Equity Market, Stock Offering and Investor Monitoring Objectives ndescribe the private equity market ndescribe investor participation in the stock markets ndescribe the process of initial public offerings ndescribe the process of secondary offerings nexplain how the stock market is used to monitor and control firms ndescribe the globalization of stock markets n Private Equity nPrivate equity is a business that is privately held and the owners cannot sell their shares to the public. nSome business owners hope to go public so that: qThey can obtain financing to support the firm’s growth qThey can “cash out” by selling their original equity investment to others. nA public offering is feasible if: qThe owners want to sell at least $50 million in stock. qThe shareholder base will be large enough to support an active secondary market. n Private Equity nFinancing by Venture Capital Funds qVenture capital funds (VC funds) receive money from wealthy investors and from pension funds that are willing to maintain the investment for a long-term period, such as 5 or 10 years. qInvestors are not allowed to withdraw their money before a specified deadline. n nFinancing by Venture Capital Funds (cont.) qVenture Capital Market nBrings together the private businesses that need equity funding and the VC funds that can provide funding. qTerms of a Venture Capital Deal nA VC fund will negotiate the terms of the deal when it decides to invest in a business. nThe VC fund will set out requirements for the business and VC fund managers may serve as advisers to the business. n nFinancing by Venture Capital Funds (cont.) qExit Strategy of VC Funds nVC funds typically plan to exit in 4 to 7 years by selling the equity stake to the public. qPerformance of VC Funds nTends to vary over time nFunds can be invested more wisely when stock prices are low nAlso influenced by the amount of investment received by investors n nFinancing by Private Equity Funds (cont.) qPrivate equity funds pool money provided by institutional investors (such as pension funds and insurance companies) and invest in businesses. qThey also rely heavily on debt to finance their investments. qPerformance of Private Equity Funds nTends to vary over time nFunds can be invested more wisely when stock prices are low nMay be especially prone to making bad investments when they receive large amounts of funds from investors n nWhen a firm goes public, it issues stock in the primary market in exchange for cash. nGoing public has two effects on the firm. qIt changes the firm’s ownership structure by increasing the number of owners. qIt changes the firm’s capital structure by increasing the equity investment in the firm. nStock markets are like other financial markets in that they link the surplus units (that have excess funds) with deficit units (that need funds). (Exhibit 10.1) nThe secondary market allows investors to sell the stock they previously purchased to other investors. n n Background on Common Stock nCommon stock = certificate representing equity or partial ownership in a corporation qIssued in primary market by corporations that need long-terms funds qTraded in secondary market nLiquidation nEvaluation of company q nOwnership and Voting Rights qOwners of small companies also tend to be the managers. In publicly traded firms, most shareholders are not the managers. qOwnership of common stock entitles shareholders to a number of rights. nNormally, only the owners of common stock are permitted to vote on certain key matters concerning the firm. nMany investors assign their vote to management through the use of a proxy. n Public Equity nPreferred stock - represents an equity interest in a firm that usually does not allow for significant voting rights. qPreferred shareholders share the ownership of the firm with common shareholders and are therefore compensated only when earnings have been generated. qA cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred stock dividends have been paid. qBecause the dividends on preferred stock can be omitted, a firm assumes less risk when issuing it than when issuing bonds. qDividends are not tax-deductible for the firm, making preferred stock less desirable than bonds. Public Equity nParticipation in Stock Markets nInvestors can be classified as individual or institutional (Exhibit 10.2) qIndividual investments commonly exceeds 50% of the total equity. qBecause of the size of investment, institutional investors can significantly affect stock market prices. n n nHow Investor Decisions Affect Stock Prices qWhen there is a shift in the demand for shares or the supply of shares for sale, the equilibrium price changes. qOverall, the prevailing market price is determined by the participation of investors in aggregate. nInvestor Reliance on Information qIn general, favorable news about a firm’s performance will make investors believe that the firm’s stock is undervalued at its prevailing price. qInformation is incorporated into stock prices through its impact on investors’ demand for shares and the supply of shares for sale by investors. n nA first-time offering of shares by a specific firm to the public. nProcess of Going Public qDeveloping a Prospectus - The issuer must develop a prospectus containing detailed information about the firm, including financial statements and a discussion of risks. The prospectus is filed with the Securities and Exchange Commission (SEC). qPricing - The lead underwriter must determine the offer price at which the shares will be offered at the time of the IPO. (Exhibit 10.3) qAllocation of IPO Shares: The lead underwriter may rely on a group (called a syndicate) of other securities firms to participate in the underwriting process and share the fees to be received for the underwriting. qTransaction Costs - Usually 7 percent of the funds raised. n n nUnderwriter Efforts to Ensure Price Stability §Underwriters may attempt to stabilize the stock’s price by purchasing shares that are for sale in the secondary market shortly after the IPO. §Lockup §Prevents the original owners of the firm and the VC firms from selling their shares for a specified period. §Prevents downward pressure that could occur if the original owners or VC firms immediately sold their shares in the secondary market. nTiming of IPOs §Initial public offerings tend to occur more frequently during bullish stock markets. n nInitial Returns of IPOs §The initial (first-day) return of IPOs in the United States has averaged about 20 percent over the last 30 years. nFlipping Shares §Investors flip shares by buying the stock at its offer price and selling the stock shortly afterward. §If many institutional investors flip their shares, the market price of the stock may decline shortly after the IPO. n nGoogle’s IPO qOn August 18, 2004, Google engaged in an IPO that generated $1.6 billion. qEstimating the Stock’s Value - investors multiplied Google’s earnings per share by Yahoo!’s price-earnings ratio. qGoogle’s Communication to Investors before the IPO - Google provided substantial financial information about its operations and recent performance. qThe Auction Process – Google used a Dutch auction process allowing all investors to submit a bid for its stock by a specific deadline. qResults of Google’s Dutch Auction - resulted in a price of $85 per share. nFacebook’s IPO qOn May 18, 2012, Facebook engaged in an IPO that generated $16 billion. qFacebook’s opening price was $38/share. The price fluctuated through the day with a high of about $43. Many traders lost experienced substantial profits are losses in the first day qThree months after the opening, the price fell to $20/share. qLesson - A company can be very valuable yet overpriced nAbuses in the IPO Market qSpinning - occurs when the underwriter allocates shares from an IPO to corporate executives who may be considering an IPO or to another business that will require the help of a securities firm. qLaddering - brokers encourage investors to place first-day bids for the shares that are above the offer price. This helps to build upward price momentum investors multiplied Google’s earnings per share by Yahoo!’s price-earnings ratio. nAbuses in the IPO Market (cont.) qExcessive Commissions - Some brokers have charged excessive commissions when demand was high for an IPO. Investors were willing to pay the price because they could normally recover the cost from the return on the first day. qDistorted Financial Statements - Even though financial statements to summarize revenue, expenses, and financial condition, accountants still have much flexibility in their reporting process, and therefore still can exaggerate earnings. n nLong-Term Performance Following IPOs qThere is strong evidence that, on average, IPOs of firms perform poorly over a period of a year or longer. qFrom a long-term perspective, many IPOs are overpriced at the time of the issue. qThis weak performance may be partially attributed to irrational valuations at the time of the IPO, which are corrected over time. n nSecondary Stock Offerings qA secondary stock offering is a new stock offering by a specific firm whose stock is already publicly traded. qCorporations sometimes direct their sales of stock toward their existing shareholders by giving them preemptive rights. qShelf Registration - Corporations can publicly place securities without the time lag often caused by registering with the SEC. nStock Repurchases qFirms tend to repurchase some of their shares when share prices are at very low levels. qMany stock repurchase plans are viewed as a favorable signal, some investors may ask why the firm does not use its funds to expand its business instead of buying back its stock. n nOrganized Exchanges qEach organized exchange has a trading floor where floor traders execute transactions in the secondary market for their clients. qNew York Stock Exchange (NYSE) is by far the largest with two broad types of members. nFloor brokers are either commission brokers or independent brokers. nSpecialists can match orders of buyers and sellers. nListing Requirements - minimum number of shares outstanding and a minimum level of earnings, cash flow, and revenue over a recent period. n Stock Secondary Markets nOver-the-Counter Market qStocks not listed on the organized exchanges are traded in the over-the-counter (OTC) market. qNasdaq - National Association of Securities Dealers Automatic Quotations (Nasdaq), which is an electronic quotation system that provides immediate price quotations. qOTC Bulletin Board - lists stocks that have a price below $1 per share, which are sometimes referred to as penny stocks. qPink Sheets - The OTC market has where even smaller stocks are traded. Some of the stocks have very little trading volume and may not be traded at all for several weeks. nExtended Trading Sessions qThe NYSE and Nasdaq market offer extended trading sessions beyond normal trading hours. qMarket liquidity during the extended trading sessions is limited. n nStock Quotations Provided by Exchanges (Exhibit 10.4) q52-Week Price Range - The stock’s highest price and lowest price over the previous 52 weeks are commonly listed just to the left of the stock’s name. qSymbol - Each stock has a specific symbol that is used to identify the firm. qDividend - The annual dividend (DIV) is commonly listed to the right of the firm’s name and symbol. qDividend Yield - Annual dividend per share as a percentage of the stock’s prevailing price. Shown next to the annual dividend. qPrice-Earnings Ratio - Represents its prevailing stock price per share divided by the firm’s earnings per share (earnings divided by number of existing shares of stock) generated over the last year. n n nStock Quotations Provided by Exchanges (Cont.) qVolume - Stock quotations also usually include the volume of shares traded on the previous day. The volume is normally quoted in hundreds of shares. qClosing Price Quotations - Stock quotations show the closing price (“Last”) on the day (on the previous day if the quotations are in a newspaper). In addition, the change in the price (“Net Chg”) is typically provided and indicates the increase or decrease in the stock price from the closing price on the day before. n nStock Index Quotations nDow Jones Industrial Average - value-weighted average of stock prices of 30 large U.S. firms. nStandard & Poor’s 500 - a value-weighted index of stock prices of 500 large U.S. firms. nWilshire 5000 Total Market Index - index now contains more than 5,000 stocks. The Wilshire 5000 is the broadest index of the U.S. stock market. nNew York Stock Exchange Indexes - The Composite Index is the average of all stocks traded on the NYSE. NYSE also provides indexes for four sectors: Industrial, Transportation, Utility, Financial. nNasdaq Stock Indexes - The National Association of Securities Dealers (NASD) provides quotations on indexes of stocks traded on the Nasdaq. n nPrivate Stock Exchanges qPrior to an IPO, some private firms list their private shares on a private stock exchange. qAdvantages - nAllows owners to obtain cash nPurchasers may be able to pay a lower price than when a firm goes with IPO. qDisadvantages nInvestors need to register with the private exchange and prove that they have sufficient income nLimited information available to investor nLittle may be known on how firm was valued nTrading volume is limited n nThe easiest way for shareholders to monitor the firm is to monitor changes in its value (as measured by its share price) over time. nIf the stock price is lower than expected, shareholders may attempt to take action to improve the management of the firm. nInvestors also rely on the board of directors of each firm to ensure that its managers make decisions that enhance the firm’s performance and maximize the stock price. n nRole of Analysts nAnalysts are often employed by securities firms and assigned to monitor a small set of publicly traded firms. nStock Exchange Rules - In the 2002–2004 period, U.S. stock exchanges imposed new rules to prevent some obvious conflicts of interest faced by analysts. nAnalysts cannot be supervised by the division that provides advisory services, and their compensation cannot be based on the amount of advisory business they generate. nSecurities firms must disclose summaries of their analysts’ ratings for all the firms that they rate so that investors can determine whether the ratings are excessively optimistic. n nAccounting Irregularities qIn recent years, many firms used unusual accounting methods to create their financial statements. qOverall, investors’ monitoring of some firms was limited because the accountants distorted the financial statements, the auditors did not properly audit, and the audit committees of those firms did not properly oversee the audit. n nSarbanes-Oxley Act qPrevents a public accounting firm from auditing a client firm whose chief executive officer (CEO), chief financial officer (CFO), or other employees with similar job descriptions were employed by the accounting firm within one year prior to the audit. qRequires that only outside board members of a firm be on the firm’s audit committee, which is responsible for making sure that the audit is conducted in an unbiased manner. qPrevents the members of a firm’s audit committee from receiving consulting or advising fees or other compensation from the firm beyond that earned from serving on the board. n nSarbanes-Oxley Act (Cont.) qRequires that the CEO and CFO of firms of a specified size (or larger) certify that the audited financial statements are accurate. qSpecifies major fines or imprisonment for employees who mislead investors or hide evidence. qAllows public accounting firms to offer nonaudit consulting services to an audit client only if the client’s audit committee pre-approves the nonaudit services to be rendered before the audit begins. qCost of Being Public - Establishing a process that satisfies the Sarbanes-Oxley provisions can be very costly. For many firms, the cost of adhering to the guidelines of the act exceeds $1 million per year. n nShareholder Activism qIf shareholders are displeased with the way managers are managing a firm, they have three choices. nDo nothing and retain their shares. nSell the stock. nEngage in shareholder activism qCommunication with the Firm - Shareholders can communicate their concerns to other investors in an effort to place more pressure on the firm’s managers or its board members. qProxy Contest - Shareholders may also engage in proxy contests in an attempt to change the composition of the board. qShareholder Lawsuits - Investors may sue the board if they believe that the directors are not fulfilling their responsibilities to shareholders. n nLimited Power of Governance §There is some evidence that the governance is not very effective. §In spite of the Sarbanes-Oxley Act, shareholder activism, proxy contests, and shareholder lawsuits, the agency problems of some firms remain severe. n nUse of LBOs to Achieve Corporate Control qThe market for corporate control is enhanced by the use of leveraged buyouts (LBOs), which are acquisitions that require substantial amounts of borrowed funds. nBarriers to the Market for Corporate Control qAntitakeover Amendments - an amendment may require that at least two-thirds of the shareholder votes approve a takeover. qPoison Pills - Special rights awarded to shareholders or specific managers on the occurrence of specified events. qGolden Parachutes - specifies compensation to managers in the event that they lose their jobs or change in control of the firm. n nMethods Used to Invest in Foreign Stocks. qDirect Purchases - Investors can easily invest in stocks of foreign companies that are listed on the local stock exchanges. qAmerican Depository Receipts - certificates representing shares of non-U.S. stock. Many non-U.S. companies establish ADRs in order to develop name recognition in the United States. qInternational Mutual Funds - portfolios of international stocks created and managed by various financial institutions. qInternational Exchange-Traded Funds - Passive funds that track a specific index. International ETFs represent international stock indexes, and they have become popular in the last few years. n