Chapter 3- Equity Markets

Key Concepts

In session three, the focus is on understanding the key concepts related to shares of stock and the
differences between debt securities (bonds) and equity securities (shares). Here's a detailed summary of
the main points covered:

Shares of Stock:

 A share of stock represents ownership in a corporation and entitles the shareholder to a

proprietary interest in the equity stock of the company.

 Shareholders have ownership rights in the company and participate in its profits. These profits
are distributed as dividends, allocated based on the number of shares held.

 Share certificates are created during the origin of the corporation when its articles are filed with
the appropriate authority (e.g., Companies House in the UK, Secretary of State in the US). These
articles outline shareholders' rights, including voting rights and management influence.

 Companies may issue more shares to raise capital as they grow, expanding the shareholder base
and increasing the number of shares in circulation.

 Moving from private ownership to public ownership involves listing the company on an
exchange, marking a significant transition in its lifecycle.

Shareholder Control:

 Shareholders exercise control over the company through voting procedures. In the US, public
companies are required to hold Annual General Meetings (AGMs) where shareholders vote on
matters such as appointing the board of directors, executive compensation, and
social/environmental issues.

 Shareholders may influence decisions related to raising capital, mergers, acquisitions, or

takeovers.

Differences between Debt and Equity:

1. Ownership:

 Debt holders (bondholders) have no ownership interest and lack voting rights.

 Shareholders have an ownership interest and can exercise control through voting
procedures.

2. Tax Treatment:

 Interest payments to debt holders are tax-deductible for the company.

 Dividends paid to shareholders are not tax-deductible for the company.

3. Longevity:
  Debt has a specific term and must be repaid at maturity.

 Shares represent a perpetual ownership, and there's no obligation to repay the initial
investment.

4. Return Risk:

 Debt holders know in advance the cash flows they will receive; their payments are
predetermined.

 Shareholders receive a share of company profits but are exposed to uncertain earnings,
making their returns less predictable.

5. Credit Risk:

 Debt holders have legal recourse and can exert control if the company defaults on
payments.

 Shareholders can't force the company to pay dividends and must wait for improved
financial circumstances.

The differences between debt and equity play a significant role in shaping a company's capital structure
decisions and impact how investors perceive and value these securities.

The concepts discussed highlight the fundamental characteristics of shares of stock, their ownership
rights, control mechanisms, and key differences between equity and debt securities in terms of tax
treatment, longevity, return risk, and credit risk. These factors are crucial in understanding the choices
companies make in raising capital and the considerations investors take into account when investing in
different types of securities.

Equity Markets
In this presentation, two methods for valuing equity, the Direct Approach (Dividend Discount Model or
DDM) and the Indirect Approach (Discounted Cash Flows or DCF), are discussed in detail.

Direct Approach (Dividend Discount Model - DDM):

 The direct approach involves valuing a share certificate by estimating the present value of
expected dividends.

 Share value is calculated as the present value of anticipated dividend payments to shareholders
or owners of the share.

 Dividends represent the cash flows distributed to shareholders.

 P0=current market price for a share

¿1=total dividends paid per

shareof stock at the end of the
year

r E=equity cost of capital for the stock ,

whichis the expectedreturnof other

investments available ∈the market

with equivalent risk ¿ the firm’ s
shares g=growth rate of dividend

Indirect Approach (Discounted Cash Flows - DCF):

 The indirect approach values the entire firm or enterprise based on the present value of cash
flows generated.

 Firm value is determined by considering cash flows generated by the business.

 Liabilities (e.g., debt, leases) are deducted from the firm value, and the remaining value belongs
to shareholders.

 Share value is then derived by dividing the residual value by the number of shares.

Estimating Dividend Payments:

 Estimating future dividend payments is crucial for valuing shares.

 Three approaches are discussed to address this challenge:

1. Assuming a constant dividend stream over time, treating it as a perpetuity.

2. Assuming a constant growth rate in dividend payments, similar to valuing a growing

perpetuity.

3. Utilizing known dividend information for the near future and assuming a constant or
growing dividend stream thereafter.

Valuing Shares Based on Assumptions:

 The value of a share is calculated based on the chosen assumption and dividend forecast.
  If dividends are assumed constant, share value equals the constant dividend divided by the cost
of equity.

 If dividends are assumed to grow at a constant rate, share value follows the formula for a
growing perpetuity.

 The third approach involves forecasting dividends for a specific period and assuming constant or
growing dividends thereafter

Equity Valuation
This section delves into the valuation of equity using the Dividend Discount Model (DDM) and its
practical applicability, along with its implications for understanding market behavior and determining
market valuation.

Applicability of DDM Model:

 The DDM model, which values shares based on expected dividends, has limitations and is most
suitable for companies with stable and constant dividend streams.

 Companies that can pay constant dividends must have a stable earnings stream, making them
mature and unlikely to experience significant growth.

 Examples include power generation and utility companies, where steady demand leads to stable
earnings and transparent dividends.

Challenges with DDM Model:

 The DDM model faces difficulties when applied to most companies, especially those with volatile
earnings.

 Determining future dividends becomes complex due to managerial discretion in dividend payout
policies.

 Companies not paying dividends or those with uncertain future dividends, such as Microsoft and
Apple, pose challenges for using the DDM model.

Market-Level Use of DDM:

  The DDM model finds value when assessing the entire market to gauge whether it is over or
undervalued.

 At the aggregate market level, earnings and dividend streams are more stable, enabling better
estimation of DDM model inputs.

 Equity strategists use the DDM model to analyze market valuation and determine if the market
is overvalued or undervalued.

Market Volatility Explanation:

 The DDM model is employed to explain market volatility by examining the relationship between
market price and required rate of return (cost of equity).

 Changes in the required rate of return, influenced by perceived risk and investor sentiment,
impact market prices significantly.

 The model demonstrates how small changes in the required rate of return can lead to
substantial shifts in market prices.

Market Valuation and Equilibrium:

 The DDM model aids in assessing whether the market is fairly valued or not.

 Dividend yield plus the growth rate equals the required rate of return for the market to be in
equilibrium.

 Comparison of historical market returns with the required rate of return helps determine if the
market is fairly valued.

 Different explanations, such as mis-measured dividends, changes in perceived risk, or market

overpricing, can account for variations in market valuation.

In summary, the DDM model serves as a valuable tool to understand market behavior, assess market
valuation, and determine whether the market is over or undervalued. While its direct application to
individual companies might be limited, its use in evaluating the overall market provides insights into
market dynamics and equilibrium.

Case Study: Shiller and Siegel

This section presents a case study involving the viewpoints of Robert Shiller and Jeremy Siegel on
whether the market is overpriced. The discussion revolves around the use of the price-to-earnings (PE)
ratio and its modified version, the cyclically adjusted PE ratio (CAPE), to assess market valuation.

PE and CAPE Ratios:

 The PE ratio, preferred by these analysts, is calculated as the price of a stock divided by its
earnings per share (EPS).

 Shiller introduces the CAPE ratio, which uses the average of the past ten years' earnings to
smooth out year-to-year volatility.
  CAPE ratio aims to provide a better measure of valuation by considering long-term earnings
trends.

k× E
P = r E−g

Where k is a value less than

1 therefore k * E =Dividend

Shiller's Arguments:

 Shiller's focus on the CAPE ratio emphasizes long-term earnings trends and averages.

 He argues that the cyclically adjusted earnings are more stable and representative of a
company's true earning power.

 Shiller's CAPE suggests that the market is overpriced, as the ratio is currently elevated due to
past economic crises affecting earnings averages.

Siegel's Rebuttals:

 Siegel questions the CAPE ratio's validity, suggesting that it is biased by including periods of
depressed earnings during crises.

 He highlights that companies tend to write down assets during downturns, further affecting
CAPE.

 Siegel argues that recent shifts in corporate behavior, including increased investment and
retained earnings, could lead to higher future growth and support higher valuations.

Company Behavior and Equilibrium PE:

 Siegel contends that recent trends of increased investment and retained earnings should lead to
faster future growth, potentially elevating the equilibrium PE ratio.

 This perspective aligns with Siegel's bullish outlook on the market.

Additional Considerations:

 The case study delves into finer points related to index aggregation and its relationship with
economic earnings, although recent research suggests this has a minor impact on the overall
argument.

Shiller vs. Siegel's Views:

 Shiller, known as the "bear," suggests that the market is overvalued based on the elevated CAPE
ratio.
  Siegel, the "bull," counters Shiller's argument, emphasizing recent corporate behavior and
potential for higher future growth to support market valuations.

The case study underscores the complexities of market valuation, the role of different valuation metrics,
and the importance of considering long-term trends and economic conditions. It highlights the
contrasting viewpoints of Shiller and Siegel and their interpretation of market valuation based on the PE
and CAPE ratios.

Equity Market Overview

This section provides an overview of equity markets, focusing on common stock features, preferred
stock characteristics, market indices, and the construction of the FTSE 100 index.

Features of Common Stock:

 Common stockholders have voting rights, exercised at shareholder meetings like AGMs.

 Proxy voting allows delegation of voting decisions to proxies, with fund managers becoming
more active in pursuing investor interests.

 Some firms have different classes of common stock with varying voting rights.

 Shareholders share in dividends and assets during liquidation.

 Pre-emptive rights give existing shareholders the option to buy new stock issues first.

 Dividends are not a liability until declared by the Board and are paid out of post-tax earnings.

Preferred Stock:

 Preferred stock is a hybrid of debt and equity.

 Payments are similar to dividends but stated in advance, e.g., 7% preferred stock.

 Dividends are paid out of profits and may be rolled over if earnings are insufficient.

 Preferred stockholders lack voting rights but have priority in liquidation over common
stockholders.

Market Indices and FTSE 100:

 Market indices track equity market performance.

 FTSE 100 represents the largest 100 UK companies based on market capitalization.

 FTSE 100 was established in 1984, with its value set at 1,000 and rebalanced every six months.

 Price index reflects price returns, while the total return index includes reinvested dividends.

 Dividends significantly contribute to historical stock market returns.

In summary, the section covers the characteristics of common and preferred stock, their voting rights,
dividends, and other rights. It also explains market indices and the construction of the FTSE 100,
highlighting the importance of dividends in stock market returns.
IPO Casestudy

This detailed explanation delves into the process of private markets and Initial Public Offering (IPO),
covering primary markets, reasons for going public, costs and benefits, the decision-making process, and
the intricate steps involved in an IPO.

Primary Markets and Going Public:

 The transition from private to public ownership marks a significant milestone for a company.

 Going public involves moving from privately held shares to publicly traded shares on an
exchange.

 Positive reasons for going public include providing an exit strategy for large shareholders,
accessing more capital, increasing company value, and improving liquidity.

Costs and Considerations:

 Going public has costs such as listing expenses and increased reporting standards.

 Public companies face greater transparency requirements and increased accounting costs.

 Public ownership can shift managerial focus towards short-term results, potentially detracting
from long-term goals.

 Paradoxically, public companies might experience reduced scrutiny and monitoring from small
shareholders.

Process of Going Public:

1. Appointment of Sponsor: A sponsor (lead underwriter) is chosen, often an investment bank, to

facilitate the IPO process.

2. Firm Commitment Underwriting: Over 90% of IPOs use firm commitment underwriting, where
the sponsor ensures all shares are sold.

3. Gross Spread and Syndicate: Underwriters' compensation comes from the gross spread, a
percentage of the total funds raised. A syndicate of underwriters may share the responsibility.

4. Registration Document and Prospectus: A registration document with a provisional prospectus

is filed with the regulatory authority (UKLA or SEC). The prospectus contains essential
information for potential investors.

5. Building Demand (Book Building): Sponsors present the provisional prospectus to potential
investors, attempting to generate demand for the shares.

6. Effective Date: The date when shares will be offered to the market, typically 2-3 weeks after
registration.

7. Intensive Book Building: Sponsors conduct roadshows to create demand and build a book of
potential investors.
 8. Price Determination: On the day before the offer day, the official price is determined after
discussions between the company and sponsor.

9. Offer Day: Orders are collected from potential investors based on the book built during the
intensive phase.

10. Allocation and Collection: Shares are allocated based on demand, and the money collected
from investors is passed to the company.

11. Sponsor's Role Post-IPO: Sponsors may engage in price stabilization, trading shares on the
market for up to 3-6 months after the IPO to ensure price stability.

The primary market process concludes with the company raising new capital through the sale of shares
to the public. The sponsor's role continues beyond the IPO date as they assist in maintaining share price
stability and market trading. This comprehensive overview highlights the intricate steps and
considerations involved in transitioning from private to public ownership through an IPO.

Reasons for Rights Issue

Reasons for Rights Issue: A rights issue is a method used to raise additional capital for a company
through the issuance of new shares. This approach is popular in the UK and Europe but less common in
the US. It enables a company to offer new shares to its existing shareholders, maintaining their
proportionate ownership and minimizing dilution. The process is effective and cost-efficient for
seasoned equity offerings.

Advantages of Rights Issue:

1. Lower Issuance Cost: Utilizing existing shareholders as the distribution mechanism reduces the
need for extensive book-building and finding new investors, thereby lowering issuance costs.

2. Pre-emptive Rights: In the UK, new share issuances must be offered to current shareholders in
proportion to their existing ownership. A rights issue satisfies this pre-emptive rights
requirement.

Understanding the Concept:

 A critical concept in rights issues is that new shares are sold at a discount to the current share
price, which may seem counterintuitive but does not destroy value.

 The objective is to ensure that existing shareholders have the incentive to exercise their rights
and purchase the new shares at a discount to avoid diminishing the value of their portfolios.

 Over time, the rights themselves have become tradable, enabling existing shareholders to sell
their rights in the market if they choose not to exercise them.

Illustrative Example: Consider a scenario where a company aims to raise $10 million in capital for a
specific project, selling new shares at a discount to the current share price of $25. The company must
issue 500,000 new shares to achieve this.

Calculations:
 1. Rights Per Share: To offer new shares proportionately to current ownership, shareholders need
10 rights to purchase 1 new share (5 million existing shares divided by 500,000 new shares).

2. Maintaining Value: The value of the firm after the rights issue should be equal to the value
before the issue to prevent value destruction.

 Before the issue: 5 million shares * $25/share = $125 million

 After raising $10 million: Firm value = $135 million

 Post-issue shares: 5.5 million shares (5 million + 500,000 new shares)

 Expected share price after rights issue = $135 million / 5.5 million shares ≈ $24.54/share

3. Value of Rights: The value of a right is calculated by maintaining the value balance.

 Share value before rights issue: $25/share

 Share value after rights issue: $24.54/share (calculated)

 Difference: $25 - $24.54 = $0.46/share

 The value of a right = $0.46/share, as it bridges the value gap caused by the discount.

Confirmation of Value:

 The value of a right is verified by assessing how one could acquire shares at the discounted
price.

 To buy 1 share at $20/share (discounted price), an investor needs 10 rights (10 * $0.46 = $4.60)
and $20 for the share itself, totaling $24.60.

 This matches the market price of $24.54 after the rights issue, confirming the consistency of the
valuation.

In summary, a rights issue allows a company to raise capital by selling new shares at a discount to
existing shareholders. Despite the initial discount, the process ensures that value is maintained, and the
rights themselves can be traded, enhancing flexibility for shareholders.