LM04 Overview of Equity Securities

Part 2

4. Non-Domestic Equity Securities

A market is said to be “integrated” with the global market if capital flows freely across its borders. However, some countries place restrictions on capital flows.

The key reasons why capital flows into a country’s equity securities might be restricted is:

• To prevent foreign entities from taking control of domestic companies.
• To reduce volatility of financial markets which can rise by the constant inflow and outflow of capital.
• To provide domestic investors the advantage of earning better returns.

The two ways to invest in the equity of companies in a foreign market are:

• Direct investing
• Depository receipts

4.1 Direct Investing

It refers to directly buying and selling securities in foreign markets. Some potential issues associated with direct investing are:

• Along with the stock performance, the returns are exposed to the currency risk as the trade is made in foreign currency.
• Investors must be aware of the investment environment and laws of the foreign land.
• The disclosure requirement of the foreign country might be low, impeding the analysis process.

4.2 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.

Process of creating a DR

A foreign company’s shares are deposited in a local bank, which in turn issues receipts representing ownership of specific number of shares. The receipts then trade on a local exchange in local currency price. For example, a Japanese firm’s shares are held by a UK bank, which then issues DR representing this stock to the UK citizens. The depository bank is responsible for handling dividends, stock splits, and other events.

Based on the foreign company’s involvement, DR can either be:

• Sponsored DR: Foreign company is involved in issuance and holders of DR are given voting rights.
• Unsponsored DR: Foreign company is not involved in issuance and the bank retains the voting rights.

Based on the geography of issuance, DRs can either be:

• Global depository receipt (GDR):
  • DRs issued outside the company’s home country and outside the U.S.
  • GDRs are issued by a depository bank which is located or has branches in the countries on whose exchanges the shares are traded.
• American depository receipt (ADR):
  • USD denominated DRs that trade like common shares on U.S. exchanges.
  • Some ADRs allow firms to raise capital and use shares to acquire other firms in the US.
• Global registered shares (GRS):
  • Shares traded on different stock exchanges in different currencies.
• Basket of listed depository receipts (BLDR):
  • Is an ETF representing a collection of DRs.

Types of ADRs

The table below shows the four types of ADRS:

5. Risk and Return Characteristics

5.1 Return Characteristics of Equity Securities

There are two sources of total return for equities: capital gains (or price change) and dividend income. That is, how much the stock appreciates in price and how much dividend is paid by the company during that period. For investors who buy foreign securities directly or through depository shares, there is another source of income: foreign exchange gains or losses due to currency conversion.

5.2 Risk of Equity Securities

Risk is based on uncertainty of future cash flows. A stock’s return is from the price change and dividends paid. Since a stock’s price is uncertain, the expected future return is uncertain. The standard deviation of the equity’s expected total return measures this risk.

The table below shows the risk characteristics of different types of equity securities.

6. Equity and Company Value

Companies issue equity in primary markets to raise capital and increase liquidity. A company needs capital for the following reasons:

• to finance revenue-generating activities (organic growth). The capital is used to purchase long-term assets, invest in profit-generating projects, expand to new territories, or invest in research and development.
• to make acquisitions (inorganic growth).
• to provide stock-based and option-based incentives to employees.
• in some cases, if the company is cash-strapped, it needs the capital to keep it a going concern, fulfill debt requirements, and maintain key ratios.

The goal of a company’s management is:

• to increase book value or shareholders’ equity on a company’s balance sheet. Management has control over the book value as it can increase net income or sell and purchase its own shares. If the company pays little or no dividends and retains the earnings, then book value increases. Book value = assets – liabilities.
• to ensure that the stock price rises (maximizing market value of equity). Management cannot directly influence what price a stock trades at. It depends on investors’ expectations, analysts’ view of the company’s future cash flows, and market conditions, etc.

Book value is based on the current value of assets and liabilities (historic) whereas market value is based on what investors expect will happen in the future (intrinsic value). Book value and market value of equity are rarely equal. A useful ratio to compute and understand this relationship better is the price to book ratio (P/B).

6.1 Accounting Return on Equity

ROE is a key ratio to determine whether the management is using its capital effectively.

ROE_t = Net Income /Average Book Value of Equity = NI_t / (BVE_t + BE_t-1) / 2

Sometimes beginning book value of equity is used instead of average book value.

ROE can increase over time because of the following reasons:

• Increase in business profitability that increases net income relatively to the increase in book value of equity.
• Rapid decline in book value i.e. net income declines at a slower rate compared to the decline in book value.
• Increase in leverage that increases net income and reduces book value of equity, thereby increasing overall risk.

As only the first case is desirable in the above three cases, a proper analysis of the increase in ROE should be done. DuPont formula can yield a better understanding of the sources of growth in the ROE ratio.

6.2 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 the 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 the expected rate of return is not maintained, the share price falls.

Cost of equity can be estimated using methods such as the dividend discount model (DDM) and the capital asset pricing model (CAPM). These models are discussed in detail in other readings.

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