Equity Markets

1
Corporations

Share market
• A formal exchange facilitating the issue, buying and selling of
equity securities

Publicly listed corporation

• A company whose shares are quoted and traded on a formal
stock exchange

Ordinary share
• The principal form of equity issued by a corporation, which
bestows a claim to residual cash flows and ownership and voting
rights

2
Corporations

The corporation differs from other business forms

• Ownership claims are widespread and easily transferable

• Owners (shareholders) do not affect the day-to-day affairs of the

company

• Shareholders’ liability is limited to:

• the issue price of shares of a limited liability company
• any partly paid portion of shares of a no-liability company

3
Advantages of the corporate form

• Can obtain large amounts of finance at a relatively cheaper cost

• The liquidity of securities facilitates investor diversification and

encourages investment in corporate securities

• Separation of ownership and control facilitates:

• appointment of specialised management
• greater effectiveness in the planning and implementation of
strategic decisions

• ‘Perpetual succession’—the corporate form is unaffected by

changes in management or ownership

• The corporate form is suited to large-scale operations

4
Disadvantages of the corporate form

• Main disadvantage arises from the separation of ownership and

control
• Agency problem - Conflict of interest between owners
(principals) and managers (agents)
• Management may try to run business for their own benefit, rather
than that of shareholders, i.e. maximise shareholder value
(share price)

• Factors moderating conflict of interest between owners and

managers
• Investors’ ability to sell shares in a corporation, causing the
share price to fall
• Dismissal from the board at AGM by shareholders
• Threat of takeover and loss of employment
• Use of performance incentives, such as share options
• More rigorous corporate governance
5
Evidence of advantage of Corporations

• Following the GFC, many corporations were forced to raise additional

capital through the stock market

• This was to ‘sure up’ their balance sheets during the tough economic
environment that followed the crisis

• The advantage of the corporate form is highlighted by such

behaviour

• Smaller firms are not able to access capital as easily and would
normally be expected to pay a higher rate of return

6
Roles of stock exchange

Various roles of a stock exchange are considered:

• Primary market role

• Secondary market role

• Managed Product role

• Derivative market role

• Interest rate market role

• Trading and settlement roles

• Information role

• Regulatory role

7
Primary role of stock exchange

• A stock exchange facilitates the efficient and orderly sale of new

financial securities
• New floats/Initial public offerings (IPOs)
• Initial listing of a corporation on the stock exchange
• Rights issue
• Issue of additional shares to existing shareholders on a pro-
rata basis
• Placements
• Issue of new shares to selected institutional investors
• Dividend reinvestment plans
• Reinvestment of dividends into corporation for additional
shares

8
Primary role of stock exchange

9
Secondary role of stock exchange

• Facilitates trading in existing shares

• No new funds are raised by the issuing company
• An active, liquid, well-organised secondary market increases the
appeal of buying new shares in the primary market
• Market liquidity
• Ratio of the value of share turnover to market capitalisation
• Market capitalisation
• Number of shares on issue x current share price

10
Managed product role

• The stock exchange provides a market for trading managed products

• Equity-based managed products are professionally managed

funds.
• The ‘units’ in these funds are bought and sold on the stock
exchange in the same way as shares in corporations.

• Managed products are described as:

• exchange traded funds (ETFs) ie, STW, SLF
• real estate investment trusts (REITs) ie, CFX, SCP
• infrastructure funds ie, EPX

11
Derivative market role

• The stock exchange provides a market for trading equity-related

derivative products

• A derivative is a financial security that derives its price from an

underlying commodity (e.g. gold) or financial instrument (e.g.
BHP shares)

• Derivative products are described as:

• exchange-traded contracts
• standardised financial contracts traded on a formal
exchange – options, warrants, futures contracts,
Contracts for difference

• over-the-counter contracts
• non-standardised contracts negotiated between writer
and buyer 12
Interest rate market role

• The listing, quotation and trading of typically longer term debt

instruments on a stock exchange

• Straight corporate bonds

• Floating rate notes (FRNs)
• Convertible notes
• Preference shares

• This role adds value to a debt issue owing to:

• transparency
• information about price, yield, maturity, credit rating of debt
instruments

• ease of entry
• electronic trading system facilitates buy and sell orders at
minimum cost and time delay at current market prices

• liquidity
• quotation on a stock exchange provides access to a wider
market 13
Trading and settlement role of stock exchange

• ASX Trade and ASX Trade24 are integrated computer-based trading

systems to trade all listed securities and derivatives

• Clients’ orders are executed via computer from the broker’s

office

• Orders are executed in order of time received and the buy/sell

price

• CHESS (Clearing House Electronic Sub-register System)

• Facilitates the settlement of transactions conducted through ASX

• Settlement of transactions within three days (T + 3)

• Provides an electronic sub-register that records the ownership of

listed securities

• A CHESS sponsor is a market participant with access to

CHESS, e.g. stockbroker 14
Information role of stock exchange

• Investor confidence in the ASX relies on informational efficiency

• The current share prices should reflect all information available
in the market, determined by:
• the speed at which new information flows to the market
• the speed at which that information is absorbed and
reflected in share prices

• The ASX has a critical role in facilitating the flow of information to the
market

• Corporations Act 2001 (Cwlth) requires information materially

affecting the share price of a listed company to be immediately given
to the ASX

15
Information role of stock exchange

• Listing rules are stock exchange rules with which a listed entity must
comply

• Examples of information disclosures required by ASX listing rules

• A change in a company’s financial forecasts
• Appointment of a liquidator
• Declaration of a dividend
• Notice of a takeover bid
• Disclosure of directors’ interests

16
Regulatory role of stock exchange
• The aim of regulation is to ensure market participants have confidence
in the integrity of market operations
• Australian Securities Exchange (ASX)

• Ensures listed companies meet specified limited levels of

performance and standards of information disclosure so
investors can make informed decisions –
• Continuous disclosure

• Prescribes appropriate behaviour of broker participants on the

exchange –
• Sanctions include discipline, penalties, loss of licence

• Electronic surveillance systems to monitor trading behaviour of

market participants
• Detect trades that fall outside certain limits
• Cross-references all trades against information on the
relevant company, directors and associated parties
17
Regulatory role of stock exchange
• The aim of regulation is to ensure market participants have confidence
in the integrity of market operations

• Australian Securities and Investments Commission (ASIC)

• Supervision of Corporations Law and markets in Australia
(Corporations Act 2001 (Cwlth))

• Market integrity and consumer protection across the financial

system, covering investment, insurance and superannuation
products

• Supervises the ASX, addressing potential conflicts of interest

as a publicly listed corporation

18
 Ch 6 – Investors in the share markets

• Learning objectives:

– Consider the role of an investor in the share market and

appreciate the range of investment choices available to 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

– Demonstrate share pricing methods

– Consider the importance of share-market indices and published

share information
 Ch 6 – Investors in the share markets

• Learning objectives:

– Consider the role of an investor in the share market and

appreciate the range of investment choices available to 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

– Demonstrate share pricing methods

– Consider the importance of share-market indices and published

share information
 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 an 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
 Share-market investment (cont.)

• Two types of risk impact on security returns

1. Systematic risk
• Factors that generally impact on share prices in the market; e.g.
economic growth, and changes in interest rates and exchange rates

2. Unsystematic risk
• Factors that impact specifically on the share price of a corporation;
e.g. resignation of the CEO, technology failure, board problems

(cont.)
 Share-market 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

– 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
 Share-market investment (cont.)

• Investors may take one of two approaches

1. Active investment approach
• Portfolio structure is based on share analysis, new information and
risk-return preferences
2. 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
 Share-market 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
 Buying and selling shares

• 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
trusts
 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
 Taxation

• 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
 Financial performance indicators

• 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

• Indicators of company performance

– Capital structure
– Liquidity
– Debt servicing
– Profitability
– Share price
– Risk
Financial performance indicators

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

– 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
Financial performance indicators

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,
such as inventory

Current ratio  current assets (maturing within one year)

current liabilities (due within one year)
Financial performance indicators

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
Financial performance indicators

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 total firm debt

• Measured by interest coverage ratio

Interest cover  earnings before finance lease charges, interest and tax
finance lease charges and interest
Financial performance indicators

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)
Financial performance indicators

Profitability (cont.)

• Wide variation in the measurement of profitability (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)
Financial performance indicators

Profitability (cont.)

• Wide variation in the measurement of profitability (cont.)

– Return on equity (net income/equity)
– Higher ratios indicate greater profitability

Return on equity  net income

equity (shareholders' funds)
Financial performance indicators

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 at which a firm’s
share price is trading relative to its NTA
Financial performance indicators

Risk
• Variability (uncertainty) of the share price
• Two components

1. Systematic risk (often referred to as beta)

• Arises from factors affecting the whole market, e.g. state of the
domestic economy and world economy

2. 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
 Pricing of shares

• 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
 Pricing of shares

• Estimating the price of a share

– General dividend valuation model


D t

t1
P
1rs t
0

Where: P  current share price

0

D  expected dividend per share in period t

t

r  required rate of return

s
 Pricing of shares

• Estimating the price of a share (cont.)

– Valuing a share with a constant dividend (D0)

D
P 0
0

rs

– Valuing a share with constant dividend growth (g)

1g
 
 
 
 

P D
 
 
0 0



r g s



 Pricing of shares - Example

• The last dividend paid to shareholders by Mega Bank Limited was

$1.80 per share. The board of directors of the bank plans to maintain a
constant dividend growth policy of 8.5 per cent. An investor, in
evaluating an investment in the bank, has determined that she would
require a 20 per cent rate of return from this type of investment. If the
current price of Mega Bank shares in the stock market is $15.50,
should the investor purchase the shares? (Show your calculations.)
Pricing of shares - Example

• Mega bank is planning to maintain constant dividend growth. Therefore,

the next dividend paid will be the last dividend multiplied by the growth
rate:

P0 = D0 (1 + g) / (rs – g)
= 1.80 (1.085) / (0.20 – 0.085)
= $16.98

at a current market price of $15.50 the investor should consider buying the
shares
 Pricing of shares
• 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
– 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
 Pricing of shares
• 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

– As no new capital is raised, there is no change in the assets or

expected earnings of the company
 Pricing of shares

• 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
 Pricing of shares

• 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
• size of the discount
 Pricing of shares

• 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 funds from 1:5 issue 0.88
Market value of 6 ex-rights shares 5.88
Theoretical ex-rights share price (5.88/6) 0.98
 Pricing of shares

• 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
• To check: Value of right + right issue price should equal theoretical
ex-right price

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.
Pricing of shares example

• Bigandbold Limited has a current share price of $15.50. The

company has made a renounceable rights issue offer to
shareholders. The offer is a three-for-ten pro-rata issue of ordinary
shares at $15.35.
• What is the price of the right?
• Calculate the theoretical ex-rights share price.
 Pricing of shares example

• 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. Therefore:
Pricing of shares example

cum-rights share price $ 15.50

Market value of 10 cum-rights shares $155.00

plus:

new cash introduced through take-up of 3 for 10 issue $ 46.05

gives:

market value of 13 ex-rights shares $201.05

therefore:

theoretical ex-rights share price $ 15.47

 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

• Factors that influence a company’s share price

– Expected future dividends
– Bonus shares issues
– Share splits
– Pro-rata rights issues