Part 9. Overview of Equity Securities

Question 1

Common shares

Answer 1

The most common form of equity and represents ownership interests.

Characteristics:

• They have residual claim (after claims of debtholders and preferred stockholders) on firms assets if firm is liquidated and govern corporation through voting rights.
• Firm are under no obligation to pay dividends on common equity, where firm determines what dividend will be paid periodically.
• stockholders are able to vote for board of directors on merger decisions, and selection of auditors, if cannot attend the annual meeting shareholders can vote by proxy.

Question 2

Statutory voting

Answer 2

• Each share held is assigned one vote in election of each member of board of directors.
  e. g. the shareholder has 300 votes, which can be cast for a single candidate or spread across multiple candidates.

Question 3

Cumulative voting

Answer 3

This is where shareholders can allocate their votes to one or more candidates as they choose.

e.g. a situation where a shareholder has 100 shares and 3 directors will be elected; where the 3 receiving the greatest number of votes are elected.

• This makes it possible for minority shareholder to have more proportional representation on the board.
• A holder of 30% shares could choose 3 of 10 directors with cumulative voting, but elect no directors in statutory voting.

Question 4

Preference shares/preferred stock

Answer 4

• dividends are not contractual obligation, and shares usually do not mature.
• they make fixed periodic payments to investors, and usually do not have voting rights.
• they may be callable, giving the firm the right to repurchase the shares at pre-specified call price.
• they may also be putable, giving the shareholder the right to sell the preference shares back to issuer at specified price.
• have stated par value and pay percentage dividend based on the par value of shares, e.g. $80 par value preferred with 10% dividend pays a dividend of $8 per year.

Question 5

Cumulative preference shares

Answer 5

Usually promised fixed dividends, and any dividends that are not paid must be made up before common shareholders can received dividends.

Question 6

Non-cumulative preference shares

Answer 6

The dividends do not accumulate over time when they are not paid, but dividends for any period must be paid before common shareholders can receive dividends.

Question 7

Participating preference shares

Answer 7

Investors receive an extra dividend if firm profits exceed a predetermined level and may receive value greater than par value of preferred stock if firm is liquidated.

Question 8

Non-participating preference shares

Answer 8

These have a claim equal to par value in the event of liquidation and do not share in firm profits.

Smaller and riskier firms whose investors may be concerned about firms future often issue participating preferred stock so investors can share in upside potential of firm.

Question 9

Convertible preference shares

Answer 9

These can be exchanged for common stock at convenience ratio determined when the shares are originally issued.

Advantages:

• Preferred dividend is higher than common dividend.
• If firm is profitable, the investor can share in profits by converting shares into common stock.
• The conversion option becomes more valuable when common stock price increases.
• preferred shares have less risk than common shares as dividends is stable and have priority over common stock in receiving dividends and event of liquidation of firm.
• due to upside potential convertible preferred shares often used to finance risky venture capital and private equity firms.
• conversion feature compensates investors for additional risk they take when investing in such firms.

Question 10

Equity classes

Answer 10

e. g. Class A, Class B
- one class may have greater voting power and seniority if firms assets are liquidated.
- classes may also be treated differently with respect to dividends, stock splits and other transactions with shareholders.
- info on ownership and voting rights of different classes of equity shares can be found in company’s filings with securities regulators.

Question 11

Private equity

Answer 11

These are usually issued to institutional investors via private placements, and markets are smaller than public markets but growing rapidly.

Characteristics:

• less liquidity as no public market for shares exists.
• share price negotiated between firm and investors, not determined in a market.
• more limited firm financial disclosure as there is no government or exchange requirement to do so.
• lower reporting costs because of less onerous reporting requirements.
• potential weaker corporate governance due to reduced reporting requirements and less public scrutiny.
• greater ability to focus on long-term prospects as there is no public pressure for ST results.
• potentially greater return for investors once firm goes public.

Question 12

3 main types of private equity:

Answer 12

1. Venture capital
2. Leveraged buyout
3. Private investment in public equity

Question 13

Venture capital

Answer 13

• This refers to capital provided to firms early in their life cycles to fund their development and growth.
• Investors can be family, friends, wealthy individuals or private equity funds.
• Investments are illiquid, and investors often have to commit fund for 3-10 years before they can cash out.
• Investors hope to profit when they can sell their shares after IPO to an established firm.

Question 14

Leveraged buyout (LBO)

Answer 14

• Investors buy all of firms equity using debt financing (leverage).
• If buyers are firms current management, the LBO is referred to as management buyout (MBO).
• Firms in LBOs 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.

Question 15

Private investment in public equity (PIPE)

Answer 15

A public frim 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 often buy stock at sizeable discount to its market price.

Question 16

Listing on foreign stock exchanges:

Answer 16

• Increases publicity for firms products.
• The liquidity of firms shares.
• Increases firms transparency due to stricter disclosure requirements of many foreign markets.
• Improves equity market performance.

Question 17

Direct investing

Answer 17

The securities of foreign companies simply refers to buying a foreign firms securities in foreign markets.

Obstacles to direct foreign investment:

• the investment and return are denominated in foreign currency.
• the foreign stock exchange may be illiquid.
• the reporting requirement of foreign stock exchanges may be less strict, impeding analysis.
• investors must be familiar with regulations and procedures of each market in which they invest.

Question 18

Other methods for investing in foreign companies:

Answer 18

These are provided by:

• global depository receipts
• American depository receipts (ADRs)
• Global registered shares (GRSs)
• Baskets of listed depository receipts (BLDRs)

Question 19

Depository receipts

Answer 19

These represent ownership in foreign firm and are traded in markets of other countries in local market currencies.

A bank deposits shares of foreign firm and then issues receipts representing ownership of a specific number of foreign shares.

Depository bank - this acts as a custodian and manages dividends, stock splits and other events.

• The investor does not need to convert to foreign currency, the value of DR is affected by ER changes, and firms fundamentals, economic events and any other factors affecting value of stock.

Question 20

Sponsored DR vs unsponsored DR

Answer 20

• Sponsored provides the investor voting rights and usually subject to disclosure requirements.
• Unsponsored means the depository bank retains the voting rights.

Question 21

Global depository receipt (GDR)

Answer 21

These are issued outside US and issuers home country, with most traded on the London and Luxembourg exchanges.

• Although not listed here, they are denominated in US dollars, and can be sold to US institutional investors.
• GDRS are not subject to capital flow restrictions imposed by gov, and offer firms and investors greater opportunities in foreign investment.
• Usually firms lists GDR in market where many investors are familiar with firm.

Question 22

American depository receipts (ADR)

Answer 22

These are denominated in US dollars and traded in US.

The security in which its based is American depository share (ADS), where trades in firms domestic market.

ADRs allow firms to raise capital in US or use shares to acquire other firms, with most requiring SEC registration, with some privately placed.

Question 23

Global registered shares (GRS)

Answer 23

These are traded in different currencies on stock exchanges around the world.

Question 24

Basket of listed depository receipts (BLDR)

Answer 24

An exchange-traded fund (ETF) that is a collection of DRs, where they trade in markets just like common stocks.

Question 25

Return characteristics of equity securities

Answer 25

This consists of:

• price changes
• dividend payments
• in case of equities denominated in foreign currency, gains or losses from changes in exchange rates.

e. g. a Japanese investor who invests in euro-denominated shares will have greater yen-based returns if the euro appreciates relative to yen.
* gains from dividends and reinvestment of dividends have important part of equity investors long term returns.
e. g. $1 invested in US stocks in 1900 would have been worth $834 in real terms in 2011 with dividends reinvested, but only $8.10 with price appreciation alone.
- over same time period, the terminal wealth for bonds and bills would have been $9.30 and $2.80 respectively.

Question 26

Risk characteristics of equity securities

Answer 26

• Most commonly measured as standard deviation of returns.
• Preferred stock is less risky than common stock as preferred stock pays known, fixed dividend to investors that large part of return, but common dividends are variable and vary with earnings.
• Preferred stockholders receive distributions before common shareholders and have claim in liquidation equal to par value of shares has priority over claims of common stock owners.
• Due to preferred stock being less risky, it has a lower average return than common stock.
• Cumulative preferred shares have less risk than non-cumulative preferred shares as they retain right to receive any missed dividends before common stock dividends can be paid.
• For preferred shares, putable shares are less risky, and callable shares more compared to shares with neither option.
• putable is less risky as if market price drops, the investor can put shares back to firm at fixed price (assuming firm has capital to honour put).
• putable shares pay lower dividend yield than non-putable shares.
• callable shares are most risky as if market price rises, the firm can call shares, limiting upside potential of shares.
• callable shares hence have higher dividend yields than non-callable shares.

Question 27

Role of equity capital/securities

Answer 27

Used for purchase of LT assets, equipment, R&D, and expansion into businesses and geographic areas.

They provide firm with ‘currency’ used to buy other companies, or can be offered to employees as incentive compensation.

Public traded equity securities provide liquidity, especially important to frim needed to meet regulatory requirements, capital adequacy ratios, and liquidity ratios.

Question 28

Book value of equity

Answer 28

The value of the firms assets on the balances sheet minus its liabilities.

This increases when the firm has positive net income, and retained earnings that flow into the equity account.

When management make decisions that increase income, and retained earnings, they increase book value of equity.

Question 29

Market value of equity

Answer 29

The total value of firms outstanding equity shares based on market prices and reflects expectations of investors about firms future performance.

Investors use perceptions of firms risk, the amounts and timing of future cash flows to determine the market value of equity.

The MV and BV of equity are seldom equal.

Management may be maximising the book value of equity, this may not be reflected in market value of equity as book value does not reflect investor expectations about future firm performance.

Question 30

Return on equity (ROE)

Answer 30

The calculated net income available to common (net income minus preferred dividends) divided by the average book value of common equity over the period.

This key ratio is used to determine management efficiency.

Question 31

Price-to-book ratio

Answer 31

The market value of a firms equity divided by the book value of its equity.

With more optimistic investors about the firms future growth, the greater its price-to-book ratio.

This is used as a measure of relative value, with firms with low price-to-book ratio considered as value stocks, while firms with high price-to-book ratios consider growth stocks.

• The BV of equity reflects firms financial decisions and operating results since inception, but MV of equity reflects markets consensus view of firms future performance.

Question 32

Cost of equity

Answer 32

The expected equilibrium total return (including dividends) on its shares in the market, usually expected in practice using dividend discount model or capital asset pricing model.

It can be interpreted as the minimum rate of return required by investors to compensate them for the risk of firms equity shares.

• a decrease in share price will increase expected return on shares, and an increase in share price will decrease expected returns, other things equal.
• the intrinsic value of firms shares is discounted PV of future cash flows, an increase (decrease) in required return used to discount future cash flows will decrease (increase) intrinsic value.
• Investor estimates expected return on stock to be greater than her minimum required rate of return on shares given their risk, then shares are an attractive investments.