CHAPTER 4: Overview of Equity Securities Flashcards
OVERVIEW OF EQUITY SECURITIES
2008 CRISIS: SUBPRIME MORTGAGES
- World Markets Fell By ___
- Ireland Markets Fell By ___
World Markets Fell by 53%
Irish Markets Fell by 70%
COMMON SHs can vote on CORP GOVERNANCE issues viz:
Election of BOD
M&A Decisions
Selection of Auditors
If SH can’t attend the annual meeting in person, he can “vote by proxy” i.e. have someone else to vote on his behalf
ORDER OF LIQUIDATION
Debt
Subordinate Debt
Mezzanine Financing (Debt+Equity)
Preference Shares
Common Shares
Different Classes of Shares (Class A and Class B)
Class A: More voting rights, higher influence.
Class B: Fewer voting rights, lower influence.
Priority in Liquidation: Can vary between classes. A»B
STATUTORY VS CUMULATIVE VOTING RIGHTS
Statutory Voting: One vote per share for each position.
Cumulative Voting: Total votes can be allocated to one candidate.
Example: With 100 shares and 3 positions:
- Statutory: 100 votes per position.
- Cumulative: 300 votes to one candidate. Can accumulate voting rights and then vote
Benefit: Cumulative voting favors minority shareholders.
PREFERENCE SHARES
EQUITY OWNERSHIP
1ST RIGHT TO DIVIDENDS (Fixed as a % to the par value)
FIRST RIGHT IN LIQUIDATION
TYPES OF PREFERENCE SHARES
Cumulative: Unpaid dividends accumulate. Dividends Carry Forward.
Non-cumulative: Unpaid dividends do not accumulate. Dividends Lapse. (Higher Risk & Returns)
Participating: Participate in PROFITS. More dividends when profits are higher + more asserts on liquidation
Non-participating: Fixed dividends, only % of par value at liquidation.
Convertible: Embedded Call Options. Can convert to common stock, lower risk. Lower Yield.
KEY CHARACTERISTICS OF PRIVATE EQUITY
- Less Liquidity
- Price Discovery maybe BIASED because of less coverage
- Long-Term Value Creation because it doesn’t have to worry about reporting results to market
- Lower Reporting Costs
- Potential for high returns when Investment is Exited
- Exit: SELL OR IPO
Require a commitment of funds for a relatively long period of time (3-10 years)
LBO
LEVERAGED BUYOUT
- Large amount of debt relative to equity is used to buy out a firm
- The large proportion of debt AMPLIFIES RETURNS if the buyout turns out to be successful.
- Leveraged buyout performed by management is termed as MANAGEMENT BUYOUT (MBO).
- The firm acquired either has to generate the adequate cash flows or sell assets to service the debt.
PIPE?
Private Investment in Public Equity
A Public Company, when needs additional capital immediately sells equity to Pvt. Investors
NON-DOMESTIC EQUITY SECURITIES
A Market is said to be INTEGRATED when
INTEGRATED: Capital flows freely across borders
SEGMENTED: Capital restrictions
WHY CAPITAL RESTRICTIONS?
* Prevent foreign control/dominance over domestic companies
* Decrease volatility due to FII inflows/outflows
* Domestic Investors get advantage to make higher returns
2 WAYS TO INVEST IN EQUITY OF COMPANIES IN A FOREIGN MARKET ARE:
- DIRECT INVESTING
- DEPOSITORY RECEIPTS
PROBLEMS WITH DIRECT INVESTING:
- Along with stock performance, returns are exposed to CURRENCY RISK as the trade is made in foreign currency
- Investors must be aware of INVESTMENT CLIMATE + LAWS of foreign land
- Disclosure requirement of foreign country might be low, impeding the analysis process
DEPOSITORY RECEIPTS & TYPES
Shares DEPOSITED to Foreign Bank
DRs trade on Foreign Exchanges
DR is a security that trades like an ordinary share on the local exchange & represents an economic interest in a foreign company.
TYPES:
- SPONSORED: Exchange-Traded; Foreign company involved in issuance; Holders given Voting Rights
- UNSPONSORED: OTC; Foreign Company not involved in issuance; Bank Retains Voting Rights
- GDRS: outside home country & outside USA
- ADR: American Depository Receipts eg: DRs of TCS & INFY traded in US exchanges
GDRs & ADRs are NOT SUBJECT TO FOREIGN OWNERSHIP & CAPITAL FLOW RESTRICTIONS IMPOSED BY THE COMPANY’S HOME COUNTRY
- GRS: GLOBAL REGISTERED SHARES:
Shares traded in DIFFERENT STOCK EXCHANGES IN DIFFERENT CURRENCIES
- BLDR: BASKET OF LISTED DRs: An ETF representing collection of DRs
Process of Creating a DR (Depository Receipt)
- Deposit: Foreign company’s shares are deposited in a local bank.
- Issue Receipts: Bank issues receipts representing ownership of these shares.
- Trade: Receipts trade on a local exchange in local currency.
Example: Japanese firm’s shares held by a UK bank, DR issued to UK citizens.
Bank Duties: Depository bank manages dividends, stock splits, and other events.
TYPES OF ADRs
Level I: Unlisted, OTC, low fees, no capital raising, F6-SEC
Level II: Listed, major exchanges, high fees, no capital raising, F6-SEC
Level III: Listed, major exchanges, high fees, can raise capital, F1+F6-SEC
Rule 144A: Unlisted, for QIBs or PIPE, low fees, private placements, SEC Registrations not required
WHY DO COMPANIES ISSUE EQUITY?
- RAISE CAPITAL
- INCREASE LIQUIDITY
Reasons:
1. ORGANIC GROWTH: Finance Revenue-Generating Activities
2. INORGANIC GROWTH: M&A
3. Stock-based & Option-based incentives to Employees (ESOPS & Sweat Equity)
4. If cash-strapped, it needs capital to keep it a going-concern, fulfill debt requirements & maintain key ratios
SOURCES OF TOTAL RETURN FOR EQUITIES
- CAPITAL GAINS (Price Appreciation)
- DIVIDEND INCOME
- FOREX GAINS/LOSSES due to CURRENCY CONVERSION
WHAT IS RISK?
UNCERTAINTY OF FUTURE CASH FLOWS
EXPECTATIONS (X) - OUTCOMES (X BAR)
WHAT IS THE MANAGEMENT’S GOAL?
- Increase Book Value (A-L)
- Maximize Market Value of Equity (SH Returns)
Management
Directly Impacts= Book Value
Indirectly Impacts= Market Value
HOW CAN MANAGEMENT INCREASE BOOK VALUE?
- Increase Net Income
- Sell (New Issue)/Buy Back Own Shares
- Hold Back Dividends to Increase Retained Earnings (RE0-Net Income-Dividends)
Book Value & Market Value are seldom same (Same in Efficient Markets)
RISK CHARACTERISTICS OF DIFF. TYPES OF EQUITIES
- COMMON vs PREFERENCE
- CUMULATIVE vs NON-CUMULATIVE
- CALLABLE vs NON-CALLABLE
- PUTTABLE vs NON-PUTTABLE
MORE RISKY? MORE RETURNS?
- COMMON: no priority in liquidation + no first right to dividends (dividends not fixed as a % to par value)
- NON-CUMULATIVE: dividends lapse: year 3 dividends is simply year 3’s dividends standalone, not Y1+Y2+Y3
- CALLABLLE: company can CALL to BUYBACK shares
- PUTTABLE: investor can’t give shares back to the company
BOOK VALUE VS MARKET VALUE
BOOK VALUE= HISTORIC (based on current value of assets & liabilities)
MARKET VALUE= INTRINSIC VALUE (based on what investors expect will happen in the future)
P/B RATIO= good ratio to understand this: PERCEPTIONS:BOOK OR PRICE:BOOK
PPS/BVPS OR MCAP/BV
RETURN ON EQUITY
NET PROFIT/EQUITY
OR
NET PROFIT/AVG. BV OF EQUITY