Study Session 14: Reading 48: Overview of Equity Securities

Direct Investing

Direct investing in securities of foreign companies simply refers to buying a foreign firm's securities in foreign markets. Obstacles: 1. The investment and return are denominated by foreign currency. 2. The foreign stock exchange may be illiquid. 3. The reporting requirements of foreign stock exchanges may be less strict, impeding analysis. 4. Investors must be familiar with the regulations and procedures of each market in which they invest.

LOS 48F: explain the role of equity securities in the financing of a company's assets:

Equity Capital is used for the purchase of long term assets, equipment, and research and development, and expansion into new businesses or geographic areas. Equity securities provide the firm with "currency" that can be used to buy other companies or that can be offered to employees as incentive compensation. Having publicly traded equity securities provides liquidity, which may be especially important to firms that need to meet regulatory requirements, capital adequacy ratios, and liquidity ratios.

Cost of Equity

Expected equilibrium total return (including dividends) on its shares in the market. It is usually estimated in practice using a dividend-discount model or the capital asset pricing model. At any point in time, a decrease in share price will increase the expected return on shares an increase in share price will decrease the expected returns, other things equal. Because the intrinsic value of a firm's shares is the discounted present value of future cash flows an increase (decrease) in the required return used to discount future cash flows will decrease (increase) intrinsic value.

Callable Common Shares

Give the firm the right to repurchase the stock at a pre-specified call price. Investors receive a fixed amount when the firm calls the stock The call feature benefits the firm because when the stock's market price is greater than the call price, the firm can call the shares and reissue them later at a higher price. Calling the shares, similarly to the repurchase of shares, allows the firm to reduce its dividend payments without changing its per-share dividend.

Putable Common Shares

Gives the shareholder the right to sell the shares back to the firm at a specific price. A put option on the shares benefits the shareholder because it effectively places a floor under the share value. Shareholders pay for the put option because other things equal, putable shares are sold for higher prices than non-putable shares and raise more capital for the firm when they are issued.

Investors also estimate the expected market returns on equity shares and compare this to the minimum return they will accept for bearing the risk inherent in a particular stock.

If an investor estimates the expected return on a stock to be greater than their minimum required rate of return on the shares, given their risk, then the shares are an attractive investment. Investors can have different required rates of return for a given risk, different estimates of a firm's future cash flows, and different estimates of the risk of a firm's equity shares. A firm's cost of equity can be interpreted as the minimum rate of return required by investors (in the aggregate) to compensate them for the risk of the firm's equity shares.

Leveraged Buyout (LBO)

Investors buy all of a firm's equity using debt financing (leverage). If the buyers are the firm's current management, the LBO is referred to as a management buyout (MBO). Firm's in LBOs usually have cash flow that is adequate to service the issued debt or have undervalued assets that can be sold to pay down the debt over time.

LOS 48H: Compare a company's cost of equity, its (accounting) return on equity, and investors' required rates of return:

Most of this completed on Notecards

LOS 48A: Describe characteristics of types of equity securities:

Placeholder

LOS 48D: Describe methods for investing in non-domestic equity securities:

Placeholder

Common Shares

The most common form of equity and represent an ownership interest. Common shareholders have a residual claim (after the claims of debt-holders and preferred stockholders) on firm assets if the firm is liquidated and govern the corporation through voting rights. Firms are under no obligation to pay dividends on common equity; the firm determines what dividend will be paid periodically. Able to vote for board of directions, on merger decisions, and on the selection of auditors. If unable to attend annual meetings, can vote by Proxy (having someone else vote as they direct them, on their behalf).

LOS 48G: Distinguish between market value and book value of equity securities:

The primary goal of firm management is to increase the book value of the firm's equity and thereby increase the market value of its equity.

American Depository Receipts (ADRs)

are denominated in U.S. dollars and trade in the United States. The security on which the ADR is based is the AMERICAN DEPOSITORY SHARE (ADS), which trades in the firm's domestic market. Some ADRs allow firms to raise capital in the United States or use the shares t acquire other firms. Most require U.S. securities and exchange commission (SEC) registration, but some are privately placed (rule 144A or Regulation S receipts)

Statutory Voting

each share held is assigned one vote in the election of each member of the board of directors. Example: Situation where shareholder has 100 shares and 3 directors will be elected, shareholder can vote 100 shares for his director choice in each election.

Basket of Listed Depository Receipts (BLDR)

is an exchange-traded fund (ETF) that is a collection of DRs. ETF shares trade in markets just like common stocks.

Global Registered Shares (GRS)

Are traded in different currencies on stock exchanges around the world.

Preferred Stock/ Preference Shares

As with common stock, preferred stock dividends are not a contractual obligation, the shares usually do not mature, and shares can have put or call features. Like debt, preferred shares typically make fixed periodic payments to investors and do not usually have voting rights.

LOS 48C Distinguish between Public and Private Equity Securities:

Three main types of private equity investments are venture capital, leveraged buyouts, and private investments in public equity.

Market Value of Equity

Total value of a firm's outstanding equity share based on market prices and reflects the expectations of investors about the firm's future performance. Invstors use their perceptions of the firm's risk and amounts and timing of future cash flows to determine the market value of equity. The market value and book value of equity are seldom equal. Although management may be maximizing the book value of equity, this may not be reflected in the market value of equity because book value does not reflect investor expectations about the future firm performance.

Private Equity

Usually issued to institutional investors via private placements. Private equity markets are smaller than public markets but are growing rapidly.

Book Value of Equity

Value of the firm's assets on the balance sheet minus its liabilities. It increases when the firm has positive net income and retained earnings that flow into the equity account. When management makes decisions that increase income and retained earnings, they increase the book value of equity.

Integration and Non-Domestic Equity Basics

When capital flows freely across boarders, markets are said to be integrated. The world's financial markets have become more integrated over time, especially as a result of improved communications and trading technologies. However, barriers to global capital flow still exist. Some countries restrict foreign ownership of their domestic stocks, primarily to prevent foreign control of domestic companies and to reduce the variability of capital flow in and out of their countries. An increasing number of countries have dropped foreign capital restrictions. Studies have shown that reducing capital barriers improves equity market performance. Furthermore, companies are increasingly turning to foreign investors for capital by listing their stocks on foreign stock exchanges or by encouraging foreign ownership of shares. From the firms perspective, listing on foreign stock exchanges increases publicity for the firm's products and the liquidity of the firm's shares. Foreign listing also increases firm transparency due to the stricter disclosure requirements of many foreign markets.

Depository Receipts (DRs)

represent ownership in a foreign firm and are traded in the markets of other countries in local market currencies. A bank deposits shares of the foreign firm and then issues receipts representing ownership of a specific number of the foreign shares. The DEPOSITORY BANK- acts as a custodian and manages dividends, stock splits, and other events. Although the investor does not have to convert to foreign currency, the value of the DR is affected by exchange rate changes as well as firm fundamentals, economic events, and any other factors that affect the value of any stock. SPONSORED DR- If the firm is involved with the issue this type of Depository receipt otherwise, it is an UNSPONSORED DR. A sponsored DR provides the investor voting rights and is usually subject to greater disclosure requirements. In an unsponsored DR, the depository bank retains the voting rights.

Cumulative Preferred Stock

usually promised fixed dividends, and any dividends that are not paid must be made up before common shareholders can receive dividends non-Cumulative Preferred shares- do not accumulate over time when they are not paid, but dividends for any period must be paid before common shareholders can receive dividends.

Compared to public equity, private equity has the following characteristics:

1. Less liquidity because no public market for the shares exist. 2. Share price is negotiated between the firm and its investors, not determined in a market. 3. More limited firm financial disclosure because there is no government or exchange requirement to do so. 4. Lower reporting costs because of less onerous reporting requirements. 5. Potentially weaker corporate governance because of reduced reporting requirements and less public scrutiny. 6. Greater ability to focus on long-term prospects because there is no public pressure for short-term results. 7. Potentially greater return for investors once the firm goes public.

LOS 48B: Describe the differences in voting rights and other ownership characteristics among different equity classes:

A firm may have different classes of common stock ("Class A" "Class B" Ex: Snapchat (SNAP)) One class may have greater voting power and seniority if the firm's assets are liquidated. The classes may also be treated differently with respect to dividends, stock splits, and other transactions with shareholders. Information on the ownership and voting rights of different classes of equity shares can be found in the company's filings with securities regulators.

Private Investment in Public Equity (PIPE)

A public firm that needs capital quickly sells private equity to investors. the firm may have growth opportunities, be in distress, or have large amounts of debt. The investors can often buy the stock at a sizeable discount to its market price.

Convertible Preferred Shares

Can be exchanged for common stock at a conversion ratio determined when the shares are originally issued. Advantages: 1. The preferred dividend is higher than a common dividend. 2. If the firm is profitable, the investor can share in the profits by converting shares into common stock. 3. The conversion option becomes more valuable when the common stock price increases. 4. Preferred shares have less risk than common shares because the dividend is stable and they have priority over common stock in receiving dividends in the event of liquidation of the firm. Because of their upside potential, convertible preferred shares are often used to finance risky venture capital and private equity firms. The conversion feature compensates investors for the additional risk they take when investing in such firms.

LOS 48E: Compare the risk and return characteristics of different types of equity securities:

Preferred stock is less risky than common stock because PS pays a known, fixed dividend to investors that is a large part of the return, whereas common dividends are variable and can vary with earnings. Preferred shares receive their distributions before common shareholders and have a claim in liquidation equal to the par value of their shares that has priority over the claims of common stock owners. Because it is less risky, preferred stock has a lower average return than common stock. Cumulative preferred shares have less risk than non-cumulative preferred shares because they retain the right to receive any missed dividends before any common stock dividends can be paid. For both common and preferred shares, putable shares are less risky and callable shares are more risky compared to shares with neither option. Putable shares are less risky because if the market price drops, the investor can put the shares back to the firm at a fixed price (assuming the firm has the capital to honor the put). Because of this feature, putable shares usually pay a lower dividend yield than non-putable shares. Callable shares are the most risky because if the market price rises, the firm can call the shares, limiting the upside potential of the shares. Callable shares, therefore, usually have higher dividend yields than non-callable shares.

Participating Preferred Shares

Receive extra dividends if firm profits exceed a predetermined level and may receive a value greater than the par value of the preferred stock if the firm is liquidated. Non-Participating Preferred Shares- Have a claim equal to par value in the event of liquidation and do not share in firm profits. Smaller and risker firms whose investors may be concerned about the firm's future often issue participating preferred stock so investors can share in the upside potential of the firm.

Venture Capital

Refers to the capital provided to firms early in their life cycles to fund their development and growth. Venture capital financing at various stages of a firm's development is referred to ass seed/start-up, early stage, or mezzanine financing. Investors can be family,friends, wealthy individuals, or private equity funds. Venture capital investments are illiquid and investors often have to commit funds for 3-10 years before they can cash out (exit) their investment. Investors hope to profit when they can sell their shares after (or as part of) an initial public offering or tan an established firm.

Cumulative Voting

Shareholders can allocate their votes to one or more candidates as they chose. Example: Situation where shareholder has 100 shares and 3 directors will be elected, the shareholder has 300 votes which can be cast for a single candidate or spread across multiple candidates. Cumulative voting makes it possible for a minority shareholder to have more proportional representation on the board. The way the math works, a holder of 30% of the firm's shares could choose 3/10 directors with cumulative voting but could elect no directors under statutory voting.

Global Depository Receipts (GDRs)

issued outside the United States and the issue's home country. Most GDRs are traded on the London and Luxembourg exchanges. Although not listed on U.S. exchanges, they are usually denominated in U.S. dollars and can be sold to U.S. Institutional investors. GDRs are not subject to the capital flow restrictions imposed by governments and thus offer the firm and investor greater opportunities for foreign investment. The firm usually chooses to list the GDR in a market where many investors are familiar with the firm.