Corporate Finance Gufeng: - PowerPoint PPT Presentation

Title: Corporate Finance Gufeng:


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Corporate FinanceGufeng Shanghai Fever

• Applying the Discounted Dividend Model Shanghai
  A and B shares in the 1990s

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Objectives

• Introduce the notion of market efficiency.
• Review DDM
• Review perpetuity
• Application in context of Shanghai Market.

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Market Efficiency

• ...all securities in an equivalent risk class
  are priced to offer the same expected return.
• In an efficient market, the market price
  provides the best estimate of value.
  Expectations of the price are involved.
• More precisely, the market price is an unbiased
  estimator of the the true value of the asset or
  investment. Hence, the market price can deviate
  from the true value but the deviations are
  random in nature. As a consequence, it is not
  possible to consistently-systematically make
  profits (risk adjusted, other qualifications).

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Information Sets and Market Efficiency

• The expectations mentioned earlier must be
  conditioned/based on an information set.
• Roberts-Fama Definition
• Weak form current price reflects information of
  all past prices (and volume)
• Semi-strong form reflects all publicly available
  information (news, financial reports, etc.)
• Strong form public and private information

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Bernstein, Against the Gods p.202

• The information you have is not the information
  you want
• The information you want is not the information
  you need
• The information you need is not the information
  you can obtain
• The information you can obtain costs more than
  you want to pay

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Forecasts are conducted using econometric
time series models. Specifically,
ARMA-ARCH- Neural Net Model (Donaldson,
Kamstra, RFS)
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Valuing Shares of Stock

• Recall, a shareholder receives dividends.
• Dividends are a cash in-flow.
• Assume we hold the stock forever.
• Assume the dividends are paid forever (each
  year).
• Assume the discount rate stays the same forever.
• Sonys stock pays a dividend of 50 yen per year.
• What is the price of Sonys stock?

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r1 is the expected return. P1 is tomorrow price
and P0 today price. Div is dividend. Note, the
dividends are expected (forecasted) dividends.
r is an expected return since P1 is not realized.
Many times we simply drop the expectations
operator.
.
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Rearrange the return equation to get
This relationship should hold for other periods,
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Continually substituting gives,
If T goes to infinity,
THIS IS THE DIVIDEND DICOUNT MODEL
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Gordon Growth Model

• Need to make some simplifications to the dividend
  discount model to make it operational.
• Assume dividends grow at constant rate, g, which
  is lower than r. Let us assume a mature, stable
  firm.

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How do we obtain g?

• Analyst forecasts.
• payout ratio and ROE approach
• payout ratio is the ratio of dividends to
  earnings per share (EPS). This the fraction of
  the earnings that is paid out as dividends. The
  remainder is plowed back into the firm/project.
  
• plowback ratio1-payout ratio
• gplowback ratio x ROE
• ROEEPS/Book equity share

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Pay-out Ratio is 50
Dividends 50
Earnings 100
Plow-back Ratio is 50
Re-invested 50 (plowed back)
Re-invested At ROE
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What is a reasonable g?

• An average g could provide a better estimate of
  r. Take averages across firms with similar
  characteristics (same industry, risk class, etc.)
• Compare the g with growth rate of the entire
  economy-GNP or GDP (or industry). The firm
  cannot grow significantly faster than the economy
  forever!

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Cont.

• The model assumes a stable g. We should be
  cautious when using estimates of g based on
  periods of unusually high growth. One could
  apply a two-stage growth model, for example.

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Shanghai Stock Market 1990s

• A firm can list its shares on both the A and B
  market. The shares are identical in terms of
  voting rights, dividends, etc. Such dual listing
  systems are not unique to China. Other similar
  markets include the Singapore market, Thai market
  (alien board), and the Finnish market.
• A class shares, quoted in RMB yuan, can be owned
  and traded by Chinese nationals. B shares, on
  the other hand, are bought and sold in US dollars
  (quoted in RMB yuan) and are open to investment
  by foreign nationals.

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• The B shares listed on the Shanghai exchange
  trade at a 65.2 discount (daily data) (23 paired
  firms) and the Shenzhen B shares(16 paired firms)
  trade at a 48.7 discount (Jan. 94-Dec. 96)
  Chakravarty, Sarkar, Wu 1999
• The Shanghai stock exchange opened in December
  19, 1990 By the end of 1996 there were 287 firms
  listed as A shares and 42 firms listed as B
  shares on the SSE. 227 firms listed A shares and
  43 as B shares in Shenzhen.

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Dividend Discount ModelPerpetuity with growth
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Difference in required returns?
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ExampleShanghai Forever Bicycle
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Note,
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Thus, the difference in required returns is
about 4.5 for Forever Bicycle in 1995.
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Why such a difference required returns?

• Difference in information to A share and B share
  investors.
• Foreign exchange risk
• Country risk
• Liquidity risk
• Alternative investments opportunities are scarce
  in China (relative).

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Asymmetric information(Chakravarty, Sarkar, Wu
(1998). J. International Financial Markets,
Institutions Money.

• Foreign investors have less information on local
  firms relative to domestic investors on average.
• Language barriers.
• Difference in accounting standards.
• Difference in information disclosure (practice).

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Alternative Investments

• Extremely large savings pool (bank deposits) in
  China.
• Interest rates are fixed.
• Alternative investments include stocks, real
  estate, bonds.
• But the stock market is easiest for the average
  individual to invest in.
• Thus, relative to the low fixed interest on
  deposits, the average investor does not require a
  large return on stocks to induce them to invest.