Ch06-Investors in The Share Market

Chapter 6
Investors in
the Share Market
Websites:
www.ato.gov.au
www.asx.com.au
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-1
Slides prepared by Anthony Stanger
Learning Objectives
• Appreciate the range of investment choices
available for the investor
• Understand the process of buying and selling
shares, the risks involved, and the importance of
taxation when investing
• Describe indicators of financial performance
• Explain share pricing methods
• Consider the importance of share-market indices
and published share information

Chapter Organisation
6.1 Stock Exchange and Share-Market Investment
6.2 Buying and Selling Shares
6.3 Taxation
6.4 Financial Performance Indicators
6.5 Pricing of Shares
6.6 Stock-Market Indices and Published Share
Information
6.7 Summary

6.1 Stock Exchange and Share-Market
Investment
• Investors buy shares to receive returns from
dividends and capital gains (losses)
• Other factors encouraging investment in securities
quoted on a stock exchange (SX)
– Depth of the market
 Overall capitalisation of corporations listed on a SX
– Liquidity of the market
 Volume of trading relative to the size of the market
– Efficient price discovery
 Speed and efficiency with which new information is reflected
in the current share price

Investment (cont.)
• The SX offers a wide range of security types to the
investor
• Securities listed on the SX are categorised into
industry groups allowing investors a choice within
a range of economic sectors

Investment (cont.)
• Two types of risk impact on security returns
– Systematic risk
 Factors that generally impact on share prices in the market,
e.g. economic growth, and changes in interest rates and
exchange rates
– Unsystematic risk
 Factors that specifically impact on the share price of a
corporation, e.g. resignation of the CEO, technology failure,
board problems

Investment (cont.)
• Diversified investment portfolio
– A portfolio containing a wide range of securities
– Diversifies most of the unsystematic risk of the individual
securities
 Investors will not receive higher returns for unnecessarily
bearing unsystematic risk
– The remaining risk is systematic risk, which is measured
by beta
 Beta is a measure of the sensitivity of the price of an asset
relative to the market

Investment (cont.)
• Diversified investment portfolio (cont.)
– Expected portfolio return is the weighted average of
expected returns of each share
– Portfolio variance (risk) is the correlation of pairs of
securities within the portfolio

Investment (cont.)
• Investors may take one of two approaches
– Active investment approach
 Portfolio structure is based on share analysis, new
information and risk-return preferences
– Passive investment approach
 Portfolio structure is based on the replication of a specific
share-market index, e.g. industrial or telecommunications
sector index
• Some managed funds are index funds
– Portfolios are structured to fully or partially replicate a
specific share-market index

Investment (cont.)
• Investors need to consider asset allocation within a
share portfolio
 Risk versus return
 Investment time horizon
 Income versus capital growth
 Domestic and international shares
• Asset allocation may be
 Strategic
 Tactical

6.1 Stock Exchange and Share Investment
6.3 Taxation
Information
6.7 Summary

• Direct investment in shares
– Investor buys and sells shares through a stockbroker
 Discount broker, i.e. phone and Internet
 Full-service advisory broker
– Consideration of liquidity, risk, return, charges, taxation,
social security etc.
• Indirect investment in shares
– Investor purchases units in a unit trust or managed fund,
e.g. equity trust

6.3 Taxation
Information
6.7 Summary

6.3 Taxation
• Pre-dividend imputation (prior to 1987)
– Dividends were taxed twice—first at company level (as
profits) and then at the investor’s marginal rate
• Dividend imputation (since 1987)
– Removed the double taxation of dividends
– Investors receive franking credit for the tax a company
pays on a franked dividend

6.3 Taxation (cont.)

6.3 Taxation (cont.)
• Capital gains tax on shares purchased
– Prior to 19/9/1985 tax free
– 19/9/1985–21/9/1999
 Taxpayer’s marginal tax rate applied if held less than 12
months
 Taxpayer’s marginal tax rate applied to indexed capital gain
if held over 12 months
– Since 21/9/1999
 50% discounted gain if held at least 12 months or
 Indexed capital gain or 50% discounted gain if purchased
19/9/1985–21/9/1999

6.3 Taxation
Information
6.7 Summary

• Potential investors are concerned with the future
level of a company’s performance
• Company’s performance affects both the

profitability of the company and the variability of
the cash flows

(cont.)
• Indicators of company performance
– Capital structure
– Liquidity
– Debt servicing
– Profitability
– Share price
– Risk

(cont.)
Capital structure
• Proportion of company assets (funding) obtained
through debt and equity
– Usually measured by debt to equity ratio (D/E)
 Higher debt levels increase financial risk, i.e. firm may not
be able to meet interest payments

(cont.)
Capital structure (cont.)
• Proportion of company assets (funding) obtained
through debt and equity (cont.)
– Also measured by proprietorship ratio, which is the ratio
of shareholders’ funds to total assets
 Indicates firm’s longer-term financial viability/stability. A
higher ratio indicates less reliance on external funding

(cont.)
Liquidity
• The ability of a company to meet its short-term
financial obligations
• Measured by current ratio
– Fails to consider the not very liquid nature of certain
current assets like inventory
Current ratio  current assets (maturing within one year)

current liabilities (due within one year)
(6.2)

(cont.)
Liquidity (cont.)
• Measured by liquid ratio
• The higher the current and liquid ratios, the better
the liquidity position of a firm
Liquid ratio  current assets - inventory stock (on hand)

current liabilities - bank overdraft

(cont.)
Debt servicing
• Ability to meet debt-related obligations, i.e. interest
and repayment of debt
• Measured by debt to gross cash flow ratio
– Indicates number of years of cash flow required to repay
firm debt

(cont.)
Debt servicing (cont.)

• Measured by interest coverage ratio
Interest cover  earnings before finance lease charges, interest and tax
finance lease charges and interest
(6.4)

(cont.)
Profitability
• Wide variation in the measurement of profitability
– Earnings before interest and tax (EBIT) to total funds
ratio
– Earnings per share (EPS)
EBIT to total funds ratio
 EBIT
total funds employed (shareholders' funds and borrowings)
(6.5)

(cont.)
Profitability (cont.)
(cont.)
– EBIT to long-term funds ratio
EBIT to long- term funds ratio
 EBIT
long- term funds (i.e. total funds less short - term debt)
(6.6)

(cont.)
Profitability (cont.)
(cont.)
– Return on equity (net income/equity)
– Higher ratios indicate greater profitability
Return on equity  net income

equity (shareholders' funds)
(6.7)

(cont.)
Share price
• Represents investors’ view of the present value of
future net cash flows of a firm
• Share price performance indicators
– Price to earnings ratio (P/E)
 Share price divided by earnings per share
 A higher P/E indicates more growth in future net cash flows
– Share price to net tangible assets ratio (P/NTA)
 Measures the theoretical premium or discount a firm’s share
price is trading relative to its NTA

(cont.)
Risk
• Variability (uncertainty) of the share price
• Two components
– Systematic risk (often referred to as beta)
 Arises from factors affecting the whole market, e.g. state of
the domestic economy and world economy
– Non-systematic risk
 Arises from firm-specific factors, e.g. management
competence, labour productivity, financial and operational
risks
 Can be eliminated in a well-diversified portfolio

6.3 Taxation
Information
6.7 Summary

• Share price is mainly a function of supply and
demand for a share
– Supply and demand are influenced mainly by information
– Share price is considered to be the present value of
future dividend payments to shareholders
– New information that changes investors’ expectations
about future dividends will result in a change in the share
price

6.5 Pricing of Shares (cont.)
• Estimating the price of a share
– General dividend valuation model

D t
P  t1 t
1rs 
0
P  current share price

0
Where D  expected dividend per share in period t

t
(6.8)
r  required rate of return
s

• Estimating the price of a share (cont.)
– Valuing a share with a constant dividend (D0)
D
P
0
0
rs
(6.9)
– Valuing a share with constant dividend growth (g)
1g
 
 
 
 
P D
 
 
0 0
r g


 s





(6.12)

• Cum-dividend and ex-dividend
– Dividends are payments made to shareholders,
expressed as cents per share
– Dividends are declared at one date and paid at a later
specified date
– During the period between the two dates, the shares
have the future dividend entitlement attached, i.e. cum-
dividend

• Cum-dividend and ex-dividend (cont.)
– Once the dividend is paid the shares are traded ex-
dividend
– Theoretically the share price will fall on the ex-dividend
date by the size of the dividend
 Example
Share price cum-dividend $1.00
Dividend paid 0.07
Theoretical ex-dividend price 0.93

• Bonus share issues
– Where a company has accumulated reserves, it may
distribute these to existing shareholders by making a
bonus issue of additional shares
– As with dividends, there will be a downward adjustment
in share price when shares go ex-bonus

• Bonus share issues (cont.)
– As no new capital is raised, there is no change in the
assets or expected earnings of the company
 Example—if a bonus 1:4 issue is made
Cum-bonus price $5.00
Market value of 4 cum-bonus shares $20.00
Theoretical value of 5 ex-bonus shares $20.00
Theoretical value of 1 ex-bonus share $4.00

• Share splits
– Involves division of the number of shares on issue
– Involves no fundamental change in the structure or asset
value of the company
– Theoretically the share price will fall in the proportion of
the split
 Example—5 for 1 split
Pre-split share price $50.00
Theoretical ex-split share price $10.00

• Pro-rata rights issue
– Involves an increase in the company’s issued capital
– Typically issued at a discount to market price
– Theoretically, the market price will fall by an amount
dependent on
 The number of shares issued
 The size of the discount

• Pro-rata rights issue (cont.)
– Example—market price cum-rights $1.00, with 1:5 rights
issue priced at $0.88
Cum-rights share price $1.00

Market value of 5 cum-rights shares 5.00
Plus new cash from 1:5 issue 0.88
Market value of 6 ex-rights shares 5.88
Theoretical ex-rights share price 0.98

• Pro-rata rights issue (cont.)
– A renounceable right is a right that can be sold before it is
exercised
 The value of the right is determined by Equation 6.13
Value of right  N (cum rights price - subscription price)

N 1
Where N is the number of shares required
to obtain the rights issue share, and the subscription
price is the discounted price of the additional share.
(6.13)

6.3 Taxation
Information
6.7 Summary

6.6 Stock-Market Indices and Published
Share Information
• Stock-market indices
– Measure of the price performance of a share market or
industry sector, e.g.
 Performance benchmark index
• Measures overall share-market performance based on
capitalisation and liquidity
 Tradeable benchmark index
• A narrow index used as the basis for pricing certain derivative
products
 Market indicator index
• Measure of overall share-market performance

Share Information (cont.)
• Market indicator indices
– Price-weighted, e.g. Dow Jones
 Weighting of a company proportional to its share price
– Capitalisation-weighted, e.g. S&P/ASX All Ords
 Weighting of a company proportional to market
capitalisation
– Share-price index measures capital gains/losses from
investing in an index-related portfolio
– Accumulation index includes share price changes and
reinvestment of dividends

Share Information (cont.)
• Market indicator indices (cont.)
– Global industry classification standard (GICS) comprises
10 standard international industry sector indices, e.g.
energy, materials, industrials
• Published share information
– Newspapers and financial journals provide share-market
information to varying degrees of detail, e.g. Australian
Financial Review

6.3 Taxation
Information
6.7 Summary

6.7 Summary
• Factors a share investor should consider
– Diversification, portfolio return and risk
– Active or passive investment
– Direct or indirect investment
– Taxation
– Company financial performance indicators
 Capital structure, liquidity, debt servicing, profitability, share
price, risk

6.7 Summary (cont.)
• Factors that influence a company’s share price
– Expected future dividends
– Bonus shares issues
– Share splits
– Pro-rata rights issues
• Various share-market indices exist that provide a
measure of the price performance of a sector or of
the market overall


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Chapter 6

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• Company’s performance affects both the

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Current ratio  current assets (maturing within one year)

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Liquid ratio  current assets - inventory stock (on hand)

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Debt servicing (cont.)

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EBIT to total funds ratio

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EBIT to long- term funds ratio

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Return on equity  net income

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P  current share price

Where D  expected dividend per share in period t

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– Valuing a share with constant dividend growth (g)

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Cum-rights share price $1.00

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Value of right  N (cum rights price - subscription price)

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