Finance and the company
Shares and the link between share price and earnings per share
This sub-section discusses methods of share valuation. Shares (or stocks as they are usually called in the US) are securities which give the holder a claim on the ownership of a company and the income arising from it. In practical terms, the purchase of a share entitles the investor to two types of income benefits:
- dividends accruing from the company earnings;
- a potential capital gain if the stock can be sold for a higher price at some future date
From the perspective of investors, an understanding of the determinants of the value of a share is of crucial importance. If at a certain point in time, the market price of the share is below such a value, an opportunity of realizing capital gains arises. Alternatively, it may happen that a certain share is temporarily overpriced; by being aware of the "true" value of the share, the investor can avoid capital losses. Knowledge of share valuation methods and of what determines share prices in the market is also important in helping a company's management maximize the value of the company's share price.
The attached footnotes and presentation examines the basic methods of share valuation which are widely employed in practice by both company managers and private investors.
Subsequent sections in the presentation outline the alternative forms of finance (debt or equity) available to a company, including what is meant by the company's cost of capital, which is closely tied to the risk-adjusted discount factor (market capitalization rate) in dividend discount share valuation models and price earnings ratio.
It closes with an exploration on gearing and the capital structure decision. This has been a major theme to the theory of finance of whether a firm's financial policy is a significant determinant of its overall valuation. Particular controversy has been attached to the question as to whether the use of debt, or retained earnings, can have an impact upon the value of the company by affecting shareholder equity capitalization rates.
Those who are interested in further understanding this subject matter may refer to Davis & Pointon, Finance and the Firm, Oxford University Press, 1990.