The document discusses market efficiency and how it benefits both investors and managers by allowing securities to be priced close to their true value. It also explains that high P/E ratios indicate expectations for future earnings growth, as seen in fast-growing industries like biotech. Finally, it notes that ordinary shareholders are at the highest risk in the event of bankruptcy, as they are last to be paid after all creditors and preference shareholders.
The document discusses market efficiency and how it benefits both investors and managers by allowing securities to be priced close to their true value. It also explains that high P/E ratios indicate expectations for future earnings growth, as seen in fast-growing industries like biotech. Finally, it notes that ordinary shareholders are at the highest risk in the event of bankruptcy, as they are last to be paid after all creditors and preference shareholders.
The document discusses market efficiency and how it benefits both investors and managers by allowing securities to be priced close to their true value. It also explains that high P/E ratios indicate expectations for future earnings growth, as seen in fast-growing industries like biotech. Finally, it notes that ordinary shareholders are at the highest risk in the event of bankruptcy, as they are last to be paid after all creditors and preference shareholders.
The document discusses market efficiency and how it benefits both investors and managers by allowing securities to be priced close to their true value. It also explains that high P/E ratios indicate expectations for future earnings growth, as seen in fast-growing industries like biotech. Finally, it notes that ordinary shareholders are at the highest risk in the event of bankruptcy, as they are last to be paid after all creditors and preference shareholders.
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Extra critical thinking and challenging question:
Q1: Why are investors and managers concerned about market efficiency?
The role of secondary markets is to bring buyers and sellers together. Ideally, we would like security markets to be as efficient as possible. Markets are efficient when current market prices of securities traded reflect all available information relevant to the security. If this is the case, security prices will be near or at their equilibrium price (true value). The more efficient the market, the more likely this is to happen. This makes it easier for managers to price the securities close to the equilibrium price. What investors are most concerned about is having complete information regarding a security’s current price and where that price information can be obtained. Efficient markets allow them to trade at prices that are closer to the true equilibrium price than otherwise possible. Thus, both investors who provide funds and managers (companies) who raise money are concerned when high transaction costs lead to inefficient markets.
Q2: What does it mean when a company has a very high P/E ratio? Give examples of industries in which you believe high P/E ratios are justified.
A high P/E ratio implies that investors believe that the company has good prospects for earnings growth in the future. In fact, they believe that the company will have higher growth potential than companies with lower P/E ratios. Companies in industries that are fast growing like biotech or any hi-tech industry have high P/E ratios. In the past, companies like Cochlear and CSL had very high P/E ratios. As these companies matured and settled to annual growth rates of 20 per cent or less, their P/E ratios have declined.
Q3: Why are ordinary shareholders considered to be more at risk than the holders of other types of securities?
In the hierarchy of lenders (suppliers) of funds to a company, ordinary shareholders
have the most to lose. In the event of a company becoming bankrupt, the law requires that creditors of different types, including bondholders, be paid off first. Next, preference shareholders are paid off. Finally, ordinary shareholders receive their investment if any funds are still available. Thus, ordinary shareholders receive their money back last and are placed at most risk. This feature of ordinary equity is referred to as residual claim. Q3: Trentham Estate Pty Ltd expects to grow at a rate of 22 per cent for the next 5 years and then settle to a constant-growth rate of 6 per cent. The company’s most recent dividend was $2.35. The required rate of return is 15 per cent. a. Find the present value of the dividends during the rapid growth period. b. What is the price of the share at the end of year 5? c. What is the price of the share today?
