1. INVESTMENT BANKING LESSON 11 UNDERSTANDING STOCK AND FOCUSING ON PAST TRANSACTIONS Investment Banking (2 nd edition) Beijing Language and Culture University Press, 2013 Investment Banking for Dummies, Matthew Krantz, Robert R. Johnson,Wiley & Sons, 2014

2. WHAT’S IN THE NEWS OR WHAT’S THERE TO LEARN? 10 Most Profitable China Companies

3. A. INTRODUCTION – What is stock? B. TYPES OF STOCK C. UNDERSTANDING STOCK PRICING D. LOOKING AT PAST TRANSACTIONS FOR CLUES ABOUT PRICING E. ANALYZING PAST TRANSACTIONS F. A KEY RATIO FOR PAST DEALS G. UNDERSTANDING PROBLEMS (PITFALLS)

4. This lesson looks at what stock, called equity, is and why the value on the market does not always match what the IB’s measure on their spreadsheets. We will see how stocks are priced by the market. And finally, how to look up past transactions, a key way that IB see what market prices have been in the past.

5. DIS, IBM, MSFT, FB. These are stock ticker symbols. To an IB this like chatter – almost like a game of chess! But what is stock? What does a share of stock represent?

6. 1. A financial security that gives its owner a claim to a portion of a company’s earnings. 2. Owners of stock are called shareholders or stockholders. 3. Ownership stake in a company 4. The number of shares indicates how much of the company a shareholder owns.

7. 5. Stock values measure the market value or also known as market capitalization, which is the total value investors are putting on a company. If a stock is trading for $100 a share and we know the company has 200 million shares what is the value of the entire company?

8. 5. 20 billion - Market value = # of shares x current price 6. Stocks can be risky and can go down to the point of even losing everything! For example in bankruptcy 7. Stockholders are last in line 8. How do you make money with stocks?

9. Two main ways make the total return: Dividends (not every company). But can also be cancelled or suspended at any time Stock price appreciation, the amount you get when you sell the stock.

10. There are 3 main types: 1.COMMON STOCK 2. PREFERRED STOCK 3. STOCK OPTIONS

11. 1.COMMON STOCK – As the word says, it is the most common. Most shares sold by the company. 2. PREFERRED STOCK: a. Pays a higher dividend yield b. Pays dividend before payment to common stock holders. c. In case of bankruptcy, preferred stock holders would be paid first

12. 2. PREFERRED STOCK: d. Pays a fixed dividend, common stocks do not. e. NO voting rights f. Can be callable, which means the company can buy at any time shares from investors at a pre-agree price.

13. 3. STOCK OPTIONS – Gives the owners the RIGHT but not the obligation (don’t have to) to buy or sell a stock in the future at a pre-set price. Speculators (risk takers) use options to “bet” that a stock price will rise or fall in the future. There are 3 types of options:

14. 3. STOCK OPTIONS a. puts – Gives the owners the right to sell b. calls – Gives a right to buy c. warrants – Can be given to company executives as a form of incentive pay

15. Stock trading is one of the financial services offered by some of the largest IB. IB often come up with a different value for a company than what the market says it is worth. So, knowing the market price of an asset is valuable, especially when the market price is different from the value IB models say.

16. REAL WORLD EXAMPLE: In the 1990’s, during the internet boom, the market and IB value of a company was quite different. Investors were willing to pay huge money during this boom time and at the end of the boom, more investors would have been wise to listen to IB. Yet, this was a boom time for IPO’s and many believe the market will never be the same.

17. Tracking the stock market to find past transactions is easy with publicly traded companies, as you can find them on websites and stock charts. But what about private companies? These are the companies IB work with for IPO’s. There are 5 ways IB find this data. Let’s look at these!

18. 1. Comparing with public companies – there are databases that can provide limited information. Using industry valuations and estimating value. 2. Checking to see if debt is sold – EDGAR is one way as private companies must file with the SEC but also debt obligations are made available by investors. 3. Finding venture capital raised – private companies will use venture capital firms.

19. 4. Looking for transactions with public companies – Public companies will often buy or sell their interests in private companies. 5. Checking pre-IPO markets – Employees of private companies may want to sell some of the shares they were given for joining the company. There are websites that show their sells to accredited investors willing to take the risk. These investors often are insurance companies, large banks, or companies with assets over $5 million.

20. As with everything from tea to going to the Beijing Opera, the price of a stock is still based on supply and demand. Companies can increase the number of shares in a follow-on offering, which is a sale of stock after the IPO. Likewise, they can reduce shares with stock buybacks. Companies use their excess cash reserves to buy back in the open market.

21. Often stock prices don’t reflect reality. It’s important that IB know these times, so they will look for these signs: 1. Valuations are too high! When P/E ratios and price-to-book are way too high when comparing them to past history that is one clue. 2. Insiders start selling their stock – There are 2 types of insider trading: the legal kind and illegal kind.

22. It’s illegal (not legal) for insiders like employees to use non-public information to trade for gain. The legal type is when company executives buy or sell stock. When CEO’s buy stock some investors might think it is under-valued (price too low). When investors see insiders selling stock, maybe the stock is over-valued.

23. 3. Companies can be glamourized (look too good) – Investors using tools like discounted cash flow analysis, IB can bring a stock price back to reality. REAL WORLD EXAMPLE: Krispy Kreme donuts was selling like “hotcakes” (most everyone in America likes hotcakes or pancakes for breakfast) at 30-35 a share and going up. It went up to almost 50 before the market realized it was way over-valued. I even owned KK at the time and made a nice profit.

24. When companies are invested in, or bought out completely, this is a time for IB to use their skills. REAL WORLD EXAMPLE: In 2013, US pork producer, SMITHFIELD, received a $4.7 billion cash buyout from Chinese conglomerate, SHUANGHUI International. The amount paid for the stock is equity value. Shuanghui was paying $34 per share for each of Smithfield’s 139 million shares outstanding..

25. This deal that was completed in 2013 gives a great look at how to put a price on a past transaction. As part of the deal Shuanghui agreed to take on all of Smithfield’s liabilities, including debt of $2.4 billion. But Shuanghui would get $310 million Smithfield had in cash. Adding the cash buyout of $4.7 billion and assumed liabilities, but subtracting Smithfield’s cash, gives the company an enterprise value of $7.1 billion.

26. Enterprise value = equity value (market value) + liabilities (debt) – cash There are 3 other ratios that IB will use to see how Shuanghui compared with the industry in this deal. Ratio Smithfield’s buyout ratiosValue Enterprise value/EBITDA 9.2x Equity value/net income 25.7x Equity value/book value 1.5x

27. Past transactions don’t always tell the whole story. It would be easy to assume that if a company sold for $1 million, a company that is four times bigger would sell for $4 million. Not so, and here’s 4 reasons why: Liquidity distortions (confusions) – You might think that if 10% of a company sold for $1 million the company is worth $10 million. But in selling that first million, shares sold at a higher price as there weren’t many sellers. But as the company gets sold off, the share price will come down, a lower value for the company

28. “Big Fish” Problem – When a small tech company has a great product there are many larger companies that might want to buy it, which can lead to “bidding wars”. But when a small company has a big valuation, that valuation does not carry over to larger companies REAL WORLD EXAMPLE: IBM bought SoftLayer technologies for $2 billion in 2013. But there aren’t many companies who can buy IBM so it does have the same valuation multiple.

29. Lack of Information – IB who are great at getting “all the facts” may not be able to get all the information especially when private companies buy other private companies. Or public companies that buy companies that are considered to be too small. They simply can’t get it all – all the information that is!