Chapters10-11

CHAPTERS 10-11

MARKETS FOR EQUITY SECURITIES

Types of Equity

Internal Equity:

External Equity: Common Stock-- represents ownership

One vote per share Have a residual (last) claim on income and assets Limited liability Stockholder compensated by:

dividends appreciation

Types of Equity

External equity: Preferred Stock -- represents ownership

Dividends are relatively high and fixed Relatively expensive Dividends paid ahead of common if declared In the event of liquidation claims are honored as follows:

Bondholders Preferred Stockholders Common Stockholders

Process of Going Public

Why does a firm go public?To raise additional capitalTo allow VCs to cash outTo raise the public profile of the firm


Initial issue (initial public offering (IPO))Prospectus – filed with SECRoad showBookbuildingTransaction cost – about 7%


Ensuring price stability Lockup period What happens to stock’s price when lockup

expires (or is close to expiring?)Why?


Other facts about IPOs IPOs are generally underpriced

IPOs occur more frequently in bullish stock markets

Can you and I “get in” on an IPO?

How did Google’s IPO increase the odds that individual investors can get in on an IPO?

Secondary Stock Offerings

What is a secondary stock offering?

Secondary Stock Offerings

What is shelf-registration? A corporation can fulfill SEC requirements up to two

years before issuing new securities Allows firms quick access to funds Potential purchasers must realize that information

disclosed in the registration is not continually updated

Stock Exchanges

Stock trading between investors occurs on an organized stock exchange or on the over-the-counter (OTC) market

Organized exchanges Includes the NYSE and AMEX The NYSE controls 80 percent of the value of all

organized exchange transactions There are 1,366 seats Floor brokers and specialists are members of the NYSE

Stock Exchanges

Listing requirements NYSE requirements include number of shares outstanding, minimum

level of earnings, cash flow, and revenue Minimum number of shares ensures adequate liquidity Exchanges charge a listing fee, which depends on the size of the firm

Stock Exchanges

Over-the-counter market Buy and sell orders are completed through a

telecommunications network Nasdaq

The Nasdaq is an electronic quotation system that provides immediate price quotations

Firms must meet requirements on minimum assets, capital, and number of shareholders

Transaction costs as a percentage of the investment tend to be higher on Nasdaq than on the NYSE

Stock Exchanges

Over-the-counter market Nasdaq

Nasdaq components are: Nasdaq National Market Nasdaq Small Cap Market

More stocks are listed on Nasdaq than on NYSE The market value of stocks listed on Nasdaq is smaller than

stocks listed on the NYSE

Stock Exchanges

Over-the-counter market OTC Bulletin Board

Lists stocks that have a price below $1 per share (penny stocks) More than 3,500 stocks are listed Stocks are mostly traded by individual investors

Pink sheets Lists stocks smaller than those listed on the OTC Bulletin Board Contains about 20,000 stocks Families and officers of the firms commonly control much of the

stock

Stock Exchanges

Stock quotations provided by exchanges The format varies among newspapers, but most provide

similar information: 52-week price range Symbol Dividend Dividend yield Price-earnings ratio Volume Previous day’s price quotations

Stock Indices

Stock Indices The Dow Jones Industrial Average (DJIA) is a price-weighted

average of stock prices of 30 large U.S. firms Assigns a higher weight over time to those stocks that experience

higher prices Does not necessarily serve as an adequate indicator of the overall

market The Standard and Poor’s (S&P) 500 is a value-weighted index of

stock prices of 500 large U.S. firms Does not serve as a useful indicator for stock prices of smaller firms

Stock Exchanges

Wilshire 5000 Total Market Index Created in 1974 to reflect the values of 5,000 U.S. stocks Represents the broadest index of the U.S. stock market Closely monitored by the Federal Reserve

New York Stock Exchange Indexes The Composite Index represents the average of all stocks traded

on the NYSE Sector indexes:

Industrial Transportation Utility Financial

Investor Participation in the Secondary Market

How do investor decisions affect the stock price? Investors buy or sell shares based on their valuation of

the stock relative to the prevailing market price Investors arrive at different valuations which means

there will be buyers and sellers at a given point in time As investors change their valuations of a stock, there is

a shift in the demand for and supply of shares and the equilibrium price changes


How do investor decisions affect the stock price? Investor reliance on information

Favorable news increases the demand for and reduces the supply of the security

Unfavorable news reduces the demand for and increases the supply of the security

Investors continually respond to new information in their attempt to purchase or sell stocks


Types of investors Individual investors typically hold more than 50

percent of the total equity in a large corporation Ownership is dispersed

Institutional investors have large equity positions in corporations and have more voting power

Can influence corporate policies through proxy contests Insurance companies, pension funds, and stock mutual funds are

common purchasers of newly issued stock in the primary market The collective sales and purchases of stocks by institutions can

significantly affect stock market prices

Monitoring by Investors

Managers serve as agents for shareholders to maximize the stock price

Managers may be tempted to serve their own interests rather than those of investors

Shareholders monitor their stock’s price movements to assess whether the managers are achieving their goal

When the stock price declines or does not rise as high as shareholders expected, shareholders may blame the weak performance on the firm’s managers


The Sarbanes-Oxley Act: Was implemented in 2002 to ensure more accurate

disclosure of financial information to investors Attempts to force accountants of a firm to conform to

regular accounting standards Attempts to force auditors to take their auditing role

seriously


The Sarbanes-Oxley Act: Requires that only outside board members of a firm be

on the firm’s audit committee Prevents the members of a firm’s audit committee from

receiving consulting or advising fees from the firm Requires that the CEO and CFO of firms that are of at

least a specified size level to certify that the audited financial statements are accurate

Specifies major fines or imprisonment for employees who mislead investors or hide evidence

The Corporate Monitoring Role

Market for corporate control A firm may engage in acquisitions to increase the value of a target

firm Can also create synergistic benefits

A high stock price is useful to exchange acquirer shares for target shares

Share prices of target firms react very positively Leveraged buyouts

LBOs are acquisitions that require substantial amounts of borrowed funds


Barriers to changes in corporate control Antitakeover amendments are designed to protect shareholders

against an acquisition that will ultimately reduce the value of their investment in the firm

e.g., may require at least two-thirds of shareholder votes to approve a takeover

Poison pills are special rights awarded to shareholders or specific managers upon specified events

e.g., the right for all shareholders to be allocated an additional 30 percent of all shares without cost whenever a potential acquirer attempts to acquire the firm


Barriers to corporate control A golden parachute specifies compensation to

managers in the event that they lose their jobs e.g., all managers have the right to receive 100,000 shares of

the firm’s stock whenever the firm is acquired

Equity Valuation Basics

Recall that to value any asset we must know: 1. 2.

Thus, we value stocks the same way we would any other asset

Preferred Stock Valuation

Preferred Stock Valuation Cashflows

What are the cashflows (how much)?

When do they occur (how often)?

What concept from time value of money (think back to FIN 3403) allows us to value preferred stock easily?

Discount Rate

Preferred Stock Valuation

So, the value of preferred is given by:

P0 = D/r

where D = dividends and r is the required return

Common Stock Valuation

Common Stock Valuation Cashflows

What are the cashflows (how much)?

When do they occur (how often)?

Discount rateDepends on risk

Common Stock Valuation

Zero growth model P0 = D1/(r)

Constant growth model P0 = D1/(r-g)

Measuring Risk

2 types of risks Diversifiable/unsystematic risk

Undiversifiable/systematic risk

Measuring Risk

Measuring Risk

Assuming the investor holds a well diversified portfolio, what is the relevant measure of risk?

We measure this risk using the stock’s beta Beta = 1: Beta less than 1: Beta greater than 1:

Measuring Risk

FIRM BETA

Disney 0.66

SunTrust 1.12

Siemens 1.25

Lockheed Martin 0.78

Source: Yahoo Finance, September 2008

Measuring Risk

What is the relationship between beta (risk) and expected return?

The security market line (SML) depicts the classic risk/return tradeoff.

The equation for the SML is expressed as:])([)(

FMjFjRREBRRE

Measuring Risk

Beta

ExpectedReturn

1.0

RF

RM

The Security Market Line (SML)

Measuring Performance

Two common methods for measuring a stock’s risk-adjusted return are:

1. Sharpe Index [R-Rf]/ where: R = the average return on the stock Rf = the average risk free rate = the standard deviation of stock’s returns

Measuring Performance

2. Treynor Index [R-Rf]/ where: R = the average return on the stock Rf = the average risk free rate = the stock’s beta

Stock Market Efficiency

Efficient Market: Prices should fully reflect all available

information Prices adjust to new information

Three Levels Of Market Efficiency Weak-Form Efficiency Semistrong-Form Efficiency Strong-Form Efficiency

Globalization of Stock Markets

Barriers between countries have been removed or reduced Firms in need of funds can tap foreign markets Investors can purchase foreign stocks

Foreign stock offerings in the U.S. Large privatization programs in Latin America and Europe can

not be digested in local markets By issuing stock in the U.S., foreign firms diversify their

shareholder base SEC regulations may prevent some firms from offering stock in

the U.S. Some foreign firms use American depository receipts (ADRs)


International placement process Many U.S. investment banks and commercial banks

provide underwriting services in foreign countries Listing on a foreign stock exchange:

Enhances the liquidity of the stock May increase the firm’s perceived financial standing Can protect the firm against hostile takeovers Entails some costs


Emerging stock markets: May not be as efficient as the U.S. stock market May exhibit high returns and high risk May be volatile because of fewer shares and trading

based on rumors


Methods used to invest in foreign stocks International mutual funds are portfolios of

international stocks created and managed by various financial institutions

World equity benchmark shares represent indexes that reflect composites of stocks for particular countries that can be purchased or sold

Major International Exchanges

Bovespa FTSE DAX CAC Hang Seng Nikkei TSX

Business

Chapters10-11