Pinto, J. E. (2020) - Equity asset valuation - Chapter 1 pg 2-15 & 21-30

Question 1

What are the learning outcomes for this chapter on equity securities?

Answer 1

Describe characteristics of types of equity securities. Describe differences in voting rights and other ownership characteristics among different equity classes. Distinguish between public and private equity securities. Describe methods for investing in non-domestic equity securities. Compare the risk and return characteristics of different types of equity securities. Explain the role of equity securities in financing a company’s assets. Distinguish between the market value and book value of equity securities. Compare a company’s cost of equity, return on equity, and investors’ required rates of return.

Question 2

What role do equity securities play in investment analysis and portfolio management?

Answer 2

Equity securities represent a significant portion of many individual and institutional portfolios. The allocation of equity affects the risk and return characteristics of the entire portfolio. Different equity types affect ownership claims on a company’s net assets and influence risk and return. Understanding equity securities’ features is crucial for valuation and market pricing.

Question 3

What are the types of equity securities discussed in this chapter?

Answer 3

Common shares, Preference shares, Convertible preference shares, Private equity securities, Depository receipts.

Question 4

What distinguishes common shares from preference shares?

Answer 4

Common shares represent ownership claims with voting rights and a claim on net assets. Preference shares give priority for dividends but may lack voting rights.

Question 5

What are convertible preference shares, and why are they used by unseasoned companies?

Answer 5

Convertible preference shares can be converted into common shares. They are often used by highly risky or unseasoned companies to raise equity funding with lower initial risk for investors.

Question 6

What are depository receipts, and why are they significant?

Answer 6

Depository receipts represent ownership of foreign securities. They provide a way to invest in non-domestic equity securities with easier access to foreign markets.

Question 7

What are the key risk factors involved in investing in equity securities?

Answer 7

Market volatility, Economic fluctuations, Company-specific risks, Political risks, Currency risks for foreign equity investments.

Question 8

How do equity securities create company value?

Answer 8

Equity securities raise capital for the company and reflect the company’s ownership structure, driving governance, financial decisions, and potential future profits.

Question 9

What is the relationship between a company’s cost of equity, return on equity, and investors’ required rate of return?

Answer 9

Cost of equity is the return required by equity investors. Return on equity is the company’s actual earnings relative to its equity. Investors’ required return reflects the risk-adjusted rate they expect for investing in the company.

Question 10

What does Exhibit 1 in the chapter illustrate about global equity markets?

Answer 10

Exhibit 1 shows the contribution of countries/regions to global GDP and market capitalization. US equity markets contribute 51% of global market capitalization but only 25% of global GDP. This highlights the overrepresentation of the US in global equity markets.

Question 11

What is the importance of analyzing equity securities from a global perspective?

Answer 11

Understanding the global equity market can help assess whether a market or region is under- or over-valued. As markets outside the US develop, their capitalization is expected to better reflect their GDP contribution.

Question 12

What are the top 3 equity markets based on total market capitalization as of 2017?

Answer 12

1. NYSE Euronext (US), 2. NASDAQ OMX (US), 3. Japan Exchange Group.

Question 13

What was the trend in the US equity market after the 2008 financial crisis?

Answer 13

The market capitalization to GDP ratio of the US fell to 59%, significantly lower than its long-run average of 79%.

Question 14

What does Exhibit 2 in the chapter show about global equity markets?

Answer 14

Exhibit 2 ranks global equity markets by market capitalization, trading volume, and number of listed companies. The US markets dominate in capitalization, but the China markets show significant growth potential.

Question 15

What does Exhibit 3 compare in terms of returns?

Answer 15

Exhibit 3 compares real returns (adjusted for inflation) on equities, government bonds, and bills in 21 countries between 1900–2017. Equities generally outperform government bonds and bills, with a world average return of 5.2%.

Question 16

What is the relationship between risk and return in equity securities compared to government bonds and bills?

Answer 16

Equity securities have higher risk levels compared to government bonds and bills. To compensate for these higher risks, they earn higher rates of return and tend to be more volatile over time.

Question 17

What factor influences equity ownership in different countries, and what trend has been observed?

Answer 17

Equity ownership is influenced by the level of risk tolerance among investors in different countries. A trend observed is a decline in share ownership in many countries due to global economic uncertainty and equity market volatility.

Question 18

What does Exhibit 6 show about equity ownership across different countries?

Answer 18

Exhibit 6 illustrates international differences in equity ownership. For example, South Korea had the lowest equity ownership (9.0%) from 2004–2014, while Australia and New Zealand had the highest (more than 20%).

Question 19

What are the two main ways companies finance their operations?

Answer 19

Companies can finance their operations by issuing debt or equity securities. The key difference is that debt is a liability and must be repaid, whereas equity represents ownership with no repayment obligation.

Question 20

What is the primary objective of investors in equity securities compared to debt securities?

Answer 20

Equity investors seek total return through capital appreciation and dividend income, while debt investors seek interest income.

Question 21

What rights do common shareholders have?

Answer 21

Common shareholders have ownership interest, voting rights in corporate governance, and a residual claim on assets in the event of liquidation. They may also receive dividends, though companies are not obligated to pay them.

Question 22

What is the difference between statutory voting and cumulative voting?

Answer 22

Statutory voting allows shareholders to vote once per share for each candidate, while cumulative voting allows shareholders to concentrate all their votes on one candidate, benefiting those with fewer shares.

Question 23

How do dual-share structures, such as in Viacom, affect voting rights?

Answer 23

In a dual-share structure, certain shares (e.g., Class A) may have more voting power than others (e.g., Class B). In Viacom’s case, Class A shares held by the founder’s family control over 70% of voting rights, despite Class B shares being more numerous.

Question 24

How do Viacom’s Class A and Class B shares differ?

Answer 24

Class A shares have voting rights, while Class B shares do not. Both classes share equally in dividends and liquidation rights, but Class A shares have more control over voting and corporate decisions.

Question 25

What is the conversion feature of Viacom's Class A shares?

Answer 25

Class A shares are convertible into Class B shares as long as there are at least 5,000 shares of Class A outstanding.

Question 26

What are the liquidation rights of Class A and Class B shares at Viacom?

Answer 26

In the event of liquidation, both Class A and Class B shareholders are entitled to share ratably in the assets, subject to the rights of preferred stock. Both classes receive the same $0.50 per share, but Class B shareholders receive an additional $1.00 per share before Class A shareholders.

Question 27

How do the voting rights in Ford Motor Company's Class A and Class B shares differ?

Answer 27

Ford's Class A shares hold 60% of the general voting power, while Class B shares hold the remaining 40%.

Question 28

What are the dividend and liquidation rights of Ford's Class A and Class B shares?

Answer 28

Both Class A and Class B shares share equally in dividends. In the case of liquidation, Class A shares receive the first $0.50 per share, Class B shares get the next $1.00 per share, and then both classes receive an equal share of remaining assets.

Question 29

What are Preference Shares?

Answer 29

Preference shares (or preferred stock) rank above common shares with respect to the payment of dividends and the distribution of the company’s net assets upon liquidation.

Question 30

What do Preference Shareholders lack?

Answer 30

Preference shareholders generally do not share in the operating performance of the company and do not have any voting rights, unless explicitly allowed for at issuance.

Question 31

How do Preference Shares compare to Debt Securities?

Answer 31

Similar to interest payments on debt securities, the dividends on preference shares are fixed and are generally higher than the dividends on common shares.

Question 32

What are Callable Preference Shares?

Answer 32

Preference shares can be callable or putable, allowing the issuer to buy back the shares or the holder to sell them back at a predetermined price.

Question 33

What are Cumulative Dividends?

Answer 33

Cumulative preference shares accrue unpaid dividends, which must be paid before dividends on common shares are paid.

Question 34

What are Non-Cumulative Dividends?

Answer 34

Non-cumulative preference shares do not accrue unpaid dividends, meaning any unpaid dividends are forfeited.

Question 35

What are Participating Preference Shares?

Answer 35

Participating preference shares entitle shareholders to receive the standard preferred dividend plus additional dividends if the company’s profits exceed a specified level.

Question 36

What are Non-Participating Preference Shares?

Answer 36

Non-participating preference shares only provide fixed dividends and the par value in the event of liquidation, without additional profit sharing.

Question 37

What are Convertible Preference Shares?

Answer 37

Convertible preference shares can be converted into common shares at a specified conversion ratio, allowing shareholders to share in the company's future profits.

Question 38

What are the Benefits of Convertible Preference Shares?

Answer 38

They provide higher dividends compared to common shares and allow investors to benefit from a rise in the price of common shares.

Question 39

What is Venture Capital?

Answer 39

Venture capital investments provide seed or start-up capital, early-stage financing, or mezzanine financing to companies in the early stages of development.

Question 40

What are Private Equity Investments?

Answer 40

Private equity securities are issued primarily to institutional investors via non-public offerings, with no active secondary market and limited liquidity.

Question 41

What is a Leveraged Buyout (LBO)?

Answer 41

A leveraged buyout occurs when a group of investors uses a large amount of debt to purchase all the outstanding common shares of a publicly traded company.

Question 42

What is a Management Buyout (MBO)?

Answer 42

A management buyout is a type of leveraged buyout where the investor group is primarily composed of the company's existing management.

Question 43

What is a Private Investment in Public Equity (PIPE)?

Answer 43

A PIPE transaction involves a public company seeking additional capital by selling a sizable ownership position to private investors at a discount.

Question 44

Can you provide an Example of a PIPE Transaction?

Answer 44

TapImmune Inc. raised $70 million through a PIPE transaction, issuing 17,500,000 shares of common stock at $4.00 per share.

Question 45

How has the Private Equity Market grown?

Answer 45

Private equity investments have grown considerably, with an increase in both the number of companies under private equity ownership and the size of investments.

Question 46

Why are Convertible Preference Shares popular in Private Equity?

Answer 46

Private equity firms are increasingly issuing convertible preference shares because they offer greater total return potential through dividends and conversion during an IPO.

Question 47

How does Private Equity compare to Public Equity?

Answer 47

Private equity is smaller in comparison to public equity, and private equity markets are less liquid, with no market-determined prices.

Question 48

How does Private Equity affect Corporate Governance?

Answer 48

Private equity firms may have lower corporate governance effectiveness, as public scrutiny and shareholder influence are reduced.

Question 49

6. RISK AND RETURN CHARACTERISTICS OF EQUITY SECURITIES

Answer 49

Different types of equity securities have different ownership claims on a company’s net assets. The type of equity security and its features affect its risk and return characteristics.

Question 50

6.1. Return Characteristics of Equity Securities

Answer 50

There are two main sources of equity securities’ total return: price change (capital gain) and dividend income.

Question 51

Total Return Formula

Answer 51

Total return, Rt = (Pt − Pt−1 + Dt)/ Pt−1

Question 52

For non-dividend-paying stocks, what constitutes the total return?

Answer 52

For non-dividend-paying stocks, the total return consists of price appreciation only.

Question 53

Why do companies in the early stages of their life cycle generally not pay dividends?

Answer 53

Because earnings and cash flows are reinvested to finance the company’s growth.

Question 54

What do companies in the mature phase of their life cycle typically do with excess cash flows?

Answer 54

They often return excess cash flows to investors via regular dividends or share repurchases.

Question 55

How does foreign exchange affect the total return for investors buying foreign shares?

Answer 55

Foreign exchange gains or losses arise from changes in the exchange rate between the investor’s currency and the currency that the foreign shares are denominated in.

Question 56

Example of ADR total return with exchange rate change,

Answer 56

If the total return for a Japanese company was 10%, and the yen depreciated by 10% against the US dollar, the ADR’s return would be approximately 0%. If the yen appreciated by 10%, the ADR’s return would be approximately 20%.

Question 57

Why is it important to consider reinvested dividends in total return?

Answer 57

Reinvested dividends are cash dividends that the investor receives and uses to purchase additional shares, significantly affecting long-term total returns.

Question 58

Impact of Reinvested Dividends on Total Return

Answer 58

Between 1900 and 2016, US$1 invested in US equities would have grown to US$1,402 with dividends reinvested, compared to just US$11.9 without reinvested dividends.

Question 59

Compounded Returns for Different Asset Classes

Answer 59

US equities with dividends reinvested showed a real compounded return of 6.4% per year, compared to 2.1% without dividends reinvested. Bonds had a 2.0% return and bills had 0.8%.

Question 60

6.2. Risk of Equity Securities

Answer 60

The risk of any security is based on the uncertainty of its future cash flows. The greater the uncertainty, the greater the risk and the more volatile the security’s price.

Question 61

How is risk of equity securities typically measured?

Answer 61

Risk is most often measured by calculating the standard deviation of the equity’s expected total return.

Question 62

What is one method for estimating an equity’s expected return and risk?

Answer 62

One method involves using the equity’s average historical return and the standard deviation of this return as proxies for future return and risk.

Question 63

Why are preference shares generally less risky than common shares?

Answer 63

Preference shares have fixed dividends, a portion of which accounts for a large portion of their total return. They also receive dividends and other distributions before common shareholders.

Question 64

What happens to common shareholders if the company is liquidated?

Answer 64

Common shareholders will receive whatever amount (if any) is remaining after the company’s creditors and preference shareholders have been paid.

Question 65

Risk and Return of Preference vs. Common Shares

Answer 65

Preference shares have lower risk and lower expected return than common shares due to less uncertainty about future dividends.

Question 66

Why are putable shares less risky than callable or non-callable shares?

Answer 66

Putable shares allow the investor to sell the shares to the issuer at a predetermined price, reducing uncertainty about future cash flows.

Question 67

What is the primary risk affecting all preference shares?

Answer 67

The primary risk for preference shares is the uncertainty of future dividend payments.

Question 68

Impact of Company’s Financial Health on Preference Shares

Answer 68

The more earnings and cash flow a company has, the lower the uncertainty and risk of paying future dividends.

Question 69

Risk of Callable Shares

Answer 69

Callable shares are riskier than non-callable shares because the issuer can redeem them at a predetermined price, limiting the investor’s future total return.

Question 70

Risk of Putable Preference Shares

Answer 70

Putable preference shares are less risky than non-putable preference shares because the investor can sell them back to the issuer at a predetermined price.

Question 71

Risk of Cumulative Preference Shares

Answer 71

Cumulative preference shares are less risky than non-cumulative preference shares because unpaid dividends must be paid before common shareholders can receive any dividends.

Question 72

1. What is the primary goal of companies issuing equity securities?

Answer 72

The primary goal is to raise capital to finance the company’s revenue-generating activities, increasing net income and maximizing shareholder wealth.

Question 73

2. How does raising capital affect a company's liquidity?

Answer 73

Raising capital increases liquidity, providing the company with additional resources, which can be used for acquisitions, employee stock options, and more.

Question 74

3. What is the book value of a company's equity?

Answer 74

The book value of equity is the difference between a company’s total assets and its total liabilities.

Question 75

4. How does a company increase its book value of equity?

Answer 75

By retaining net income, the company increases its equity, with more retained earnings contributing to the growth of its book value.

Question 76

5. What reflects the market value of a company’s equity?

Answer 76

The market value reflects investors' expectations about the company’s future cash flows, timing, and uncertainty.

Question 77

6. What is Return on Equity (ROE)?

Answer 77

ROE measures the profitability generated by equity capital invested by shareholders, calculated as: ROE = NI / Average BVE

Question 78

7. How is ROE calculated?

Answer 78

ROE = Net Income (NI) / Average Book Value of Equity (BVE). The average BVE is computed as (BVE beginning + BVE end) / 2.

Question 79

8. What is an alternative formula for ROE calculation?

Answer 79

ROE = Net Income (NI) / BVE at the beginning of the year (BVE−1).

Question 80

9. What can affect ROE calculations?

Answer 80

Accounting methods like depreciation or inventory methods can affect net income and the book value of equity, making comparisons difficult.

Question 81

10. What does a higher ROE indicate?

Answer 81

A higher ROE indicates that a company is effectively and efficiently using shareholder capital to generate profits.

Question 82

11. How does an increase in net income affect ROE?

Answer 82

If net income increases faster than equity, ROE will rise, indicating better use of equity to generate profits.

Question 83

12. Can an increasing ROE always be considered positive?

Answer 83

No, an increasing ROE could indicate increasing leverage, which might raise equity risk, or slower decreases in net income relative to equity.

Question 84

13. How does the DuPont formula help analyze ROE?

Answer 84

The DuPont formula breaks down ROE into three components: Profit margin, Asset turnover, and Financial leverage.

Question 85

14. What factors contribute to the market value of a company’s equity?

Answer 85

The market value is based on investors’ expectations regarding future cash flows and the company’s investment opportunities, as well as current operating decisions.

Question 86

15. How is market value of equity calculated?

Answer 86

Market value of equity is calculated by multiplying the market price per share by the number of shares outstanding.

Question 87

16. What is the price-to-book ratio?

Answer 87

The price-to-book ratio is the market price per share divided by the book value per share, indicating investors’ expectations about a company’s future cash flows.

Question 88

17. Why is the price-to-book ratio higher for certain companies?

Answer 88

A higher price-to-book ratio indicates that investors expect higher future growth opportunities for the company.

Question 89

18. What does a price-to-book ratio of more than 1.00 mean?

Answer 89

It means the market price per share exceeds the book value per share, indicating investors expect the company to have positive future growth opportunities.

Question 90

19. Why is it inappropriate to compare the price-to-book ratios of companies in different industries?

Answer 90

Different industries have varying growth expectations, so companies in high-growth industries tend to have higher price-to-book ratios.

Question 91

20. What is the intrinsic value of a company according to Warren Buffett?

Answer 91

Intrinsic value is the discounted value of future cash flows that can be taken from a business during its remaining life, estimating the company’s true value.

Question 92

21. How does intrinsic value differ from book value?

Answer 92

Book value reflects historical accounting decisions, while intrinsic value reflects the company’s potential for generating future cash flows.

Question 93

22. How does Warren Buffett explain the difference between book value and intrinsic value?

Answer 93

Buffett explains that book value is an understated measure, while intrinsic value, though subjective, is essential for evaluating investments.

Question 94

23. How does Buffett compare book value to a college education?

Answer 94

Buffett uses a college education as an analogy, where the cost (book value) must be compared to the future earnings (intrinsic value) that the education can generate.

Question 95

7.2. What is the cost of equity?

Answer 95

The cost of equity is the return that investors require for providing capital to the company. Unlike debt, there are no contractual payments, making it more difficult to estimate.

Question 96

7.2. How is the cost of equity estimated?

Answer 96

The cost of equity is estimated using models like the Dividend Discount Model (DDM) and the Capital Asset Pricing Model (CAPM), as the required return is based on the future, uncertain cash flows.

Question 97

7.2. What is the difference between the cost of debt and cost of equity?

Answer 97

The cost of debt is easy to estimate as it reflects the contractual interest payments on debt, while the cost of equity is uncertain and must be estimated based on investors' expected returns from future cash flows.

Question 98

7.2. What is the minimum required rate of return for investors?

Answer 98

The minimum required rate of return is the return investors expect to receive from the company’s debt or equity, reflecting their compensation for providing capital.

Question 99

7.2. How does the company’s cost of equity relate to investors' required rate of return?

Answer 99

The company’s cost of equity can be thought of as the minimum expected rate of return that it must offer its investors in the primary market and maintain in the secondary market.

Question 100

7.2. How does a change in share price affect the cost of equity?

Answer 100

If the share price falls, the cost of equity increases, as investors demand a higher return. This occurs when the company’s cost of equity doesn’t match investors' required rate of return.

Question 101

7.2. What happens if investors require a higher rate of return than the company’s cost of equity?

Answer 101

Investors would sell their shares and invest elsewhere, causing the company’s share price to decline. The cost of equity would then increase to meet the higher return that investors demand.

Question 102

7.2. What are two models used to estimate the cost of equity?

Answer 102

The Dividend Discount Model (DDM) and the Capital Asset Pricing Model (CAPM) are used to estimate the cost of equity and the investors' minimum required rate of return.

Question 103

7.2. What is the Capital Asset Pricing Model (CAPM)?

Answer 103

The CAPM calculates the cost of equity as: Cost of Equity = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)

Question 104

7.2. What is the Dividend Discount Model (DDM)?

Answer 104

The DDM estimates the cost of equity based on expected dividends and stock price growth, often represented as: Cost of Equity = (Dividend / Price) + Growth Rate

Question 105

7.2. What is the Weighted Average Cost of Capital (WACC)?

Answer 105

The WACC is the minimum required rate of return that a company must earn on its long-term investments to satisfy all providers of capital, including both debt and equity holders.

Question 106

7.2. What role does the cost of equity play in capital budgeting?

Answer 106

The cost of equity, along with the cost of debt, is used in the capital budgeting process to evaluate potential long-term investments and estimate the company’s WACC.

Question 107

7.2. What happens if the expected return on an investment is lower than the WACC?

Answer 107

If the expected return on an investment is lower than the WACC, the company should reject the investment because it won’t generate enough return to satisfy the capital providers.

Question 108

7.2. What is the relationship between the company's cost of equity and its share price?

Answer 108

If the company’s cost of equity increases, the share price declines. This is because the market adjusts to reflect the higher expected return required by investors.

Question 109

8. What is the primary role of equity securities?

Answer 109

Equity securities play a fundamental role in investment analysis and portfolio management by providing ownership interests in a company and offering potential for high returns.

Question 110

8. What are the types of common equity shares?

Answer 110

Common shares represent ownership in a company, giving investors a claim on its performance, voting rights, and a claim on assets in liquidation.

Question 111

8. What are callable common shares?

Answer 111

Callable common shares give the issuer the right to buy back the shares from shareholders at a price determined when the shares are issued.

Question 112

8. What are putable common shares?

Answer 112

Putable common shares give shareholders the right to sell the shares back to the issuer at a price specified when the shares are issued.

Question 113

8. What are preference shares?

Answer 113

Preference shares give priority in dividend payments over common shares, with certain preferences such as cumulative and non-cumulative dividends.

Question 114

8. What are cumulative preference shares?

Answer 114

Cumulative preference shares accrue unpaid dividends, which must be paid before dividends are paid to common shareholders.

Question 115

8. What are non-cumulative preference shares?

Answer 115

Non-cumulative preference shares do not accumulate unpaid dividends, meaning any missed payments are not owed in the future.

Question 116

8. What are participating preference shares?

Answer 116

Participating preference shares allow investors to receive standard preferred dividends plus a share of corporate profits above a pre-specified amount.

Question 117

8. What are non-participating preference shares?

Answer 117

Non-participating preference shares only receive standard preferred dividend and any accrued dividends in liquidation, without sharing in company's profits.

Question 118

8. What is role of private equity?

Answer 118

Private equity involves investing in companies not publicly traded, with goal increasing long-term value and potentially taking company public after meeting profit benchmarks.

Question 119

8. What are depository receipts?

Answer 119

Depository receipts represent an economic interest in a foreign company, allowing its shares to trade on an exchange outside its domestic market.

Question 120

8. What are American Depository Receipts (ADRs)?

Answer 120

ADRs are U.S dollar-denominated securities that trade like standard U.S securities, representing shares in foreign companies.

Question 121

8. What are Global Depository Receipts (GDRs)?

Answer 121

GDRs are similar to ADRs but have restrictions on resale, and they represent shares in foreign companies traded outside their domestic market.

Question 122

8. What factors affect risk and return characteristics of equity securities?

Answer 122

Factors such as company performance, market conditions, economy, and type of equity security can significantly impact risk and return characteristics of equity investments.

Question 123

8. What is company's accounting return on equity?

Answer 123

Accounting return on equity is total return that a company earns on its shareholders’ book equity, reflecting how effectively company uses equity to generate profits.

Question 124

8. What is relationship between company's cost of equity and its accounting return on equity?

Answer 124

A company's accounting return on equity should ideally exceed its cost of equity, indicating that company generates sufficient returns to meet investors' required return.

Question 125

8. What happens if company's accounting return on equity is lower than its cost of equity?

Answer 125

If accounting return on equity is lower than cost of equity, company may be underperforming in terms profitability, which can lead to decline in shareholder value.