Introduction to Corporate Finance

5: Valuing Shares

make no specific promises to investors about how much cash they will receive, or when. Companies may

choose to make cash payments to shareholders, called dividends, but they are under no obligation to do so.

Loosely speaking, a company distributes cash to ordinary shareholders if it is generating more cash from its

operations than it needs to pay expenses and fund new profitable investment opportunities. For this reason,

shareholders are sometimes referred to as residual claimants – their claim is only on the cash remaining

after the company pays all of its bills and makes necessary new investments in the business. Because it

is very hard to predict the magnitude of these residual cash flows and the timing of their distribution to

shareholders, valuing ordinary shares is much more difficult than valuing bonds.

In light of this discussion, it should not surprise you to learn that debt and equity securities differ,

both in terms of the risks they require investors to bear and the potential rewards for taking those risks.

Debt securities offer a relatively safe and predictable return; but safety comes at a price. Bond returns

are rarely high enough to generate wealth quickly, and bondholders (creditors) exercise almost no direct

influence on corporate decisions, except when a missed payment allows bondholders to force a company

into insolvency. Ordinary shareholders accept more risk than do bondholders or creditors. For example,

an investor who purchased $10,000 worth of shares of Inabox (a telecommunications company) when it

debuted in July 2013 saw that investment grow by July 2014 to more than $13,400 in the company’s first

year of operation, a 34% increase. A year further on, in July 2015, the share price for Inabox was trading

at $1, making the value of the original investment now $10,000.^1 Because ordinary shareholders are

asked to take large risks, they expect higher returns on average than do bondholders.

Investors who own ordinary shares also have opportunities to exercise some control over corporate

decisions through their voting rights. Usually, investors are entitled to one vote for each share of ordinary

shares that they own, and they may exercise their right to vote at shareholders’ meetings. At these

meetings, shareholders elect the board of directors to oversee management and approve major decisions

such as a large acquisition. As a practical matter, however, most investors do not attend shareholder

meetings, but they can still exercise their voting rights by signing proxy statements. Proxy statements are

documents that describe the issues that will be voted on at the shareholder meeting. By signing these

documents, shareholders transfer their voting rights to another party. Usually, shareholders give their

proxies to the company’s current board of directors, but occasionally, outsiders who are dissatisfied with

the company’s management or who view the company as an attractive takeover target will wage a proxy

fight. In a proxy fight, outsiders try to acquire enough votes from shareholders to elect a new slate of

directors and thereby take control of the company, or at least effect a change in company policy.

Not all shareholders have voting rights. Preferred shares represent a kind of hybrid security, meaning

that they have some of the features of debt and some of ordinary shares. The cash payments that preferred

shareholders receive are called dividends, just like the payments that ordinary shareholders receive, but

these dividends are usually fixed, like the interest payments made to bondholders. That makes valuing

preferred shares easier than valuing ordinary shares. Like bondholders, preferred shareholders may not

have voting rights, but their claims are senior to ordinary shares, meaning that preferred shareholders have

a higher priority claim on a company’s cash flows. For instance, companies usually must pay the dividend

on preferred shares before they can pay a dividend on their ordinary shares. Many preferred shares

have a feature known as cumulative dividends, meaning that if a company misses any preferred dividend

payments, it must catch up and pay preferred shareholders for all the dividends they missed (along with

the current dividend) before it can pay dividends on ordinary shares. In all these instances, preferred

shares seem more like debt than equity.

1 Data from Yahoo Finance. https://au.finance.yahoo.com/echarts?s=IAB.AX. Accessed 15 December 2015.

LO5.1

dividends

Periodic cash payments

that companies make to

shareholders

residual claimants

Investors who have the right

to receive the cash that

remains after a company

pays all of its bills and makes

necessary new investments in

the business

proxy statements

Documents that describe the

issues to be voted on at an

annual shareholders meeting

proxy fight

An attempt by outsiders to

gain control of a company by

soliciting a sufficient number

of votes to elect a new slate

of directors and effect a

change in company policy