Stocks

A Remedial Lesson

What does the Inc. after the names of many companies mean? In short, Inc. stands for incorporated, a legal term that makes an entity a legal company. There are many forms of incorporation from which a company can choose. With the help of a lawyer, a company files papers/applications in court to define itself as one of these forms. A company can be incorporated as a C Corp, an S Corp, an LLC (Limited Liability Corporation), or a partnership. There are different rules of ownership for each of these forms, which determine in part how a company pays out profits, is taxed, and so on.

The incorporation of a company can be regarded as its birth. And when a company is born, it has equity. This equity is also referred to as stock, and refers to ownership in a company. Most people unfamiliar with the finance world equate stock with the running tickers in the pits of Wall Street trading floors, and other symbols of publicly traded stock. You should realize that companies do not have to be publicly traded in order to have stock they just have to be incorporated and owned.

Equity vs. Debt (Stocks vs. Bonds)

Companies are traditionally financed through a combination of debt and equity. Equity, or ownership stake, is more volatile as its value fluctuates with the value of the firm. The equity of a company is represented by securities called stocks. Here, when we refer to stock, we are referring to common stock, or stock without a guaranteed return (as opposed to prefered stock).

Equity has a book value this is a strictly defined value that can be calculated from the company s Balance Sheet. It also has a market value. The market value of equity or stock for a publicly traded firm can be found in The Wall Street Journal or any of the stock quote services available today. (Market value of a company s equity can be understood with the simple formula: stock price x number of shares outstanding [or common stock outstanding] = market value of equity.) The market value of a private company can be estimated using the valuation techniques discussed in the valuation section of this guide. However, any method used to measure either the book value or market value of a company depends on highly volatile factors such as performance of the company, the industry and the market as a whole and is thus highly volatile itself. Investors can make lots of money based on their equity investment decisions and the subsequent changing value of those stocks after they are bought.

The other component of the financing of a company is debt, which is represented by securities called bonds. (In its simplest form, debt is issued when investors loan money to a company at a given interest rate.) Typically, banks and large financial institutions originate debt. The returns for debt investors are assured in the form of interest on the debt. Sometimes, the market value of the debt changes (see chapter on bonds), but bond prices usually do not change as drastically as stock prices. On the downside, bonds also have lower expected returns than stocks. U.S. Treasury bonds, for example, can provide returns of 5 to 7 percent a year or so, while volatile stocks may rise 10 percent in a single day. On the other hand, bonds usually have less downside risk than stock. Though they won t post big gains, U.S. Treasury bonds won t lose 10 percent of their value in a single day, either.

A simple analogy of how debt and equity make up financing for a company is to consider how most people buy homes. Homebuyers generally start with a down payment, which is a payment on the equity of the house. Then, the homebuyer makes mortgage payments that are a combination of debt (the interest on the mortgage) and equity (the principal payments). Initially, a homebuyer generally pays primarily interest (debt), before gradually buying larger and large portions of the principal (equity). Common stock and debt are the two extremes in the continuum of the forms of investment in a company.

In the middle of the continuum is preferred stock. One type of preferred stock is referred to as convertible preferred. If the preferred stock is convertible, it can be converted into common stock as prescribed in the initial issuance of the preferred stock. Like bondholders, holders of preferred stock are assured an interest-like return also referred to as the preferred stock s dividend. (A dividend is a payment made to stockholders, usually quarterly, that is intended to distribute some of the company s profits to shareholders.)

The other key difference between preferred and common stock comes into play when a company goes bankrupt. In what is referred to as the seniority of creditors, the debt holders have first claim on the assets of the firm if the company becomes insolvent. Preferred shareholders are next in line, while the common stock shareholders bring up the rear. This isn t just a matter of having to wait in line longer if you are a common stock shareholder. If the bondholders and owners of preferred stock have claims that exceed the value of the assets of a bankrupt company, the common stock shareholders won t see a dime.

There is a tax advantage for corporations who invest in preferred stock rather than in bonds for other companies. Corporate investors are taxed for only 30 percent of the dividends they receive on preferred stock. On the other hand, 100 percent of the interest payments on bonds paid to corporate investors are taxed. This tax rule comes in handy when structuring mergers.

Seniority of creditors:

1. Bondholders

2. Preferred stockholders

3. Common stockholders

Stock Terminology

Of course, a company's commitment to its stock doesn't end after the issuance of shares. Companies communicate with shareholders regarding the firm's past revenues, expenses and profits and the future of the business. There are also ways a company can manage their shares once the stock is on the open market to maximize shareholder value, the company's reputation and the company's future ability to raise funds. Here are several concepts and terms you'll need to be familiar with when you study stocks and how public companies manage their shares.

Dividends

Dividends are paid to many shareholders of common stock (and preferred stock). However, the directors cannot pay any dividends to the common stock shareholders until they have paid all outstanding dividends to the preferred stockholders. The incentive for company directors to issue dividends is that companies in industries that are particularly dividend sensitive have better market valuations if they regularly issue dividends. Issuing regular dividends is a signal to the market that the company is doing well.

Unlike bonds, however, the company directors decide when to pay the dividend on preferred stock. In contrast, if a company fails to meet bond payments as scheduled, the bondholders can force the company into Chapter 11 bankruptcy. (Bankruptcy filing in court comes in two categories: Chapter

Stocks

7 and Chapter 11. If a Chapter 11 bankruptcy filing is approved, the court puts a stay order on all interest payments management is given a period of protection during which it can clean up its financial mess and try to get the house marching toward profitability. If the management fails to do so within the given time, there can be a Chapter 7 bankruptcy filing, when the assets of the company are liquidated.) This action, in theory, wipes out the value of the company s equity.

Stock splits

As a company grows in value, it sometimes splits its stock so that the price does not become absurdly high. This enables the company to maintain the liquidity of the stock. If The Coca-Cola Company had never split its stock, the price of one share bought when the company s stock was first offered would be worth millions of dollars. If that were the case, buying and selling one share would be a very crucial decision. This would adversely affect a stock s liquidity (that is, its ability to be freely traded on the market). In theory, splitting the stock neither creates nor destroys value. However, splitting the stock is generally received as a positive signal to the market; therefore, the share price typically rises when a stock split is announced.

Stock buybacks

Often you will hear that a company has announced that it will buy back its own stock. Such an announcement is usually followed by an increase in the stock price. Why does a company buy back its stock? And why does its price increase after?

The reason behind the price increase is fairly complex, and involves three major reasons. The first has to do with the influence of earnings per share on market valuation. Many investors believe that if a company buys back shares, and the number of outstanding shares decreases, the company s earnings per share goes up. If the P/E (price to earnings-per-share ratio) stays stable, investors reason, the price should go up. Thus investors drive the stock price up in anticipation of increased earnings per share.

The second reason has to do with the signaling effect. This reason is simple to understand, and largely explains why a company buys back stock. No one understands the health of the company better than its senior managers. No one is in a better position to judge what will happen to the future performance of the company. So if a company decides to buy back stock (i.e., decides to invest in its own stock), these managers must believe that the stock price is undervalued and will rise (or so most observers would believe). This is the signal company management sends to the market, and the market pushes the stock up in anticipation.

The third reason the stock price goes up after a buyback can be understood in terms of the debt tax shield (a concept used in valuation methods). When a company buys back stock, its net debt goes up (net debt = debt - cash). Thus the debt tax shield associated with the company goes up and the valuation rises (see APV valuation).

New stock issues

The reverse of a stock buyback is when a company issues new stock, which usually is followed by a drop in the company s stock price. As with stock buybacks, there are three main reasons for this movement. First, investors believe that issuing new shares dilutes earnings. That is, issuing new stock increases the number of outstanding shares, which decreases earnings per share, which given a stable P/E ratio decreases the share price. (Of course, the issuing of new stock will presumably be used in a way that will increase earnings, and thus the earnings per share figure won t necessarily decrease, but because investors believe in earnings dilution, they often drive stock prices down) .

There is also the signaling effect. In other words, investors may ask why the company s senior managers decided to issue equity rather than debt to meet their financing requirements. Surely, investors may believe, management must believe that the valuation of their stock is high (possibly inflated) and that by issuing stock they can take advantage of this high price.

Finally, if the company believes that the project for which they need money will definitely be successful, it would have issued debt, thus keeping all of the upside of the investment within the firm rather than distributing it away in the form of additional equity. The stock price also drops because of debt tax shield reasons. Because cash is flushed into the firm through the sale of equity, the net debt decreases. As net debt decreases, so does the associated debt tax shield.

Questions

1. What kind of stocks would you issue for a startup?

A startup typically has more risk than a well-established firm. The kind of stocks that one would issue for a startup would be those that protect the downside of equity holders while giving them upside. Hence the stock issued may be a combination of common stock, preferred stock and debt notes with warrants (options to buy stock).

2. When should a company buy back stock?

When it believes the stock is undervalued, has extra cash, and believes it can make money by investing in itself. This can happen in a variety of situations. For example, if a company has suffered some decreased earnings because of an inherently cyclical industry (such as the semiconductor industry), and believes its stock price is unjustifiably low, it will buy back its own stock. On other occasions, a company will buy back its stock if investors are driving down the price precipitously. In this situation, the company is attempting to send a signal to the market that it is optimistic that its falling stock price is not justified. It s saying: We know more than anyone else about our company. We are buying our stock back. Do you really think our stock price should be this low?

3. Is the dividend paid on common stock taxable to shareholders? Preferred stock? Is it tax deductible for the company?

The dividend paid on common stock is taxable on two levels in the U.S. First, it is taxed at the firm level, as a dividend comes out from the net income after taxes (i.e., the money has been taxed once already). The shareholders are then taxed for the dividend as ordinary income (O.I.) on their personal income tax. Dividend for preferred stock is treated as an interest expense and is tax-free at the corporate level.

4. When should a company issue stock rather than debt to fund its operations?

There are several reasons for a company to issue stock rather than debt. If the company believes its stock price is inflated it can raise money (on very good terms) by issuing stock. Second, if the projects for which the money is being raised may not generate predictable cash flows in the immediate future, it may issue stock. A simple example of this is a startup company. The owners of startups generally will issue stock rather than take on debt because their ventures will probably not generate predictable cash flows, which is needed to make regular debt payments, and also so that the risk of the venture is diffused among the company s shareholders. A third reason for a company to raise money by selling equity is if it wants to change its debt-to-equity ratio. This ratio in part determines a company s bond rating. If a company s bond rating is poor because it is struggling with large debts, the company may decide to issue equity to pay down the debt.

5. Why would an investor buy preferred stock?

1) An investor that wants the upside potential of equity but wants to minimize risk would buy preferred stock. The investor would receive steady interest-like payments (dividends) from the preferred stock that are more assured than the dividends from common stock. 2) The preferred stock owner gets a superior right to the company s assets should the company go bankrupt. 3) A corporation would invest in preferred stock because the dividends on preferred stock are taxed at a lower rate than the interest rates on bonds.

6. Why would a company distribute its earnings through dividends to common stockholders?

Regular dividend payments are signals that a company is healthy and profitable. Also, issuing dividends can attract investors (shareholders). Finally, a company may distribute earnings to shareholders if it lacks profitable investment opportunities.

7. What stocks do you like?

This is a question often asked of those applying for all equity (sales & trading, research, etc.) positions. (Applicants for investment banking and trading positions, as well as investment management positions, have also reported receiving this question.) If you re interviewing for one of these positions, you should prepare to talk about a couple of stocks you believe are good buys and some that you don t. This is also a question asked of undergraduate finance candidates to gauge their level of interest in finance.

8. What did the S&P 500 close at yesterday?

Another question designed to make sure that a candidate is sincerely interested in finance. This question (and others like it What s the Dow at now? What s the yield on the Long Bond? ) can be expected especially of those looking for sales and trading positions.

9. Why did the stock price of XYZ company decrease yesterday when it announced increased quarterly earnings?

A couple of possible explanations: 1) the entire market was down, (or the sector to which XYZ belongs was down), or 2) even though XYZ announced increased earnings, the Street was expecting earnings to increase even more.

10. Can you tell me about a recent IPO that you have followed?

Read The Wall Street Journal and stay current with recent offerings.

11. What is your investing strategy?

Different investors have different strategies. Some look for undervalued stocks, others for stocks with growth potential and yet others for stocks with steady performance. A strategy could also be focused on the long-term or short-term, and be more risky or less risky. Whatever your investing strategy is, you should be able to articulate these attributes.

12. How has your portfolio performed in the last five years?

If you are applying for an investment management firm as an MBA, you d better have a good answer for this one. If you don t have a portfolio, start a mock one using Yahoo! Finance or other tools. Also, if you think you are going to say it has outperformed the S&P each year, you better be well prepared to explain why you think this happened.

13. If you read that a given mutual fund has achieved 50 percent returns last year, would you invest in it?

You should look for more information, as past performance is not necessarily an indicator of future results. How has the overall market done? How did it do in the years before? Why did it give 50 percent returns last year? Can that strategy be expected to work continuously over the next five to 10 years? You need to look for answers to these questions before making a decision.

Stocks

14. You are on the board of directors of a company and own a significant chunk of the company. The CEO, in his annual presentation, states that the company s stock is doing well, as it has gone up 20 percent in the last 12 months. Is the company s stock in fact doing well?

Another trick stock question that you should not answer too quickly. First, ask what the Beta of the company is. (Remember, the Beta represents the volatility of the stock with respect to the market.) If the Beta is 1 and the market (i.e. the Dow Jones Industrial Average) has gone up 35 percent, the company actually has not done too well compared to the broader market.

15. Which do you think has higher growth potential, a stock that is currently trading at $2 or a stock that is trading at $60?

This question tests your fundamental understanding of a stock s value. The short answer to the question is, It depends. While at first glance it may appear that the stock with the lower price has more room for growth, price does not tell the entire picture. Suppose the $2 stock has 1 billion shares outstanding. That means it has $2 billion market cap, hardly a small cap stock. On the flip side, if the $60 stock has 20,000 shares gives it a market cap of $1,200,000, and hence it is extremely small and is probably seen as having higher growth potential. Generally, high growth potential has little to do with a stock's price, and has more to do with it's operations and revenue prospects.

16. What do you think is happening with ABC stock?

Expect to be asked this question if you say you like to follow a given sector like technology or pharmaceuticals. Interviewers will test you to see how well you know your industry. In case you don t know that stock, admit it, and offer to describe a stock in that sector that you like or have been following.

17. Where do you think the DJIA will be in three months and six months and why?

Nobody knows the answer to this one. However, you should at least have some thoughts on the subject and be able to articulate why you take your stance. If you have been following the performance of major macroeconomic indicators (which will be reviewed in the next section), you can state your case well.

18. Why do some stocks rise so much on the first day of trading after their IPO and others don t? How is that money left on the table?

By money left on the table, bankers mean that the company could have successfully completed the offering at a higher price, and that the difference in valuation thus goes to initial investors rather than the company. Why this happens is not easy to predict from responses received from investors during roadshows. Moreover, if the stock rises a lot the first day it is good publicity for the firm. But in many ways it is money left on the table because the company could have sold the same stock in its initial public offering at a higher price. However, bankers must honestly value a company and its stock over the long-term, rather than simply trying to guess what the market will do. Even if a stock trades up significantly initially, a banker looking at the long-term would expect the stock to come down, as long as the market eventually correctly values it.

19. What is insider trading and why is it illegal?

Undergraduates may get this question as feelers of their general knowledge of the finance industry. Insider trading describes the illegal activity of buying or selling stock based on information that is not public information. The law against insider trading exists to prevent those with privileged information (company execs, I-bankers and lawyers) from using this information to make a tremendous amount of money unfairly.

20. Who is a more senior creditor, a bondholder or stockholder?

The bondholder is always more senior. Stockholders (including those who own preferred stock) must wait until bondholders are paid during a bankruptcy before claiming company assets.

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