CHAPTER 10

EQUITY MARKETS

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Common Stock

Ownership in a CorporationOne 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 DateIncreases Credit Worthiness of the FirmCommon 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 Shares Necessary

=

Number of Directors Desired

Number of Shares Outstanding

X

Number of Directors Being Elected

+ 1

+ 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 stockDividends 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 conversionInvestor 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’ diversificationFacilitates raising new corporate cash

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Primary Market for Equities (continued)

Equities may be:sold directly to investors by the firmpurchased and sold at a higher price (underwriter’s spread) by investment bankers in an underwriting offeringsold to existing shareholders in a rights offering

Shelf RegistrationUnderwritten Offering vs. “Best Efforts”

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Primary Market for Equities (concluded)

The size of the underwriter’s spread is:

Related to the size of the offeringUncertainty of the shares’ market valueShelf Registration

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The Secondary Market for Equity Securities

Subsequent Trading in Securities after primary issueStock may trade on:

Organized ExchangesNYSE

Over the counterNASDAQPrimarily 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 dealer’s 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 company’s stock held on deposit by the U.S. bank in the issuing firm’s 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 marketSecurities 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 ValuationDiscount 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/rThe 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

)( pk

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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) RiskProper 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 S&P 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:

E R R B E R Rj F j M F( ) [ ( ) ]

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The Security Market Line

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Stock Market Indexes

Price-Weighted IndexFirst computed by summing the prices of the individual stocks composing the indexSum of the prices is divided by a “divisor” to yield the chosen base index valueExample: Dow Jones Industrial Average

Market Value-Weighted IndexComputed 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 & Poor’s 500 Index

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Conclusion

Common StockPreferred StockConvertiblesPrimary MarketsSecondary MarketsEquity ValuationDiversificationBetaSecurity Market LineIndexes