Distributing Stock

Defining Spread

The spread is the difference between the prices for immediate purchase and sale of a stock, which is one measure of market liquidity.

Learning Objectives

Describe the importance of spread in a stock transaction

Key Takeaways

Key Points

  • The party that initiates the trade is the liquidity demander who pays the spread. The counterparty is the liquidity supplier who earns the spread.
  • Liquidity suppliers use limit orders. A limit order is when the buyer waits until the stock reaches a designated price.
  • The spread is one component of transaction cost, which along with brokerage fees, reflects the cost of making an instantaneous trade.

Key Terms

  • liquidity: Availability of cash over short term: ability to service short-term debt.
  • tender offer: an invitation to shareholders of a corporation to exchange their shares in return for a monetary buy-out
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Signals from dividend policy may give clues about stocks.: The spread measures the cost of executing an instant trade.

Concept

The bid –offer spread for securities is the difference between the prices quoted for an immediate sale (offer) and an immediate purchase (bid). The size of the bid-offer spread in a security is one measure of the liquidity of the market and size of the transaction cost. If the spread is 0 then the security is a frictionless asset.

Liquidity

The trader initiating the transaction is said to demand liquidity, and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders.

Limit Order

A limit order is an order to buy or sell a stock at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. A limit order is not guaranteed to execute. A limit order can only be filled if the stock’s market price reaches the limit price. While limit orders do not guarantee execution, they help ensure that an investor does not pay more than a pre-determined price for a stock.

Example

If the current bid price for the EUR/USD currency pair is 1.5760 and the current offer price is 1.5763, this means that currently you can sell the EUR/USD at 1.5760 and buy at 1.5763. The difference between those prices (3 pips) is the spread.

For a round trip (a purchase and sale together), the liquidity demander pays the spread and the liquidity supplier earns the spread. In some markets such as NASDAQ, dealers supply liquidity. However, on most exchanges, such as the Australian Securities Exchange, there are no designated liquidity suppliers, and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders.

Transaction Costs

The bid–offer spread is an accepted measure of liquidity costs in exchange traded securities and commodities. On any standardized exchange, two elements comprise almost all of the transaction cost—brokerage fees and bid-offer spreads. Under competitive conditions, the bid-offer spread measures the cost of making transactions without delay.

Pricing a Security

The price of a security is the market determination of the value of the underlying asset.

Learning Objectives

Differentiate the different methods of pricing a security

Key Takeaways

Key Points

  • Several methods are used to determine the value of a company including Present Value, Comparable Company Analysis, and Net Asset Value. The goal of each of these methods is to determine the worth of a potential investment in the company.
  • Financial analysis of this sort determines what investors are willing to pay for a given security because it is what they think the security is worth.
  • If most investors think a stock is worth a lot, or will be in the future, they buy it and this demand drives price up. The opposite occurs if investors are not confident about the stock. Therefore, stock price reflects investor expectations.

Key Terms

  • security: proof of ownership of stocks, bonds, or other investment instruments.W

Concept

The price of a security reflects the value of the asset underlying it. Therefore, the market price for a security indicates the consensus value placed on its asset by all the buyers and sellers in the market. It is the result of the valuation of the asset.

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Price: Price fluctuates depending on how the market values the security.

Valuation

In finance, valuation is the process of estimating what something is worth. There are different valuation methods. The choice of which method to use depends in part on what kind of security one is valuing. For instance, some financial instruments such as options are valued using mathematical models which take several variables into account. The price of stocks, on the other hand, depends on the value of the company. There are several methods used to value the company itself.

Present Value

This method estimates the value of an asset based on its expected future cash flows, which are discounted to the present. This concept of discounting future money is commonly known as the time value of money. The time value of money says that if you have an asset that matures in one year and pays $1 at that time, it is worth less than $1 today. This is because if you have a dollar today, you can do all kinds of things with it: invest it, use it to buy something you want, or pay back a debt. On the other hand, if you have to wait a year to get your dollar, you miss out on all these opportunities. Those missed opportunities are called the opportunity cost. Therefore, money you get in the future needs to be reduced to approximate the opportunity cost. The size of the discount is based on the opportunity cost of capital and it is expressed as a percentage. This percentage is the discount rate.

For a valuation using the discounted cash flow method, one first estimates the future cash flows from the investment and then estimates a reasonable discount rate after considering the riskiness of those cash flows and interest rates in the capital markets. Then one makes a calculation to compute the present value of the future cash flows.

Comparable Company Analysis

This method determines the value of a firm by observing the prices of similar companies that sold in the market. Those sales could be shares of stock or sales of entire firms. The observed prices serve as valuation benchmarks. From the prices, one calculates price multiples such as the price-to-earnings or price-to-book value ratios. Next, one or more price multiples are used to value the firm. For example, the average price-to-earnings multiple of the guideline companies is applied to the subject firm’s earnings to estimate its value.

Net Asset Value

The third common method of estimating the value of a company looks to the assets and liabilities of the business. At a minimum, a solvent company could shut down operations, sell off the assets, and pay the creditors. Any cash that would remain establishes a floor value for the company. This method is known as the net asset value. Normally, the discounted cash flows of a well-performing company exceed this floor value. However, some companies are “worth more dead than alive,” such as weakly performing companies that own many tangible assets. This method can also be used to value heterogeneous portfolios of investments, as well as non-profit companies for which discounted cash flow analysis is not relevant.

Financial Analysis

Financial professionals make their own estimates of the valuations of assets or liabilities that they are interested in. Their calculations are of various kinds including analyses of companies that focus on

  • price-to-book
  • price-to-earnings
  • price-to-cash-flow
  • present value calculations

All of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing stock or bond prices, and may result in buying or selling by market participants.

Price and Valuation

Investors use valuation methods to estimate what a company is worth, but the price of a stock on the market usually does not rest at the book-value of the company. Typically there will be people who are either optimistic about the company–because they anticipate that it will be worth more in the future than it is in the present–or pessimistic–because they think it will do worse in the future. Optimists will buy more of the stock and drive the price up, while pessimists will sell and drive it down. Therefore, a stock’s market price also takes into account expectations for the future performance of the company.

Shelf Registration

Shelf registration is a type of public offering in which the issuer is allowed to offer several types of securities in a single prospectus.

Learning Objectives

Describe the self registration process

Key Takeaways

Key Points

  • A company can file a shelf registration statement with a prospectus that offers different classes of securities. It can then sell all, none, or some of the classes at any time.
  • Regulators generally grant shelf registration to companies that are reliable. They also require a statement of material changes in business since the prospectus was filed before each security is actually sold.
  • Shelf registration can be used by a company as a strategy to quickly sell securities for funds when market conditions become favorable.

Key Terms

  • prospectus: A document that describes a proposed endeavor (venture, undertaking) such as a literary work (which one proposes to write).

Definition

Shelf registration or shelf offering is a type of public offering where certain issuers are allowed to offer and sell securities to the public without a separate prospectus for each act of offering. Instead, there is a single prospectus for multiple, undefined future offerings. The prospectus (often as part of a registration statement) may be used to offer securities for up to several years after its publication.

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Shelf Registration: Some of the securities in the prospectus can be “shelved,” and sold later.

Application

A company can file a shelf registration statement with, for instance, a prospectus for 100,000,000 shares, $1,000,000,000 face value of bonds, $500,000,000 dollar face value of convertible bonds, $50,000,000 Series A warrants, and $50,000,000 Series B warrants. These five different classes or series of securities are offered in a single document. The company may offer to sell all of them, none of them, or any part of some class. It can sell 30,000,000 shares at one time and another 50,000,000 a year later. In that case, it will then have 20,000,000 unissued shares covered by the shelf prospectus.

Material Changes in Business

Before each offering and sale is actually made, the company must file a relatively short statement regarding material changes in its business and finances since the shelf prospectus was filed.

Regulation

Shelf registration is usually available to companies deemed reliable by the securities regulation authority in the relevant country. Shelf offerings, due to their purposefully time-constrained nature, are examined far less rigorously by those authorities, compared to standard public offerings.

Strategy

Shelf registration is a registration of a new issue which can be prepared up to two years in advance, so that the issue can be offered quickly as soon as funds are needed or market conditions are favorable. By using shelf registration, the firm can fulfill all registration-related procedures beforehand and go to market quickly when conditions become more favorable.

Firms often use universal shelf filings and choose between debt and equity offerings based on the prevailing relative market conditions.