Shares (Equity): Basics

Basics of Shares (Equity). An equity share is a unit of ownership in a company. Learn more.

Corporate Ownership

At the outset, a company can be financed by DEBT or EQUITY (common stock (shares). Once a company is established, it may need further financing for additional projects. This too can come from issuing more DEBT or EQUITY (common stock (shares), as well as using existing retained profits.

A corporation is owned by its common stockholders. – The shareholders

The shareholders are entitled to all the company profits after the debt holders have been paid their interest. They also have voting rights. Shareholders exercise control over the firm by voting for its board of directors and on all major issues.

Most voting is done on a majority basis with each common share representing one vote.

Where a company is voting on being taken over or other substantial issues, individual or groups of shareholders try to influence the vote by either buying a majority of the issued and outstanding shares or persuading the majority of existing shareholders to vote with them.

In rare cases, defense companies or companies of national strategic importance the government may have a blocking vote without a majority.

Equity ; Common Stock; Shares

Authorized Share Capital – is the maximum number of shares that the company is permitted to issue under its rules without additional shareholder approval. There may be rules that limit the amount that can be issued in any financial year.

Issued shares and Outstanding Shares – are the number of shares actually issued by the company and held by shareholders.

Share repurchases – Treasury stock are shares that have been repurchased by the company and held in its treasury. A company may choose to buy back its own shares because of a lack of potential growth opportunities.

Shareholders demand returns on their investments in the form of dividends – the cost of equity. Buying back shares can reduce the overall cost of capital i.e. future dividend payments. Another major reason is to take advantage of perceived undervaluation. This may prove wrong, many companies bought back shares before the price collapsed during the financial crisis. This has been the case in the recent collapse in share prices, many companies bought back their own shares at higher prices prior to the coronavirus rout of the share markets.

Companies are often measured by the growth in earnings per share. By reducing the number of outstanding shares, a company’s earnings per share ratio is automatically increased. NOTE Donald Trump has stated that companies will not be able to buy back their own shares until any bailout money they receive has been paid back.

The term fully-diluted includes shares that could be issued as part of employee share option schemes, or any instruments issued by the company such as convertibles bonds or warrants, that allow the holder to convert these instruments into shares in the future.

Common Stock (Ordinary shares)

Common Stock (Ordinary shares) – All companies have common stock, (some corporations have preferred stock in addition to their common stock.)

Shares of common stock provide evidence of ownership of a corporation. Holders of common stock elect the corporation’s directors and share the profits of the company via dividends.

Common shareholders bear the highest risk as in bankruptcy, the secured lenders (debt owners) would be paid first, followed by unsecured lenders, preferred stockholders (if any), and lastly the common stockholders. The greater the risk the higher the investors required rate of return. Hence the cost of debt is lower than the cost of equity and government bonds (risk-free) have the lowest cost (required rate of return) of all instruments.

Additional Paid in Capital

When a firm issues new equity, it records each new share in its books at par value.

If the price at which new equity is issued is above the par value, the difference between the issue price and the par value of a stock is known as the Additional Paid-in Capital. In some cases equity finance can be raised at a value below the face value.

If a firm has recently issued 10 million new shares at $15 per share; when the par value of each is $1.50.

What is the value of additional paid-in capital (APIC)? $135,000,000

APIC = (10,000,000x$15) – (10,000,000x$1.5)

Treasury Stock / Retained Earnings

Treasury stock – A corporation’s own shares that have been repurchased from shareholders. The cash value of the shares purchased is recorded in a shareholders account (treasury stock account) as a negative number.

Retained earnings – A shareholders’ equity account that records the net profit (income) of a company from its formation until the most recent company year end, (balance sheet date) less the dividends paid to shareholders/ declared (to be paid to shareholders) from the company’s formation to that balance sheet date.

Common Equity – Share Capital

A company’s share capital is the total amount contributed directly by shareholders when the firm issues new stock, and the NET PROFIT (earnings) plowed back into the company.

It should be noted, that buying shares in stock markets above (or below) the face value of a share , DOES NOT INCREASE / (DECREASE) THE SHARE CAPITAL. That is simply a transaction between a BUYER and a SELLER of the share. The profit or loss goes to the SELLER and not the company.

Shareholders (Common) Equity = Par Value + Additional Paid-in Capital + Retained Earnings – Share Repurchases

Shareholder’s (Common) Equity

A firm has 150 million authorized shares.

120 million shares are currently in issue and 115 million shares are currently trading on the NYSE (outstanding shares).

As at 31 December 2015, the company’s share price was $5.25.

Shareholders (Owners) Equity

Shareholders Equity Account ($)

• Common Stock: 1,200,000
• Additional paid-in capital: 55,500,000
• Retained Earnings: 210,800,000
• Treasury Shares: (15,000,000)
• Shareholder’s Equity: 252,500,000

Questions

Calculate the par value of each share? 

Par value is $0.10 per share, which is computed as follows: 
$1,200,000 (Common Stock A/C) /120,000,000 issued shares = $0.01 per share

Estimate the average price at which shares were sold? 

The shares were sold at an average price of: 
[$1,200,000 + $55,500,000 (Additional Paid in Capital)]/ 120,000,000 shares = $0.4725

Calculate the number of shares that were repurchased? 

The company has repurchased: 120,000,000 issued shares – 115,000,000 outstanding shares= 5,000,000 shares

PRICE / BOOK RATIO (P/B Ratio)

Estimate the average price at which the shares were repurchased?

The average repurchase price: $15,000,000 (Treasury Stock Account)/ 5,000,000 shares = $3.00 per share.

What is net book value of the company? Calculate the market value to book ratio for the company

Book Value = Is the total shareholder’s equity $252,500,000
Shareholders Equity = Assets – Liabilities

Share price / Book Value per share (P/B ratio)
= $5.25 / ($252,500,000 / 120,000,000 shares) = $5.25 /$2.1041 =2.495

Price to book ratio

Comment on the Market Value to Book Value (Price / Book Value) ratio.

The book value of equity is the value of a company’s net assets (assets minus liabilities) recorded on the balance sheet.

The company is trading at 2.495 times its book value. A book value of more than 1, indicates the market believes asset values are understated in the balance sheet or the company is or will be earning a high return on its assets. Technology and service companies have few assets, the lawyers, accountants and geeks generate the profits and not buildings/machinery. Employees are not assets in the financial statements. Manufacturing companies have lower P/B ratios.Investors are attracted to businesses trading with a book value below 1, if they believe a new management or better market conditions will improve the returns. Alternatively, the sale of all the assets would be at more than the price paid for the shares.

Book value has several limitations. Principally, the balance sheet records assets based on historic cost and not the cost of replacement, which would result in a much higher ratio for companies with very old assets bought at lower prices than their current cost.

Reasons for Share Repurchases

Why do companies repurchase shares? Discuss the share repurchase scheme.

Companies purchase their own shares, when they have surplus funds and the management have no potential investments or projects that meet their cost of capital. (remember NPV calculations).

Companies may also purchase their own shares to achieve a more optimal capital structure. The cost of equity (shares) is higher than the cost of debt. Issuing debt or using surplus cash to repurchase shares will reduce the weighted average cost of capital (WACC).

Finally, the management may be measured (and incentivised) by the share price performance. By reducing the number of outstanding shares, future profits will be shared by fewer shareholders, potentially increasing the share price.

The repurchase of shares is like dividends, a way of returning money to shareholders (part of their required rate of return). The shareholder sells part or all of their shares to the company. The sale of shares is subject to capital gains tax and dividends to income tax. Depending on an investors tax status, they may prefer share repurchases or dividends.

The company repurchased shares at an average price of $3.00, which is lower than the current share price. The decision was good for the company; shareholders would have made $5.25 per share, if they held on and sold them on the stock market not $3.00. The time value of money is relevant here, when were the shares repurchased, what was the share price then?

Corporate Debt

When issuing debt, companies are legally bound to make payments and repay the principal. But in the case of bankruptcy ; debt is not always repaid. Corporate debt is therefore more risky than GOVERNMENT DEBT / TREASURY BILLS and has a higher required rate of return than the RISK FREE RATE. The interest rate on a bond reflects the risk associated with the issuing company.

Zero-coupon Bonds – a bond that is issued at a deep discount to its face value but pays no interest. The difference between the amount you receive at maturity and the amount you paid represents the interest payment. The advantage to the company is cash flow, it delays interest payments and to the investor there is certainty and the chance that if interest rates fall the price of the bond will rise.

Debt Characteristics

Seniority – Debt can vary in seniority, i.e. some debt is paid back before other debt, usually in the order in which it was issued ..the more senior the less the risk and so this debt has a lower coupon. – Subordinated Debt

Security – some debt can be secured against company assets and in the event of bankruptcy when the company assets are sold. Secured Debt will be paid from the sale of the assets, this can be against general assets or a specific asset. Leases are an example, where the lender provides Long-term rental agreements for business assets. If the company doesn’t pay the rental, the lender can take the assets back.

Debt can be issued in a foreign currency such as Eurodollars or Eurobonds, which will then have currency risk.. The Nigerian Naira could fall 40% against these currencies, making it more difficult for the company to make repayments.

Debt is often issued with PROTECTIVE COVENANTS i.e a company must always have an operating profit of 2x its interest payments . These restrictions on a firm protect the debtholders

Preferred Stock

A preferred share entitles the holder to a fixed dividend, whose payment takes priority over that of ordinary share dividends.

Preferred shares usually do not carry voting rights. But can appreciate in value like common stock.

Preferred shares is technically equity, but is similar to a bond issue and in some cases can act as debt from a tax perspective.

Preferred shareholders may have the right to receive payment in arrears before the dividend can be resumed for common shareholders.

In short, preferred shares have less risk than common stock and can be more flexible than debt for the company in terms of legal interest and principal payments.

Key Areas

The single most important factor will be the company’s future sales – this will be driven by your expectations of the economies where the company has sales. How long and by how much you expect COVID-19 to impact sales. Unemployment is important, if you predict a longer term for people’s income to recover. Personal debt levels and rising interest rates will reduce people’s spending power. (ask friends from different countries, your parents and do some research).

Remember companies are valued until infinity, the impact of COVID-19 may have a small impact on the long term value, unless the lack of cashflow will result in serious financial distress.

Also consider your expectations for the cost of producing or purchasing what they sell. Tariffs push prices higher and reduce sales.

Academic Questions

Academic questions, projects, assignment questions on this topic.

• When using a DISCOUNTED CASH FLOW VALUATION (actually most valuation methods), the calculated equity value must be divided by the NUMBER OF OUTSTANDING SHARES.
• Students must use the latest available financial report. The last SEC 10K report for the year.
• Make sure you use the correct number as this will impact your valuation.