Introduction to Corporate Finance

PARt 2: VALUAtIoN, RISk ANd REtURN

5 -1 tHE ESSENtIAL FEAtURES oF

PREFERREd ANd oRdINARY SHARES

How do companies raise money when they need to fund a new investment project? If a company does

not have enough internal funding (such as past profits), it will often turn to the capital markets to raise

funds by issuing debt or equity securities. Debt securities, such as bonds, generally offer investors a

legally enforceable claim to cash payments that are either fixed or vary according to a predetermined

formula. Because the cash flow streams offered by bonds are typically fixed, valuing bonds is a relatively

straightforward exercise, as Chapter 4 demonstrated. The market price of a bond should equal the

present value of the cash payments that the bond promises to make.

The same valuation principle applies to equity securities, such as ordinary shares, but investors confront

a difficult challenge when they estimate the value of these securities. Companies issuing ordinary shares

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

describe the differences between

preferred and ordinary shares

calculate the estimated value of

preferred and ordinary shares using

zero, constant and variable growth

models

value an entire company using the free

cash flow approach

apply alternative approaches for pricing

shares that do not rely on discounted cash

flow analysis

understand how investment bankers help

companies issue equity securities in the

primary market

be aware of the Australian secondary

securities exchange markets in which

investors trade shares.

LO5.1

LO5.2

LO5.3

LO5.4

LO5.5

LO5.6

This chapter focuses on valuing preferred and

ordinary shares. We begin by describing the

essential features of these instruments, comparing

and contrasting them with the features of bonds,

which we covered in the previous chapter. Next, we

apply the information from this chapter’s first three

sections to the basic discounted cash flow valuation

framework from Chapter 4 to develop a method

for pricing preferred and ordinary shares. The focus

here is to show that expected cash flows from the

company drive the value of its shares, so that if a

company is doing well in terms of its operations and

financial activities in generating net positive cash

flows, the value of its shares will rise.

We introduce three simple approaches for

valuing shares – the zero, constant and variable

growth models – based on the dividend streams

each pays over time. We also present the

free cash flow approach for valuing the entire

enterprise. Then, we review some other popular

share valuation measures, including book value,

liquidation value and comparable company

multiples. Finally, we explain how companies,

with the assistance of investment bankers and

other advisers, issue these securities to investors,

and how trades between investors occur on an

ongoing basis once the securities have been

issued.