Level I Equity Investments

Overview of Equity Securities

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Introduction and Contents

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Introduction
Equity Securities in Global Financial Markets
Types and Characteristics of Equity Securities
Private versus Public Equity Securities
Investing in Non-Domestic Equity Securities
Risk and Return Characteristics of Equity Securities
Equity Securities and Company Value

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2. Equity Security in Global Financial Markets

Equity markets are very large
Exhibit 1: Regional contributions to global GDP and equity market capitalizations
Exhibit 2: Equity market capitalizations at the end of 2008

Historically equity markets have offered high returns relative to government bonds
and T-bills, but at higher risk

Exhibit 3: Return numbers across countries

Exhibit 4: Return numbers in three different time periods
Exhibit 5: Extreme losses
Exhibit 6: Stock ownership in different countries

Bottom line: equity securities are a key asset class for global investors

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3. Types and Characteristics of Equity Securities

Common shares represent an ownership interest in a company and give investors a
claim on its operating performance, the opportunity to participate in decision
making, and a claim on the companys net assets in the case of liquidation.

Statutory voting versus cumulative voting

Different classes (Class A and Class B)
Callable common shares
Putable common shares

Preference shares are a form of equity in which payments made to preference

shareholders take precedence over payments to common shareholders
Cumulative and non-cumulative preference shares
Participating and non-participating preference shares
Convertible preference shares
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4. Private versus Public Equity Securities

Private equity securities are issued primarily to institutional investors in
private placements and do not trade in secondary equity markets
Companys management can focus on long term value creation
Highly illiquid
Potentially high returns

Types of private equity

Venture capital
Leveraged buyout
Management buyout
Private investment in public entity (PIPE)
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5. Investing in Non-Domestic Equities

Technological innovations have accelerated the integration and growth
of global financial markets
Increased integration makes it easier for
companies to raise money and expand internationally
investors to invest internationally

Some countries impose foreign exchange restrictions

Direct investing versus depository receipts

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Depository Receipts
A depository receipt (DR) is a security that trades like an ordinary share on a local
exchange and represents an economic interest in a foreign company
Equity shares are deposited in a bank (depository) in the country on whose exchange the shares
will trade; depository bank issues receipts that represent deposited shares
A DR can be sponsored or unsponsored
GDR is issued outside the companys home country and outside the U.S.
ADR is a USD denominated security that trades like a common share on U.S. exchanges; four
types are shown on the next slide
GDRs and ADRs are not subject to foreign ownership and capital flow restrictions that may be
imposed by issuing companys home country

A global registered share (GRS) is traded on different stock exchanges in different

currencies
A basked of listed depository receipts (BLDR) is an ETF that represents a portfolio of
depository receipts
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American Depository Receipts

Level I
(Unlisted)

Level II
(Listed)

Level III
(Listed)

Rule 144A
(Unlisted)

Objectives
Raising Capital on US
Markets?
SEC Registration
Trading
Listing fees
Size and earnings
requirements

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6. Risk and Return Characteristics of Equity Securities

Return Characteristics of Equity Securities
Capital gains and dividend
Foreign exchange gain
Risk of Equity Securities
Risk is based on uncertainty of future cash flows
Compare the risk/return characteristics of
Common shares vs. preference shares
Cumulative vs. non-cumulative preference shares
Callable vs. non-callable shares
Putable vs. non-putable shares
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7. Equity Securities and Company Value

Companies issue equity to raise capital and increase liquidity
Finance revenue generating activities
Acquisitions
Option-based incentives for employees

Management goal is to increase book value and maximize market value of equity
Management actions can directly influence book value
Management actions have an indirectly impact on market value
Book value and market value are seldom the same

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Accounting Return on Equity

ROE is an important measure to determine whether management is
effectively using capital
ROE = Net Income / Average BVE
Sometimes beginning BVE is used
ROE increases if income increases at a faster rate than equity
Is increasing ROE always good?

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The Cost of Equity and Investors Required Rates of Return

When investors purchase company shares, their minimum required rate of return
is based on the future cash flows they expect to receive
Cost of equity is the minimum expected rate of return that a company must offer
its investors to purchase its shares (not easily determined)
Cost of equity may be different from investors required rate of return
Because companies try to raise capital at the lowest possible cost, the cost of equity is often
used as a proxy for the investors minimum required rate of return
If expected rate of return is not maintained share price falls

Cost of equity can be estimated using

Dividend Discount Model (DDM)
Capital Asset Pricing Model (CAPM)
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Summary
Importance of equity securities
Characteristics of various types of securities
Risk-return

Public versus private securities

Voting rights
Non-domestic securities
Financing a companys assets
Market value versus book value
Return on equity
Cost of equity and required rates of return
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Conclusion
Read the summary
Review learning objectives
Examples
Practice problems
Practice questions from other sources

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