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:
The two ways to invest in the equity of companies in a foreign market are:
It refers to directly buying and selling securities in foreign markets. Some potential issues associated with direct investing are:
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:
Based on the geography of issuance, DRs can either be:
Types of ADRs
The table below shows the four types of ADRS:
|Level I||Level II||Level III||Rule 144A|
|Objectives||Broaden U.S. investor base with existing shares.||Broaden U.S. investor base with existing shares.||Broaden U.S. investor base with existing shares.|
Attract new investors.
|Access qualified institutional buyers.|
|Raising capital on U.S. markets?||No||No||Yes, through public offerings.||Yes, through private placements or QIBs.|
|SEC Registration||Required||Required||More registration required||Not required|
|Trading places||Over-the-counter (OTC)||Stock exchanges||Stock exchanges||Private placement|
|Earnings requirements||None||Size constraint is applicable.||Size constraint is applicable.||None|
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.
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.
|Risk characteristics of different types of equity securities|
|Common shares vs. preference shares. |
Preference shares are less risky.
1. Dividends on preference shares are fixed as a percentage of the par value.
2. Dividends are paid before common shares.
3. On liquidation, preference shareholders get par value of the shares.
1. Returns are unknown as can be from capital gains (price appreciation) and dividends.
2. On liquidation, common shareholders have residual claim, i.e., they get paid after claims of debt and preferred shares have been met; hence the amount to be received is unknown.
3. Foreign investments are subject to currency exposure risk.
|Cumulative vs. non-cumulative preference shares.|
Cumulative shares are less risky.
|1. Any unpaid dividends are accumulated and paid before common stock dividends are paid.|
Companies issue equity in primary markets to raise capital and increase liquidity. A company needs capital for the following reasons:
The goal of a company’s management is:
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).
ROE is a key ratio to determine whether the management is using its capital effectively.
ROEt = Net Income /Average Book Value of Equity = NIt / (BVEt + BEt-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:
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.
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 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.