Chapters10-11

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  • Chapters10-11

    1. 1. CHAPTERS 10-11 MARKETS FOR EQUITY SECURITIES
    2. 2. Types of Equity <ul><li>Internal Equity: </li></ul><ul><li>External Equity: </li></ul><ul><ul><li>Common Stock-- represents ownership </li></ul></ul><ul><ul><ul><li>One vote per share </li></ul></ul></ul><ul><ul><ul><li>Have a residual (last) claim on income and assets </li></ul></ul></ul><ul><ul><ul><li>Limited liability </li></ul></ul></ul><ul><ul><ul><li>Stockholder compensated by: </li></ul></ul></ul><ul><ul><ul><ul><li>dividends </li></ul></ul></ul></ul><ul><ul><ul><ul><li>appreciation </li></ul></ul></ul></ul>
    3. 3. Types of Equity <ul><li>External equity: </li></ul><ul><ul><li>Preferred Stock -- represents ownership </li></ul></ul><ul><ul><ul><li>Dividends are relatively high and fixed </li></ul></ul></ul><ul><ul><ul><li>Relatively expensive </li></ul></ul></ul><ul><ul><ul><li>Dividends paid ahead of common if declared </li></ul></ul></ul><ul><ul><ul><li>In the event of liquidation claims are honored as follows: </li></ul></ul></ul><ul><ul><ul><ul><li>Bondholders </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Preferred Stockholders </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Common Stockholders </li></ul></ul></ul></ul>
    4. 4. Process of Going Public <ul><ul><li>Why does a firm go public? </li></ul></ul><ul><ul><ul><li>To raise additional capital </li></ul></ul></ul><ul><ul><ul><li>To allow VCs to cash out </li></ul></ul></ul><ul><ul><ul><li>To raise the public profile of the firm </li></ul></ul></ul>
    5. 5. Process of Going Public <ul><ul><li>Initial issue (initial public offering (IPO)) </li></ul></ul><ul><ul><ul><li>Prospectus – filed with SEC </li></ul></ul></ul><ul><ul><ul><li>Road show </li></ul></ul></ul><ul><ul><ul><li>Bookbuilding </li></ul></ul></ul><ul><ul><ul><li>Transaction cost – about 7% </li></ul></ul></ul>
    6. 6. Process of Going Public <ul><li>Ensuring price stability </li></ul><ul><ul><li>Lockup period </li></ul></ul><ul><ul><li>What happens to stock’s price when lockup expires (or is close to expiring?) </li></ul></ul><ul><ul><ul><li>Why? </li></ul></ul></ul>
    7. 7. Process of Going Public <ul><li>Other facts about IPOs </li></ul><ul><ul><li>IPOs are generally underpriced </li></ul></ul><ul><ul><li>IPOs occur more frequently in bullish stock markets </li></ul></ul><ul><ul><li>Can you and I “get in” on an IPO? </li></ul></ul><ul><ul><li>How did Google’s IPO increase the odds that individual investors can get in on an IPO? </li></ul></ul>
    8. 8. Secondary Stock Offerings <ul><li>What is a secondary stock offering? </li></ul>
    9. 9. Secondary Stock Offerings <ul><li>What is shelf-registration? </li></ul><ul><ul><li>A corporation can fulfill SEC requirements up to two years before issuing new securities </li></ul></ul><ul><ul><li>Allows firms quick access to funds </li></ul></ul><ul><ul><li>Potential purchasers must realize that information disclosed in the registration is not continually updated </li></ul></ul>
    10. 10. Stock Exchanges <ul><li>Stock trading between investors occurs on an organized stock exchange or on the over-the-counter (OTC) market </li></ul><ul><li>Organized exchanges </li></ul><ul><ul><li>Includes the NYSE and AMEX </li></ul></ul><ul><ul><li>The NYSE controls 80 percent of the value of all organized exchange transactions </li></ul></ul><ul><ul><ul><li>There are 1,366 seats </li></ul></ul></ul><ul><ul><ul><li>Floor brokers and specialists are members of the NYSE </li></ul></ul></ul>
    11. 11. Stock Exchanges <ul><ul><li>Listing requirements </li></ul></ul><ul><ul><ul><li>NYSE requirements include number of shares outstanding, minimum level of earnings, cash flow, and revenue </li></ul></ul></ul><ul><ul><ul><li>Minimum number of shares ensures adequate liquidity </li></ul></ul></ul><ul><ul><ul><li>Exchanges charge a listing fee, which depends on the size of the firm </li></ul></ul></ul>
    12. 12. Stock Exchanges <ul><li>Over-the-counter market </li></ul><ul><ul><li>Buy and sell orders are completed through a telecommunications network </li></ul></ul><ul><ul><li>Nasdaq </li></ul></ul><ul><ul><ul><li>The Nasdaq is an electronic quotation system that provides immediate price quotations </li></ul></ul></ul><ul><ul><ul><li>Firms must meet requirements on minimum assets, capital, and number of shareholders </li></ul></ul></ul><ul><ul><ul><li>Transaction costs as a percentage of the investment tend to be higher on Nasdaq than on the NYSE </li></ul></ul></ul>
    13. 13. Stock Exchanges <ul><li>Over-the-counter market </li></ul><ul><ul><li>Nasdaq </li></ul></ul><ul><ul><ul><li>Nasdaq components are: </li></ul></ul></ul><ul><ul><ul><ul><li>Nasdaq National Market </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Nasdaq Small Cap Market </li></ul></ul></ul></ul><ul><ul><ul><li>More stocks are listed on Nasdaq than on NYSE </li></ul></ul></ul><ul><ul><ul><li>The market value of stocks listed on Nasdaq is smaller than stocks listed on the NYSE </li></ul></ul></ul>
    14. 14. Stock Exchanges <ul><li>Over-the-counter market </li></ul><ul><ul><li>OTC Bulletin Board </li></ul></ul><ul><ul><ul><li>Lists stocks that have a price below $1 per share (penny stocks) </li></ul></ul></ul><ul><ul><ul><li>More than 3,500 stocks are listed </li></ul></ul></ul><ul><ul><ul><li>Stocks are mostly traded by individual investors </li></ul></ul></ul><ul><ul><li>Pink sheets </li></ul></ul><ul><ul><ul><li>Lists stocks smaller than those listed on the OTC Bulletin Board </li></ul></ul></ul><ul><ul><ul><li>Contains about 20,000 stocks </li></ul></ul></ul><ul><ul><ul><li>Families and officers of the firms commonly control much of the stock </li></ul></ul></ul>
    15. 15. Stock Exchanges <ul><li>Stock quotations provided by exchanges </li></ul><ul><ul><li>The format varies among newspapers, but most provide similar information: </li></ul></ul><ul><ul><ul><li>52-week price range </li></ul></ul></ul><ul><ul><ul><li>Symbol </li></ul></ul></ul><ul><ul><ul><li>Dividend </li></ul></ul></ul><ul><ul><ul><li>Dividend yield </li></ul></ul></ul><ul><ul><ul><li>Price-earnings ratio </li></ul></ul></ul><ul><ul><ul><li>Volume </li></ul></ul></ul><ul><ul><ul><li>Previous day’s price quotations </li></ul></ul></ul>
    16. 16. Stock Indices <ul><li>Stock Indices </li></ul><ul><ul><li>The Dow Jones Industrial Average (DJIA) is a price-weighted average of stock prices of 30 large U.S. firms </li></ul></ul><ul><ul><ul><li>Assigns a higher weight over time to those stocks that experience higher prices </li></ul></ul></ul><ul><ul><ul><li>Does not necessarily serve as an adequate indicator of the overall market </li></ul></ul></ul><ul><ul><li>The Standard and Poor’s (S&P) 500 is a value-weighted index of stock prices of 500 large U.S. firms </li></ul></ul><ul><ul><ul><li>Does not serve as a useful indicator for stock prices of smaller firms </li></ul></ul></ul>
    17. 17. Stock Exchanges <ul><ul><li>Wilshire 5000 Total Market Index </li></ul></ul><ul><ul><ul><li>Created in 1974 to reflect the values of 5,000 U.S. stocks </li></ul></ul></ul><ul><ul><ul><li>Represents the broadest index of the U.S. stock market </li></ul></ul></ul><ul><ul><ul><li>Closely monitored by the Federal Reserve </li></ul></ul></ul><ul><ul><li>New York Stock Exchange Indexes </li></ul></ul><ul><ul><ul><li>The Composite Index represents the average of all stocks traded on the NYSE </li></ul></ul></ul><ul><ul><ul><li>Sector indexes: </li></ul></ul></ul><ul><ul><ul><ul><li>Industrial </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Transportation </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Utility </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Financial </li></ul></ul></ul></ul>
    18. 18. Investor Participation in the Secondary Market <ul><li>How do investor decisions affect the stock price? </li></ul><ul><ul><li>Investors buy or sell shares based on their valuation of the stock relative to the prevailing market price </li></ul></ul><ul><ul><li>Investors arrive at different valuations which means there will be buyers and sellers at a given point in time </li></ul></ul><ul><ul><li>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 </li></ul></ul>
    19. 19. Investor Participation in the Secondary Market <ul><li>How do investor decisions affect the stock price? </li></ul><ul><ul><li>Investor reliance on information </li></ul></ul><ul><ul><ul><li>Favorable news increases the demand for and reduces the supply of the security </li></ul></ul></ul><ul><ul><ul><li>Unfavorable news reduces the demand for and increases the supply of the security </li></ul></ul></ul><ul><ul><ul><li>Investors continually respond to new information in their attempt to purchase or sell stocks </li></ul></ul></ul>
    20. 20. Investor Participation in the Secondary Market <ul><li>Types of investors </li></ul><ul><ul><li>Individual investors typically hold more than 50 percent of the total equity in a large corporation </li></ul></ul><ul><ul><ul><li>Ownership is dispersed </li></ul></ul></ul><ul><ul><li>Institutional investors have large equity positions in corporations and have more voting power </li></ul></ul><ul><ul><ul><ul><li>Can influence corporate policies through proxy contests </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Insurance companies, pension funds, and stock mutual funds are common purchasers of newly issued stock in the primary market </li></ul></ul></ul></ul><ul><ul><ul><ul><li>The collective sales and purchases of stocks by institutions can significantly affect stock market prices </li></ul></ul></ul></ul>
    21. 21. Monitoring by Investors <ul><li>Managers serve as agents for shareholders to maximize the stock price </li></ul><ul><li>Managers may be tempted to serve their own interests rather than those of investors </li></ul><ul><li>Shareholders monitor their stock’s price movements to assess whether the managers are achieving their goal </li></ul><ul><ul><li>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 </li></ul></ul>
    22. 22. Monitoring by Investors <ul><li>The Sarbanes-Oxley Act: </li></ul><ul><ul><li>Was implemented in 2002 to ensure more accurate disclosure of financial information to investors </li></ul></ul><ul><ul><li>Attempts to force accountants of a firm to conform to regular accounting standards </li></ul></ul><ul><ul><li>Attempts to force auditors to take their auditing role seriously </li></ul></ul>
    23. 23. Monitoring by Investors <ul><li>The Sarbanes-Oxley Act: </li></ul><ul><ul><li>Requires that only outside board members of a firm be on the firm’s audit committee </li></ul></ul><ul><ul><li>Prevents the members of a firm’s audit committee from receiving consulting or advising fees from the firm </li></ul></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>Specifies major fines or imprisonment for employees who mislead investors or hide evidence </li></ul></ul>
    24. 24. The Corporate Monitoring Role <ul><li>Market for corporate control </li></ul><ul><ul><li>A firm may engage in acquisitions to increase the value of a target firm </li></ul></ul><ul><ul><ul><li>Can also create synergistic benefits </li></ul></ul></ul><ul><ul><li>A high stock price is useful to exchange acquirer shares for target shares </li></ul></ul><ul><ul><li>Share prices of target firms react very positively </li></ul></ul><ul><ul><li>Leveraged buyouts </li></ul></ul><ul><ul><ul><li>LBOs are acquisitions that require substantial amounts of borrowed funds </li></ul></ul></ul>
    25. 25. The Corporate Monitoring Role <ul><li>Barriers to changes in corporate control </li></ul><ul><ul><li>Antitakeover amendments are designed to protect shareholders against an acquisition that will ultimately reduce the value of their investment in the firm </li></ul></ul><ul><ul><ul><li>e.g., may require at least two-thirds of shareholder votes to approve a takeover </li></ul></ul></ul><ul><ul><li>Poison pills are special rights awarded to shareholders or specific managers upon specified events </li></ul></ul><ul><ul><ul><li>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 </li></ul></ul></ul>
    26. 26. The Corporate Monitoring Role <ul><li>Barriers to corporate control </li></ul><ul><li>A golden parachute specifies compensation to managers in the event that they lose their jobs </li></ul><ul><ul><ul><li>e.g., all managers have the right to receive 100,000 shares of the firm’s stock whenever the firm is acquired </li></ul></ul></ul>
    27. 27. Equity Valuation Basics <ul><li>Recall that to value any asset we must know: </li></ul><ul><ul><li>1. </li></ul></ul><ul><ul><li>2. </li></ul></ul><ul><li>Thus, we value stocks the same way we would any other asset </li></ul>
    28. 28. Preferred Stock Valuation <ul><li>Preferred Stock Valuation </li></ul><ul><ul><li>Cashflows </li></ul></ul><ul><ul><ul><li>What are the cashflows (how much)? </li></ul></ul></ul><ul><ul><ul><li>When do they occur (how often)? </li></ul></ul></ul><ul><ul><ul><li>What concept from time value of money (think back to FIN 3403) allows us to value preferred stock easily? </li></ul></ul></ul><ul><ul><li>Discount Rate </li></ul></ul>
    29. 29. Preferred Stock Valuation <ul><li>So, the value of preferred is given by: </li></ul><ul><ul><li>P 0 = D/r </li></ul></ul><ul><ul><li>where D = dividends and r is the required return </li></ul></ul>
    30. 30. Common Stock Valuation <ul><li>Common Stock Valuation </li></ul><ul><ul><li>Cashflows </li></ul></ul><ul><ul><ul><li>What are the cashflows (how much)? </li></ul></ul></ul><ul><ul><ul><li>When do they occur (how of ten)? </li></ul></ul></ul><ul><ul><li>Discount rate </li></ul></ul><ul><ul><ul><li>Depends on risk </li></ul></ul></ul>
    31. 31. Common Stock Valuation <ul><li>Zero growth model </li></ul><ul><ul><li>P 0 = D 1 /(r) </li></ul></ul><ul><li>Constant growth model </li></ul><ul><ul><li>P 0 = D 1 /(r-g) </li></ul></ul>
    32. 32. Measuring Risk <ul><li>2 types of risks </li></ul><ul><ul><li>Diversifiable/unsystematic risk </li></ul></ul><ul><ul><li>Undiversifiable/systematic risk </li></ul></ul>
    33. 33. Measuring Risk
    34. 34. Measuring Risk <ul><li>Assuming the investor holds a well diversified portfolio, what is the relevant measure of risk? </li></ul><ul><li>We measure this risk using the stock’s beta </li></ul><ul><ul><li>Beta = 1: </li></ul></ul><ul><ul><li>Beta less than 1: </li></ul></ul><ul><ul><li>Beta greater than 1: </li></ul></ul>
    35. 35. Measuring Risk FIRM BETA Disney 0.66 SunTrust 1.12 Siemens 1.25 Lockheed Martin 0.78 Source: Yahoo Finance, September 2008
    36. 36. Measuring Risk <ul><li>What is the relationship between beta (risk) and expected return? </li></ul><ul><ul><li>The security market line (SML) depicts the classic risk/return tradeoff. </li></ul></ul><ul><ul><li>The equation for the SML is expressed as: </li></ul></ul>
    37. 37. Measuring Risk Beta Expected Return 1.0 R F R M The Security Market Line (SML)
    38. 38. Measuring Performance <ul><li>Two common methods for measuring a stock’s risk-adjusted return are: </li></ul><ul><li>1. Sharpe Index </li></ul><ul><ul><li>[R-R f ]/  </li></ul></ul><ul><ul><li>where: </li></ul></ul><ul><ul><li>R = the average return on the stock </li></ul></ul><ul><ul><li>R f = the average risk free rate </li></ul></ul><ul><ul><li> = the standard deviation of stock’s returns </li></ul></ul>
    39. 39. Measuring Performance <ul><li>2. Treynor Index </li></ul><ul><ul><li>[R-R f ]/  </li></ul></ul><ul><ul><li>where: </li></ul></ul><ul><ul><li>R = the average return on the stock </li></ul></ul><ul><ul><li>R f = the average risk free rate </li></ul></ul><ul><ul><li> = the stock’s beta </li></ul></ul>
    40. 40. Stock Market Efficiency <ul><li>Efficient Market: </li></ul><ul><ul><li>Prices should fully reflect all available information </li></ul></ul><ul><ul><li>Prices adjust to new information </li></ul></ul><ul><li>Three Levels Of Market Efficiency </li></ul><ul><ul><li>Weak-Form Efficiency </li></ul></ul><ul><ul><li>Semistrong-Form Efficiency </li></ul></ul><ul><ul><li>Strong-Form Efficiency </li></ul></ul>
    41. 41. Globalization of Stock Markets <ul><li>Barriers between countries have been removed or reduced </li></ul><ul><ul><li>Firms in need of funds can tap foreign markets </li></ul></ul><ul><ul><li>Investors can purchase foreign stocks </li></ul></ul><ul><li>Foreign stock offerings in the U.S. </li></ul><ul><ul><li>Large privatization programs in Latin America and Europe can not be digested in local markets </li></ul></ul><ul><ul><li>By issuing stock in the U.S., foreign firms diversify their shareholder base </li></ul></ul><ul><ul><li>SEC regulations may prevent some firms from offering stock in the U.S. </li></ul></ul><ul><ul><li>Some foreign firms use American depository receipts (ADRs) </li></ul></ul>
    42. 42. Globalization of Stock Markets <ul><li>International placement process </li></ul><ul><ul><li>Many U.S. investment banks and commercial banks provide underwriting services in foreign countries </li></ul></ul><ul><ul><li>Listing on a foreign stock exchange: </li></ul></ul><ul><ul><ul><li>Enhances the liquidity of the stock </li></ul></ul></ul><ul><ul><ul><li>May increase the firm’s perceived financial standing </li></ul></ul></ul><ul><ul><ul><li>Can protect the firm against hostile takeovers </li></ul></ul></ul><ul><ul><ul><li>Entails some costs </li></ul></ul></ul>
    43. 43. Globalization of Stock Markets <ul><li>Emerging stock markets: </li></ul><ul><ul><li>May not be as efficient as the U.S. stock market </li></ul></ul><ul><ul><li>May exhibit high returns and high risk </li></ul></ul><ul><ul><li>May be volatile because of fewer shares and trading based on rumors </li></ul></ul>
    44. 44. Globalization of Stock Markets <ul><li>Methods used to invest in foreign stocks </li></ul><ul><ul><li>International mutual funds are portfolios of international stocks created and managed by various financial institutions </li></ul></ul><ul><ul><li>World equity benchmark shares represent indexes that reflect composites of stocks for particular countries that can be purchased or sold </li></ul></ul>
    45. 45. Major International Exchanges <ul><li>Bovespa </li></ul><ul><li>FTSE </li></ul><ul><li>DAX </li></ul><ul><li>CAC </li></ul><ul><li>Hang Seng </li></ul><ul><li>Nikkei </li></ul><ul><li>TSX </li></ul>

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