Stock offerings and monitoring investo r 6


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Stock offerings and monitoring investo r 6

  1. 1. Chapter 10 Stock Offerings and Investor MonitoringFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 1
  2. 2. Chapter Outline Background on stock Initial public offerings Secondary stock offerings Stock exchanges Investor participation in the secondary market Monitoring by investors The corporate monitoring role Globalization of stock markets 2
  3. 3. Background on Stocks A stock is a certificate representing partial ownership in a corporation Stock is issued by firms to obtain long-term funds Owners of stock:  Can benefit from the growth in the value of the firm  Are susceptible to large losses Individuals and financial institutions are common purchasers of stock The primary market enables corporations to issue new stock The secondary market creates liquidity for investors who invest in stock Some corporations distribute earnings to investors in the form of dividends 3
  4. 4. Background on Stocks (cont’d) Ownership and voting rights  The owners are permitted to vote on key matters concerning the firm:  Election of the board of directors  Authorization to issue new shares  Approval of amendments to the corporate charter  Adoption of bylaws  Voting is often accomplished by proxy  Management typically receives the majority of the votes and can elect its own candidates as directors 4
  5. 5. Background on Stocks (cont’d) Preferred stock  Preferred stock represents an equity interest in a firm that usually does not allow for significant voting rights  A cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred dividends have been paid  Preferred stock is less risky because dividends on preferred stock can be omitted  Preferred stock is a less desirable source of funds than bonds because:  Dividends are not tax deductible  Investors must be enticed to purchase the preferred stock since dividends do not legally have to be paid 5
  6. 6. Background on Stocks (cont’d) Issuer participation in stock markets  The ownership feature attracts many investors who want to have an equity interest but do not necessarily want to manage their own firm  A firm issuing stock for the first time engages in an IPO  If a firm issues additional stock after the IPO, it engages in a secondary offering 6
  7. 7. Initial Public Offerings An IPO is a first-time offering of shares by a specific firm to the public Usually, a growing firm first obtains private equity funding from VC firms An IPO is used to obtain new funding and to offer VC firms a way to cash in their investment  Many VC firms sell their shares in the secondary market between 6 and 24 months after the IPO 7
  8. 8. Initial Public Offerings (cont’d) Process of going public  An investment banking firm normally serves as the lead underwriter for the IPO  Developing a prospectus  The issuing firm develops a prospectus and files it with the SEC  The prospectus contains detailed information about the firm and includes financial statements and a discussion of risks  The prospectus is intended to provide investors with the information they need to decide whether to invest in the firm  Once approved by the SEC, the prospectus is sent to institutional investors  Underwriters and managers meet with institutional investors in the form of a “road show” 8
  9. 9. Initial Public Offerings (cont’d) Process of going public (cont’d)  Pricing  The offer price is determined by the lead underwriter  During the road show, the number of shares demanded at various prices is assessed  Bookbuilding  In some countries, an auction process is used for IPOs  Transaction costs  The issuing firm typically pays 7 percent of the funds raised  The lead underwriter typically forms a syndicate with other firms who receive a portion of the transaction costs 9
  10. 10. Initial Public Offerings (cont’d) Underwriter efforts to ensure price stability  The lead underwriter’s performance can be measured by the movement in the IPO shares following the IPO  If stocks placed by a securities firm perform poorly, investors may no longer purchase shares underwritten by that firm  The underwriter may require a lockup provision  Prevents the original owners from selling shares for a specified period  Prevents downward pressure  When the lockup period expires, the share price commonly declines significantly 10
  11. 11. Initial Public Offerings (cont’d) Timing of IPOs  IPOs tend to occur more frequently during bullish stock markets  Prices are typically higher  In the 2000–2001 period, many firms withdrew their IPO plans  Initial returns of IPOs  First-day return averaged about 20 percent over the last 30 years  In 1998, the mean one-day return for Internet stocks was 84 percent  Most IPO shares are offered to institutional investors  About 2 percent of IPO shares are offered as allotments to brokerage firms 11
  12. 12. Initial Public Offerings (cont’d) Abuses in the IPO market  In2003, regulators attempted to impose new guidelines that would prevent abuses  Spinning is the process in which an investment bank allocated IPO shares to executives requiring the help of an investment bank  Laddering involves increasing the price above the offer price on the first day of issue in response to substantial demand  Excessive commissions are sometimes charged by brokers when there is substantial demand for the IPO 12
  13. 13. Initial Public Offerings (cont’d) Long-term performance following IPOs  IPOs perform poorly on average over a period of a year or longer  Many IPOs are overpriced at the time of issue  Investors may be overly optimistic about the firm  Managers may spend excessively and be less efficient with the firm’s funds than they were before the IPO 13
  14. 14. Secondary Stock Offerings A secondary stock offering is:  A new stock offering by a firm whose stock is already publicly traded  Undertaken to raise more equity to expand operations  Usually facilitated by a securities firm In the late 1990s, the volume of publicly placed stock increased substantially From 2000 to 2002, the volume of publicly placed stock declined as a result of the weak economy Existing shareholders often have the preemptive right to purchase newly-issued stock 14
  15. 15. Secondary Stock Offerings (cont’d) 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 15
  16. 16. Stock Exchanges Stock trading between investors occurs on an organized stock exchange or on the over-the- counter (OTC) market Organized exchanges  Includesthe 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 16
  17. 17. Stock Exchanges (cont’d) Organized exchanges (cont’d)  Trading floor  Consists of trading posts and trading booths  20 trading posts are maintained by specialists and their clerks  There are 1,500 trading booths along the perimeter of the floor where brokers obtain orders  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 17
  18. 18. Stock Exchanges (cont’d) 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 18
  19. 19. Stock Exchanges (cont’d) Over-the-counter market (cont’d)  Nasdaq (cont’d)  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 19
  20. 20. Stock Exchanges (cont’d) Over-the-counter market (cont’d)  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 20
  21. 21. Stock Exchanges (cont’d) Extended trading sessions  The NYSE, AMEX, and Nasdaq markets all offer extended trading sessions  Late trading sessions enable investors to buy or sell stocks after the market closes  An early morning session enables investors to buy or sell stock just before the market opens on the following day  Total trading volume of widely traded stocks is typically about 5 percent or less of the trading volume during the day  ECNs also allow for trading at any time 21
  22. 22. Stock Exchanges (cont’d) 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 22
  23. 23. Computing A Dividend YieldXYZ Corporation annual dividend is $1.02 pershare. XYZ’s prevailing stock price is $20.What is the annual dividend yield of XYZ?stock Dividends paid per share Dividend yield = Prevailing stock price $1.02 = = 5.10% $20 23
  24. 24. Stock Exchanges (cont’d) Stock index quotations  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 indicators 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 24
  25. 25. Stock Exchanges (cont’d) Stock index quotations (cont’d)  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 25
  26. 26. Stock Exchanges (cont’d) Stock index quotations (cont’d)  Other stock indexes  AMEX indexes  Nasdaq indexes 26
  27. 27. Investor Participation in theSecondary Market The price of a firm’s stock represents the value of the firm per share of stock: Value of firm Stock price = Number of shares  The stock price by itself does not clearly indicate the firm’s value  The return on the investment is determined by dividends received and the price of the stock from the time when they purchased the shares until they sell them 27
  28. 28. Investor Participation in theSecondary Market (cont’d) How 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 28
  29. 29. Investor Participation in theSecondary Market (cont’d) How investor decisions affect the stock price (cont’d)  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 29
  30. 30. Investor Participation in theSecondary Market (cont’d) Types of investors  Individual investors typically hold more then 50 percent of the total equity in a large corporation  Ownership is scattered  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 30
  31. 31. Type of Financial Participation in Stock MarketsInstitutionCommercial banks Issue stock Manage trust fundsStock-owned savings Issue stock to boost their capital baseinstitutionsSavings banks Invest in stocks for their investment portfoliosFinance companies Issue stockStock mutual funds Use the proceeds from selling shares to invest in stocksSecurities firms Issue stock Place new issues of stock Offer advice to corporations that consider acquiring stock companies Execute buy and sell ordersInsurance companies Issue stock Invest a large proportion of their premiums in the stock marketPension funds Investa large proportion of pension fund contributions in the stock market 31
  32. 32. 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 32
  33. 33. Monitoring by Investors (cont’d) Accounting irregularities  To the extent that firms can manipulate financial statements they may be able to hide information from investors  e.g., Enron, Tyco, and WorldCom  The auditors hired to audit financial statements allowed them to use unusual accounting methods  Board members on the audit committee were not always monitoring the audit 33
  34. 34. Monitoring by Investors (cont’d) 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  Prevents a public accounting firm from auditing a client whose CEO, CFO, or other employees are employed by the client firm within one year prior to the audit 34
  35. 35. Monitoring by Investors (cont’d) 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  Allows public accounting firms to offer non-audit consulting services to an audit client only if the client pre-approves those services 35
  36. 36. Monitoring by Investors (cont’d) Shareholders activism  Communication with the firm  Shareholders can communicate their concerns to other investors to place more pressure on managers or its board members  Institutional investors commonly communicate with high- level corporate managers and offer their concerns  Institutional Shareholder Serves (ISS) Inc. is a firm that organizes institutional shareholders to push for a common cause 36
  37. 37. Monitoring by Investors (cont’d) Shareholders activism (cont’d)  Proxy contest  Normally considered only if an informal request for a change in the board is ignored  If dissident shareholders gain enough votes, they can elect one or more directors who share their views  As a result of a more organized effort, institutional shareholders are more influential on management decisions 37
  38. 38. Monitoring by Investors (cont’d) Shareholders activism (cont’d)  Shareholder lawsuits  Investors may sue the board if they believe that the directors are not fulfilling their responsibilities to shareholders  Lawsuits are often filed when corporations prevent takeovers, pursue acquisitions, or make other restructuring decisions that shareholders believe will reduce the stock’s value  When directors are sued, courts typically focus on whether the director’s decision seems reasonable, rather than on whether the decision led to higher profitability 38
  39. 39. The Corporate Monitoring Role If managers believe their stock is undervalued in the market, they may take actions to capitalize on this discrepancy Stock repurchases  Use excess cash to purchase shares in the market at a low price  Stock prices respond favorably to stock repurchase announcements 39
  40. 40. The Corporate Monitoring Role(cont’d) 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  A reverse LBO is desirable when the stock can be sold at a high price 40
  41. 41. The Corporate Monitoring Role(cont’d) Barriers to 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 41
  42. 42. The Corporate Monitoring Role(cont’d) Barriers to corporate control (cont’d) 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 42
  43. 43. 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) 43
  44. 44. Globalization of Stock Markets(cont’d) 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 44
  45. 45. Globalization of Stock Markets(cont’d) Global stock exchanges  Recently, stocks outside the U.S. have been issuing stock more frequently  The percentage of individual versus institutional ownership varies across countries Emerging stock markets:  Enable foreign firms to raise large amounts of capital by issuing stock  Provide a means for investors from other countries to invest their funds  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 45
  46. 46. Globalization of Stock Markets(cont’d) Methods used to invest in foreign stocks  Direct purchases involves directly buying stock of foreign companies listed on the local stock exchanges  American depository receipts are attractive because:  They are closely followed  They are required to file financial statements with the SEC  They are quoted reliably 46
  47. 47. Globalization of Stock Markets(cont’d) Methods used to invest in foreign stocks (cont’d)  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 47