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INITIAL PUBLIC OFFERINGS (IPOs) & STOCK VALUATION INITIAL PUBLIC OFFERINGS (IPOs) & STOCK VALUATION

Introduction • The modern U. S. corporation was born in a courtoom in Washington, Introduction • The modern U. S. corporation was born in a courtoom in Washington, D. C. , on February 2, 1819. On that day the U. S. Supreme Court established the legal precedent that the property of a corporation, like that of a person, is private and entitled to protection under the U. S. Constitution. • The Four Types of Firms • Sole Proprietorship • Partnership • Limited Liability Company • Corporation

The Four Types of Firms • Sole Proprietorship – Business is owned and run The Four Types of Firms • Sole Proprietorship – Business is owned and run by one person – Typically has few, if any, employees – Advantages • Easy to create – Disadvantages • Unlimited personal liability • Limited life

The Four Types of Firms • Partnership – Similar to a sole proprietorship, but The Four Types of Firms • Partnership – Similar to a sole proprietorship, but with more than one owner – All partners are personally liable for all of the firm’s debts. A lender can require any partner to repay all of the firm’s outstanding debts. – The partnership ends with the death or withdrawal of any single partner.

The Four Types of Firms • Partnership – Limited Partnership has two types of The Four Types of Firms • Partnership – Limited Partnership has two types of owners. • General Partners – Have the same rights and liability as partners in a “regular” partnership – Typically run the firm on a day-to-day basis • Limited Partners – Have limited liability and cannot lose more than their initial investment – Have no management authority and cannot legally be involved in the managerial decision making for the business

The Four Types of Firms (cont'd) • Limited Liability Company (LLC) – All owners The Four Types of Firms (cont'd) • Limited Liability Company (LLC) – All owners have limited liability but they can also run the business. – Relatively new business form in the U. S.

The Four Types of Firms • Corporation – A legal entity separate from its The Four Types of Firms • Corporation – A legal entity separate from its owners • Has many of the legal powers individuals have such as the ability to enter into contracts, own assets, and borrow money • The corporation is solely responsible for its own obligations. Its owners are not liable for any obligation the corporation enters into. • Corporations must be legally formed. The corporation files a charter with the state it wishes to incorporate in.

The Four Types of Firms • Corporation – Ownership • Represented by shares of The Four Types of Firms • Corporation – Ownership • Represented by shares of stock • Owner of stock is called – Shareholder – Stockhoder – Equity Holder • Sum of all ownership value is called equity. • There is no limit to the number of shareholders, and thus the amount of funds a company can raise by selling stock. • Owner is entitled to dividend payments.

The Four Types of Firms • Because most corporations have many owners, each owner The Four Types of Firms • Because most corporations have many owners, each owner owns only a small fraction of the corporation. • The entire ownership stake of a corporation is divided into shares known as stock. • The collection of all the outstanding shares of a corporation is known as the equity of the corporation. • An owner of a share of stock in the corporation is known as a shareholder, stockholder, or equity holder and is entitled to dividend payments, that is, payments made at the discretion of the corporation to its equity holders. .

Types of U. S. Firms Source: www. bizstats. com Types of U. S. Firms Source: www. bizstats. com

Corporations: Ownership vs Control • It is often not feasible for the owners of Corporations: Ownership vs Control • It is often not feasible for the owners of a corporation to have direct control of the firm because there are sometimes many owners • In a corporation, direct control and ownership are often separate. Rather than the owners, the board of directors and chief executive officer possess direct control of the corporation. • The shareholders of a corporation exercise their control by electing a board of directors, a group of people who have the ultimate decision‐ making authority in the corporation. In most corporations, each share of stock gives a shareholder one vote in the election of the board of directors, so investors with the most shares have the most influence. • The board of directors makes rules on how the corporation should be run (including how the top managers in the corporation are compensated), sets policy, and monitors the performance of the company.

Corporations: Ownership vs Control • The board of directors delegates most decisions that involve Corporations: Ownership vs Control • The board of directors delegates most decisions that involve day-to-day running of the corporation to its management. • The chief executive officer (CEO) is charged with running the corporation by instituting the rules and policies set by the board of directors. • The separation of powers within corporations between the board of directors and the CEO is not always distinct. • In fact, it is not uncommon for the CEO also to be the chairman of the board of directors. • The most senior financial manager is the chief financial officer (CFO), who often reports directly to the CEO.

Organizational Chart of a Typical Corporation Organizational Chart of a Typical Corporation

Corporations: Ownership vs Control • Goal of the Firm – Shareholders will agree that Corporations: Ownership vs Control • Goal of the Firm – Shareholders will agree that they are better off if management makes decisions that maximizes the value of their shares.

The Stock Market • The stock market provides liquidity to shareholders. – Liquidity • The Stock Market • The stock market provides liquidity to shareholders. – Liquidity • The ability to easily sell an asset for close to the price you can currently buy it for • Public Company – Stock is traded by the public on a stock exchange. • Private Company – Stock may be traded privately.

The Stock Market • Primary Markets – When a corporation itself issues new shares The Stock Market • Primary Markets – When a corporation itself issues new shares of stock and sells them to investors, they do so on the primary market. • Secondary Markets – After the initial transaction in the primary market, the shares continue to trade in a secondary market between investors.

The Stock Market • In bank-based systems (as in Germany and Japan) banks play The Stock Market • In bank-based systems (as in Germany and Japan) banks play a leading role in mobilizing savings, allocating capital, overseeing the investment decisions of corporate managers, and providing risk management vehicles. • In market-based systems (as in England the United States) securities markets share center stage with banks in getting society's savings to firms, exerting corporate control, and easing risk management. • “For over a century, economists and policy makers have debated the relative merits of bank-based versus market-based financial systems. Recent research, however, argues that classifying countries as bank-based or market is not a very fruitful way to distinguish financial systems (“Bank-Based or Market-Based Financial Systems: Which is Better? ”, 2012, Ross Levine, Carlson School of Management, University of Minnesota)

The Stock Market • Since the 19 th century, many economists have argued that The Stock Market • Since the 19 th century, many economists have argued that bank-based systems are better at mobilizing savings, identifying good investments, and exerting sound corporate control, particularly during the early stages of economic development and in weak institutional environments. • Proponents of the bank-based view also stress that liquid markets create a myopic investor climate [Bhide, 1993]; also, banks form long-run relationships with firms. • However, powerful banks can stymie innovation by extracting informational rents and protecting established firms with close bank-firm ties from competition (Hellwig, 1991; Rajan, 1992). • Others, emphasize the advantages of markets in allocating capital, providing risk management tools, and mitigating the problems associated with excessively powerful banks. • On the other hand, well-developed markets quickly reveal information in public markets, which reduces the incentives for individual investors to acquire information [Stiglitz, 1985].

The Stock Market • Largest Stock Markets – New York Stock Exchange (NYSE) • The Stock Market • Largest Stock Markets – New York Stock Exchange (NYSE) • Market Makers/Specialists – Each stock has only one market maker – NASDAQ • Does not meet in a physical location • May have many market makers for a single stock – Bid Price versus Ask Price • Bid-Ask Spread – Transaction cost

Worldwide Stock Markets Ranked by Two Common Measures Source: www. world-exchanges. org Worldwide Stock Markets Ranked by Two Common Measures Source: www. world-exchanges. org

Εισηγμένες Επιχειρήσεις, ΝΥ Εισηγμένες Επιχειρήσεις, ΝΥ

GOING PUBLIC Initial Public Offerings (IPOs) GOING PUBLIC Initial Public Offerings (IPOs)

Raising Capital • • Bank Loans Issuing Bonds Issuing Stocks Retained Earnings • For Raising Capital • • Bank Loans Issuing Bonds Issuing Stocks Retained Earnings • For example, with bonds the rate may often be less compared to a bank loan, but the firm must make coupon payments even when it has no profits. • With stocks the cash generated does not have to be repaid, however, new stock issuance dilutes ownership, may affect management, and profits are shared with more stockholders.

Why firms go public? • Myers and Majluf (1984) and Myers (1984), based on Why firms go public? • Myers and Majluf (1984) and Myers (1984), based on information asymmetry and possible mis-pricings argue that there is a pecking order of financing: → → → internal funds loans external funding

Why firms go public? • Many theories • Firms decide to go public when Why firms go public? • Many theories • Firms decide to go public when external funds minimize the cost of capital, and thus, they maximize the value of the firm (Scott (1976), Modigliani and Miller (1963)). • Others argue that through IPOs internal investors may get their capital back i. e. cash out, (Zingales (1995), Mello and Parsons (2000)). • Ang and Brau (2003) show that internal investors find an opportunity to sell their shares in the IPO with a profit • Black and Gilson (1998) argue that through IPOs Venture Capitals take their profits

Why firms go public? • Through IPOs Mergers and Acquisitions (M&As) are possible (Zingales Why firms go public? • Through IPOs Mergers and Acquisitions (M&As) are possible (Zingales (1995)). • For example, an IPO may be the first step of an acquisition: a publically traded stock may be used as “currency” for an M&A (e. g. stock for stock merges) and assist significantly in the valuation.

Why firms go public? • An IPO may be a strategic move, e. g. Why firms go public? • An IPO may be a strategic move, e. g. to broaden the shareholder base of the firm (Chemmanur and Fulghieri (1999)). • An IPO may give an advantage to the firm against competitors (that are not public firms), increase its reputation and publicity about the firm (Maksimovic and Pichler (2001)). • Finally, Bradley, Jordan, and Ritter (2003) also show that analyst reports and suggestions are positively biased after and IPO.

Why IPOs come in waves? • Management wants to take advantage of the positive Why IPOs come in waves? • Management wants to take advantage of the positive sentiment in bull (up) markets in order to sell the stock in attractive valuations • (Ritter and Welch (2002), Ritter (1991), Loughran and Ritter (1995)). • Lowery and Schwert (2002) argue that the IPO first day abnormal returns drive other firms to go public

Why IPOs come in waves? • Choe, Masulis, and Nanda (1993) argue that many Why IPOs come in waves? • Choe, Masulis, and Nanda (1993) argue that many firms will proceed with an IPO when other good firms do • Choe, Masulis, and Nanda (1993) and Lowery (2002) argue that firms will do an IPO when they reach a certain point in the life-cycle of the sector and need external capital to continue growing

Table 2 • CFOs feel that it is very important to proceed with an Table 2 • CFOs feel that it is very important to proceed with an IPO in order to create currency (stocks) for future Mergers and Acquisitions (M&As) (mean = 3. 56; % agreeing = 59) • This holds for all samples, i. e. firms that did a successful IPO, firms that did not do an IPO finally (withdrawn), and firms that did not even tried(not tried) • Only one other reason (to create a market price for their firm) is supported by answers. • Note that to establish a market price is the first step for M&As

Table 3 • Timing is the single most important reason for CFOs to proceed Table 3 • Timing is the single most important reason for CFOs to proceed with an IPO (mean = 4. 21; % agreeing = 83). • This finding is important for all sub-samples • Other important factors are the conditions in the industry (3. 87; % agreeing = 70) and the need for capital to support growth (3. 82; % agreeing = 66). • The IPO underpricing are relatively not important

The role of the Underwriter • It has been observed that firms often change The role of the Underwriter • It has been observed that firms often change underwriter between the IPO and a subsequent capital raising (Krigman et al. (2001)). • Why? See Table 4 • The findings suggest that CFOs believe that the ability of the underwriter to provide sophisticated know-how and advice is the most important reason • overall reputation (mean = 4. 39, % agreeing = 91) • quality of research (4. 25, 83%) • industry expertise (4. 24, 88%)

IPO underpricing • A global phenomenon • The pricing of an initial public offering IPO underpricing • A global phenomenon • The pricing of an initial public offering (IPO) below its market value. • When the offer price is lower than the price of the first trade, the stock is considered to be underpriced. • A stock is usually only underpriced temporarily because the laws of supply and demand will eventually drive it toward its intrinsic value. • IPOs have historically had very large initial first day gains compared to the performance of the rest of the market.

IPO underpricing • Underpricing: shares traded publicly for the first time substantially jump in IPO underpricing • Underpricing: shares traded publicly for the first time substantially jump in price on the first trading day. • This implies that investors are willing to pay higher prices for shares when trading begins than investors paid for their share allocation from the investment bank that accompanied the prospective IPO. • Since a large amount of money is left on the table when oweners sell their shares too low underpricing is costly to firm owners (Ljungqvist (2006)).

Do differences in institutional and legal environments explain cross-country variations in IPO underpricing? C Do differences in institutional and legal environments explain cross-country variations in IPO underpricing? C Hopp, A Dreher - Applied Economics, 2013

Differences between European & American IPO market, Jay Ritter, European Financial Management, 2003, Vol. Differences between European & American IPO market, Jay Ritter, European Financial Management, 2003, Vol. 9(4)

Differences between European & American IPO market, Jay Ritter, European Financial Management, 2003, Vol. Differences between European & American IPO market, Jay Ritter, European Financial Management, 2003, Vol. 9(4)

A Review of IPO Activity, Pricing, and Allocations, Jay R Ritter, Ivo Welch The A Review of IPO Activity, Pricing, and Allocations, Jay R Ritter, Ivo Welch The Journal of Finance, 2003, Vol. 579(4)

Theories of underpricing • Differences between the IPO offering price and the first day Theories of underpricing • Differences between the IPO offering price and the first day closing price occur too often and are, on average, too large to be explained away by error in auditing practices (for a review see also P. Karlis, The Park Place Economist / vol. VIII, p. 81 -89, see next slides). • If this were the case, then an auditing firm or investment bank would also error on the side of overpricing the stock. • Any price movement upwards from the IPO price (minus floatation fees) is precious money left on the table by the issuing firm that will be needed someday. • Ideally, stock prices should match the per share present value of the discounted future earnings of the company, theoretically paid out as dividends.

Theories of underpricing • IPO underpricing cannot be explained by asset-pricing risk premia, systematic Theories of underpricing • IPO underpricing cannot be explained by asset-pricing risk premia, systematic risk, liquidity risk (Ritter & Welsh, 2002, pp. 1802 -1803) • Attempts to explain: • Asymmetric information theories • Symmetric information theories • Theories focusing on the allocation of shares

Theories of IPO Underpricing • Adverse Selection Theory (Rock, 1986) • There are two Theories of IPO Underpricing • Adverse Selection Theory (Rock, 1986) • There are two different investor groups, informed and uninformed; the informed investors know the true value of the stock and uninformed investors invest randomly without any knowledge of the company. • Rock assumes that the investment bank has perfect knowledge of the issuing firm’s real value and the issuing firm must rely on the investment bank’s audit for this information. • Since the supply of a company’s common stock is held constant, the price fluctuates by changes in the demand for the stock. Here, demand is separated into two categories: informed investor demandand uninformed investor demand.

Theories of underpricing • Adverse Selection Theory (Rock, 1986) • If companies had IPO Theories of underpricing • Adverse Selection Theory (Rock, 1986) • If companies had IPO prices that reflected their true value then, by the law of large numbers, the uninformed investors would either break even or lose money because the informed investors would only invest in the “good” IPOs, crowding out the uninformed investors, and be the only ones turning profits. • Thus, uninformed investors would choose not to participate in the IPO market, thereby cutting the demand for stock in IPOs. • This drop in demand for IPOs would leave less promising issuing firms with undersubscribed IPOs. • To compensate for this, companies intentionally underprice IPOs as a rational behavior in order to induce the uninformed investors to participate in the market and thereby raising the demand for the issues.

Theories of underpricing • Principal-Agent Theory (Baron, 1982) • Baron & Holmstrom (1980) and Theories of underpricing • Principal-Agent Theory (Baron, 1982) • Baron & Holmstrom (1980) and Baron (1982) argue that the underwriters use their superior knowledge and underprice (asymmetric information) in an attempt to reduce their cost of promoting the issue and attract buyside clients. • Assumption: the issuing firm does not know its own true value and must rely on the auditing of outside companies and the investment bank to report accurate information. • The issuing firm and investment bank agree to an IPO contract based on the report that the investment bank gives the issuing firm concerning its value.

Theories of underpricing • Principal-Agent Theory (Baron, 1982) • The price of the IPO Theories of underpricing • Principal-Agent Theory (Baron, 1982) • The price of the IPO must be low enough to induce the investment bank, to act in the issuing firm’s best interest. • That is, the issuing firm leaves some money on the table for the investment bank in order to insure that they (the agent) disclose all information about the firm and act in the firm’s best interest.

Theories of underpricing • Symmetric information theories • Tinic (1988), Hughes & Thakor (1992), Theories of underpricing • Symmetric information theories • Tinic (1988), Hughes & Thakor (1992), Hensler (1995): issuers underprice in order to reduce the risk or the threat of court action by investors after the IPO • Investors have the right to ask for compensation if the initial stock price is too high compared to the price that prevails later (and thus investors suffer losses) • Underpricing: insurance against court action

Theories of underpricing • Signaling effects • Willenborg (1999) separates issuing firms into two Theories of underpricing • Signaling effects • Willenborg (1999) separates issuing firms into two categories depending on how established a company is. • If a company hires a more reputable firm, the signal to the investor is that the company will stand to benefit from having its financial statements more accurately analyzed. • Logically, the management of a firm would only desire this if, in fact, its financial statements were positive. • Therefore, the better the auditing firm, the better the perceived health of a firm’s finances. This is the informational signaling effect which raises the demand for the IPO.

Theories of underpricing • Also, when a company employs a reputable auditor, it also Theories of underpricing • Also, when a company employs a reputable auditor, it also benefits from the fact that if the IPO is overpriced and/or is involved in securities litigation, it is more likely that the investor seeking to get his investment back will be successful if the defendant auditing firm is large and well established. • This is the insurance signaling effect which also serves to increase the demand for the IPO • The investment bank, knows about these signaling effects and takes them into account when agreeing to an IPO contract. • To reduce downside risk, the underwriter will lower the share price of the IPO.

Theories of underpricing • Signaling models • (Allen & Faulhaber (1989), Grinblatt & Hwang Theories of underpricing • Signaling models • (Allen & Faulhaber (1989), Grinblatt & Hwang (1989), Welch (1989)). • Underpricing is used as a signal that the company is of high quality whereby an IPO company that underpriced more is considered a better company. • Informational Cascades (Welsch, 1992): Investors try to uncover the interest of other investors for an IPO. • They ask to participate when they believe that the issue is “hot”. Thus, if issuers set a high price investors will not participate because other investors will not participate • Amihud, Hauser, Kirsch (2001): IPOs are either oversubscribed or undersubscribed

Theories of underpricing • Other Asymmetric Information Theories • Ibbotson (1975): New issues are Theories of underpricing • Other Asymmetric Information Theories • Ibbotson (1975): New issues are underpriced intentionally in order to make a good impression to investors (leave a good taste in investor's mouth”) • The owner of a company has a motive to leave a good impression to investors since he/she may return to the market at a later stage in order to sell stocks at more attractive terms and raise more capital • Empirical results: many issues proceed with an IPO in order to return to the market later (Welch, 1989; Grinblatt & Hwang, 1989) • Also signaling models expect companies to raise additional funds in the future through seasoned equity offerings (SEOs). The SEO is an important mechanism by which high quality companies recoup the underpricing costs.

Theories of underpricing • Other Asymmetric Information Theories • Carter και Manaster (1990): Banks Theories of underpricing • Other Asymmetric Information Theories • Carter και Manaster (1990): Banks with the highest reputation are involved with the least risky IPOs • They examine the issuers in depth and use not publically available information, which reduces uncertainty • Investors know this and they also know that buying stocks from reputable underwriters involves les risk. • Thus the underwriter's reputation is important in underpricing

Theories of underpricing • Theories focusing on the allocation of shares • Loughran & Theories of underpricing • Theories focusing on the allocation of shares • Loughran & Ritter (2002): underwriters may “leave money on the table” and then allocate stocks to preferred clients in order to create new businesses and collect commissions • But why do issuers accept this? • Because they know that IPOs will create significant abnormal returns and their wealth will increase significantly

Theories of underpricing • Theories focusing on the allocation of shares • For instance, Theories of underpricing • Theories focusing on the allocation of shares • For instance, in one case a bank (Credit Suisse First Boston) admitted after investigation and settlement with the Securities and Exchange Commission (SEC) in the USA (11 Jan 2002) that it allocated shares from IPOs to more than 100 clients → which later returned to the bank anything between 33% and 66% of the profits (they were selling the first days after the IPO) back to CSFB in the form of very high commissions → The fine was 100 million $

A Review of IPO Activity, Pricing, and Allocations, Jay R Ritter, Ivo Welch The A Review of IPO Activity, Pricing, and Allocations, Jay R Ritter, Ivo Welch The Journal of Finance, 2003, Vol. 579(4)

Theories of underpricing • Theories focusing on the allocation of shares • Ritter & Theories of underpricing • Theories focusing on the allocation of shares • Ritter & Welsh (2002): The money “left on the table” during the IPOs of the internet bubble was aproximatelly 66 billion US$ • Assume the a mere 20% finds its way back to underwriters in the form of increased commissions: 13 billion US$ • Ritter & Welsh (2002): they estimate that approximately 10% of all stocks traded in the internet bubble was for this reason

Theories of underpricing • Theories focusing on the allocation of shares • Stoughton & Theories of underpricing • Theories focusing on the allocation of shares • Stoughton & Zechner (1998): the underpricing creates a motive for block trades by institutional investors, who may latter want to oversee the management • «Big investors add value»

Long term performance of IPOs • Globally long term performance is lower • when Long term performance of IPOs • Globally long term performance is lower • when the risk of the issuer is higher • when the IPO took place during a hot market

A Review of IPO Activity, Pricing, and Allocations, Jay R Ritter, Ivo Welch The A Review of IPO Activity, Pricing, and Allocations, Jay R Ritter, Ivo Welch The Journal of Finance, 2003, Vol. 579(4)

Determinants of initial returns • The next table (Lowry, Officer, Schwert, 2013) shows correlations Determinants of initial returns • The next table (Lowry, Officer, Schwert, 2013) shows correlations between the monthly average characteristics of firms going public and the monthly averages and standard deviations of initial returns. • Months in which a greater proportion of firms are subject to higher levels of information asymmetry should exhibit both higher average and a higher standard deviation of initial returns. • Both average initial returns and the dispersion of initial returns are substantially higher in months when the firms offering stock are (on average) younger, and when a greater proportion of IPO firms are in high-tech industries. • Also, months with more firms listing on NASDAQ tend to have a higher mean and standard deviation of initial returns, while months with more firms listing on the NYSE tend to have lower initial returns. • To the extent that the absolute price update reflects the amount of learning that occurs during the registration period when the IPO is first marketed to investors, the strong positive correlations between this variable and both average initial returns and the dispersion of initial returns are similarly consistent with our predictions. • The positive correlation of the average and standar deviation of initial returns with underwriter rank suggests that issuers’ focus on analyst coverage dominates any incremental skill that highly ranked underwriters have in accurately valuing companies

The variability of IPO initial returns M Lowry, MS Officer, GW Schwert - The The variability of IPO initial returns M Lowry, MS Officer, GW Schwert - The Journal of Finance, 2010

Determinants of initial returns • Next table (Lowry, Officer, Schwert, 2013) • To avoid Determinants of initial returns • Next table (Lowry, Officer, Schwert, 2013) • To avoid such biases without completely omitting the bubble period (arguably an important time in the IPO market), we focus our discussion on column (2). • Focusing first on the mean effect in the MLE results, most findings are consistent with the OLS regressions and with prior literature. • Consistent with Loughran and Ritter (2002), Lowry and Schwert (2004), Ritter (1991), and Beatty and Ritter (1986) the results suggest that technology firms, firms with venture capital backing, younger firms, and NASDAQ firms have the most underpricing. • The results also suggest that firms listing on the NYSE have higher initial returns than firm s listing on either Amex or the OT • Underwriter rank has a significantly positive coefficient in the OLS specification, which is inconsistent with Carter and Manaster’s (1990) reputation hypothesis, but it becomes insignificant in the maximum likelihood estimation.

The variability of IPO initial returns M Lowry, MS Officer, GW Schwert - The The variability of IPO initial returns M Lowry, MS Officer, GW Schwert - The Journal of Finance, 2010

IPO underpricing and Liquidity • Hahn, Ligon, and Rhodes (Journal of Banking & Finance, IPO underpricing and Liquidity • Hahn, Ligon, and Rhodes (Journal of Banking & Finance, 2013) find that underpricing generally increases the secondary market liquidity of IPOs over the first year of trading, irrespective of the horizon over which liquidity is measured. • For example, for two model specifications over the eight measures, fifteen regressions display signs consistent with higher underpricing increasing liquidity and thirteen of these are statistically significant. • They also find that higher initial returns are significantly negatively correlated with the probability of informed trade.

IPO underpricing and regulatory environment • Engelen and Van Essen (Journal of Banking & IPO underpricing and regulatory environment • Engelen and Van Essen (Journal of Banking & Finance, 2010) find that about 10% of the variation in the level of underpricing is between countries. • They show that the quality of a country’s legal framework, as measured by its level of investor protection, the overall quality of its legal system and its level of legal enforcement, reduces the level of underpricing significantly. • They examine a large firm-level dataset of 2920 IPOs from 21 countries

IPO underpricing and corporate governance • Boulton, Smart, and Zutter (Journal of International Business IPO underpricing and corporate governance • Boulton, Smart, and Zutter (Journal of International Business Studies, 2010) examine 4462 IPOs across 29 countries, and find that underpricing is higher in countries with corporate governance that strengthens the position of investors relative to insiders. • They argue that when countries give outsiders more influence, IPO issuers underprice more to generate excess demand for the offer, which in turn leads to greater ownership dispersion and reduces outsiders’ incentives to monitor the behavior of corporate insiders. • In other words, underpricing is a cost that insiders pay to maintain control in countries with legal systems designed to empower outsiders.

IPO underpricing and corporate governance • Hopp and Dreher (Applied Economics, 2013) analyze panel IPO underpricing and corporate governance • Hopp and Dreher (Applied Economics, 2013) analyze panel IPO data for 24 countries. They find evidence that underpricing is higher in countries with stronger protection of outside investors • This suggests that incumbent managers try to use underpricing as a tool to safeguard their private benefits of control when going public. • They also find that underpricing is reduced when stronger law enforcement and the availability of accounting information reduce the value of private benefits of control.

IPO underpricing and corporate governance • Michel, Oded, and Shaked (Journal of Banking & IPO underpricing and corporate governance • Michel, Oded, and Shaked (Journal of Banking & Finance, 2014) investigate whether the post-IPO market performance of IPO stocks is related to the percentage of shares issued to the public, namely, the public float. • They find that as public float increases, long-run returns decrease for low levels of public float and increase for high levels of public float. • The best long‐term performers are firms that sell either very little or sell most of their stock in the IPO. • They suggest that the choice of public float level creates a trade-off between incentives to insiders and power granted to outsiders.

IPO underpricing and Earnings quality • Boulton, Smart, Zutter (The Accounting Review, 2011) examine IPO underpricing and Earnings quality • Boulton, Smart, Zutter (The Accounting Review, 2011) examine 10, 783 IPOs from 37 countries and find that IPOs are underpriced less in countries where public firms produce higher quality earnings information. • This finding persists after controlling for other factors that affect IPO underpricing, and it not driven by the transparent markets in the U. S. and U. K. or the Jappanese market. • The impact of low earnings quality on underpricing is partially offset by the use of a top-tier underwriter.

IPO underpricing and litigation risk • Lin, Pukthuanthong, and Walker (Journal of Corporate Finance, IPO underpricing and litigation risk • Lin, Pukthuanthong, and Walker (Journal of Corporate Finance, 2013) examine 13, 759 IPOs in 40 countries. • While the majority of single-country studies do not find support for the lawsuit avoidance hypothesis, they find a significant positive relationship between litigation risk and underpricing in a cross‐country framework. • Their findings imply that the degree of litigation risk in a given country affects the level of underpricing for firms that go public in that country, i. e. differences in legal risk factors can partially explain differences in underpricing across countries

IPO underpricing and litigation risk • Hanley and Hoberg (Journal of Financial Economics, 2012) IPO underpricing and litigation risk • Hanley and Hoberg (Journal of Financial Economics, 2012) use word content analysis on the time-series of IPO prospectuses in the US. • They show that issuers use underpricing and strategic disclosure as potential hedges against litigation risk. • This tradeoff explains a significant fraction of the variation in prospectus revision patterns, and IPO underpricing. • They find that strong disclosure is an effective hedge against all types of lawsuits, and that underpricing is an effective hedge only against lawsuits which are most damaging to the underwriter. Underwriters who fail to adequately hedge litigation risk experience economically large penalties, including loss of market share.

IPO underpricing and information • Banerjee, Dai, and Shrestha (Journal of Corporate Finance, 2011) IPO underpricing and information • Banerjee, Dai, and Shrestha (Journal of Corporate Finance, 2011) study IPO underpricing in 36 countries. They find: • A positive and significant effect of country-level information asymmetry on IPO underpricing. • Effective contract enforcement mechanisms help to reduce IPO underpricing. • A positive relation between the accessibility of legal recourse and IPO underpricing.

IPO underpricing and private equity‐backed IPOs • Levis (Financial Management, 2011) examines the performance IPO underpricing and private equity‐backed IPOs • Levis (Financial Management, 2011) examines the performance of private equity-backed IPOs and compares it to the performance of equivalent samples of venture capital-backed and other non-sponsored issues on the London Stock Exchange during the period 1992 -2005. • The evidence suggests marked differences across the three groups in terms of market size, industry classification, first-day returns, and key operating characteristics at the time of flotation. • In fact, private equity-backed IPOs are larger firms in terms of sales and assets, more profitable, and relatively modest first‐day returns. In the three years following the public listing, they display better operating and market performance when compared to other IPOs. • Private equity typically refers to investment funds organized as limited partnerships that are not publicly traded and whose investors are typically large institutional investors, university endowments, or wealthy individuals. Private equity firms are known for their extensive use of debt financing to purchase companies, which they restructure and attempt to resell for a higher value.

IPO underpricing and quality of underwriters • Dong, Michel, and Pandes (Financial Management, 2011) IPO underpricing and quality of underwriters • Dong, Michel, and Pandes (Financial Management, 2011) analyze the relationship between the quality of underwriters and the long-run performance of IPOs • They find that higher underwriter quality predicts better long ‐run performance. • They also find that the effects of the number of managing underwriters and underwriter reputation are especially strong among IPOs with high uncertainty.

IPO underpricing and fair values • Roosenboom (Journal of Banking & Finance, 2012) 228 IPO underpricing and fair values • Roosenboom (Journal of Banking & Finance, 2012) 228 reports from French underwriters. • These reports are issued before the IPO shares start trading on the stock market and detail how underwriters determined fair value. • The results indicate that underwriters often employ multiples valuation, dividend discount models and discounted cash flow (DCF) analysis to determine fair value • This fair value estimate is subsequently used as a basis for IPO pricing. • The author argues that underwriters deliberately discount the fair value estimate when setting the preliminary offer price. Part of the intentional price discount can be recovered by higher price updates.

STOCK VALUATION STOCK VALUATION

STOCK VALUATION • The Law of One Price implies that to value any security, STOCK VALUATION • The Law of One Price implies that to value any security, we must determine the expected cash flows an investor will receive from owning it. • Thus, we begin our analysis of stock valuation by considering the cash flows for an investor with a one-year investment horizon. • We then consider the perspective of investors with longer investment horizons. • We show that if investors have the same beliefs, their valuation of the stock will not depend on their investment horizon. • Using this result, we then derive the first method to value a stock: the dividenddiscount model.

The Dividend Discount Model • A One-Year Investor – Potential Cash Flows: Dividend, Sale The Dividend Discount Model • A One-Year Investor – Potential Cash Flows: Dividend, Sale of Stock – Timeline for One-Year Investor • Since the cash flows are risky, we must discount them at the equity cost of capital.

The Dividend Discount Model • A One-Year Investor – If the current stock price The Dividend Discount Model • A One-Year Investor – If the current stock price were less than this amount, expect investors to rush in and buy it, driving up the stock’s price. – If the stock price exceeded this amount, selling it would cause the stock price to quickly fall.

The Dividend Discount Model • Dividend Yield • Capital Gain – Capital Gain Rate The Dividend Discount Model • Dividend Yield • Capital Gain – Capital Gain Rate • Total Return – Dividend Yield + Capital Gain Rate • The expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk.

The Dividend Discount Model • What is the price if we plan on holding The Dividend Discount Model • What is the price if we plan on holding the stock for two years?

The Dividend Discount Model • What is the price if we plan on holding The Dividend Discount Model • What is the price if we plan on holding the stock for N years? – This is known as the Dividend Discount Model. • Note that the above equation holds for any horizon N. Thus all investors (with the same beliefs) will attach the same value to the stock, independent of their investment horizons.

The Dividend Discount Model • The price of any stock is equal to the The Dividend Discount Model • The price of any stock is equal to the present value of the expected future dividends it will pay.

The Dividend Discount Model • Constant Dividend Growth – The simplest forecast for the The Dividend Discount Model • Constant Dividend Growth – The simplest forecast for the firm’s future dividends states that they will grow at a constant rate, g, forever.

The Dividend Discount Model • Constant Dividend Growth Model – The value of the The Dividend Discount Model • Constant Dividend Growth Model – The value of the firm depends on the current dividend level, the cost of equity, and the growth rate.

Dividends Versus Investment and Growth • A Simple Model of Growth – Dividend Payout Dividends Versus Investment and Growth • A Simple Model of Growth – Dividend Payout Ratio • The fraction of earnings paid as dividends each year

Dividends Versus Investment and Growth • A Simple Model of Growth – Assuming the Dividends Versus Investment and Growth • A Simple Model of Growth – Assuming the number of shares outstanding is constant, the firm can do two things to increase its dividend: • Increase its earnings (net income) • Increase its dividend payout rate

Dividends Versus Investment and Growth • A Simple Model of Growth – A firm Dividends Versus Investment and Growth • A Simple Model of Growth – A firm can do one of two things with its earnings: • It can pay them out to investors. • It can retain and reinvest them.

Dividends Versus Investment and Growth • A Simple Model of Growth – Retention Rate Dividends Versus Investment and Growth • A Simple Model of Growth – Retention Rate • Fraction of current earnings that the firm retains

Dividends Versus Investment and Growth • A Simple Model of Growth – If the Dividends Versus Investment and Growth • A Simple Model of Growth – If the firm keeps its retention rate constant, then the growth rate in dividends will equal the growth rate of earnings.

Dividends Versus Investment and Growth • Profitable Growth – If a firm wants to Dividends Versus Investment and Growth • Profitable Growth – If a firm wants to increase its share price, should it cut its dividend and invest more, or should it cut investment and increase its dividend? • The answer will depend on the profitability of the firm’s investments. – Cutting the firm’s dividend to increase investment will raise the stock price if, and only if, the new investments have a positive NPV.

Changing Growth Rates • We cannot use the constant dividend growth model to value Changing Growth Rates • We cannot use the constant dividend growth model to value a stock if the growth rate is not constant. – For example, young firms often have very high initial earnings growth rates. – During this period of high growth, these firms often retain 100% of their earnings to exploit profitable investment opportunities. – As they mature, their growth slows. – At some point, their earnings exceed their investment needs and they begin to pay dividends.

Changing Growth Rates • Although we cannot use the constant dividend growth model directly Changing Growth Rates • Although we cannot use the constant dividend growth model directly when growth is not constant, → we can use the general form of the model to value a firm by applying the constant growth model to calculate the future share price of the stock once the expected growth rate stabilizes.

Changing Growth Rates • Dividend-Discount Model with Constant Long-Term Growth Changing Growth Rates • Dividend-Discount Model with Constant Long-Term Growth

Limitations of the DDM • There is a tremendous amount of uncertainty associated with Limitations of the DDM • There is a tremendous amount of uncertainty associated with forecasting a firm’s dividend growth rate and future dividends. • Small changes in the assumed dividend growth rate can lead to large changes in the estimated stock price.

Total Payout and Free Cash Flow Valuation Models • Share Repurchases and the Total Total Payout and Free Cash Flow Valuation Models • Share Repurchases and the Total Payout Model – Share Repurchase • When the firm uses excess cash to buy back its own stock – Implications for the Dividend-Discount Model • The more cash the firm uses to repurchase shares, the less it has available to pay dividends. • By repurchasing, the firm decreases the number of shares outstanding, which increases its earnings per and dividends per share.

Total Payout and Free Cash Flow Valuation Models • A share repurchase is a Total Payout and Free Cash Flow Valuation Models • A share repurchase is a program by which a company buys back its own shares from the marketplace, usually because management thinks the shares are undervalued, reducing the number of outstanding shares. • The company buys shares directly from the market or offers its shareholders the option of tendering their shares directly to the company at a fixed price.

Total Payout and Free Cash Flow Valuation Models • Share Repurchases and the Total Total Payout and Free Cash Flow Valuation Models • Share Repurchases and the Total Payout Model – Total Payout Model • Values all of the firm’s equity, rather than a single share. You discount total dividends and share repurchases and use the growth rate of earnings (rather than earnings per share) when forecasting the growth of the firm’s total payouts.

The Discounted Free Cash Flow Model • Discounted Free Cash Flow Model – Determines The Discounted Free Cash Flow Model • Discounted Free Cash Flow Model – Determines the value of the firm to all investors, including both equity and debt holders – The enterprise value can be interpreted as the net cost of acquiring the firm’s equity, taking its cash, paying off all debt, and owning the unlevered business.

The Discounted Free Cash Flow Model • Valuing the Enterprise – Free Cash Flow The Discounted Free Cash Flow Model • Valuing the Enterprise – Free Cash Flow • Cash flow available to pay both debt holders and equity holders – Discounted Free Cash Flow Model

The Discounted Free Cash Flow Model • A key difference between the discounted free The Discounted Free Cash Flow Model • A key difference between the discounted free cash flow model and the earlier models we have considered is the discount rate. • In previous calculations we used the firm’s equity cost of capital, r. E, because we were discounting the cash flows to equity holders. • Here we are discounting the free cash flow that will be paid to both debt and equity holders. • Thus, we should use the firm’s weighted average cost of capital (WACC), which is the average cost of capital the firm must pay to all of its investors, both debt and equity holders.

The Discounted Free Cash Flow Model • Implementing the Model – Since we are The Discounted Free Cash Flow Model • Implementing the Model – Since we are discounting cash flows to both equity holders and debt holders, the free cash flows should be discounted at the firm’s weighted average cost of capital, rwacc. – If the firm has no debt, rwacc = r. E.

The Discounted Free Cash Flow Model • Implementing the Model – Often, the terminal The Discounted Free Cash Flow Model • Implementing the Model – Often, the terminal value is estimated by assuming a constant long-run growth rate g. FCF for free cash flows beyond year N, so that:

The Discounted Free Cash Flow Model • Connection to Capital Budgeting – The firm’s The Discounted Free Cash Flow Model • Connection to Capital Budgeting – The firm’s free cash flow is equal to the sum of the free cash flows from the firm’s current and future investments, so we can interpret the firm’s enterprise value as the total NPV that the firm will earn from continuing its existing projects and initiating new ones. • The NPV of any individual project represents its contribution to the firm’s enterprise value. To maximize the firm’s share price, we should accept projects that have a positive NPV.

A Comparison of Discounted Cash Flow Models of Stock Valuation A Comparison of Discounted Cash Flow Models of Stock Valuation

Valuation Based on Comparable Firms • Method of Comparables (Comps) – Estimate the value Valuation Based on Comparable Firms • Method of Comparables (Comps) – Estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future.

Valuation Based on Comparable Firms • In the method of comparables (or “comps”), rather Valuation Based on Comparable Firms • In the method of comparables (or “comps”), rather than value the firm’s cash flows directly, we estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future. • For example, consider the case of a new firm that is identical to an existing publicly traded company. • If these firms will generate identical cash flows, the Law of One Price implies that we can use the value of the existing company to determine the value of the new firm.

Valuation Multiples • Valuation Multiple – A ratio of firm’s value to some measure Valuation Multiples • Valuation Multiple – A ratio of firm’s value to some measure of the firm’s scale or cash flow • The Price-Earnings Ratio • P/E Ratio • Share price divided by earnings per share • Stock price is equal to the product of EPS with a comparable P/E ratio • P 0 = EPS 0 (P/EPS 1)

Valuation Multiples • Firms with high growth rates, and which generate cash well in Valuation Multiples • Firms with high growth rates, and which generate cash well in excess of their investment needs so that they can maintain high payout rates, should have high P/E multiples.

Alternative Example • Problem – Best Buy Co. Inc. (BBY) has earnings per share Alternative Example • Problem – Best Buy Co. Inc. (BBY) has earnings per share of $2. 22. – The average P/E of comparable companies’ stocks is 19. 7. – Estimate a value for Best Buy using the P/E as a valuation multiple. – The share price for Best Buy is estimated by multiplying its earnings per share by the P/E of comparable firms. – P 0 = $2. 22 × 19. 7 = $43. 73

Valuation Multiples • It is also common practice to use valuation multiples based on Valuation Multiples • It is also common practice to use valuation multiples based on the firm’s enterprise value. • As we discussed earlier, because it represents the total value of the firm’s underlying business rather than just the value of equity, using the enterprise value is advantageous if we want to compare firms with different amounts of leverage. • Because the enterprise value represents the entire value of the firm before the firm pays its debt, to form an appropriate multiple, we divide it by a measure of earnings or cash flows before interest payments are made. • Common multiples to consider are enterprise value to EBIT, EBITDA (earnings before interest, taxes, depreciation, and amortization), and free cash flow.

Valuation Multiples • Enterprise Value Multiples (ASSUMING CONSTANT GROWTH) – This valuation multiple is Valuation Multiples • Enterprise Value Multiples (ASSUMING CONSTANT GROWTH) – This valuation multiple is higher for firms with high growth rates and low capital requirements (so that free cash flow is high in proportion to EBITDA).

Alternative Example • Problem – Best Buy Co. Inc. (BBY) has EBITDA of $2, Alternative Example • Problem – Best Buy Co. Inc. (BBY) has EBITDA of $2, 766, 000 and 410 million shares outstanding. – Best Buy also has $1, 963, 000 in debt and $509, 000 in cash. – If Best Buy has an enterprise value to EBITDA multiple of 7. 7, estimate the value for a share of Best Buy stock. • Solution – Using the enterprise value to EBITDA multiple, Best Buy’s enterprise value is $2, 766 million × 7. 7 = $21, 298. 20 million. – Subtract out the debt, add the cash and divide by the number of shares to estimate the Best Buy’s share price.

Valuation Multiples • Other Multiples – Multiple of sales – Price to book value Valuation Multiples • Other Multiples – Multiple of sales – Price to book value of equity per share – Enterprise value per subscriber • Used in cable TV industry

Limitations of Multiples • When valuing a firm using multiples, there is no clear Limitations of Multiples • When valuing a firm using multiples, there is no clear guidance about how to adjust for differences in expected future growth rates, risk, or differences in accounting policies. • Comparables only provide information regarding the value of a firm relative to other firms in the comparison set. – Using multiples will not help us determine if an entire industry is overvalued,

Comparison with Discounted Cash Flow Methods • Discounted cash flows methods have the advantage Comparison with Discounted Cash Flow Methods • Discounted cash flows methods have the advantage that they can incorporate specific information about the firm’s cost of capital or future growth. – The discounted cash flow methods have the potential to be more accurate than the use of a valuation multiple.

Stock Prices and Multiples for the Footwear Industry, January 2006 Stock Prices and Multiples for the Footwear Industry, January 2006

Stock Valuation Techniques • No single technique provides a final answer regarding a stock’s Stock Valuation Techniques • No single technique provides a final answer regarding a stock’s true value. • All approaches require assumptions or forecasts that are too uncertain to provide a definitive assessment of the firm’s value. – Most real-world practitioners use a combination of these approaches and gain confidence if the results are consistent across a variety of methods.

Range of Valuation Methods for KCP Stock Using Alternative Valuation Methods Range of Valuation Methods for KCP Stock Using Alternative Valuation Methods

Range of Valuation Methods for KCP Stock Using Alternative Valuation Methods • Valuations from Range of Valuation Methods for KCP Stock Using Alternative Valuation Methods • Valuations from multiples are based on the low, high, and average values of the comparable firms from Table 9. 1 (see Problems 25 and 26 at the end of the chapter). • The constant dividend growth model is based on an 11% equity cost of capital and 4%, 8%, and 10% dividend growth rates, as discussed at the end of Section 9. 2. • The discounted free cash flow model is based on Example 9. 7 with the range of parameters in Problem 22. • (Midpoints are based on average multiples or base case assumptions. Red and blue regions show the variation between the lowest-multiple/ worstcase scenario and the highest-multiple/best-case scenario. • KCP’s actual share price of $26. 75 is indicated by the gray line. )