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OVERVIEW OF EQUITY SECURITIES

 Chapter One

Learning Objectives
a.Describe characteristics of types of equity
securities;
b.Distinguish between public and private equity
securities;
c.Describe methods for investing in non-domestic
equity securities;
d.Compare the risk and return characteristics of
different types of equity securities;
e.Explain the role of equity securities in the financing
of a company’s assets;
f. Distinguish between the market value and book
value of equity securities;
g.Compare a company’s cost of equity, its
(accounting) return on equity, and investors’
required rates of return.
 TYPES OF EQUITY
INVESTMENTS 1

PRIVATE EQUITY 2
Chapter FOREIGN EQUITIES 3
One 1 EQUITY INVESTMENTS
RISK & RETURN 4
OVERVIEW OF EQUITY
SECURITIES
MARKET VALUE VERSUS
BOOK VALUE 5
COST OF EQUITY, RETRUN
ON EQUITY, & REQUIRED
RETURN
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CHAPTER ONE: OVERVIEW OF EQUITY SECURITIES
1.1: TYPES OF EQUITY INVESTMENTS
1.1.1: Common Shares
q The most common form of equity and represent an ownership interest. It has a residual claim (after the claims
of debtholders and preferred stockholders) on firm assets if the firm is liquidated and govern the corporation
through voting rights.
q There is no obligation to pay dividends for the common shares; the firm determines what dividend will be
paid periodically.
q Common stockholders has the right to vote for the board of directors, on merger decisions, and on the
selection of auditors. If they are unable to attend the annual meeting, shareholders can vote by proxy
(having someone else vote as they direct them, on their behalf).
q In a statutory voting system, each share held is assigned one vote in the election of each member of the
board of directors. Under cumulative voting, shareholders can allocate their votes to one or more
candidates as they choose. Cumulative voting makes it possible for a minority shareholder to have more
proportional representation on the board.

1.1.2: Preference Shares

q Also known as preferred stock, it has features of both common stock and debt. Preferred stock dividends are
not a contractual obligation and the shares usually do not mature, similar to common shares. Like debt,
preferred shares typically make fixed periodic payments to investors and do not usually have voting rights.
q Preferred shares have a stated par value and pay a percentage dividend based on the par value of the
shares. An $80 par value preferred with a 10% dividend pays a dividend of $8 per year.

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CHAPTER ONE: OVERVIEW OF EQUITY SECURITIES
1.1: TYPES OF EQUITY INVESTMENTS
1.1.2: Preference Shares
q Preference shares may be callable, giving the firm the right to repurchase the shares at a pre-specified call
price. It can be also be putable, giving the shareholder the right to sell the preference shares back to the
issuer at a specified price.
q Cumulative preference shares are usually promised fixed dividends, and any dividends that are not paid
must be made up before common shareholders can receive dividends. The dividends of non-cumulative
preference shares do not accumulate over time when they are not paid.
q Participating preference shares receive extra dividends if firm profits exceed a predetermined level and may
receive a value greater than the par value of the preferred stock if the firm is liquidated. Non-participating
preference shares have a claim equal to par value in the event of liquidation and do not share in firm profits.
q Smaller and riskier firms whose investors may be concerned about the firm’s future often issue participating
preferred stock so investors can share in the upside potential of the firm.
q Convertible preference shares can be exchanged for common stock at a conversion ratio determined when
the shares are originally issued. It has the following advantages:
q The preferred dividend is higher than a common dividend.
q If the firm is profitable, the investor can share in the profits by converting his shares into common stock.
q The conversion option becomes more valuable when the common stock price increases.
q Preferred shares have less risk than common shares because the dividend is stable and they have
priority over common stock in receiving dividends and in the event of liquidation of the firm.
q Convertible preferred shares has an upside potential, so it is used to finance risky venture capital and private
equity firms. The conversion feature compensates investors for the additional risk they take when investing in
such firms. 5
CHAPTER ONE: OVERVIEW OF EQUITY SECURITIES
1.2: PRIVATE EQUITY
q Private equity is usually issued to institutional investors via private placements. Private equity markets are
smaller than public markets but are growing rapidly.
q Compared to public equity, private equity has the following characteristics:
q Less liquidity because no public market for the shares exists.
q Share price is negotiated between the firm and its investors, not determined in a market.
q More limited firm financial disclosure because there is no government or exchange requirement to do
so.
q Lower reporting costs because of less onerous reporting requirements.
q Potentially weaker corporate governance because of reduced reporting requirements and less public
scrutiny.
q Greater ability to focus on long-term prospects because there is no public pressure for short-term results.
q Potentially greater return for investors once the firm goes public.
q The three main types of private equity investments:
q Venture capital refers to the capital provided to firms early in their life cycles to fund their development and
growth. Venture capital investments are illiquid and investors often have to commit funds for three to ten
years before they can cash out (exit) their investment. Investors hope to profit when they can sell their shares
after (or as part of) an initial public offering or to an established firm.
q leveraged buyout (LBO), investors buy all of a firm’s equity using debt financing (leverage). Firms in LBOs
usually have cash flow that is adequate to service the issued debt or have undervalued assets that can be
sold to pay down the debt over time.
q Private investment in public equity, a public firm that needs capital quickly sells private equity to investors. 6
CHAPTER ONE: OVERVIEW OF EQUITY SECURITIES
1.3: FOREIGN EQUITIES
q When capital flows freely across borders, markets are said to be integrated. The world’s financial markets
have become more integrated over time, especially as a result of improved communications and trading
technologies.
q There are some barriers to global capital flows still exist. Some countries restrict foreign ownership of their
domestic stocks, primarily to prevent foreign control of domestic companies and to reduce the variability of
capital flows in and out of their countries.
q An increasing number of countries have dropped foreign capital restrictions. Studies have shown that
reducing capital barriers improves equity market performance. Furthermore, companies are increasingly
turning to foreign investors for capital by listing their stocks on foreign stock exchanges or by encouraging
foreign ownership of shares.
q From the firm’s perspective, listing on foreign stock exchanges increases publicity for the firm’s products and
the liquidity of the firm’s shares. Foreign listing also increases firm transparency due to the stricter disclosure
requirements of many foreign markets.
1.3.1: Direct Investing
q Direct investing in the securities of foreign companies simply refers to buying a foreign firm’s securities in
foreign markets. Some obstacles to direct foreign investment are that:
q The investment and return are denominated in a foreign currency.
q The foreign stock exchange may be illiquid.
q The reporting requirements of foreign stock exchanges may be less strict, impeding analysis.
q Investors must be familiar with the regulations and procedures of each market in which they invest.
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CHAPTER ONE: OVERVIEW OF EQUITY SECURITIES
1.3: FOREIGN EQUITIES
1.3.2: Depository Receipts
q Depository receipts (DRs) represent ownership in a foreign firm and are traded in the markets of other
countries in local market currencies. A bank deposits shares of the foreign firm and then issues receipts
representing ownership of a specific number of the foreign shares. The depository bank acts as a custodian
and manages dividends, stock splits, and other events.
q Although the investor does not have to convert to the foreign currency, the value of the DR is affected by
exchange rate changes, as well as firm fundamentals, economic events, and any other factors that affect
the value of any stock.
1.3.3: Global Depository Receipts
q Global depository receipts (GDRs) are issued outside the United States and the issuer’s home country. Most
GDRs are traded on the London and Luxembourg exchanges.
q Although not listed on U.S. exchanges, they are usually denominated in U.S. dollars and can be sold to U.S.
institutional investors.

1.3.4: American Depository Receipts

q American depository receipts (ADRs) are denominated in U.S. dollars and trade in the United States.
1.3.5: Global Registered Shares
q Global registered shares (GRS) are traded in different currencies on stock exchanges around the world.

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CHAPTER ONE: OVERVIEW OF EQUITY SECURITIES
1.4: EQUITY INVESTMENTS RISK & RETURN
q The returns on equity investments generate from the price changes, dividend payments, and, gains or losses
from changes in exchange rates, in case of foreign equity investments.
q A Egyptian investor who invests in euro-denominated shares will have greater EGP based returns if the euro
appreciates relative to the EGP.
q The risk of equity securities is most commonly measured as the standard deviation of returns.
q Preferred stock is less risky than common stock because preferred stock pays a known, fixed dividend to
investors that is a large part of the return, whereas common dividends are variable and can vary with
earnings. Also, preferred stockholders receive their distributions before common shareholders and have a
claim in liquidation equal to the par value of their shares that has priority over the claims of common stock
owners. Because it is less risky, preferred stock has a lower average return than common stock.
q Cumulative preferred shares have less risk than non-cumulative preferred shares because they retain the
right to receive any missed dividends before any common stock dividends can be paid.
q For both common and preferred shares, putable shares are less risky and callable shares are more risky
compared to shares with neither option.
q Putable shares are less risky because if the market price drops, the investor can put the shares back to the
firm at a fixed price (assuming the firm has the capital to honor the put). Because of this feature, putable
shares usually pay a lower dividend yield than non-putable shares.
q Callable shares are the most risky because if the market price rises, the firm can call the shares, limiting the
upside potential of the shares. Callable shares, therefore, usually have higher dividend yields than non-
callable shares.

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CHAPTER ONE: OVERVIEW OF EQUITY SECURITIES
1.4: EQUITY INVESTMENTS RISK & RETURN
q Equity capital is used for the purchase of long-term assets, equipment, research and development, and
expansion into new businesses or geographic areas.
q Equity securities provide the firm with “currency” that can be used to buy other companies or that can be
offered to employees as incentive compensation. Having publicly traded equity securities provides liquidity,
which may be especially important to firms that need to meet regulatory requirements, capital adequacy
ratios, and liquidity ratios.

1.5: MARKET VALUE VERSUS BOOK VALUE

q The primary goal of firm management is to increase the book value of the firm’s equity and thereby increase
the market value of its equity.
q The book value of equity is the value of the firm’s assets on the balance sheet minus its liabilities. It increases
when the firm has positive net income and retained earnings that flow into the equity account. When
management makes decisions that increase income and retained earnings, they increase the book value of
equity.
q The market value of equity is the total value of a firm’s outstanding equity shares based on market prices and
reflects the expectations of investors about the firm’s future performance. Investors use their perceptions of
the firm’s risk and the amounts and timing of future cash flows to determine the market value of equity.
q The market value and book value of equity are seldom equal. Although management may be maximizing
the book value of equity, this may not be reflected in the market value of equity because book value does
not reflect investor expectations about future firm performance.
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CHAPTER ONE: OVERVIEW OF EQUITY SECURITIES
1.6: COST OF EQUITY, RETRUN ON EQUITY, & REQUIRED RETURN
1.6.1: Return on Equity

q Accounting return on equity is used to determine management efficiency, usually referred to simply as the
return on equity (ROE). ROE is calculated as net income available to common (net income minus preferred
dividends) divided by the average book value of common equity over the period:

q Alternatively, ROE is often calculated using only beginning-of-year book value of equity (i.e., book value of
equity for end of year t − 1):

q The first method is more appropriate when it is the industry convention or when book value is volatile. The
latter method is more appropriate when examining ROE for a number of years or when book value is stable.
q Higher ROE is generally viewed as a positive for a firm, but the reason for an increase should be examined.
For example, if book value is decreasing more rapidly than net income, ROE will increase. This is not,
however, a positive for the firm. A firm can also issue debt to repurchase equity, thereby decreasing the book
value of equity. This would increase the ROE but also make the firm’s shares riskier due to the increased
financial leverage (debt).

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CHAPTER ONE: OVERVIEW OF EQUITY SECURITIES
1.6: COST OF EQUITY, RETRUN ON EQUITY, & REQUIRED RETURN
1.6.2: Cost of Equity
q A firm’s cost of equity is the expected equilibrium total return (including dividends) on its shares in the market.
It is usually estimated in practice using a dividend discount model or the capital asset pricing model.
q At any point in time, a decrease in share price will increase the expected return on the shares and an
increase in share price will decrease expected returns, other things equal.
q Because the intrinsic value of a firm’s shares is the discounted present value of its future cash flows, an
increase (decrease) in the required return used to discount future cash flows will decrease (increase) intrinsic
value.

1.6.3: Required Return

q Investors also estimate the expected market returns on equity shares and compare this to the minimum return
they will accept for bearing the risk inherent in a particular stock.
q If an investor estimates the expected return on a stock to be greater than her minimum required rate of
return on the shares, given their risk, then the shares are an attractive investment.
q Investors can have different required rates of return for a given risk, different estimates of a firm’s future cash
flows, and different estimates of the risk of a firm’s equity shares.
q A firm’s cost of equity can be interpreted as the minimum rate of return required by investors (in the
aggregate) to compensate them for the risk of the firm’s equity shares.

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