Equity Financing

Learning Outcomes: Outline different types of company securities & their characteristics Explain the pros and cons of a stock market listing Explain and compare the methods by which firms seek a stock market listing Explain rights issues and the alternatives for raising new cash. Explain different methods of valuing shares & companies
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(I) Different types of company securities

Debt Equity hybrids e.g. convertibles

Starts as a bond but can be turned into share capital at a later date Option

Longer term finance given by:

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Company securities

Bonds

Debentures secured company bond Loan stock

Preference shares Ordinary shares Hybrid- e.g. convertible

Unsecured loan stock but with the option to exchange loan for ordinary shares According to pre-arranged formula
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(II) Equity finance: New issue market

Private company: Prohibited from offering shares to general public Going public seek a public quotation a stock market listing When e.g. 1. Existing owners unwilling or unable to contribute further equity 2. Want to unlock wealth
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(A) Advantages - benefits

Prestige status complies with the rules of the stock exchange Growth raise cheaper funds Access wider pool shareholders Able to use equity to buy business Visibility publicity Flexibility -- whether to pay dividend or not (instead of having to pay debt interests no matter what in case of debt financing) Can attract better management Borrow more easily and cheaply
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(B) Disadvantages potential drawbacks

Accountability new responsibilities on directors e.g. need to consult shareholders before taking major decisions Disclosure/Responsibility Meet rigorous monitoring Give price-sensitive information timely/orderly Regulation SE ongoing strict monitoring Compliance with rules Threat of takeover/loss of control Increased Cost of maintaining a quote: e.g. SE fees, extra disclosure costs, management time

(C) Stock market launch who raises cash?

Floatation shares offered on market for the first time Who raises cash 1. Existing shares sold by e.g. founders 2. New shares created cash to company In practice often mix of old and new shares sold

(D) London Stock Exchange Listing Requirements

Rules of the game to: Protect investing public Set standards for prospective/newly quoted companies In addition to LSE own mechanisms:

1980 Companies Act Insider dealing criminal offence 1986 Financial Services Act legal controls enforced through self regulatory organisations
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(E) The Markets

The Main Market Alternative Investment Market (AIM) Designed for shares of younger or smaller companies These may not qualify for full listing Keep costs down, keeps rules as simple as possible Shares on AIM quoted or traded not listed
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(F) Listing requirements

Main market requirements e.g. 1. Accounts over last 3 years 2. Independent business activity earning revenues over last 3 years 3. Senior managers must not have changed significantly have expertise 4. A controlling shareholder must not prevent operating independently 5. At least 25%ordinary shares in public hands after listing
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(G) Key elements:

Annual financial statements, past trading performance Annual reports profit & loss account etc future earnings Aim to assure that:

A company does not launch prematurely Shares can be traded actively

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(H) Aims and methods of issue

Aim ensure shares fully taken at appropriate price Give fair value for issuing company and shareholders Advice on:

Timing Terms Methods of issue

Consider the relative costs and benefits

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(I) Methods of obtaining a listing

Offer for sale Placing

The introduction raises no new cash

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(1) Offer for sale

Shares offered to public prospectus, newspaper information or mini prospectus Two types:

Fixed price offers Offer for sale by tender Fixed price offer more common
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(2) Placing

Company arranges to sell share privately to range investors gain initial spread of shareholders Usually arranged by issuing house or Co. broker Place with own clients directly No offer to public After placing permission to trade shares on stock market spread Intermediaries offer offered to clients financial intermediaries
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(3) Methods of listing: which method is best?

Depends on various factors, consider aim: Relative costs e.g.:

Administration transaction costs Costs incurred in the pricing process Sale price Obtaining a spread of investors
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Relative benefits e.g.:

(4) Problems: Pricing Offer for Sale

Fixed Price Offer: How is the price set? Every issue requires sponsors e.g. broker, investment bank (AIM) nominated adviser Forecast profits and dividend for current year and give historical figures
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(5) Pricing:

Look for quoted firm in similar business Examine P/E ratios and yield of that firm Adjust for superior or inferior growth prospects Larger issues book building see what major investors would buy Pitch price below equilibrium to ensure shares be taken up by the public
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(6) Tender Offer

A share issue where prospective investors tender for shares at a price of their own choice. Companies difficult to value no comparable quoted company

Sponsors calculate p at which all shares available sold

Strike price: Pe in diagram
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(7) Stock market Introduction

An established firm obtains a Stock Market listing without selling any shares Applicable when the shares are already widely held, more than 25% of shares held in public.

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(8) Market Capitalisation

Market capitalisation value equal to: No. of ordinary shares x market price For example: If P = 4 Quantity shares = 20 million Market value = 80 million
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(III) Equity issues by quoted companies: Rights Issue*

A method of raising further equity by a quoted company with good trading and profit record. Pre-emptive rights Companies Act 1985

Gives the right for existing shareholders to be offered newly issued shares before making them available to outside investors

Shareholders of company option to buy shares in proportion to their existing holding

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(A) Why make a rights issue?

For example: 1. To finance new investment 2. To pay off debt

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(B) Working out rights values: Pisces Products plc

Announcement: 1 for 4 rights issue @ 70p Cum rights market price 90p Shareholder has 10,000 shares. Simplifying assumptions: 1. co. market value predicted to rise by amount of new capital raised. Zero NPV project. 2. No transactions costs or taxes
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(C) Value and Wealth

Value of old shares

10,000 @ 90p 2,500 @ 70p

9,000 1,750

Can buy new shares

Total wealth Total number of shares (Old and new)

10,750
12,500
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(D) To find ex-rights price

Total wealth divided by total number of shares: 10,750 / 12,500 Ex-rights price 0.86

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(E) The value of rights on a new share

Ex rights price issue price 86p 70p = 16p In order to maintain wealth must either 1. Take up the rights offer Or 2. Sell the rights for 16p per new share
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1. Take up rights: buy new shares

Cash for rights purchase: 1,750 Wealth falls in building society or bank by 1,750 Wealth in Co now 10,750 But overall total wealth is unchanged @ 9,000

All that has happened is wealth rearranged.

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2. Do not take up rights: sell rights

Value of original old shares ex rights 8,600 Value of cash from rights sale (2,500 x 16p) = 400 Leaves 9,000
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(F) Impact on wealth:

Give assumptions e.g. no transactions costs No wealth effect if take up or sell rights Voting power diluted if sell rights dont buy new shares 3. If do not sell or take up the rights? Ex-rights price 86p x 10,000 = 8,600 Wealth loss = 400
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Valuing shares and companies

To examine the basis for determining which stocks to buy and which stocks to sell. Distinguish between a growth stock and the stock of a growth company. Applying the stock valuation principle to valuing businesses in general.

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Technical Analysis of stock values

Technical Analysis

Also known as chartists plotting of past price patterns to identify trends of stock price changes. The search for recurring and predictable patterns in stock prices Assumes a sluggish response of stock prices to fundamental supply and demand factors, hence analysts will be able to identify a trend that can be exploited during the adjustment period

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Fundamental Analysis of stock values

It uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. The hope is to attain some insight into the future performance of the firm that is not yet recognised by the rest of the market Aim to identify undervalued or overvalued stocks
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Fundamental analysis

Looking for growth stocks or value stocks

Growth stocks stocks that may have above-average future growth in earnings and thus above-average valuations (and high P/E ratios). Value stocks: stocks that are cheap in the stock market relative to their book (accounting) values. Analysis of the economy and the market Industry analysis Company analysis
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3-levels of analysis:

More on growth stocks and growth companies

A growth company:

is a firm that can achieve an overall investment yield (e.g. 20%) greater than its required rate of return (e.g. 10%) (or its weighted average cost of capital) due to the management ability compared to similar risk firms. Might have low dividend payout ratios because larger portion of earnings retained to fund its above-average investment opportunities. Hence growth stocks are not necessarily shares in growth companies.
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A growth stock

A stock with a higher rate of return than other stocks in the market with similar risk characteristics. Might have been undervalued by the market and is now in the process of being adjusted. During this period of adjustment, it will be considered as a growth stock. Hence shares of growth companies and stocks that are undervalued by the market alike could become growth stocks at some point.
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Stock Selection Strategies

(1) The Active strategy

Adopted by investors who believe that they have some superior information or skill in analysing and selecting stocks Aim at outperforming the market Some common active strategies:

Security selection Sector rotation Market timing

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Stock Selection Strategies

(2) The Passive strategy

Not aiming to outperform the market, but only to do as well as the market. Adopters try to minimise the transaction costs and the time spent in managing portfolio Assuming market is effiecient Some passive strategies:

Buy and hold strategy Investing in index funds

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Stock Returns and Risk

Total Returns (TR) of common stocks can be separated into 2 components: 1. Capital gains (or losses) <CG(L)>

the difference between the purchase and the selling price Dividend divided by the share price
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2. Dividend yield (DY)

Stocks Return
TR = CG(L) + DY

or

where P1 is the selling price P0 is the buying price Div are the dividends
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An Example

If you buy a stock at 100p, sell it after a year at 135p and in the meantime you get a dividend of 10p, your total return is: TR = [(135 100) + 10] / 100 = 45 / 100 = 45% If you sell the stock for 75p, your total return would be: TR = [(75 100) + 10] / 100 = -15 / 100 = -15%
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Total risk of a stock

Usually measured by the standard deviation ( ) or the variance ( ) They are measures of dispersion of estimated returns from the expected return (or mean). The greater the SD (or dispersion), the higher the risk and vice versa.
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Standard deviation as a measure of risk

A Stock B is riskier than Stock A

Expected return 10%

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Methods of stock valuation

(A) The PV approach to estimating the intrinsic or theoretical value of a stock

The intrinsic value is equal to the discounted (present) value of the future stream of cash flows expected to be received from the stock

where CF is the expected cash flows and k is the appropriate rate of return.
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The Dividend Discount Model

Dividends are likely to be the only cash flows that an investor will receive from the firm. Applying the formula on slide 14 to valuing stocks based on the discounted value of all future dividends, we have the following DDM:

where D1Dn are the dividends at year 1..n k is the opportunity cost of capital for investment of similar risk
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Problems with the DDM

1. The stream of cash flow is uncertain 2. The number of periods that has to be estimated is very big.

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Different versions of DDM: 1. The Zero-Growth Model

Assumptions

Dividends will be fixed to the current levels from now to infinity No growth in the dividends The fixed dividend reduces to a perpetuity

The model:

where D0 is the current dividend

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2. The Constant Growth Model

Assumptions

Dividends will grow at a constant rate g. Current dividend (D0) must be compounded to the future before it is discounted.

The model: or

where D0 and D1 are current dividend and dividend at year 1 respectively. and k must be greater than g to produce any meaningful results
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Use of intrinsic value of a stock to make investment decisions

Compare the intrinsic or theoretical value with current market value of an asset. If IV > MV

The stock is undervalued Should be bought if not already owned

If IV < MV

The stock is overvalued Should not be bought, or should be sold if already owned

If IV = MV

The stock is correctly valued in the market

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(B) The non-PV approach to valuing stocks

(1) The P/E Approach

The current market price divided by the latest 12month earnings. It tells investors the price being currently paid at the market place for each 1 of the companys earnings. For example, if the price of company A is 358p and the earnings per share for the last 12 months are 45p, then the P/E ratio is: 358p/45p = 7.9 In other words, investors are willing to pay 7.9 times earnings for company A
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(2) The Price to Book Value approach

P/B is calculated as the ratio of current stock market value to the book (accounting) market value of the company This ratio should be close to 1 if the market and book values are equal.

It gives signs of undervalued or overvalued stocks.

For example, if the P/B of a stock is 0.80, this means that this stock sells in the market place at 80% of its book value and it may present a buying opportunity.
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Discussion
1. Discuss the applicability of the Constant Dividend Growth Model in valuing shares in the real world. 2. It is always better for a business to go public than to stay private. Do you agree with this view and why?

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