Some Case Studies
Some case questions with interesting answers.
CASE STUDY
In 1998, IBM announced that it would repurchase $2.5 billion in stock. Its price jumped 7% after the announcement. Why? How would the market have reacted if IBM increased dividends instead? Suppose Intel made the same announcement. Would we expect the same price response?
okay so how I like to tackle this kind of problem is by thinking from the perspective of shareholders and then the company management. People buy stocks in hopes that they will go up, that is when someone thinks the stock is undervalued, that person will buy it. Here IBM is buying IBM stocks, so IBM thinks that IBM is undervalued. This is what I think led to this positive signal by the stock market. People were like if IBM thinks they are undervalued then sure they would be undervalued. Now the management could also think that if they give dividends then they would have to repeat it in the future and also if they decrease the total number of stocks in the market, then the EPS goes up. To better understand EPS, please see my other blog. Also I think the market would have reacted positively but not as much as compared to the first case. As now by increasing the dividends, the company is obligated to continue this in the future. What if the company cannot do this cause of lack of cash available.
Now if Intel did this then I think it will be the other way round. Intel was still growing in 1998 unlike IBM. This ment that Intel should be investing whatever they generate into R&D. If they reinvested the money, then I think market would have thought that they aren't really going to grow much as much as the market anticipated.
Your firm needs to raise capital to finance growth. Should you issue debt or equity or obtain a bank loan? How will the stock market react to your decision? If you choose debt, should the bonds be convertible? callable? Long or short maturity? If you choose equity, what are the trade-offs between common and preferred stock?
Okay so again to answer this problem we would need to know what kind of firm and like how does our financials look like. Firstly let's answer debt vs equity vs bank loan. I think here if the company has stable profits and cash flow and at the same time we think that the company is undervalued then I would go for debt. As if the company is undervalued there is no point of selling ourselves and if we have stable cashflow then debt seems like a good option. Also by going for debt we will not be diluting our company and also the payment on interest is tax-deductible so it is good for us. The market will take us going for debt positively as that means that we think that the company is undervalued. We can go for equity when we think that the stock is overvalued and/or we don't have steady cash flow (common with startups). Here the market will not take this nicely as the market now thinks that the stock is overvalued. The traditional bank loan is perfect if we want to be away from market (we don't let market know anything in this case), so market will be neutral. Bank loans are good for short term capital requirement. There is one downside of more interest than bonds in this case.
Now if we choose debt. Then we can go for convertible if we don't want a big interest rate. Here as convertible debt leads to dilution of the company as we give ownership. Here there is a potential issue of diluting the ownership. If we want something more flexible for repayment of debt, we can go for callable. There is a potential issue of investors asking for more interest rate than the convertible option. Short term maturity is when we can repay very fast. This is a risky option as there is a chance of not paying it in a given time period. Although it has less interest compared to the long term option. Long term option is more safer but more expensive too. If we choose equity then we can go for common stock when we want growth focused investors but it leads to dilution of ownership. Preferred stock is for more risk cautious investors.
In the 5 years from Jan. 1995 to Dec. 1999, the U.S. stock market increased in value by 227%. DY on the S&P 500 dropped from 2.90% to 1.17%, and the P/E ratio increased from 14.9 to 32.4. Why? What does this tell us about future returns? How should it affect our financing and investment decisions?
Firstly let's quantitatively think what is happening. The S&P 500 is like a basket of stocks. From 1995 to 1999 the basket's price by 227%. The Dividend yield (DY) on this basket has dropped from 2.9% to 1.17%. The price to earnings ratio increased from 14.9 to 32.4. Note that DY = annual dividends/bucket price. The P/E = total price/(net income - total dividends). Now from the looks of it the price doubled, DY halved, so investors are paying a lot more for 1$ earnings and excepting a much lower dividend, maybe optimism. That time period was the time of dot-com boom and falling interest rates (stocks are better than bonds here).
Now as price has increased a lot, and annual dividends have decreased, we would have to increase the earnings by a lot to justify this. Here it seems that the bucket has become very overvalued and so reversion should take place. This is telling me that future returns will be negative (also data is backing me up here as from 2000 to 2002 we see a drop of 34% in price of the basket, haha). For financing it is very basic, as the company is overvalued, go for equity. Dilute the holdings and get this cheap money. For Investing decisions however this is a bad period. Go for diversification, avoiding overvalued sector is a bad idea (especially the IT sector cause of the dot-com boom).
From 1946 – 1999, small firms returned 17.8% and large firms returned 12.8%. From 1963 – 1999, stocks with low B/M ratios returned 13.8% and those with high B/M ratios returned 19.6%. What explains the differences? How can we measure a stock’s risk? What does this mean for financing and investment decisions?
Here there are 2 different cases. Firstly the case of small vs large firm. Now small firms are the firms which just have started, have small market capitalisation and like are more risky. Small firms have a huge chance of improving and so high returns. We can also think of this like more the risk, more the returns. Here smaller firms are more risky investments as they have higher chances of bankruptcy. The large firms returned less then small firms as they are less risky and like there is not a very big scope of improvement. They are more expected and so less returns.
The second case is of the book value/market value. Now it makes sense that when market value > book value, the stock is popular, priced high and so this makes it have lower future returns. The lower future returns is cause of the high priced (think of this like being overvalued). Now when market value < book value, this means that the stock is not that popular, risky and undervalued. This makes it have higher returns but at the same time more risk. For financing we think of being overvalued or undervalued. We can raise equity/debt or not do anything depending on the "value" of the stock. For investors, it is a question of what kind of risk are we thinking of getting ourselves in. More the risk, more the profit.