Chapter 10
IN THIS CHAPTER
Understanding what stock is and what types of stock are available
Seeing how stocks are priced by the markets and how that affects investment banking
Examining past financial transactions for clues about pricing
Examining marketplaces for companies that haven’t yet filed to sell shares to the public
Analyzing past transactions to get a grasp on what the market will bear
Much of what investment bankers do is based on complex mathematical formulas, ratio analysis, and forecasting. In other words, investment bankers are pros at making educated guesses about all things financial, ranging from what companies are worth to how much an asset should sell for.
The ability to formulate reasonable hypotheses is a key aspect of investment banking. After all, investment bankers are often in the situation of having to sell investment products that have never been sold before and, thus, are difficult to value based on history.
But even though financial history rarely repeats itself exactly, there’s no question that it often rhymes. Savvy investment bankers know that one of the best ways to gauge what something may be worth is seeing how similar assets are valued on the open market.
This chapter explains what stock, often called equity, is and why the value on the market may not be equal to the value investment banker’s measure on their spreadsheets. You see how securities markets are created to determine price for various assets. Market prices, even if the investment banker disagrees with them, are important to investment bankers’ work. You also find out how to look up past transactions, a key way investment bankers see what the market prices for assets have been. You also see how to not just look at market prices but use those prices in a way to improve your understanding of the assets and the values they may garner.
DIS. IBM. MSFT. FB. These are the stock ticker symbols of some of the most recognizable American companies, Walt Disney, International Business Machines, Microsoft, and Facebook, respectively. These unique stock symbols are typed into computer trading systems and punched into investment bankers’ computer systems to get up-to-date stock prices and trading volumes. Investment bankers are so used to chattering about companies like symbols, almost like chess pieces on a game board, that the idea of what the stock represents can lose its meaning.
But what is a share of stock? What does a share of stock represent? In its simplest form, common stock is a financial security that gives its owner a claim to a prorated portion of the company’s earnings. Stock, often referred to as equity by investment bankers, is an ownership stake in a company.
The owners of stock, called stockholders or shareholders, have dibs on a proportionate part of a company’s earnings. The number of shares of stock owned indicates how much of the company the shareholder owns. For instance, imagine a company has carved itself into 208.9 million pieces, or shares. Those are the number of shares the company has outstanding, as is the case with Hershey as of 2019.
Stock values can also be helpful to an investment banker measuring the market value, or total value investors are putting on a company, also known as market capitalization. You just need to know:
Market Value = Number of Shares Outstanding × Current Per-Share Stock Price
Using Hershey as an example, imagine the stock is trading for $143.07 a share. Because you know the company has 208.9 million shares outstanding, you know that stock investors are valuing the entire company at $29.9 billion. Now, that’s a whole lot of chocolate.
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.
TABLE 10-1 Where Stock Investors Get Return on S&P 500
Year Ending |
Total Return Change |
Stock-Price Appreciation |
Dividend Yield |
December 31, 2018 |
–4.4% |
–6.2% |
1.9% |
December 31, 2017 |
21.8% |
19.4% |
2.4% |
December 31, 2012 |
16.0% |
13.4% |
2.6% |
December 30, 2011 |
2.1% |
0.0% |
2.1% |
December 29, 2000 |
–9.1% |
–10.1% |
1.0% |
December 31, 1995 |
37.6% |
34.1% |
3.5% |
December 31, 1990 |
–3.1% |
–6.6% |
3.5% |
Source: S&P Dow Jones Indices
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:
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.
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.
Don’t expect to get an email or phone call when a big investor is going to buy or sell a particular stock. Although that knowledge would be helpful, so you could update your company valuation, that’s not how the world works.
Most trading activity is done in private using the buying and selling facilities of stock market exchanges including the NYSE and NASDAQ. There are some exceptions when investors are significant enough that they do have to report their trades (see Chapter 6). But they only have to report these trades with a significant time lag.
But don’t let the fact most investors don’t have to tell you what they’re doing discourage you from digging into past transactions. Investment bankers who know where to look can easily find out how investors are valuing various assets.
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.
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:
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).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.
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.
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.
When you understand how to track past transactions and how investors place their bets on securities and investments, patterns begin to emerge. By examining the stock prices of publicly traded companies, as well as smaller, privately held competitors, you can see how much demand there is for securities in the industry. Knowing what investors will pay for securities, and how easy it will be to sell them, is a critical aspect of investment bankers’ jobs.
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.
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.
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.
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.
Implied Enterprise Value = Implied Equity Value + Assumed Liabilities – Cash
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.
TABLE 10-2 Breaking Down Red Hat’s Buyout Ratios
Ratio |
Value |
Implied enterprise value/EBITDA |
56.4x |
Implied equity value/net income |
120.8x |
Implied equity value/book value |
26.8x |
Source: S&P Global Market Intelligence
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.
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:
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