk theory is consistent with the fundamental theory of share values. It accepts that a share
should have an intrinsic price dependent on the fortunes of the company and the expectations of
investors. One of its underlying assumptions is that all relevant information about a company is
available to all potential investors who will act on the information in a rational manner.

The key feature of random walk theory is that, although share prices will have an intrinsic or fundamental
value, this value will be altered as new information becomes available, and that the behaviour of investors
is such that the actual share price will fluctuate from day to day around the intrinsic value.

2.4 Marketability and liquidity of shares
In financial markets, liquidity is the ease of dealing in the shares; how easily the shares can be bought
and sold without significantly moving the price.
In general, large companies, with hundreds of millions of shares in issue, and high numbers of shares
changing hands every day, have good liquidity. In contrast, small companies with few shares in issue and
thin trading volumes can have very poor liquidity.
The marketability of shares in a private company, particularly a minority shareholding, is generally very
limited, a consequence being that the price can be difficult to determine.
Shares with restricted marketability may be subject to sudden and large falls in value and companies may
act to improve the marketability of their shares with a stock split. A stock split occurs where, for example,
each ordinary share of $1 each is split into two shares of 50c each, thus creating cheaper shares with
greater marketability. There is possibly an added psychological advantage in that investors may expect a
company which splits its shares in this way to be planning for substantial earnings growth and dividend
growth in the future.
As a consequence, the market price of shares may benefit. For example, if one existing share of $1 has a
market value of $6, and is then split into two shares of 50c each, the market value of the new shares might
settle at, say, $3.10 instead of the expected $3, in anticipation of strong future growth in earnings and
dividends.

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18: Market efficiency  Part F Business valuations

2.5 Availability and sources of information
In Section 1 of this chapter it was stated that an efficient market is one where the prices of securities
bought and sold reflect all the relevant information available. Efficiency relates to how quickly and how
accurately prices adjust to new information.
Information comes from financial statements, financial databases, the financial press and the internet.

2.5.1 Dividend information
It has been argued that shareholders see dividend decisions as passing on new information about the
company and its prospects. A dividend increase is usually seen by markets to be good news and a
dividend decrease to be bad news, but it may be that the market will react to the difference between the
actual dividend payments and the market's expectations of the level of dividend. For example, the market
may be expecting a cut in dividend but if the actual decrease is less than expected, the share price may
rise.

2.6 Market imperfections and pricing anomalies
Various types of anomaly appear to support the views that irrationality often drives the stock market,
including the following.
(a)

Seasonal month of the year effects, day of the week effects and also hour of the day effects seem
to occur, so that share prices might tend to rise or fall at a particular time of the year, week or day.

(b)

There may be a short-run overreaction to recent events. For example, during the stock market
crash in 1987, the market went into free fall, losing 20% in a few hours.

(c)

Individual shares or shares in small companies may be neglected.

The paradox of efficient markets is that an efficient market requires people to believe that the market is
inefficient so that they trade securities in an attempt to outperform the market.
A noise trader is a trader who buys and sells irrationally and erratically; for example, overreacting to good
or bad news. Noise traders can cause prices and risk levels to change from expected levels.

2.7 Market capitalisation
The market capitalisation is the market value of a company's shares multiplied by the number of issued
shares.
The market capitalisation or size of a company has also produced some pricing anomalies.
The return from investing in smaller companies has been shown to be greater than the average return
from all companies in the long run. This increased return may compensate for the greater risk associated
with smaller companies, or it may be due to a start from a lower base.

2.8 Behavioural finance
Speculation by investors and market sentiment is a major factor in the behaviour of share prices.
Behavioural finance is an alternative view to the efficient market hypothesis. It attempts to explain the
market implications of the psychological factors behind investor decisions and suggests that irrational
investor behaviour may significantly affect share price movements. These factors may explain why share
prices appear sometimes to overreact to past price changes.

Behavioural finance considers the emotional and 'illogical' factors that affect the decision-making of
investors. These behavioural factors may explain why investors often do not act rationally. For example,
behavioural theory may explain stock market bubbles, such as inexplicable bubbles in the share prices of
technology stocks (in the early 2000s and the 2010s in the US) and a stock market crash, like the crashes
of 1929 and 1987.

Part F Business valuations  18: Market efficiency

367

Chapter Roundup




The theory behind share price movements can be explained by the three forms of the efficient market
hypothesis.


Weak form efficiency implies that prices reflect all relevant information about past price
movements and their implications.



Semi-strong form efficiency implies that prices reflect past price movements and publicly available
knowledge.



Strong form efficiency implies that prices reflect past price movements, publicly available
knowledge and inside knowledge.

Fundamental analysis is based on the theory that share prices can be derived from a rational analysis of
future dividends.
Technical analysts or chartists work on the basis that past price patterns will be repeated, therefore
future price movements can be predicted from historical patterns of share price movements in the past,
and there are some patterns that continually reappear.
Random walk theory is based on the idea that share prices will alter when new information becomes
available.

Share prices are also affected by marketability and liquidity of shares, availability and sources of
information, market imperfections and pricing anomalies, market capitalisation and investor speculation.

Quick Quiz
1

Which theory of share price behaviour does the following statement describe?
'The analysis of external and internal influences on the operations of a company with a view to assisting in
investment decisions.'

A
B
C
D

Technical analysis
Random walk theory
Fundamental analysis theory
Chartism

2

What is meant by 'efficiency' in the context of the efficient market hypothesis?

3

The different 'forms' of the efficient market hypothesis state that share prices reflect which types of
information? Tick all that apply.
Form of EMH
Weak
Semi-strong
Strong
No information
All information in past share price record
All other publicly available information
Specialists' and experts' 'insider' knowledge

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18: Market efficiency  Part F Business valuations