EQUITY MARKETS

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CHAPTER 10

• EQUITY MARKETS

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Common Stock

• Ownership in a Corporation
• One vote per share.
• Have a residual (last) claim on income and assets
  in liquidation, thus a riskier position than
  bonds and preferred stockholders.
• Shareholders liability for the debts of the
  corporation is limited to their investment in the
  common stock. (Limited Liability)

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Common Stock (concluded)

• Shareholders return is derived from dividends
  declared by the board of directors and from
  market appreciation in the value of the stock.
  (No Fixed Charges)
• No Maturity Date
• Increases Credit Worthiness of the Firm
• Common shareholders may vote their shares to
  elect the members of the board of directors.
• Straight voting vs. cumulative voting

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Cumulative Voting for Common Stock
Number of Directors Desired
Number of Shares Outstanding
X
Number of Shares Necessary
1

Number of Directors Being Elected
1
Formula from page 242 of Moyer Text (9th
Edition).
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Capital Gains Taxes

• In accordance with The Taxpayer Relief Act of
  1997, gains on stock held for more than 12 months
  is taxed at a maximum rate of 20 percent. The
  maximum tax rate on ordinary dividends and
  short-term gains was 39.1 (for 2002).

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Preferred Stock

• A Preferred or prior claim on earnings and assets
  compared to common stock
• Dividends paid ahead of common if declared.
• Cumulative feature
• Preferred stockholders are usually excluded from
  voting for board of directors and shareholder
  issues.
• Many corporations buy preferred stock.
• A high percentage, depending on the extent of
  ownership, of dividends received from one
  corporation by another corporation are federally
  tax exempt.
• Investors are concerned about after-tax return.

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Yields on Preferred Stock vs. Bonds for
Corporations

• Corporations are concerned about after-tax
  returns.
• Preferred stock are generally held by
  corporations because of the Dividends Received
  Deduction (DRD).
• Assume a 9 bond and a 35 tax rate
• 9(1-.35) 5.85 yield
• Assume an 8 preferred stock
• 8 - 8(.3)(.35) 8 - .84 7.16 yield

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Convertible Securities

• Convertible preferred stock -- convertible to
  common stock at specific common price or number
  of shares (conversion ratio).
• Dividends received until conversion
• Investor may participate in growth of firm.
• Convertible bonds -- convertible to common stock
  at specific common price or number of shares
  (conversion ratio).
• Pays fixed bond rate until conversion.
• Lower interest rate than nonconvertible bonds.
• Provides potential for higher returns for
  investors.

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Equity Owners
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Primary Market for Equities

• The first time shares are sold in the market is
  an unseasoned offering or an initial public
  offering (IPO) additional shares may be sold
  later as a seasoned offering.
• Permits founders diversification
• Facilitates raising new corporate cash

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Primary Market for Equities (continued)

• Equities may be
• sold directly to investors by the firm
• purchased and sold at a higher price
  (underwriters spread) by investment bankers in
  an underwriting offering
• sold to existing shareholders in a rights
  offering
• Shelf Registration
• Underwritten Offering vs. Best Efforts

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Primary Market for Equities (concluded)

• The size of the underwriters spread is
• Related to the size of the offering
• Uncertainty of the shares market value
• Shelf Registration

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The Secondary Market for Equity Securities

• Subsequent Trading in Securities after primary
  issue
• Stock may trade on
• Organized Exchanges
• NYSE
• Over the counter
• NASDAQ
• Primarily a dealer market
• Provides investor liquidity

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The Secondary Market for Equity Securities
(concluded)

• Stable prices are related to the extent of
• Breadth of the market or the number of varied
  traders of the stock.
• Depth of the market or the extent to which there
  are conditional orders to buy and sell below and
  above the current price, respectively.
• Resiliency of the market or the ability of the
  market to attract buyer/sellers when the stock
  prices decreases/increases, respectively.

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Secondary Markets

• Bring Buyers/ Sellers Together Four Ways
• A buyer may incur search costs and find a seller
  on their own, called a direct search.
• A broker may bring buyer and seller together,
  charging a commission.
• A dealer may sell/buy (bid/ask) securities from
  an inventory of securities, reducing search
  costs. The dealers return is the bid/ask
  spread.
• An auction market allocates the selling shares to
  the highest bidder, providing a buyer/seller.

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The Size of Dealer Bid/ask Spreads

• are proportionately higher for low priced stocks
  due to fixed costs of operations.
• are higher for trades of a few shares.
• are higher for a large block trade a liquidity
  service is performed.
• are narrower with more frequent trading, where
  the costs of providing liquidity are less.
• are wider with traders with insider information,
  where the dealer may have to incur the cost of
  price discovery, or buying high, selling low!

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Market Terms

• Market Order
• Buy or sell at the best price available at the
  time the order reaches the post
• Limit Order
• An order to buy or sell at a designated price or
  at any better price
• Specialists
• Members of the exchange who combine the
  attributes of both dealers and order clerks

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American Depository Receipts (ADR)

• ADRs are dollar-denominated claims issued by U.S.
  banks representing ownership of shares of a
  foreign companys stock held on deposit by the
  U.S. bank in the issuing firms home country.
• Subject to U.S. Security Laws

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Regulation of Securities Markets

• Securities Act of 1933 required full disclosure
  of relevant information relating to the issue of
  new securities in the primary market
• Securities Exchange Act of 1934 established the
  Securities and Exchange Commission and extended
  the disclosure to outstanding securities on
  secondary exchanges.

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Equity Valuation Basics

• The value of a security is the present value of
  expected cash flows, discounted at the required
  rate of return.
• Identify the size of the relevant, future cash
  flows and when the cash flows occur.
• Select the appropriate discount rate.
• Calculate the present value by discounting the
  cash flows at the discount rate, recognizing when
  the cash flows occur.

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Preferred Stock Valuation

• Discount the expected cash flow dividend stream
  at the required rate of return to determine its
  value.
• A fixed rate perpetual preferred stock
  approximates a perpetuity and the value can be
  found by dividing the annual dividends by the
  discount rate, P0 D/kp
  or D/r
• The preferred stock price varies to give the
  going rate of return to the new investor.
• Many preferred stock issues have a maturity, such
  as 15 years.
• TOPS, QUIPS

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Common Stock Valuation

• The analyst must approximate the future cash flow
  stream and select an appropriate discounting
  equation that approximates the cash flow of the
  stock.
• The value of a stock held for a long time is the
  present value of the dividend stream discounted
  at the required rate of return. It conceivably
  might be a perpetuity similar to the perpetual
  preferred stock.
• Use your financial calculator

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Common Stock Valuation (concluded)

• The value of a stock to be held for a determined
  period of time is the present value of the
  dividend stream plus the PV of the expected
  selling price of the stock.
• The present value, now in period zero, of a
  steadily increasing stream of cash flow is the
  value of the cash flow in the first year divided
  by the difference between the discount rate and
  the rate of growth. This expression is a math
  expression of a steadily growing perpetuity.

P0 D1 / ( ke g) or D1 / ( r g)
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The Total Risk of a Security

• Comprised of the Systematic (Market or
  Undiversifiable) Risk and the Unsystematic Risk
  (Diversifiable) Risk
• Proper diversification can reduce unsystematic,
  unique, or security-specific risk.
• A portfolio of securities can result in
  diversification, the reduction of total risk or
  the variability of returns (portfolio) below that
  of holding the individual securities.

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The Total Risk of a Security - concluded

• Diversification occurs when securities, whose
  historic returns have correlation coefficients
  less than 1, are assembled in a portfolio.
  Unsystematic or diversifiable risks offset one
  another.
• The systematic risk of the portfolio cannot be
  diversified away by adding additional securities.

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The Effect of Diversificationon Portfolio Risk
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Measuring Systematic Risk Beta

• Investors are assumed to hold securities in a
  diversified portfolio with only systematic or
  market risk to analyze.
• The relevant risk of a security is how it
  correlates with the portfolio.
• The extent to which the variability of returns
  (risk) of a stock related to the risk of a
  broad-based market portfolio is called the beta
  of the stock. It is a measure of relative risk
  of a security.

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Measuring Systematic Risk Beta (concluded)

• If a stock varies as the market portfolio does,
  the beta is 1.0 and the stock has a risk level
  matching the market portfolio such as the SP
  500.
• A beta greater than one is riskier (aggressive
  stock) than the market while a beta less than
  one is not as risky as the market and is called a
  defensive stock.
• Betas calculated for securities identify their
  relative historic riskiness.

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Selected Betas
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Security Market Line (SML)

• The security market line depicts the offsetting
  returns demanded for increased increments of
  risk, the classic risk/return tradeoff.
• The security market line enables one to
  conceptualize the risk of a stock as the sum of
  the risk free rate plus the market risk premium
  adjusted for the relative risk of the stock
  (beta).
• The equation for the SML is expressed as

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The Security Market Line
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Stock Market Indexes

• Price-Weighted Index
• First computed by summing the prices of the
  individual stocks composing the index
• Sum of the prices is divided by a divisor to
  yield the chosen base index value
• Example Dow Jones Industrial Average
• Market Value-Weighted Index
• Computed by calculating the total market value of
  the firms in the index and the total market value
  of those firms on the previous trading day.
• Example Standard Poors 500 Index

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Conclusion

• Common Stock
• Preferred Stock
• Convertibles
• Primary Markets
• Secondary Markets
• Equity Valuation
• Diversification
• Beta
• Security Market Line
• Indexes