01 fm&i chap 7 part 1 stock mkt

■ describe the private equity market ■ describe investor participation in the stock markets ■ describe the process of initial public offerings ■ describe the process of secondary offerin

Chapter 7: Stock Markets

-Stock Offerings and Investor Monitoring

■ describe the private equity market

■ describe investor participation in the stock markets

■ describe the process of initial public offerings

■ describe the process of secondary offerings

■ explain how the stock market is used to monitor and control firms

Private Equity

⚫ Private equity is a business that is privately held

and the owners cannot sell their shares to the public.

growth

investment to others.

stock.

support an active secondary market.

Private Equity

⚫Financing by Venture Capital Funds

Venture 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

Investors are not allowed to withdraw their money before a specified deadline

Private Equity

need equity funding and the VC funds that can provide funding.

when it decides to invest in a business

business and VC fund managers may serve as advisers to the business.

Private Equity

⚫Exit Strategy of VC Funds

VC funds typically plan to exit in 4 to 7 years

by selling the equity stake to the public

⚫Financing by Private Equity Funds

Private equity funds pool money provided by institutional investors (such as pension

funds and insurance companies) and invest

in businesses

They also rely heavily on debt to finance

their investments

Public Equity

⚫ When a firm goes public, it issues stock in the

primary market in exchange for cash.

⚫ Going public has two effects on the firm.

 It changes the firm’s ownership structure by increasing the number of owners

 It changes the firm’s capital structure by

increasing the equity investment in the firm

⚫ The secondary market allows investors to sell the stock they previously purchased to other

investors

How Stock Markets Facilitate the Flow of Funds

Ownership and Voting Rights

managers In publicly traded firms, most

shareholders are not the managers.

to a number of rights.

permitted to vote on certain key matters

directors, authorization to issue new shares,

amendments to corporate charter etc.

through the use of a proxy

Preferred Stock

⚫Preferred stock represents an equity

interest in a firm that usually does not allow for significant voting rights

⚫Preferred shareholders share the ownership

of the firm with common shareholders and are therefore compensated only when

earnings have been generated

⚫A cumulative provision on most preferred

stock prevents dividends from being paid on common stock until all preferred stock

dividends have been paid

Preferred Stock

■ Because the dividends on preferred stock can be omitted, a firm assumes less risk when issuing it than when issuing bonds

■ Dividends are not tax-deductible for the

firm, making preferred stock less desirable than bonds

Institutional Use of Stock Markets

Initial Public Offerings

⚫ A first-time offering of shares by a specific firm to the public.

 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)

 The lead underwriter must determine the offer price at which the shares will be offered at the time of the IPO

Allocation 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.

Transaction Costs - Usually 7 percent of the funds

raised

Initial Public Offerings

⚫ Underwriter 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.

⚫ Timing of IPOs : Initial public offerings tend to occur

more frequently during bullish stock markets

Initial Public Offerings

⚫ Initial Returns of IPOs

States has averaged about 20 percent over the last 30 years

Flipping Shares

offer price and selling the stock shortly afterward

the market price of the stock may decline shortly after the IPO

Initial Public Offerings

⚫ Google’s IPO

 On August 18, 2004, Google engaged in an IPO that

generated $1.6 billion

Estimating the Stock’s Value - investors multiplied

Google’s earnings per share by Yahoo!’s PE ratio.

Google’s Communication to Investors before the IPO Google provided substantial financial information about its operations and recent performance

-The Auction Process – Google used a Dutch auction

process allowing all investors to submit a bid for its stock by

a specific deadline.

Results of Google’s Auction : a price of $85/share.

Trading after the Auction - took place in the secondary

market.

Initial Public Offerings

⚫ Abuses in the IPO Market

Spinning - 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

Laddering - brokers encourage investors to place

first-day bids for the shares that are above the offer

price This helps to build upward price momentum

Excessive 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

Initial Public Offerings

⚫Long-Term Performance Following IPOs

There is strong evidence that, on

average, IPOs of firms perform poorly

over a period of a year or longer

From a long-term perspective, many

IPOs are overpriced at the time of the

Stock Offerings and Repurchases

⚫ Secondary Stock Offerings

offering by a specific firm whose stock is

already publicly traded.

stock toward their existing shareholders by

Shelf Registration - Corporations can

publicly place securities without the time lag often caused by registering with the SEC

Stock Offerings and Repurchases

⚫Stock Repurchases

Firms tend to repurchase some of their shares when share prices are at very

low levels

Many 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

Listing Requirements - minimum

number of shares outstanding and a

minimum level of earnings, cash flow,

and revenue over a recent period

OTC Market

⚫ Over-the-Counter Market

 Stocks not listed on the organized exchanges are

traded in the over-the-counter (OTC) market

Nasdaq - National Association of Securities Dealers

Automatic Quotations (Nasdaq), which is an electronic quotation system that provides immediate price

quotations.

OTC Bulletin Board - lists stocks that have a price

below $1 per share, which are sometimes referred to as penny stocks.

Pink 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

Stock Secondary Markets

 The Dow Jones Industrial Average (DJIA) is a

price-weighted average of stock prices of 30 large U.S firms

⚫ Assigns a higher weight over time to those stocks that experience higher prices

⚫ Does not necessarily serve as an adequate indicators of the overall market

 The Standard and Poor’s (S&P) 500 is a

value-weighted index of stock prices of 500 large U.S firms

⚫ Does not serve as a useful indicator for stock prices

of smaller firms

Stock Secondary Markets

⚫VN-Index is a value-weighted index of all stocks listed on HCM Stock Exchange

(HSX)

⚫VN30: 30 companies listed on HSX with biggest capitalization

⚫VNMidcap: The next 70 companies

⚫VN100: Includes all stocks of VN30 and VNMidcap

⚫Vnsmallcap

⚫Sector indexes

Investor Trading Decisions

⚫How investor decisions affect the stock

price

 Investors buy or sell shares based on their

valuation of the stock relative to the prevailing

Investor Trading Decisions

⚫New information translated into trading decisions impacting supply/demand for shares

⚫New equilibrium price established until new information appears

Increased Demand for Security

Reduced Supply of Security for Sale

Increase in Equilibrium (Market) Price of Security

New Favorable Information

Disclosed

to Investors

New Unfavorable

Information

Disclosed

to Investors

Increased Valuation of Security

by Investors

Reduced Valuation of Security

by Investors

Reduced Demand for Security

Increased Supply of Security for Sale

Decrease in Equilibrium (Market) Price of Security

Monitoring Publicly Traded Companies

⚫Managers serve as agents for shareholders (principals) to maximize the stock price

⚫Managers may be tempted to serve their

own interests rather than those of investors (principal – agent problem)

⚫Shareholders monitor their stock’s price

movements to assess whether the

managers are achieving their goal

Monitoring Publicly Traded Companies

⚫If the stock price is lower than expected,

shareholders may attempt to take action to improve the management of the firm

⚫Investors 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

Monitoring Publicly Traded Companies

⚫Accounting irregularities

statements they may be able to hide information from investors

allowed them to use unusual accounting

methods

not always monitoring the audit

Monitoring Publicly Traded Companies

Monitoring Publicly Traded Companies

⚫Shareholder Activism

 Communication with the firm

 Proxy contest

 Shareholder lawsuits

Monitoring Publicly Traded Companies

⚫Communication with the firm

 Shareholders can communicate their concerns

to other investors to place more pressure on managers or its board members

 Institutional investors commonly communicate with high-level corporate managers and offer their concerns

Monitoring Publicly Traded Companies

⚫Proxy contest

 Normally considered only if an informal request for a change in the board is ignored

 If dissident shareholders gain enough votes,

they can elect one or more directors who share their views

 As a result of a more organized effort,

institutional shareholders are more influential on management decisions

Monitoring Publicly Traded Companies

⚫Shareholder lawsuits

 Investors may sue the board if they believe that the directors are not fulfilling their

responsibilities to shareholders

 Lawsuits are often filed to prevent takeovers,

pursue acquisitions, or make other restructuring decisions that shareholders believe will reduce the stock’s value

 When directors are sued, courts typically focus

on whether the director’s decision seems reasonable, rather than on whether the decision led to higher profitability

Corporate Monitoring of Firms in the Stock Market

⚫If managers believe their stock is

undervalued in the market, they may take actions to capitalize on this discrepancy

⚫Stock repurchases

 Use excess cash to purchase shares in the

market at a low price

 Stock prices respond favorably to stock

repurchase announcements

⚫Stock offerings

 Signals overvalued shares

Market for Corporate Control

⚫A firm may engage in acquisitions to increase the value of a target firm

 Can also create synergistic benefits

⚫A high stock price is useful to exchange

acquirer shares for target shares

⚫Share prices of target firms react very

positively

⚫Leveraged buyouts

 LBOs are acquisitions that require substantial

amounts of borrowed funds

 A reverse LBO is desirable when the stock can be sold at a high price

Corporate Monitoring of Firms in the

Stock Market

Antitakeover amendments are designed to protect

shareholders against an acquisition that will ultimately reduce the value of their investment in the firm, e.g., may require at least two-thirds of shareholder votes to approve a takeover

Poison pills are special rights awarded to

shareholders or specific managers upon specified

events, e.g., the right for all shareholders to be

allocated an additional 30 percent of all shares without cost whenever a potential acquirer attempts to acquire the firm

 A golden parachute specifies compensation to

managers in the event that they lose their jobs, e.g., all managers have the right to receive 100,000 shares

of the firm’s stock whenever the firm is acquired