Chapter 7 Stocks (Equity) – Characteristics and Valuation

1. Chapter 7 Stocks (Equity) – Characteristics and Valuation

2. Background on Stock • 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. Background on Stock (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. Background on Stock (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. Background on Stock (cont’d) • Issuers participating 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. 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. Initial Public Offerings (cont’d) • 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. Initial Public Offerings (cont’d) • 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. 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. Initial Public Offerings (cont’d) • IPO Timing • 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. Initial Public Offerings (cont’d) • Abuses in the IPO market • In 2003, 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. 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. 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. 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. Basic Valuation • The (market) value of any investment asset is simply the present value of expected cash flows. • The interest rate that these cash flows are discounted at is called the asset’s required return. • The higher expected cash flows, the greater the asset’s value. • It makes sense that an investor is willing to pay (invest) some amount today to receive future benefits (cash flows).

16. Basic Valuation Model V0 = CF1 + CF2 + … + CFn (1 + k)1 (1 + k)2 (1 + k)n Where: V0 = value of the asset at time zero CFt = cash flow expected at the end of year t k = appropriate required return (discount rate) n = relevant time period

17. Common Stock Valuation • If an investor buys a share of stock, it is expected to receive cash in two ways • The company pays dividends • The investor sell shares, either to another investor in the market or back to the company • As with bonds, the price of the stock is the present value of these expected cash flows

18. Common Stock Valuation - Example Suppose an investor is thinking of purchasing the stock of Moore Oil, Inc. and he expects it to pay a €2 dividend in one year, and he believes that he can sell the stock for €14 at that time. If he requires a return of 20% on investments of this risk, what is the maximum he would be willing to pay? • Solution: • Compute the PV of the expected cash flows • Price = (14 + 2) / (1.2) = €13.33 Now what if he decides to hold the stock for two years? In addition to the dividend in one year, he expects a dividend of €2.10 in and a stock price of €14.70 at the end of year 2. Now how much would he be willing to pay? • Solution: • PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33

19. Developing the valuation model Value of ˆ = = = V P PV of expected future dividends s 0 stock ˆ ˆ ˆ D D D ¥ 1 2 = + + + L ¥ 1 2 + + + (1 k ) (1 k ) (1 k ) s s s The price of the stock is just the present value of all expected future dividends

20. Stock Valuation Models The Zero Growth Model • The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year.

21. The Zero Growth Model

22. Stock Valuation Models The Constant Growth Model • The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate each year -- year after year.

23. The Constant Growth Model

24. The Efficient Markets Hypothesis • Weak form efficiency—past price information is contained in current prices • Semistrong form efficiency—publicly available information is contained in current prices • Strong form efficiency—all information, public and private, is contained in current prices