Corporate Financial Strategy
4th edition
Dr Ruth Bender
Chapter 2
What does the share price tell us?
Corporate Financial Strategy
What does the share price tell us? Contents
 Learning objectives
 The share price reflects market expectations
 Different variants of the P/E ratio
 The P/E ratio and market perceptions of growth
 The dividend growth model
 The Ansoff matrix and growth strategies
 Share prices, growth and steady state
 Steady state
 PVGO and strategies for achieving required growth
 What does the share price mean?
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Learning objectives
1. Understand how the P/E ratio should change with market expectations
of growth and risk.
2. Distinguish between different versions of the P/E ratio and determine
which is most relevant for your needs.
3. Appreciate how the theoretical construct of steady state is derived
from the dividend growth model.
4. Calculate and interpret the present value of growth opportunities
(PVGO) inherent in a company’s share price.
5. Calculate the expected eps growth built into a company’s share price.
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Different calculations for price/earnings ratio
P/E ratio = Share price ÷ eps
Basic eps
Actual earnings ÷ average shares in
issue
This is the default figure to
use
Diluted eps
Actual earnings ÷ increased shares in
issue
Use if dilution is inevitable
and already priced in
Adjusted eps
Adjusted earnings ÷ average (or
diluted) shares in issue
Use if the adjustments are
valid
Historic eps
Taken from the financial statements.
Useful because it is audited
Of less use as the year
progresses
Prospective eps
Based on analysts’ consensus, or your
own forecast
Use as the year progresses,
as share prices are forwardlooking
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Figure 2.1 P/E ratio and market perceptions of growth
Earnings per
share
High plc
Low plc
Current
eps
Time
Assuming risk is the same, we can say that the market
expects higher growth from High plc than from Low plc
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Dividend growth model
P
D
1
Ke  g
D
P/E 
1
1

eps Ke  g
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Figure 2.2 The Ansoff matrix and growth strategies
Products
Existing
New
Existing
Market
penetration
(1)
Product
development
(2)
Market
development
(3)
Diversification
(4)
Markets
New
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Share prices, growth, and steady state
At steady state:
P
growth is zero
D 1 = D2 = … Dn
full payout of earnings
1
Ke  g
Therefore: P/e = 1/Kess ; Kess = eps/P
(This is ONLY true at steady state)
Steady state value of share
= eps/Kess ;
or eps x p/ess
Current price less SS value = PVGO
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D
Steady state
Present value of growth
opportunities
(PVGO)
Current eps
E1
Perpetuity value of earnings
Share
price
eps
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Time
Figure 2.3 PVGO and strategies for achieving required growth
Eps growth based
on Quadrants 2-4
of Ansoff matrix
P1 = current share
price
Share price relating
to successfully
getting new
customers/products
Share
price
relating to
extending
the
current
strategy
Eps growth
based on
Quadrant 1 of
Ansoff matrix
Current eps
E1
P0 = Value of share
that relates to
current eps
Share
price
eps
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Time
Why does the share price matter?
 A high price is seen as a sign of success.
 A high price is seen as a sign of the strength of the underlying business.
 Share price is often used as a proxy for performance.
 A high share price is the best protection against takeover.
 Raising future capital becomes easier if the price is high, as fewer shares have to be
issued, and the existing investors are well disposed to the company already.
 Shareholders expect a growing share price.
 Share price is often used as a metric for calculating management bonuses.
 Management have share options, which only have value if the share price rises.
 A high share price improves morale, particularly if employees own shares.
 There is a strong correlation between power, influence, and company size.
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