Dallas Business Consultant Elijah ClarkDallas Business Consultant Elijah Clark

Initial Public Offering (IPO)

Initial Public Offering
Initial public offerings (IPOs) are transactions in which businesses publicly sell their common stock within an inefficient market. In the IPO market, sellers often have more company information than buyers and insider trading is considered legal. The day in which the IPO begins trading, the stock price is likely to close higher than its original value in an attempt to sell the stocks in aftermarket trading. Within the aftermarket trading is where the value reflects the true stock price, as buyers and sellers bargain transactions. A benefit of IPOs is that they grant liquidity to company owners and raise company capital. Taking a company public is when daily operations are overseen by corporate officers who are monitored by shareholder-appointed board of directors.

The Hypothesis
Selling shares in the aftermarket can be referred to as spinning. The term spinning defines IPOs that are immediately sold in the aftermarket and are spun for a quick profit. As firms try to prevent their willingness to participate in underpricing, they may hire a lead underwriter with a highly ranked analyst. This process is known as analyst lust hypothesis. Both the spinning hypothesis and the analyst lust hypothesis are associated with the changing issuer objective function hypothesis. First-day returns create low-frequency movements in underpricing that is less common than hot issue markets. The change in underpricing is known as the changing risk composition hypothesis. The hypothesis states that riskier IPOs are underpriced more often than less-risky IPOs. IPOs are underpriced as a way to entice investors to participate within the market. The realignment of incentives hypothesis is similar to the changing risk composition hypotheses in that its ownership changes instead of pricing relations in average underpricing.

Market Efficiency
Market efficiency is when stock price values are determined by all publicly available information. According to the efficiency market hypothesis, no one investor has the ability to outperform the stock market based on private information. Consequently, stock values are equally priced because of market efficiency. Furthermore, market efficiency requires investors to use their skills and knowledge to interpret the information to achieve profitability.

Market Inefficiency
Market inefficiency creates undervaluation for investors looking to buy into the market. Additionally, it creates overvaluation in which investors can sell. An inefficient market opposes an efficient market by stating that stock prices are not priced accurately and deviate either above or below their true value.

The hypothesis states that issuing firms are willing to accept underpricing when they hold constant the level of characteristics and managerial ownership. Within the changing issuer objective function hypothesis issuers are more likely to leave money on the table considering they place more attention and value on hiring a lead underwriter. Consequently, they are less concerned with avoiding underwriters with a history of excessive underpricing. This method of doing business is referred to as analysts lust hypothesis.

IPO proceeds are functions based on the choices of underwriters and auction and bookbuilding contracts. The changing issuer objective function hypothesis states issuers may put weight on proceeds from future sales and side payments instead of IPO proceeds. Within the changing issuer objective function issuers hire prestigious underwriters who charge by leaving more money on the table. Decision-makers of the issuing firms pay the price because they receive side payments and positive analyst coverage.

To launch an IPO, company’s work with investment banking firms as advisors and underwriters. As an underwriter, the bank purchases the IPO shares from the company and distributes the shares to the market. Underwriters advise issuers on pricing decisions. When an underwriter receives compensation for their recommendation, it creates an incentive to recommend a lower offer price. Bookbuilding is used to price and allocate IPOs. If there is an excess demand for shares, underwriters make the decision to whom to allocate those shares. With bookbuilding, underwriters can allocate who receives hot IPOs. Money on the table is when underwriters have influence over venture capitalist and issuing firm executives. Allocating IPOs allows for underwriters to continually underprice stocks. Decision-makers gain profits in their personal accounts when hot IPOs are allocated to them.

A hot IPO is considered an IPO that is expected to spike in price immediately upon trading. Spinning creates incentives for issuers to select bankers who underprice. The term spinning was formed when the underwriters for the firms allocated hot IPOs to brokerage accounts. The analyst lust hypothesis states that the coverage of analyst is an important factor when choosing a lead underwriter. Considering underwriters are not paid high fees for providing analyst coverage, issuers pay via the cost of underpricing. However, a concern with the analyst lust hypothesis is that it does not consider conflict of interest between managers and pre-issue shareholders, which could benefit pre-issue shareholders in situation where the analyst coverage produces higher market value.

Trade-off and Pecking-order Theories

Trade-off and Pecking-order Theories
A profitable company requires less need for external financing. To satisfy financial needs, firms will often turn to debt. A profitable company usually relies on less debt. However, according to the trade-off theory, the more cash flow a profitable firm has, the more debt it will generate. As the debt capacity accumulates, it will be used to capture tax shields and leverage benefits. Within the trade-off theory, managers seek optimal capital structure. Trade-off theory translates into empirical hypothesis as it predicts a relationship between average debt ratios and asset risk, profitability, tax status, and asset type. The pecking order theory has no optimally well-defined debt ratio. Financial distress is not a concern for the pecking order theory, and tax shields are a more attractive method to use according to the model.

The pecking order theory is built on the struggles of obtaining cost efficient financing. The theory suggests that managers should use bonds because they are a lesser risk for stock price declines. Considering firms know they will need cash within the future to manage profitable projects, they accumulate the cash today, so they will not have to forcibly go to capital markets when financing is needed. Nonetheless, because of the additional cash, managers are tempted to purchase and will likely generate wasteful spending on activities.

Pecking order theory explains the variances of debt ratios, rather than the target adjustment model based on static trade-off theory. The pecking order theory can be rejected if financing flows with the target-adjustments specified. However, the trade-off theory may appear to work, which will create false positive results from time patterns of capital expenses, which creates reverting debt ratios.

Applicable Industries
Pecking order is unlikely to do well for companies investing into intangible assets. Trade-off theory works well within industries that have room for growth and expansion. Mature industries that can practically predict their future like Coca-Cola have nothing to lose by using external funds. In 2014 The Coca-Cola Company (Coke) had a long-term debt of $19,063 million and a net income of $45,998 million. The debt ratio at Coke is optimal and is maximizing its market capitalization value at their debt levels. The company has a long-term debt of less than one year’s current net earnings. Consequently, a single year earnings can pay the debt.

Intel is a company that follows the pecking order theory, particularly because of its high-risk industry. Although the company is large, considering the technology industry is forever changing at a rapid pace, the company struggles to remain relevant, which creates the industry to be high risk. Because of the large market and competition, the company has to create innovative products and quickly get them to market. This causes a problem by not allowing revenue to fund the company’s growth, and the firm has to rely on debt to satisfy the market.

In addition to the theories, capital structure is beneficial as it presents the type of financing a firms uses. The mixture of methods includes equity and debt. To determine the right type of capital structure, firms often use a combination of debt and equity in order to maximize their market value. With leverage, a firm can lower its weighted average cost of capital. However, leverage increases financial risk of firms that must service their debt regularly. Trade-off theory helps determine the most optimal debt-to-equity ratio. Pecking-order theory allows for firms to finance themselves through retained earnings. When there are no retained earnings, the firm issues debt, and as a last resort may issue equity. Debt informs investors that management is confident with servicing the debt, and equity signals that the firm may be overvalued and could trigger a stock price fall. In regards to management, pecking-order theory suggests capital structure is rooted to agency theory and suggest that financial decisions are affected by the firms’ attempt to minimize shareholder supervision. Pecking-order theory seems to focus on examining the financial behaviors of larger firms, which have a larger borrowing capacity.

Trade-off theory focuses on bankruptcy cost and debt, which states there are advantages to debt financing. Pecking-order theory focuses on financing from internal funds, and using external funds as a last resort. Trade-off theory has dominated corporate finance circles. The pecking-order theory assumes there is no capital structure. Additionally, pecking-order can easily be applied to small firms considering smaller firms borrow based on their needs rather than optimal capital structure. Increased financial leverage affects a company’s WACC. With financial leverage, the company’s WACC decreases until optimal debt ratio is achieved, after which, the WACC rises with more debt. Increasing the debt of the capital structure also increases the tax benefits considering the interest is tax deductible. The company’s market capitalization is increased when WACC is decreased considering trade-off theory assumes the company’s risk of bankruptcy.

Customer Perception

Customer perception is a significant predictor of customer purchasing outcomes. The customer’s perception of your purchasing processes can influence your business’s reputation and sales. Customers with a positive perception of your business will likely react differently to reviews posted by previous customers compared to customers that do not have a positive perception.

Value Perception. As a business, you should seek to position positive product knowledge at the beginning of your customers’ journey. While attempting to examine the relationship between customer uncertainty reduction and value perception, I found that customer uncertainty about a business influenced the overall value perception of the selected businesses. To reduce the concern of potential customer uncertainty, your business should publicly display reviews and testimonials to assist in improving the value perception of your business.

— For more lessons like this, purchase your copy of Act Like a Business: Think Like a Customer by Dr. Elijah Clark from all major bookstores. —

Dividend and Non-Dividend Stock Valuation

Dividend and Non-Dividend Stock Valuation
Investors who invest in stocks often like to receive returns on their investment in the form of dividends. However, not all companies opt to offer dividends to their investors. There are three variables that affect the valuation of a dividend and non-dividend paying stocks and how stock valuation is influenced. Those variable influences include size, timing, and uncertainty of cash flows that the asset will generate for investors over its lifetime.

Company that does not pay dividends.
A company offering dividends is a potential signal to investors that the company is settling down and that its growth days are over. Dividends often depend on the size of earnings, and are key in determining the value of equity. Google Inc. is a company that actively invests in future company growth initiatives. Google does not offer dividends as the company hopes to continue its expansion into new business ventures. Taking into consideration the size of Google as a company, it is highly likely that the company will provide dividends at some point in the future. The dividend growth model can be calculated as the stock value equals next year’s dividends divided by the required rate of return difference and the constant growth assumption in dividends. A dividend growth model evaluates and considers dividends within share value and growth.

Merits and/or pitfalls of using the dividend growth model
Organizations that are likely to pay dividends in the future can benefit from using the dividend model. Investors can gain a return on their investment by purchasing stock from non-dividend paying companies and then resell those stocks for a profit. The problem with this method is that the stock is only worth what the next investor is willing to pay. If a company does not pay dividends and instead reinvest the profits into other investments, it could raise the value of the shares to be sold. The concern with using the dividend growth model is that it does not include risks. Furthermore, the model is only effective for company’s that pay dividends and is growing at a constant rate.

How variables affect the valuation of a dividend paying stock and a non-dividend paying stock.
Dividend paying stocks usually perform better than non-dividend paying stocks, considering the immediate value. Non-dividend paying stocks such as Google could use the model to predict future growth rate if Google were to ever start paying dividends. Cash dividends are generally easier to measure. Considering Google is a well-known stable company, if it were to ever begin paying stocks, the model could assume that the dividends would be constant for a time. As an investor, dividend-paying stocks are often a better investment as it can predict a return on investment. In determining equity value, both dividend and earnings-based models can be used.

The Gordon Growth Model is a good way of calculating a stock value. However, it can only used with company’s that pay a regular dividend at a constant rate. Consequently, the model is only effective for stable companies. In addition, it will only work if it the assumptions are continually proven accurate. The model also values the company based on investor payment and assumptions and does not consider anything other than the dividend when valuing the company. Investors and analyst like the model because It is an easy and simple to use method for generating assumptions. For lower dividend paying companies with high dividend growth, the Gordon growth model may not be appropriate. Regarding the dividend growth model, its shortcoming is that the model assumes the growth will be constant. However, there is no guarantee that the growth will be constant as it can be cut. A solution to this shortcoming is to move toward a two-stage or multi-stage dividend discount model (DDM). A multi-stage DDM estimates that a dividend will grow over a number of years at a certain rate.

A dividend discount model (DDM) is a way of applying net value analysis to estimate the future stock dividends and how much it will payout. The dividends calculated are then discounted back to their current value. DDMs assess the stock value based on growth rate. The projected growth rate is compared to the associated discount rate, and the current value is then determined. If the current value is more than the future market value, then that stock is undervalued, which is good for purchasing. The model is an effective tool used by many investors and analyst looking to select stocks. A disadvantage of the model is that it is not suitable for company’s that do not pay dividends. While DDM does not explicitly consider risk, it does assist in estimating the market risk premium. The DDM requires long-term growth rate data in dividends. The advantage of DDM is its simplicity of use.

Loan Evaluation

Financial Ratio Evaluations
Determining the ratio level of a company is a predictor of failure for small businesses, and obtaining data can be difficult. Financial ratios are effective for comparing different types of financial information. Short-term solvency financial ratios should be examined to determine whether a small business is an ideal business for a loan. Short-term solvency measures the company’s ability to meet its financial obligations by providing details about the company’s liquidity measures. Short-term solvency analyzes the company’s assets from cash, stress level, and ability to pay back its loan within the coming year.

Small Business Ratio
Of the short-term solvency, the current ratio is most important. A higher current ratio indicates a positive working capital, and there is a correlation between the current ratio and business size. The higher the current ratio, the more likely the company will be profitable the following year. In addition to current ratio, quick ratio could help in determining whether a business has the ability to meet its obligations. Quick ratio analyzes whether the company has assets in inventory and then deducts the valuation of those items to determine the true value of the organizations assets.

Additional Information
Additional information to obtain from the business owner before making a decision about a loan would be to check the market value and the company’s debt. Analyzing the business ratio to the ratio value of businesses within the same industry can be a predictor of business failure. Determining the debt of the company would help determine the risks level of the company. Debt has a negative effect on a company’s performance. A company with a large amount of debt would generate a high risk of insolvency and potential financial distress.

Large Business Ratio
If a larger company were to ask for a loan, instead of using short-term solvency, I would use long-term solvency considering it focuses on the capital structure and earning power. Long-term solvency is the ability to assure lenders with periodic payments of interest and repayment on the maturity of the loan. It also measures the company’s long-term ability to resolve its loans.

Earnings are better than cash flows for measuring firm value. However, small and unprofitable companies often value cash flows over earnings. As an investor, predictable earnings would be ideal considering they give a sense of how much profit will be paid versus what will be reinvested. In an attempt to avoid negative earnings, CFOs equate the idea of smooth earnings. In a 2003 study, 86.3 percent of nearly 3,200 financial executives stated that maintaining and increasing the company’s stock price helps to build credibility within the capital market as well as attract investors. In regards to meeting financial earnings target, several interviewed CFOs mentioned that they often made economic sacrifices in an attempt to deliver expected earnings. The results of the survey conclude that a majority of companies will sacrifice long-run value for short-run earnings due to market pressures.

If CEO’s have high stock options the firm is less likely to report fraudulent finances. Stock options with incentives can make moral hazard facing CEOs worse. Self-interested CEOs with opportunity to fraud, will likely harm shareholders. Executives with large stockholdings reduce the likelihood of fraud. Industry and firm characteristics are key factors that may affect fraudulent financial reporting. Industry characteristic and firm size are important organizational variations that influence white-collar crime. Principal-agent theory suggests that an increase in CEO options decreases the likelihood of fraudulent financial reporting. The presence of CEO duality and board stock options decrease the likelihood of fraudulent financial reporting. If no CEO duality and no board options are produced, fraudulent financial reporting becomes less likely. If there are board options, that likelihood increases. When a firm’s board of directors has stock options, the likelihood of fraudulent reporting decreases. The higher the CEO options, the less likely the firm is to report financial fraud.

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