Characteristics of stock

Stock investors are typically seen as being among the daredevils of the investment world. Stocks are generally high-risk, high-return types of investments. Stocks typically generate some of the highest returns of any major investment (see Chapter 4). Stocks typically deliver returns to investors in the form of

• Dividends: Companies, if they choose, may make periodic (usually quarterly) cash payments to the shareholders of record. These payments, typically made from cash generated by the business, can be an important part of the total return investors receive by holding a stock. Companies may also choose to make large one-time dividend payments. Dividends can be a very significant part of a company’s total return to investors (see Table 10-1).

  Investors typically look at dividends in terms of a dividend yield. The dividend yield puts the dividend in relation to the stock price, by dividing the annual dividend by the stock price to arrive at a percentage return. For instance, if a stock that is trading for $50 a share pays an annual $1-per-share dividend, the dividend yield is 0.02, or 2 percent of the share price.

• Stock price appreciation: After companies first sell shares to the public, the investors who buy those shares are free to buy and sell at will in the secondary market. Investors are constantly buying and selling the shares based on what they think the future of the company will be. The price investors are willing to pay for the share ebbs and flows as new information comes into the market and future prospects for the firm rise and fall.
• Special business transactions: Although not nearly as common as dividends and stock price appreciation, some companies may look to special transactions to unlock value. One of the most common events, and one that involves investment bankers, are spinoffs. Spinoffs occur when companies break out a part of their business and set it up as a separate company, often with its own stock.

Stock sounds pretty ideal so far, with the dividends and the chance at stock price appreciation. But there are some pretty grave downsides to equity that are the constant boogeyman for stockholders to think about, including the following:

• Dividends can be suspended or canceled at any time. Unlike interest payments on bonds, which must be paid by companies, dividends can be halted or cut at any time. And cutting dividends is a constant danger when times get tough. During the financial crisis that erupted in 2007, most large banks cut their dividends to a penny a share or eliminated them completely.
• Stocks can go down, too. Stocks aren’t for the weak of heart. They can fall or even plummet during times of economic uncertainty or crisis. Sometimes stock declines can be complete, resulting in a total loss for investors. Complete losses on stock investments were commonplace for many dot-com investors in the 1999–2000 time period.
• Stocks investors’ claims to assets are inferior. If things go really wrong at a company, stockholders are last in line at the asset buffet. If a company sells itself off, or liquidates, the assets generated are first paid to the employees and short-term creditors and then to the bondholders. When things go really bad, when companies enter bankruptcy protection for instance, it’s pretty typical for stockholders to wind up with nothing and the bondholders to end up as the new owners of the company.

Types of stock

Stock comes in all shapes and sizes. Companies and their investment bankers have great latitude in deciding what rights they bestow on the ownership they sell to shareholders. Stock offerings can be customized in various ways, but typically there are three main types of stock to be aware of:

• Common stock: If you buy 100 shares of Walt Disney stock, you’re most likely buying the common stock. The shares of common stock are the typical shares being sold by the company. Common stock, at most companies, accounts for a vast majority of the shares outstanding.
• Preferred stock: Sometimes to encourage investors to become owners of a company, there’s a bit more inducing required. Preferred stock is a unique type of stock that attempts to give shareholders a more bond-like experience. Preferred stock typically pays a higher dividend yield than what’s being paid on the common shares. That’s attractive to investors who may normally steer clear of stock and instead go for bonds. Preferred stock dividends, though, can be halted like common stock. But if a company halts preferred stock dividends, shareholders must be made whole with the lapsed dividends before there can be a dividend paid on common shares. Preferred stock can also be callable, meaning the company can at any time buy the shares from investors at a pre–agreed-upon price. But don’t get seduced by the name — preferred stock really isn’t better for investors if the company is wildly successful. Preferred stockholders don’t share in the upside like common stockholders do.
• Stock options: Options are financial instruments that give their owners the right, but not the obligation, to buy or sell a stock at a pre-set price sometime in the future. Options can be used by speculators who want to bet that a stock price will rise or fall in the future. Options come in different varieties, including puts, which give owners the right to sell, and calls, which give the right to buy. Options can also be granted to company executives as a form of incentive pay. Warrants are types of long-term options that are issued by the company itself, rather than standard options that are issued by exchanges like the Chicago Board Options Exchange. Options are complex tools; you can read more about them in Trading Options For Dummies, by Joe Duarte (Wiley).

Understanding stock pricing

Stock trading is part of the financial services offered by some of the largest investment banking firms. But trading is also a matter for investment bankers to be aware of because it can affect the perception of what assets are worth. Investment bankers may dutifully calculate what they think an investment is truly worth, using prudent financial analysis. But all that goes out the window when investors and markets value the asset entirely differently.

The value of assets, especially shares of a company, is determined by the active market bringing together willing buyers and sellers. This process creates a price at which sellers are willing to part with the asset and buyers are willing to pay for that same asset. Knowing the market price of an asset is very valuable, especially when the market price is different from the value that the investment bankers’ models say.

When the value being placed on companies varies wildly from what investment bankers think companies are worth, it can be a huge opportunity. During the dot-com boom of the late 1990s and 2000, investors were willing to pay astronomical sums for Internet companies that often didn’t have earnings much less revenue. Investment bankers’ models would have shown that these companies were long on promise, but short on real value. Nonetheless, investment bankers made fortunes preparing these companies to sell stock to the public that had a voracious appetite to own a piece of what they thought was the future. The curious thing is that these investors were correct in a sense — the Internet was an innovation that transformed our lives and the way we do business. However, many of the Internet companies simply weren’t good investments. Even to this day, some observers of the initial public offering (IPO) market believe the market will never be as active as it was during the Internet boom.

But hope does spring eternal. In 2019, money-losing IPOs returned to the market, such as ride-sharing app Uber Technologies. But the stock, which sold to the public at $45 a share, sank in its first year. Sometimes investors just get fed up. The We Company, a firm that provides shareable workspaces, tried to sell IPO shares to the public in late 2019. Investors saw the company’s massive losses — $1.6 billion in 2019 — and shunned the IPO. The company shelved its IPO dream, cancelled the deal, and the founder and CEO quit. The lesson shows that investors have their limits.

Tracking the stock market

The investment banker’s best friend in tracking the value of companies is the stock market. Usually starting after a company sells stock to the public in an IPO, those shares are free to trade as investors buy and sell. Those transactions, conducted on an exchange with publicly traded securities, are recorded and posted for all to see.

Investors are well trained to find stock prices, and they can do that easily using most well-known financial websites, including a few you can read about in Chapter 21. Investors can view stock charts, to see graphically how stock prices have changed over time, or download tables of historical stock prices into their spreadsheets for further analysis.

Studying private deals

Just to make things more difficult, not all companies have publicly traded stock. Privately held companies (those that are closely held by private investors and that don’t have shares of stock trading on an exchange) are much more difficult to track. Some private companies may have shares of stock, usually held by early employees or investors, but these shares can’t be traded as freely as can shares of publicly traded companies.

Looking up historical transaction data on private companies is much more tricky, and sometimes it isn’t even possible. That means that analyzing private transaction deals also requires a bit of estimation and approximation, with techniques such as the following:

• Comparing with public companies: Even if a company isn’t publicly traded, you can sometimes triangulate its value using valuation techniques. Databases such as those from Dun & Bradstreet, Bloomberg, and S&P Global Market Intelligence may often provide limited financial statements for private companies. Sometimes, though you can’t get the profit reported by private companies, there are decent estimates of its revenue. You may be able to extrapolate the value of the private company by applying the industry’s valuation, such as by using price-to-revenue or price-to-book multiples.
• Checking to see if debt is sold: Just because a company doesn’t have stock that’s publicly traded doesn’t mean there isn’t any market pricing available. Many large private companies may have debt outstanding. Investors can buy and sell a company’s debt obligations and investors can look up the prices of the debt to get an idea of how creditworthy the company is considered. Another bonus: Even private companies must provide financial statements on the Securities and Exchange Commission’s EDGAR system if they have sold debt to the public.
• Finding rounds of venture capital raised: Even private companies may disclose when they’ve lined up significant amounts of money in a round of financing with investors, such as venture capital firms. Twitter disclosed it was planning to raise $100 million in funds on November 17, 2010, well before the company even thought about an IPO.
• Looking for transactions with public companies: Private sales aren’t so private when they’re done by publicly traded companies. When a company makes a significant buy or sell of interests in another company, that transaction may need to be disclosed. For instance, investment bankers took note of the 8-K filing by advertising firm Interpublic Group on November 20, 2012. That filing disclosed that the company sold its remaining stake in Facebook for $95 million. Similarly, companies may disclose when they buy or sell their interests in private companies, giving a rare glimpse at their market value.
• Checking pre-IPO marketplaces: The wait for a company to sell shares in an IPO can be a long one for early employees. Employees, who may have been granted shares as part of joining the company, may be eager to sell so they can buy those Ferraris they’ve been pining for. Not long ago, these investors would just have to wait for the IPO. But the introduction of new marketplaces for investors to sell their shares in a company that hasn’t gone public yet are springing up. Two of the emerging pre-IPO marketplaces are Nasdaq Private Market (www.nasdaq.com/solutions/nasdaq-private-market) and SharesPost (www.sharespost.com). Both are websites that allow holders of shares of private companies to sell those shares to accredited investors (those deemed to be sophisticated or wealthy enough to handle the risks).

Companies that sell stock to the general public must typically follow all the rules of IPOs. The most important rule that affects companies looking to go public is the requirement to register securities with the SEC. Companies and their investment bankers must follow strict disclosure and filing guidelines to meet securities registration rules.

There are exceptions to the rule that calls for public securities to be registered, though. For instance, a company may sell shares to investors who are accredited. Accredited investors are those considered to know the risks of buying unregistered securities. Typically accredited investors are large banks, investment companies, and insurance companies. But accredited investors may also be charitable organizations or companies with assets of more than $5 million, according to SEC rules. Individuals must meet pretty high bars to be considered accredited, including a net worth of more than $1 million (excluding a primary residence) or annual income of more than $200,000.

Looking at pre-IPO marketplaces

The pre-IPO marketplaces have morphed from obscure websites to useful guides for investment bankers interested in private companies. These sites aggregate the shares private investors are looking to sell in companies that are privately held. The systems then pair up willing buyers for the shares and facilitate the transaction. Transactions are then compiled allowing members of the pre-IPO marketplaces to see what kinds of valuations the companies have.

Both Nasdaq Private Market and SharesPost are only available to members. Once you register to sign up, if you’re an accredited investor, you can view some of the shares and companies that are available on the site.

Pre-IPO marketplaces help illuminate the long-dark area of private companies. They’re a breakthrough in creating a somewhat orderly market for an area of securities that was long orphaned. But don’t make the mistake of thinking that the prices on pre-IPO marketplaces are indications of what companies are truly worth once they do go public. A classic example was Facebook. On private marketplaces, the company commanded a value, when extrapolated, of $100 billion. But just a year after the company conducted its IPO in May 2012, the market value of the company on the NASDAQ fell to roughly $60 billion. We Company is an even more dramatic example. The company commanded a value of nearly $50 billion in early 2019. But by September, after investors saw the size of the company’s losses and resisted the IPO, its private-market valuation fell to about $10 billion in just nine months. Pre-IPO marketplaces can cause market values to appear distorted because they lack the liquidity, or deep pool of buyers and sellers, which can unrealistically distort the price.

Examining buyouts

Buyouts can be precious pieces of information for investment bankers trying to see what different companies, especially smaller, private ones, are worth. If a buyout is large enough, the buying company will put out an 8-K regulatory filing alerting its investors of the size and value of the deal. Not all these mergers and buyouts pan out for the acquiring companies, but they can give investment bankers comparable transactions to analyze.

Consider an example. Google’s parent company Alphabet is known for being a big acquirer of small companies. By monitoring deals made by Alphabet, investors can see what internet companies are going for on the market. During the first part of 2019, for instance, Alphabet either outright bought or made private placement investments in nine different companies. Private placements are significant investments in a company that comes short of buying the whole thing. Because private placements are offered to a select group of large investors, these offerings don’t need to be registered with the SEC.

Knowing what the market will bear

As is the case with everything from ice cream cones to baseball tickets, the price of a stock hinges on the balance of supply and demand. When companies sell stock for the first time, those shares eventually need to find their way into the hands of investors willing to hold them.

The supply of stock is somewhat stable. Companies can increase the number of shares by selling stock in a follow-on offering, which is an additional sale of stock following the IPO. Conversely, companies can reduce the number of shares outstanding with stock buybacks. In a stock buyback, companies use their excess cash reserves to buy stock in the open market.

Investors have grown increasingly skeptical of the value of stock buybacks. Fans of buybacks point out companies may buy back their stock to boost their much-watched earnings per share. How? When the company’s profit, or net income, is divided by a smaller number of shares, then earnings per share rises. Earnings per share is net income divided by the number of shares outstanding. If the number of shares outstanding falls, earnings per share rises. But critics point out that some companies routinely buy back stock when it’s expensive, a bad timing decision. Critics say that, in many cases, shareholders would’ve been better off just getting a dividend than they are when the company buys its own shares.

The supply of stock may be relatively stable, but demand for the shares is anything but. Investors, traders, and speculators crowd into the stock market and buy and sell shares of companies the same way 10-year-olds trade Pokemon cards. The process pushes the stock price up and down, causing buyers to constantly examine their financial models to decide if the stock is attractively priced or is too expensive.

Knowing when the market is distorted

Examining stock prices and other market prices is valuable, because the data is based on actual dollars and shares trading hands. But investment bankers need to be aware of the fact that oftentimes stock prices don’t exactly reflect reality.

Sometimes even sophisticated investors get so enamored with a stock, an industry, or the entire market that they chase the stock to astronomical heights. Investment bankers need to be aware of periods of temporary insanity in the markets — they need to be the sober parties even when there’s a stock mania brewing. The market is usually effective pricing stocks over the long run. But investment bankers may get a tip that market prices aren’t reflecting reality when

• Valuations get stretched. Valuation ratios, such as the P/E and price-to-book can be a reality check for investors during times of market insanity. When investment bankers see the P/Es of certain stocks or industries blow away historical averages, it can be a clue that something strange is afoot.

  Stocks can be overvalued or undervalued for a very long time. Just because a stock has an elevated P/E doesn’t guarantee that the P/E will revert to the mean anytime soon. But an elevated P/E is a sign that investment bankers need to pay attention to.

• Insiders start selling their stock. There are two types of activities often referred to as insider trading: the legal kind and the illegal kind. It’s illegal for insiders of companies, such as employees, to use material and non-public information to trade for personal gain.

  But there’s a legal type of insider trading, which is simply when company executives buy or sell shares of the company’s stock. When CEOs buy company stock, some investors see it as a sign the stock is undervalued. Similarly, when investors see lots of insiders dumping stock, that’s a sign the stock may be overvalued.

  Investment bankers know insiders must reveal their trades in regulatory filings called the Form 4. You can access Form 4 documents from the SEC’s website (www.sec.gov).

  Sometimes, insider moves can be very prescient. For instance, an early investor in Facebook and board member, Peter Thiel, filed a Form 4 on May 22, 2012. In this filing, Thiel disclosed he was selling more than 10 million shares of Facebook stock at $37.58. Talk about perfect timing. Facebook’s shares began to decline in September 2012, hitting a low of $17.55. But other times, CEOs just sell to raise money to buy a house or put their kids through college. They also may be selling to diversify their portfolios as they typically have a lot of eggs in the company basket. (They’re people too, you know.) These types of insider stock sales aren’t very indicative of the future direction of the stock.

• Stocks start gaining in parabolic moves higher. Sometimes the public gets so enamored with a company’s stock or an entire industry that the price gets pushed to ridiculous heights. Armed with tools such as discounted cash flow analysis (see Chapter 12), investment bankers can dispassionately estimate how much a stock is worth based on certain assumptions and realize when market values are much higher.

  Some investors push shares of popular stocks well above the actual value of the company. Marijuana stocks were a classic example. In 2018, shares of companies participating in the legalized cannabis market were one of the most popular for many investors to talk about or own. But reality soon caught up with pot stocks, with many falling 20 percent or more in 2019.

Tabulating key ratios for past deals

Looking up past stock transactions may be like a bit like financial sleuthing. You may have to dig into somewhat obscure financial documents to look up past transactions. If you’re lucky, and the company is public, you can just punch the stock’s symbol into a computer and get the prices and historical quotes.

But obtaining the past transaction data, the number of shares bought or sold, and when they were bought or sold is just part of the puzzle. To complete the historical transaction analysis, investment bankers must combine their knowledge of the company’s outstanding stock to put some real numbers behind the market’s moods.

When companies are invested in, or bought out completely, that presents a whole new opportunity for investment bankers to apply their ratio analysis skills. Investors can look at past transactions to give them a rundown of the company’s valuation.

Take a recent example of leading cloud-computing software company, Red Hat, which in late 2018 received a $34.6 billion cash buyout offer from International Business Machines. The amount paid for the stock is the implied equity value. Specially, IBM was paying $190 a share for each of Red Hat’s roughly 180 million shares outstanding.

The deal, finalized in 2019, gives a fascinating glimpse into how to put a price tag on a past transaction. Digging further into the ratios and terms of the deal reveals much more to investors. First of all, as part of the deal, IBM also agreed to assume Red Hat’s significant liabilities, including debt, amounting to $516 million. At the same time, though, IBM would pick up the company’s impressive $1.8 billion pile of cash. Adding the assumed liabilities to the $34.6 billion cash buyout offer, but subtracting Red Hat’s cash, gives the company an implied enterprise value of $33.9 billion.

The implied enterprise value of a proposed transaction can be tricky. Just remember that the cash buyout price for the stock is just part of the deal. The buyer is also on the hook for the liabilities and debt, which adds to the price tag. But the buyer also gets the company’s cash pile, which in effect reduces the cost of the deal. Think of it this way. It’s like selling your house for $30,000, but the buyer takes on your mortgage of $200,000. The enterprise value of the value is $230,000. The formula for enterprise value is:

Implied Enterprise Value = Implied Equity Value + Assumed Liabilities – Cash

After you measure the deal’s implied enterprise value, you can really put the deal through the ratio wringer. Investment bankers particularly like to see what the buyer is paying for the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA). You can calculate this by dividing the implied enterprise value by EBITDA. This calculation gives you a ratio that you can use to compare with the industry to see how the buyer fared.

Likewise, you can calculate the deal’s implied equity value divided by net income, which can be compared to other companies’ price-to-earnings ratios. And don’t forget implied equity value to book value, which can be compared with other companies’ price-to-book ratios. These ratios typically state how many times value is to the underlying financial measures. For instance, if a company’s implied enterprise value is $9.20 and the EBITDA is $1, that means implied enterprise value is 9.2 times, or 9.2x, EBITDA. The analysis looks much like what you see in Table 10-2.

The transaction ratios above can then be compared against those of other deals to gauge what kind of deal the buyer has negotiated. For instance, another big meatpacking deal occurred in November 2017 when private investor Thoma Bravo bought software firm Barracuda Networks for $1.6 billion. But that deal was valued at 43.1x enterprise value to EBITDA, well below the 56.4x IBM paid for Red Hat, says S&P Global Market Intelligence.

Understanding the pitfalls

Past financial transactions may seem like they’re etched in stone. Real deals by actual buyers and sellers involve investors trading money for securities and are not the output of some theoretical mathematical model. But investment bankers must remember that past transactions, though very telling of where the market was then, aren’t always indicative of how the market will value things now or what they will be worth in a few months.

Sometimes it can be tempting to assume that if another company sold for $1 million, for instance, a company that’s four times bigger would be worth $4 million. But that kind of thinking has some serious shortcomings due to pitfalls in historical price analysis, such as the following:

• Liquidity distortions: One of the most common mistakes made when analyzing past data is extrapolation. Investors often falsely figure that if 10 percent of a company sold for $1 million, the whole company is worth $10 million. But reality isn’t that simple. Keep in mind that when just 10 percent of the company was sold, the shares were scarcer and buyers had to compete more vigorously for those shares. But try unloading the other 90 percent of the stock, and the market gets awash in shares, and the price may come down.
• Big fish problem: When a small company has an interesting technology or product, there’s often no shortage of larger companies with the financial wherewithal to buy that company. And it’s not all that uncommon for big companies to have bidding wars with each other for smaller companies with promising products. But when a small company commands a massive valuation, don’t make the mistake of carrying that valuation multiple to other, larger companies in the industry.
• Lack of information: Investment bankers willing and able to do some digging can usually find some details on the valuation of companies that were bought out or invested in. And there’s a plethora of information available on companies that sell shares to the public in IPOs. These companies produce prospectuses (see Chapter 3), which contain piles of data that can be analyzed. But investment bankers must appreciate the fact that many deals fly under the financial radar. When private companies buy other private companies, for instance, those deals are difficult to get details on. Even public companies don’t have to give much in the form of details on deals that are considered to be small. Missing the complete story on past transactions limits the value of this type of analysis a bit.