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Chapter 6 Investors in the Share Market Websites: www.ato.gov.au www.asx.com.au Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-1 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-2 Chapter Organisation 6.1 6.2 6.3 6.4 6.5 6.6 6.7 Stock Exchange and Share-Market Investment Buying and Selling Shares Taxation Financial Performance Indicators Pricing of Shares Stock-Market Indices and Published Share Information Summary Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-3 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-4 6.1 Stock Exchange and Share-Market 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-5 6.1 Stock Exchange and Share-Market 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-6 6.1 Stock Exchange and 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-7 6.1 Stock Exchange and Share-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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-8 6.1 Stock Exchange and Share-Market 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-9 6.1 Stock Exchange and 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-10 Chapter Organisation 6.1 6.2 6.3 6.4 6.5 6.6 6.7 Stock Exchange and Share Investment Buying and Selling Shares Taxation Financial Performance Indicators Pricing of Shares Stock-Market Indices and Published Share Information Summary Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-11 6.2 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 trust Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-12 Chapter Organisation 6.1 6.2 6.3 6.4 6.5 6.6 6.7 Stock Exchange and Share Investment Buying and Selling Shares Taxation Financial Performance Indicators Pricing of Shares Stock-Market Indices and Published Share Information Summary Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-13 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-14 6.3 Taxation (cont.) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-15 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-16 Chapter Organisation 6.1 6.2 6.3 6.4 6.5 6.6 6.7 Stock Exchange and Share Investment Buying and Selling Shares Taxation Financial Performance Indicators Pricing of Shares Stock-Market Indices and Published Share Information Summary Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-17 6.4 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-18 6.4 Financial Performance Indicators (cont.) • Indicators of company performance – – – – – – Capital structure Liquidity Debt servicing Profitability Share price Risk Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-19 6.4 Financial Performance Indicators (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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-20 6.4 Financial Performance Indicators (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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-21 6.4 Financial Performance Indicators (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) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-22 6.4 Financial Performance Indicators (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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-23 6.4 Financial Performance Indicators (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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-24 6.4 Financial Performance Indicators (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) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-25 6.4 Financial Performance Indicators (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) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger (6.5) 6-26 6.4 Financial Performance Indicators (cont.) 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) (6.6) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-27 6.4 Financial Performance Indicators (cont.) 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) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger (6.7) 6-28 6.4 Financial Performance Indicators (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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-29 6.4 Financial Performance Indicators (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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-30 Chapter Organisation 6.1 6.2 6.3 6.4 6.5 6.6 6.7 Stock Exchange and Share Investment Buying and Selling Shares Taxation Financial Performance Indicators Pricing of Shares Stock-Market Indices and Published Share Information Summary Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-31 6.5 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-32 6.5 Pricing of Shares (cont.) • Estimating the price of a share – General dividend valuation model D t1 P 1rs t t 0 Where P current share price D expected dividend per share in period t r required rate of return 0 t (6.8) s Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-33 6.5 Pricing of Shares (cont.) • Estimating the price of a share (cont.) – Valuing a share with a constant dividend (D0) D P rs 0 0 (6.9) – Valuing a share with constant dividend growth (g) P D 0 0 1g r g s Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger (6.12) 6-34 6.5 Pricing of Shares (cont.) • 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. cumdividend Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-35 6.5 Pricing of Shares (cont.) • Cum-dividend and ex-dividend (cont.) – Once the dividend is paid the shares are traded exdividend – Theoretically the share price will fall on the ex-dividend date by the size of the dividend Example Share price cum-dividend Dividend paid Theoretical ex-dividend price Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger $1.00 0.07 0.93 6-36 6.5 Pricing of Shares (cont.) • 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-37 6.5 Pricing of Shares (cont.) • 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 Market value of 4 cum-bonus shares Theoretical value of 5 ex-bonus shares Theoretical value of 1 ex-bonus share Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger $5.00 $20.00 $20.00 $4.00 6-38 6.5 Pricing of Shares (cont.) • 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 Theoretical ex-split share price Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger $50.00 $10.00 6-39 6.5 Pricing of Shares (cont.) • 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-40 6.5 Pricing of Shares (cont.) • 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 Market value of 5 cum-rights shares Plus new cash from 1:5 issue Market value of 6 ex-rights shares Theoretical ex-rights share price Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger $1.00 5.00 0.88 5.88 0.98 6-41 6.5 Pricing of Shares (cont.) • 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. Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger (6.13) 6-42 Chapter Organisation 6.1 6.2 6.3 6.4 6.5 6.6 6.7 Stock Exchange and Share Investment Buying and Selling Shares Taxation Financial Performance Indicators Pricing of Shares Stock-Market Indices and Published Share Information Summary Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-43 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-44 6.6 Stock-Market Indices and Published 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-45 6.6 Stock-Market Indices and Published 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-46 Chapter Organisation 6.1 6.2 6.3 6.4 6.5 6.6 6.7 Stock Exchange and Share Investment Buying and Selling Shares Taxation Financial Performance Indicators Pricing of Shares Stock-Market Indices and Published Share Information Summary Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-47 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-48 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 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 6-49