Finance – 1

Session 15

Any Questions?

Behavioral Finance, Netscape IPO, Review

K Kiran Kumar
Behavioral finance is a field of financial thought that examines investor
behavior and how this behavior affects what is observed in the financial
markets. The behavior of individuals, in particular their cognitive biases,
has been offered as a possible explanation for a number of pricing
anomalies.

Behavioral Finance versus Traditional Finance

Behavioral Finance
Assumes:
• Investors suffer from
cognitive biases that may lead
to irrational behavior /
decision making.
• Investors may overreact or
under-react to new
information.
Traditional Finance
Assumes:
• Investors behave rationally.
• Investors process new
information quickly and
correctly.
The Behavioral Challenge
 Rationality
 People are not always rational.
 Many investors fail to diversify, trade too much, and seem to
lose by selling winners and holding losers.

 Deviations from Rationality

 Psychologists argue that people deviate from rationality in
predictable ways:
Loss Aversion
 Behavioral Biases

Representativeness: investors assess outcomes depending on how similar they are

to the current state. drawing conclusions from too little data
Gambler’s fallacy: recent outcomes affect investors’ estimates of future
probabilities.
Mental accounting: investors keep track of the gains and losses for different
investments in separate mental a/cs.
Conservatism: investors tend to be slow to react to changes.
Disposition effect: investors tend to avoid realizing losses but, rather, seek to
realize gains.
Narrow framing: investors focus on issues in isolation.

The basic idea behind the noted behavioral biases is that investors are humans
and, therefore, imperfect and that the beliefs they have about a given asset’s
value may not be homogeneous. These behaviors help explain observed pricing
anomalies.
 Information Cascades
• Herding is clustered trading that may or may not be based on
information. A participant’s trading decision does not necessarily
influence the decisions of others.

Informed Uninformed
Release of
1 2 traders 3 traders imitate
information
trade informed traders

• An information cascade is the transmission of information from those

participants who act first and whose decisions influence the decisions of
others. Information cascades may result in serial correlation of stock
returns, which is consistent with overreaction anomalies.

• Are information cascades rational? If the informed traders act first and
uninformed traders imitate the informed traders, this behavior is
consistent with rationality. The imitation trading by the uninformed
traders helps the market incorporate relevant information and improves
market efficiency. The empirical evidence is consistent with the idea
that information cascades are greater for a stock when the information
quality regarding the company is poor.
 Implications for Corporate Finance
 If information is reflected in security prices quickly, investors should
only expect to obtain a normal rate of return.
 Awareness of information when it is released does an investor little
good.The price adjusts before the investor has time to act on it.
 Firms should expect to receive the fair value for securities that they
sell.
 Fair means that the price they receive for the securities they issue is the
present value.
 Thus, valuable financing opportunities that arise from fooling investors
are unavailable in efficient markets.
 Netscape Communications

Does fundamentals support $1 billion

for a loss-making company
with a book value of $6 million?

Problems associated with the valuation of small, rapidly-growing high-

tech stocks when few comparable firms to benchmark against.
Netscape IPO – Prospectus -> $14.0
 Netscape Communications Corporation
 Founded in April 1994
 Business – Comprehensive line of client, server, and integrated
applications software for communications and commerce on the
internet and private Internet Protocol (IP) networks
 Financial Highlight – Losses of $4.3 million on total revenues
worth $16.6 million during the first two quarters
Entrance in the Internet Market
(December 1994)
 It entered through its flagship browser, Netscape Navigator
 Netscape’s Strengths at this time –
1. Original Mosaic Code – by paying $2.4 million
2. Jim Clark’s Management Experience
3. $3 Million in Seed Money
4. Mark Andreessen’s Technical Expertise – creator of Mosaic
 Challenges at this time –
1. It had to set a new industry standard – immediate concern
2. It had to make money
Competitors and Market Leadership
 Netscape – Market leader in the Internet Browser market
with a 75 % market share by mid 1995
 Nearest Competitors
1. Spyglass – owner of Mosaic
2. Microsoft –Windows
3. AOL and Prodigy – transformation from online platform
to internet platform (market)
Objective of Netscape’s IPO
 Increasing Global Competition
 To fund expected future growth – Investment in R&D
 To stockpile cash reserves for potential acquisitions
 To gain visibility and credibility within the industry
 To sustain in this dynamic and nascent market
General Options to Capitalize

• A private equity transaction

• Another debt transaction
• A public equity transaction – IPO
• Joint venture with another firm
Fund Raising at Different Stages of a Life Cycle
Investors and Instrument issued depend on the option and the stage of lifecycle
Depository Shares
Receipts with
the underlying Strategic
Foreign being Shares Investment
Currency Bond
Depository convertible into
ADR Customer, Supplier,
Receipts with Shares Competitor
the
underlying US QIB
FCCB
being Shares

GDR Hedge Funds and FIIs

Shares

Shares / PCD
QIP FII
/ FCD

Rights QIB
Shares Issue
Shares /
Warrants / Follow-on
Public Existing Shareholders
FCD / PCD
Issue
Private FIIs, FI, Banks, Insurance Cos, MF,
Shares Placement HNI, Individuals including NR

IPO Promoters, Financial Investor,

Shares Strategic Investor
Warrants /
Private FIIs, FI, Banks, Insurance Cos, MF,
Shares
Equity HNI, Individuals including NR
Venture
Private Equity investors
Shares Capital IPO: Initial Public Offer

Seed Venture Capitalist QIP: Qualified Institutions Placement

Capital GDR: Global Depository Receipts
Personal Contribution, FCCB: Foreign Currency Convertible Bond
Family, Friends, Angel
Investors ADR: American Depository Receipts
Benefits of Listing
Benefits Description

 Indian Stock Exchanges have a high number of listed companies and provide significant liquidity
High Liquidity and Depth
 Additional recognition in case of presence in Sensex/ Nifty/ Index constituents

Flexibility for future

capital raising  Multiple choice: QIP, Rights, Follow-on public issue, GDR, ADR, FCCB
opportunities

 Sharing history, business operations, strategy and growth plans helps develop franchise value
Establishes profile  Enables branding and customer awareness; provides access to retail investors; lenders have higher
comfort with listed entities

Positive impact on  Greater awareness amongst research analysts, fund managers, investment advisors
valuation  Creates greater liquidity and market if part of the derivatives segment

 Ability to create wealth for promoters and shareholders

Wealth creation
 Provides a benchmark for Company valuation

 Ability to create currency for strategic initiatives

Creation of currency
 Leverage as currency for M&A, alliance etc.

 Ability to serve HR initiatives; serves as an incentive mechanism for management and employees e.g.:
Employee incentivization ESOS/ ESPS
 Mechanism for tracking management performance
Costs of going public!
 Costs of reporting
 Filing quarterly and annual reports to SEBI & SEs
 Compliance with SEBI / Govt → expensive for SMEs
 Disclosure and auditing
 Mgmt may not like the idea of reporting operating
data,
 Holdings of insiders is known → they mayn’t like it
 Self-dealings of insiders is hard to arrange
 Payment of high salaries, personal transactions with
the business (such as a leasing arrangement), and
not-truly-necessary fringe benefits.
Costs of going public!
 Inactive market/low price.
 For small firms with infrequent trading, the market price
may not represent true value.
 Security analysts and stockbrokers simply will not
follow the stock <== there will not be sufficient trading
activity to generate enough brokerage commissions to
cover the costs of following the stock.
 Investor relations.
 Public companies must keep investors abreast of current
developments.
 Many CFOs of public firms spend two full days a week
talking with investors and analysts.
 Takeover threat from hostile bidders (control)
 Managers who do not have voting control must be
concerned about maintaining control.
 There is pressure on such managers to produce
annual earnings gains, even when it might be in the
shareholders’ best long-term interests to adopt a
strategy that reduces short-term earnings but raises
them in future years. (Short-termism)
 Potential shareholder lawsuits
 Very expensive transaction
IPO Process
 Underwriter is to be chosen (an important decision!)
 Begins with an initial prospectus, an initial price range ($12 – 14 in
this case) and an initial range for no. of shares to offer (3.5 million in
this case)

 Road shows to stimulate the interest in the stock!

 Both UW and mgmt make presentations to investors
 An order book of indications of interest is assembled (Grey market)➔ used to
help establish a final offering price!
 Distribution takes place through syndicate of IBs
 Underwriters usually make a market in the stock
 Assigns analysts to track the stock
 Provide liquidity support for initial period
Key Parties and Responsibilities for an IPO
Intermediary Structure

Book Runners’
BRLM Broker / Syndicate
Legal Counsel

Legal IPO Grading Advertising

Registrars Bankers Printers
Counsels Agency Agency

Issuer Company /
Selling Shareholder
Arrangement
Coordination
Role Played By Book Running Lead Manager
 Suggesting optimal Capital structure for the Company

 Appropriately positioning the Company vis-à-vis its peers

 Advising on all critical aspects related to the Issue

 Overall transaction management responsibility

 Navigating transaction strategy, including structuring, timeline and execution

 Conducting due-diligence and participating in the Drafting sessions

 Co-ordination with all parties involved in the transaction; liaison with SEBI
and Stock Exchanges

 Issue marketing, including co-ordination of Research briefing and

management road shows

 Managing the Book, advice on pricing and allocation and assisting in post-
issue management
 Netscape IPO
The Investment bankers and Underwriters determined the price
@ $14 per share for the public issue of 3.5 million shares

Road show – The underwriters inferred the demand for

Netscape’s share to be very high

Thus, they proposed to the management to issue 5 million shares

at a price that was 100 % higher

Board’s dilemma: To justify the proposed increase in price by

100%; Proposed valuation to $1B from book value of $16mlns
Risks Associated with Over Valuation
 Dynamic Internet Browser Industry
 Industry at nascent stage – Difficult to predict the future
 Negative Bottomline - Netscape was yet to earn a profit
 Public reaction was very uncertain
 ‘Hot Issue’ IPO Market – Historical pricing of IPO issues
 Enthusiasm in the Wall Street
Can recommended $28 price per share justified!
 There is precious little to go on as far as valuation
analysis is concerned!
 There are few true comparables to Netscape, and
 Netscape had negative earnings and OCF at the time of offering
(Case exhibit 3)

 Let us resort to the DCF approach using assumptions,

which is patterned after Microsoft’s operating history.
 Build a valuation model and carryout the sensitivity analysis
with sales growth as variable.
Brief Overview / Review of Fin-1
 S1 -- Firm Value Max ;Financing, Investment and Dividend Decisions;
 S2 -- Accounting to Finance view; NOPAT, FCF, ROIC, EVA, MVA,
 S3 -- Financial Planning and Forecasting; AFN formula –Tire City case
 S4 -- Tire City Contd… Forecasting Financial Statements
 S5 --Working Capital – Credit terms – Multitech exercise
 S6 --Working Capital – CCC -Dell case – Efficient use of WC →Fuel
 S7 -- Time Value of Money – Various streams of cash flows
 S8 -- Bond Valuation –YTM, Interest rate sensitivity
 S9 -- Stock Valuation – DCF approach – Forecasting FCF --Ranger Sports
 S10n11-- Overview of Financial System & Markets –Market Structure of NSE
 S12 -- Risk – Return – Portfolios
 S13 -- Portfolio diversification – Beta -- Relevant risk of stock -- CAPM
 S14 -- Market Efficiency – various forms; Techinical Analysis TrdStrategy
 S15 -- Behavioral Finance – Anomalies - Netscape IPO -- Review
At Market Equilibrium: Intrinsic Value = Market Price
End Term Exam format
 Part A ~ approx. 30% weight ~ conceptual questions with fill up blanks
 Part B ~ approx. 70% weight ~ Short problems / exercises
 No comprehensive problems / exercises
 Duration about 120minutes
 Total Max Marks :80

 Good luck n See you in Finance Electives ☺