How to determine share prices
Market perception influences the price of preference shares
I AGREE with most of the statements in the letter below but allow me to again dwell on the capital value or prices of perpetual preference shares. This will also address the sudden decline in the value of these shares in May last year.
The value of perpetual shares should always be about 100c or R100 or even R1 000, or more or less the price at which they were issued, provided they were originally correctly priced. Absa was not. A typical benchmark preference share should be one that pays a dividend equal to 70% of prime and that should be trading at 100% of the issue price. At the current prime of 12,5% the dividend yield on the preference share will be 8,75%. Dividends are paid twice a year and the share price should therefore slowly reflect the amount of dividend accumulated on the share. Five months after the previous dividend, the share price of R100 nominal value should rise to about R103,50.
In a perfect market, the prices will be R104,40 on the last day of cum dividend trading. On the first ex dividend date, the share price should readjust to R100.
In this perfect market the price of a preference share should therefore rise from R100 to R104 after six months, back to R100 on the ex dividend date and then up to R104 again.
The actual level of the prime rate should have no effect on the price of the preference share. With the prime rate at 10,5% the yield on the typical 70% preference share was 7,35% and that has now improved to 8,75%. If the prime rate, for some reason, should again rise to 17%, the yield on these shares will rise to a market-related 12% and it should not affect the price of the preference share.
The only event that does affect the price of preference shares is the market perception at a certain point on what percentage of prime is a fair value. That’s what caused the dramatic change in prices between May last year and current values.
For some reason, investors were happy with a return of only 63% of prime last year. The market price of our typical preference share in May last year was therefore R100 x 70% / 63% or R111. Late last year the market reverted to the previous level of 70% of prime and all of a sudden these so-called safe investments enjoyed a 10%-plus drop in capital values. This completely destroyed the return on these investments for the past year.
Why did the market perceptions change from 63% of prime back to 70%? We simply don’t know and nobody has come up with a satisfactory explanation.
Perhaps the market was just a bit silly last year. It’s perhaps a good idea to place a value of no more than 70% of prime plus the accrued dividend on these shares. The maximum price should therefore be R104 per R100 of nominal value if the issue price is 70% of prime.
Secondly, remember that the 70% of prime applies only to the five major local banks, the so-called AAA companies. Adjust the required yield to 75% for the medium category like PSG and 80% for the likes of Astrapak and Capitec. Never ever get sucked into a market when these shares are trading at, say, 65% or less of the prime rate.