Question

Often times when a company becomes large enough, it will sell off a minority portion of their ownership to the public as shares to gain capital. This capital is then reinvested into the company to assist in new projects or expansion in general. For this week's discussion assignment, research how a company's stock is initially appraised when they decide to go public, how it is determined the number of shares are to be distributed and the advantages/disadvantages of common and preferred stock.

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Answer 1

A company's stock is apraised before an IPO by an investment bank who is bank is hired to determine the value of the company and its shares before they are listed on an exchange. The most important factor that affects a company's value is consumer demand for the company's shares. Strong demand for the company will lead to a higher stock price. In addition to the demand for a company's shares, there are several other factors that determine an IPO valuation, including industry comparables, growth prospects, and the story of a company.

1. Demand

   Strong demand for a company's shares does not necessarily mean the company is more valuable. However, it does mean that the company will have a higher valuation. An IPO valuation is the process by which an analyst determines the fair value of a company's shares.

2. Industry Comparables

   Industry comparables are another aspect of the process of IPO valuation. If the IPO candidate is in a field that has comparable publicly-traded companies, the IPO valuation will include a comparison of the valuation multiples being assigned to its competitors. The rationale is that investors will be willing to pay a similar amount for a new entrant into the industry as they are currently paying for existing companies.

3. Growth Prospects

   An IPO valuation depends heavily on the company's future growth projections. The primary motive behind an IPO is to raise capital to fund further growth. The successful sale of an IPO often depends on the company's projections and whether or not they can aggressively expand.

4. A Compelling Corporate Narrative

   Not all of the factors that make up an IPO valuation are quantitative. A company's story can be as powerful as a company's revenue projections. A valuation process may consider whether or not a company is offering a new product or a service that may revolutionize an industry or be on the cutting edge of a new business model.

The specific number of shares of stock that a company authorizes and/or issues is simply a mathematical convenience that is used to implement the division of ownership among multiple people. As such, the actual number is irrelevant...it is the relative number that is important.

If I am the only owner of a company and therefore own all the shares, it doesn't matter whether I own one, one million, or 1,234,567,890 shares. In every case, I own 100% of the shares.

Advantages of Preference Shares

Owners of preference shares receive fixed dividends, well before common shareholders see any money. In either case, dividends are only paid if the company turns a profit. But there is a wrinkle to this situation because a type of preference shares known as cumulative shares allow for the accumulation of unpaid dividends that must be paid out at a later date. So, once a struggling business finally rebounds and is back in the black, those unpaid dividends are remitted to preferred shareholders before any dividends can be paid to common shareholders.

Disadvantages of Preference Shares

The main disadvantage of owning preference shares is that the investors in these vehicles don't enjoy the same voting rights as common shareholders. This means that the company is not beholden to preferred shareholders the way it is to traditional equity shareholders. Although the guaranteed return on investment makes up for this shortcoming, if interest rates rise, the fixed dividend that once seemed so lucrative can dwindle. This could cause buyer's remorse with preference shareholder investors, who may realize that they would have fared better with higher interest fixed-income securities.

Advantages of Common Stocks

1. Right to Vote in Issues of the Company: After buying shares in a common stock, you’re entitled to speak in the matters of the company. For every share you purchase in the common stock, you’re awarded a vote. You may be asked to vote for electing the board of directors in the company or in decisions regarding mergers and acquisitions. Higher the number of shares you’ve in common stocks, more will be your voting power.
2. High Dividends on Increased Market Value: Since you have a partial ownership of the company, you will be awarded dividends and profits with the increase in market value of the company stock. If the company performs extremely well and it becomes more valuable, you will be able get capital gains, that are a measure of the worth of the company. Similarly, in case, company profits by its business, it may decide to benefit its common stockholders by giving individual dividends or payments in the form of cash or stocks.
3. Lowered Financial Risks Relative to Fixed-Income Investments: It is a fact that stocks are not as adversely hit by harsh economic conditions or inflation as fixed income securities like bonds. If you view history of stocks during times of moderate inflation, you’ll find that stocks may have slowed down in their performance during difficult market conditions but they never perform worst. The net effect of inflation rates is heightened in fixed income securities than in stock investment.
4. Preemptive Rights Remain Intact: One of the best advantages of buying shares in the common stocks is that the individual proportional ownership rights are never challenged. To make it more clear, let us suppose that you have 10% ownership rights in a company. To raise capital, if there is an issuance of common stock in the company and it releases 100 more shares in the market, then you can buy 10 new shares even before they’re issued to the public. This step doesn’t dilute your ownership in the firm even if new shares are being introduced in the market. Your share of ownership in the company remains same the always.
5. Easier and Quicker to Trade Due to High Liquidity: Common stocks are the most common (the name itself says it all) shares and they’re easier to buy and trade, without any restrictions. Young, old, stock market savvy, a beginner investor – anyone can buy and trade them. Large corporations trade frequently and you can buy or sell shares of big companies almost every day; however, you won’t find such trends in shares of small companies.
6. Minimum Legal Complications: As an individual investor, you’re not legally obliged for action taken by the company management except for your financial investment. Being a stockholder, you’ve got minimum legal liabilities for any wrongdoings or fraud of the company.

Disadvantages of Common Stocks

1. Erratic Fall in Market Price: The functioning of markets is very speculative and sometimes, even without some major reasons, there is a drop in prices of the shares. A simple rumor in the market about the performance of the company can lead to fall or increase in share prices. As such, nobody can be sure about how the market will turn out to be at the end of the day. Erratic nature of the market can be very demotivating for investors
2. Downsizing of Dividends: It is a fact that dividends of shareholders are cut in harsh economic times and that is one of the biggest demerits of common stocks. If not due to recession, dividends or capital gains may not be given to shareholders because of the poor performance of the company.
3. Common Stockholders Are the Last Priority: In case of failure of the company, common stockholders are given the last priority. That’s why it is said that those owning common stocks suffer the most during times of bankruptcy or failure of the business. Only after a company is done with all issues like paying employees, creditors and managing taxes, the owners are entitled to get paid.
4. Limited Rights of Common Stock Shareholders:Though it may appear extremely lucrative to have purchased common stocks, in practicality, it may not always be so. Information regarding a company’s performance that is given in the annual reports and is uploaded on the official websites is very complex for a common shareholder to understand. Media news besides the complexity of the stock industry makes it even more difficult to take effective investment decisions. Similarly, no matter shareholders are regarded to be the “company owners”, they don’t have exact rights and powers as that of the CEO or board of directors.
5. Taxes are Cut on Capital Gains: Capital gains are liable to tax cuts. If the shares of common stock perform fairly well, you’re awarded capital gains by the company. You’re expected to pay some tax on the awarded capital gain. This is applicable for shares that have been held for more than one year. The tax rates are variable and keep on fluctuating every year. You can visit the Internal Revenue Service (IRS) website for more details about the tax laws and rules applicable on capital gains.