9. Corporate Stocks

published on July 13, 2020

Talking about corporate stocks this time we've talked already about them a little bit we talked about how people would set up a corporation and then divide it up into shares and and then the company grows and more shares are issued and some people sell their shares it's a

It's a way of creating an organization that that worked we talked about the first real corporation with traded shares that was the Dutch East India Company in the early well 1602 it was an idea that took hold and became

A scheme for organisation of business and has become extremely important around the world I actually had my own personal experience I've created two corporations in my life first time it was one of my students here at Yale Alan

Weis actually he was not an undergraduate he would say getting an MBA from the School of Management but he came to me after he graduated and said I'd see that you create home price indexes I'd like to start a company and

Sell them okay and so he wanted me to advise the company and then we decided to make it a corporation and we called it we brought in my colleague chip case who's at Wellesley College and it was called Case Shiller Weiss incorporated

And we brought on a fourth a real businessman so but he said it would be ridiculous to have four names on the company so he generously allowed his name his check long field but then we set up the company I remember saying you

Know I'm not going to be that involved I'll be somewhat involved but I'm not going to I'm going to keep teaching at Yale and you know I can't do more than a day a week at most or less than that so we had to decide how many shares we got

All right the only guy who gave it money was the businessman so he actually that's how you do it I put money into the country the rest of us just agreed to put it in time so it question is how do we divide

Up the company who gets how many shares the businessman put in money I'm putting in time how do we how do we do that and I know I'm not going to put in as much time as Alan Weiss who's actually running the company but you know what we

Did we just divided it four ways and we set it up and it's not a big company but I'm saying it's my own personal experience having done this we sold that was 1991 we sold it in 2002 to Vice Irv Inc and at that time we had 12 employees

Never got that big but then later on S&P bought the indexes and we have the home price index is called the S&P case-shiller index –is which now they're quoted a lot thought it was a success it didn't get really big but it

It was a success one thing that I learned from this experience is an appreciation for lawyers okay because I had never found a company before I didn't know what kind of things would happen just all you know it's done in

Dividing up the company he was just fairness that we thought will all make our own contribution in our own way we can't decide who's more important but you know honestly I didn't really care about the money for me it was just a new

Experience you know it was kind of like we could all be in this together if we're all trying to make money and making something big so it was just kind of a story for me that made it in a little bit of an adventure I was in it

For the fun of it because I really don't feel like I need any money I have a job right I don't I don't aspire to a mansion or anything like that but we just did it it was fun the reason why I appreciated lawyers is that they

Seem to anticipate all of our conflicts and they wrote things we had a corporate charter a long document but it made sense because we did get into some conflicts this is what happens in a company somebody isn't working as hard

As somebody else and then some resentment develops so what do you do the the salve is more shares okay if one guy is doing more than another it gets brought up at the board meeting and someone says well let's give this guy

More it's called a bonus right so we kind of discovered the wisdom of this of this system and I think a lot of people around the world have discovered it and that's why corporations are such a important component of our of our

Economy so that's just my own personal story but I wanted to talk about big and important corporations not not mine but first I wanted to give you some sense of perspective on how important corporations are corporate stock okay as

Traded on stock markets so I have data here from the World Bank and that's the website you can get all the countries of the world from it if you want and the latest data they have is 2008 and for various countries of the world here they

Have our various regions of the world they have the value of the stock market of the listed stocks in those countries in trillions of US dollars and they also have that's this column the trillions of dollars they also have the fraction of

GDP represented by the stock markets in that country so you can see that the biggest stock market and the world is the United States so it's eleven point seven trillion in 2008 according to the World Bank second biggest is the euro

Area five trillion and UK is very big because the United Kingdom's very early to become a financial center and its enormous financial centered now the interesting thing though is as a fraction of GDP now

Understood are confused by when we talk about fraction of GDP because it's one year's GDP we're talking about we're comparing a stock with a flow a stock of wealth in the stock market dividing that by one year's GDP so it shows here that

The united states is a stock market in 2008 was worth almost a year's GDP and it was higher than any other at least other major country again this is a symbol of capitalism all the value if you want to invest in stocks anywhere

You live in the world they're going to probably come to the United States because it's it's much higher than that I mean if you do Asia Asia and the Pacific 3 trillion there but us is for almost four times as large that's

Because of the long history this is a capitalist country and it as I was saying the the New York corporate law of 1811 kind of got this ball rolling and so it has led the world on that but I think if we look at this chart again in

10 or 20 years it's going to look different because stock markets are growing around the world as a form of Organization for enterprise so these numbers are on the rest of the world are all going up and we'll see more and more

Value elsewhere I think this is and the reason is because it works the system coordinates the activity it allows people to work together and it allows them to avoid conflicts and motivate people to work and and get things done

And it creates wealth and people like that and so it seems like something that was learned we had a big grand experiment with socialism obviously in many places of the world and the socialist kind of gave

Up on it they decided this works better that's why we have in China now market socialism still socialism in a sense maybe it's transformed and it's different but it does have a stock market and it's growing rapidly there

But I don't want to exaggerate the importance of these either because the total value here for the United States is only 82% of one year's GDP another way of putting it is let's round that to twelve trillion and there were about 300

Million Americans in 2008 that's $40,000 per capita is the total value of the stock market now does that sound like a lot of money to you well I think of it this way for a family of four that's a hundred and sixty thousand that won't

Buy you a house okay so it's not that big it's big but it's not that big what you have to remember is that corporate stocks are claims on the profits of corporations but most of what corporations do is take money in and pay

It out they pay it out to their employees and to other people bondholders and taxes lots of other places the money goes to so the actual value of the stock market I think most people exaggerate it in their mind

It's not that big it's big but not that then it's smaller in other countries you might wonder why is it that in Europe it's only thirty eight percent of GDP that sounds funny right I mean in Europe they tend to do things on a they're

Moving I think in the direction of more modern corporation with big exchange traded corporations but they often do things on a smaller they'll still so for example in Germany you notice that often companies in

Germany after the end of their name they have a G that stands for Aktiengesellschaft and it means stock market company but others have GM the age do I have that capitalized right gesellschaft net disrupt their respect

Their half stone that means a family company or its company that's not traded on the stock exchange what we're looking at here are traded stocks alright and you can you actually my company that was just telling you about was never traded

So that's called private equity if it's on the stock exchange it's public equity and and it's if it's on me if it's on if it's not traded then it's private so this is private and this is public and there are similar distinctions in other

Company countries but this is Germany I just wanted to be clear about one thing which the word equity it has many different meanings but the meaning that we have here is shares in a corporation I was curious about how long how far

Back that term goes that word equity referring to shares was not coined until I think it was 1904 according to the Oxford English Dictionary so and it was American it's an American term it's now spread over the world but we use equity

I try to think why do we call it equity I think equity means equality and fairness all right and so what it means is each share is equal I think that's what it means we're treating people with equality so

So that's what we have an equitable division of profits among owners of a corporation by the way I was making the comparison I said the value of shares in the United States is 40,000 per capita and it must be much less in Europe like

Twenty thousand or less of traded stocks I just want to compare that with with houses I said a hundred and sixty thousand would be the share of a family of four in that value of the US stock market actually it is quite clear that

The value of houses in the United States is greater than the value of the stock market according to the Federal Reserve the total value of houses in the United States in 2010 was eighteen trillion that's quite a bit higher than the value

Of the stock market incidentally the Federal Reserve estimates the total assets of households in the United States and in 2010 that was 69 trillion so people own a lot of other things besides stocks so I'm kind of minimizing

The importance of the topic in my lecture because stocks aren't that valuable we we couldn't solve the poverty problem by redistributing the stocks among all the people suppose we did that all right suppose we said let's

Grab all of the stocks away from the wealthy people and let's just share them equally among the whole people so some poor family would get a hundred and sixty thousand dollars one time only right remember one time only it's it's a

Stock it's not a per year amount so you know would that lift them out of poverty not if we have to live the rest of your life on one hundred and sixty thousand you'd still be in poverty so the solution to poverty is not

Redistributing stocks I think the solution to poverty is instead making these markets work better so that we produce more okay so I'm going to talk about stocks and the different kinds of stocks and

The laws of the stock market here today and then I'm going to come at the end with a couple of examples of companies I having an example of Xerox and Microsoft both high-flying companies in their days so so another term that I just want to

Use corporation corporation comes from the Latin corpus meeting body and incorporate the idea of a corporation is like a a legal person everyone every person every lawyer say natural person each one of you is a natural person but

There are artificial persons as well and the corporation is called an artificial person even though it really only is owned by people it's like a slave belonging to the shareholders so that's the origin of the term actually

Corporations go back to ancient Rome where they were called publicani but and they had a stock market in the Roman Forum but they were never allowed to proliferate the laws encouraging them

Did not create a swell of new companies there were very very few of them it wasn't until the 19th century that corporations really became important now corporation is has is owned by the shareholders okay and in most

Corporations they're all the shareholders are equal that's why we call it equity and they all have one vote it's one share one vote not always there have been options there are non-voting shares but

Usually they all vote and the idea is that the shareholders vote to elect a board of directors this is what they call shareholder democracy it's inspired by political democracy so we're going to set up a company that's democratic but

It's not democratic in that every person has a right to vote it's each share has a right to vote and so that's the essential idea the board of directors is it and the true by tradition it's when you form a company

In the United States you have to choose a state to incorporate it okay and then each state has its own corporate laws so my company we did it in Massachusetts a lot of people like to do it in Delaware because they like those laws of Delaware

And the taxes of that state but so you choose and then the state will dictate some basic rules typically that you have to have an annual shareholders meeting where you vote that's the idea and you know we did that

I remember we followed the law it was a great you know someone had a plan and it worked and so what do you do at the shareholders meeting well anything according to the bylaws of the company certain things have to be decided there

But not many the basic thing you do is you hire a chief executive officer you agree to hire that person and then this chief executive officer reports to the board is an employee of the company okay and in the us the chief executive

Officer has by tradition often been named as chairman of the board but in Europe that's less likely there are some different traditions and in the rest of the world a lot of people say it's not good to have the CEO as chairman of the

Board but it's better to have the Board of Directors are not generally working at the company the Board of Directors are people who were brought together to give wisdom to the company it's just what happens you're setting up a company

And you don't know where to go and what to do you need someone to run the company that's the CEO and the CEO is probably a gung-ho guy is going to work 80 hours a week and he's ready to go but he needs guidance guidance and so you

Get people with different perspectives someone who ran a business years ago and is retired or you know any number of different kinds of people and the board will meet more regularly than the shareholders shareholders the

Shareholders don't want to get involved typically because they typically own many companies and they don't have time to worry about but you keep a boards if you keep it small enough there's not too many people like six to ten people and

And they they know everything about the company they're privy to all the information and they talk to each other at regular big meetings and they they call each other up on weekends and it's part of the concept of a director that

You know you just take responsibility for this company you don't run it but you're responsible for it and then the law says in the United States that if you join a board of directors you have a duty of loyalty to the shareholders okay

That you were elected by the shareholders to be on the board and that those are you have a duty you may not own any shares in the company typically don't and the board of directors is typically paid only a member of the

Board has paid some token amount of money you wonder why people do it they often do it just to kind of stay involved and keep themselves learning but they can make substantial money but they're not the owners of the company

They don't get rich they're the kind of wise people that were brought in to just you know this is your you join the board it's your you're taking on a responsibility you're not taking on a massive responsibility you

Know you only meet you know a minimum maybe of four times a year you'll be on phone calls but you have some responsibility for the company and some people like that and they kind of sense that well I'm a productive part of

Society I have this company I'll learn all about it and think about it in a broader perspective and so that seems to work this sort of organization seems to work really well you know what will happen the board will be talking

Informally among themselves and let's say it's a CEO really doing a good job you know and they think about it so I want to just sort of ask around with our customers and what do they think and so someone might say you know we could just

Get a new CEO let's do it and then the guys out immediately if they vote at the board meeting and that this this is a structure that keeps companies really good in one of the previous semesters I had Carl Icahn come who is a notorious

Board breaker well he comes in his career he told our class here that he he likes to buy enough shares in a company to get himself on the board and he loves to go and show up at board meetings he buys companies with his relatively

Ineffective boards and the board is not really not really paying attention they're kind of lazy and he comes in and he makes shocking statements like fire the CEO right now this is guys a loser and Andy the board gets all upset

Because they kind of like the guy is cozy but Icahn says you know I can do it I go in there and I lay it all out and maybe take a few meetings I can bring them around and get the company straightened out so this is shareholder

Democracy see how it works well not everyone agrees with Carl icons and interpretation he's a he's a controversial guy but now another thing I want to say there there are basically

Two kinds of corporations there's for-profit and nonprofit the I've been talking about for-profit and all these people listed as owning all these people listed I had on the screen as listed shares are for-profit okay that means

They have shareholders there's another kind of corporation which is called nonprofit and we're standing in one right now it's called Yale University it's a nonprofit corporation and it has a board of directors they call it the

Corporation they meet regularly it's like other corporations but there are no shareholders so it has how so how can that be who owns Yale well it's it's another it's a person Yale University like other

Universities is a legal person and its rights are defined by law and the profits go back to Yale and accumulate there and are spent for a cause namely education and research so the board of directors of Yale has a different

Purpose they don't have an a duty of loyalty to shareholders because there are no shareholders I mean we can call you shareholders I guess if you're students here but that's not what you're called and you don't have any rights to

The profits profits are spent to for good causes so you kind of wonder well those two sound very different don't they because at for-profit is trying to make money and the nonprofit is doing something for a cause that seems totally

Different but they're not always totally different because a lot of what happens in corporations is set up it is determined by the kind of the sociology of the organizational structure so if you have a board of directors you know

Some people serve on multiple boards they'll be on Yale University and they'll be on some other company for profit but they probably the same person they probably behave kind of similarly in both places so oddly enough

For-profit and nonprofit don't often mean that much we're going to come back to nonprofits later in this semester but I'm really talking about for-profit now that sounds kind of selfish right in a sense I kind of like none a lot of us

Like nonprofits better they have a different cachet in our society I I was talking to Peter Tufano who's a professor at Harvard Business School who set up a non-profit company called doorways to dreams that's the name of

His company they said there's a website search on doorways to dream and it's all about Finance for the poor and the less representative people and he said setting up a non-profit was the greatest thing he ever did because because he it

Opens doors for him he walked in and says I'm I'm running a non-profit to benefit poor people in the United States getting their financial things in order he said everyone respects me and you know if I say I'm trying to make a

Profit they were skeptical we have one professor in our econ Department Dean Karlan who's set up a big nonprofit at Yale so that it's kind of rare anyway I'm talking here today about his is called innovations for poverty action

And just last night I had a door-to-door that's my surprise I had a young Yale freshman come by asking me to donate here in New Haven there's no donations to cook I guess Yale gets donations it's all ambiguous but but private companies

Don't get donations generally all right the value of a share in the company is equal to the total value of the company divided by the number of shares okay so the market cap of a company is equal to the value per share times the number of

Share market cap is short for market capitalization and that is that is the value of the company so the the key thing you have to know about a company is how many shares are there and how many shares do I have right maybe I'm

Repeating myself but if there's a million shares outstanding and I own a thousand shares then I own one one thousandth of everything the company owns which I own after after their death and so but if there's ten million shares

And I own a thousand shows and I only one ten thousandth you have to know the number of shares if the number of shares that you own is meaningless unless you know the total number of shares in the company and all the different shares are

Treated equally if they pay out any money to one shareholder they've got to pay it out to all the other shareholders in proportion to the number of shares now companies issue dividends a dividend is paid to shareholders when the Board

Of Directors decides to do it and the Board of Directors doesn't have to do it I'm talking now exclusively about for profit all right so the board meeting they can say hey let's pay a dividend I remember this because

We had exactly this meeting in our little company but we gave shares to all of our employees to motivate them right everyone's a shareholder at all but they had tiny in numbers some of them had very little shares and we had a board

Meeting and we said you know we've never paid a dividend should we do it should we pay a dividend and then we had a discussion and someone said well you know all these employees wonder if their shares are worth anything so maybe if

They got a check in the mail they'd feel better but you see the dividend is subject to the discretion of the company ultimately people own shares to get dividends right because they need the dividends is the distribution of profits

If a company never distributed dividends it would be like a non profit right if all they if they kept all the profits they can do that there's no law saying that they have to distribute dividends they can just keep it in the company and

Like Yale University get a huge endowment and just let it get bigger and bigger but you know the whole purpose of a for-profit company is to pay dividends it's a sooner or later they do it but typically young companies don't pay

Dividends why not because everybody knows that our money is in the future we're starting up we're not making a lot of money in the future we'll have a lot of money so let's let's pay dividends later for example Microsoft that I'm

Going to describe went through decades without ever paying a dividend they just kept plowing it back into the company now if you if you knew that they would never pay a dividend then you wouldn't want to own Microsoft shares

But you'd think well eventually they're going to and so that's why you own the company but this is a very common misunderstanding a lot of people think that you buy stocks because the price

Will go up okay well the price will go up only because people think there are more dividends coming at least in theory that's the way it should be the price ought to be will question this later but it ought to be the

Present value of expected future dividends and so the true value of a company is entirely in the dividends it seems a little funny because you think well the Board of Directors doesn't have to pay a dividend and they could just

Get nasty and never pay it out but remember you elect the Board of Directors and so if you're frustrated that our company is accumulating lots of money and it's not paying it out I want the money right so I'm not going to vote

For this board I'll put Carl Icahn on or someone else pay it out and then that's what happens they start paying it out when they pay out a dividend the share price falls tip generally right very simple why would the share price fall

When they pay out a dividend well because the company is worth less they had this money and they paid it out so it should fall by the amount they paid out divided by the number of shares right and companies do that routinely

When they when they declare a dividend price Falls it's called the ex-dividend price and they show it in newspaper well don't do it it used to show it in newspapers now it would be on the website they put a little X buy the

Stock price on the day after a dividend is paid to tell you that the price decline that you just saw is not anything to worry about it doesn't mean there's bad news about the company it just means they just paid a dividend so

The price routinely goes down by the amount of the dividend it doesn't mean anything some stockbrokers have tried to alarm investors about dividend payment dates and mislead them and and some

Stockbrokers would say why don't you buy the stock right now because if you buy it right now you'll get a dividend they're going to pay a dividend in three days hurry up and buy it and you'll get the dividend that's called selling

Dividends and it's considered unethical for a broker every you that because you know it really doesn't matter because if you buy it later you won't get the dividend but you'll get the share cheaper and it all

Comes out to about the same so it doesn't you know not to worry about dividend payment dates because the stock price jumps down right after a dividend so it doesn't matter with you except maybe if some second-order

Effects doesn't matter with you by the before or after a dividend all right so you see the idea here the idea of a corporation is we have these shares and the shares are always saleable so let's say four of us young people form a

Company and then after a couple years one of us says I get another job I'm tired of this I want out and you say fine we'll buy your shares back okay we agree on a price so it's very fair and easy so people can be can get in and out

As they see and only the only people involved are people who who want to be involved and then you'll find some new person you know the four of us set up a company there's some new guy who just heard of us anything this is a great

Idea I want in so then you say alright well we'll sell you shares in the company but maybe the price has changed right when we started we might have been worth a lot less so the guy has to come in at a new price and the price is

Changing every day it makes very good sense so moreover if the company needs to raise money to go to bed so we've started a company and we need to build a new factory let's say to expand our

Operations well we can go out and issue more shares to buy the factory you know so we go to a stock broker who like a real estate broker who who issues who deals in markets for shares I'm talking about a small company so I'm thinking of

A private company for which there is no stock market price but the stock broker can go out and say I'll find a buyer you know I talk I have various tax I I know people who deal with individuals who wealthy individuals who

Looking around for an investment maybe this person will buy some shares and then you'll get the money that's an alternative that's called equity financing that's an alternative to financing by debt your company could

Also go to a bank and ask for a loan called a corporate loan or your company could borrow money on the bond market by issuing bonds you can go to a broker and say we want to sell corporate bonds but the difference of those is that it's at

A fixed interest rate and it's not a share in the profits so equity financing tends to attract lively investors who take risks see if a company gets debt then the debt leverages up the risk of the company

Because you as a shareholder now are paid only after the debtors are paid you own the value of the company which is the assets minus the liabilities as a shareholder but you've got to subtract off the liabilities so companies having

A choice of how to finance their operations typically they start out with equity I guess they could start out with debt as well but in our case of our little company it was all equity at first then we got bank loans and so we

Started to get leveraged and that's what happens big companies do the same thing I'd like to talk about the simple company that you might set up with your friends because it seems so personal and you can imagine doing that right and you

Can imagine the kind of conflicts that would have but these little companies have a way of growing really really big so I'm going to talk about a little company set up by Bill Gates and Paul Allen in 1975

Bill Gates was an undergraduate at Harvard and he saw an opportunity and he dropped out he was right he never got his harvard degree i suggest that if you see such an opportunity you do the same thing i hate to say if you if you

Can see an opportunity like that so it started out just you know bill and paul and their little company but they have a way to grow into bigger and bigger things the question is are they are they really different later

Do they know so one important question is about whether big companies really use equity financing are they still functioning the way I'm describing see I set the idea of a company up as it as a structure that lawyer is invented that

Allow people to work together and allow them to get in and out of the company does it really still work that way for really big companies and there's been a complaint about the stock market that the companies generally don't issue any

More shares once they're big this is a complain not saying it's right and that the stock market ends up as a market for existing shares and see the idea is is the stock market or are the stock market's of the world

Functioning in a to make capitalism work better well I could say well then they should be because the price of a share in a company is an indicator of the value of the company and it directs resources I mean people look at that

Price and they decide where to invest but if they're not issuing any more shares does it matter so I had a quote from Karl Marx here you've heard of Karl Marx the founder of communism and he in his book capital Das

Kapital of his classic work said I'm quoting Marx since property here exists in the form of stock its movement and transfer become purely a result of gambling on the stock exchange where the little fish are swallowed by the Sharks

And the Lambs by the stock exchange wolves okay that was that was Marx's view but even in communist countries that view doesn't seem to be holding sway anymore the thing that that Lent some credibility to these theories

Is that it often seems that big companies don't issue many shares anymore and I'm going to qualify that but there was a very influential article written by Stewart G Myers who is a professor of

Finance that at MIT and that was in the Journal of Finance 1984 and he said that he gave some statistics that this this was an influential article making it sound like Cher's don't really matter for big companies he said well how do

Companies really finance their how do they really finance their needs and he gave data this is Mira's data from 1973 to 1982 and he found that 62 percent of corporate financing needs came from in

The United States retained earnings what he's saying his companies they didn't sell new shares they just accumulated profits and then they when they had to build a new factory they went to their own piggy bank and they bought the new

Factory or whatever it was I needed and only six percent was equity issue this is for the whole US stock market and the rest was debt that they would borrow money for it so he said so Stewart Myers said you know all this idea that stock

Markets function to allocate resources and sharemarket means something is really misleading so what he proposed is what he called the pecking order theory what he meant is companies really don't want

To issue new shares they just don't want to do it you know we own this company we're not letting more people in so what they first do is they just try to save their own money this is Myers explanation companies save money and

When they have money they spend it on expanding it and then that's the highest on the pecking order they like that the best but if they really need money and they can't save enough to expand they need they have a lot of expansion

Opportunity they'll go to a bank and borrow they'll go to an investment bank and issue bonds and then only if it's really really important and they can't get enough money they will go to selling new shares so I don't know if Stuart

Myers said Karl Marx was right but he seemed to be saying that equity issuance wasn't that important however I think that is misleading and I'm going to refer them to another article that came in much later criticizing Myers and the

Article is by Eugene fama and Kenneth French it's at Chicago and Dartmouth respectively they wrote an article up in it was 2004 2005 and again in this is the Journal of Financial Economics 2005 they said that the

Problem with Meyer is pecking order theory is that Myers was looking at aggregate data and he was looking at a time period when there was relatively little of equity now when Myra said only 6% of corporate financing comes from

Equity issuance they were talking about net equity that's total new purchases new sales of shares by companies – repurchases of shares by company and so it out to be a low number but in fact

As pharma and French point out in in the same year that Myra study from 1973 to 82 sixty-seven percent of US companies issued new shares each year that's and also in subsequent years the percent went up from 1993 to 2002 it was 86

Percent so you know they're all issuing shares just that some are issuing and some are buying back so I think that we should include that that companies really do use equity financing and even big companies and the stock market is

Important for the price discovery I just wanted to remind you of the term dilution dilution refers to what happens when a company issues more shares so imagine that you are showing up at a shareholders meeting and someone saying

Well the board has decided to issue the board let's say our company has a million shares outstanding they've decided to issue another million okay at $10 a share and so what do you think about that well if the company had a

Million shares and I owned a thousand shares then I owned one thousandth of the company right if they issue another million shares then there will be two million shares and our own only one mm of the company so my first thought is I

Don't like that I own one thousandth of the company and how I'm falling in half but they would say on the other hand look we're selling them for so the company will have ten million dollars to invest so even though your

Fraction of the company has been diluted the company is worth more then you have to decide whether $10 a share is a good enough price is it is it worth that and so it's never obvious you always have to consider dilution because anything that

Expands the number of shares decreases your interest in the company the opposite of dilution occurs when the company buys back its shares and so that's repurchase of a shares by a company so a company can always do that

They can decide to go either way if they need more money they can issue shares and if they want to get money back they can Bob if you want to get money out they can buy back shares and that these things are very common there are

Statistics like what pharma and Trent showed for equity issuance which show that repurchases are very common and it happens all the time so the market that's what makes the stock market so active one reason traditionally for

Share repurchases tax reasons if the company repurchases its own shares the the if a company pays a dividend that goes in as income to the shareholders and it's taxed it used to be taxed at a higher rate

Than capital gains so there was an advantage to share repurchases instead of paying dividends I should just buy back shares and then the the shareholders would have a better tax they would be taxed in a more

Advantageous rate but now the tax rate on dividends and the tax rate on capital gains is the same but still there's always going to be complicated tax issues and so issues of Taxation may still motivate some decisions about

Share repurchase but you have to understand that it's getting money out of the company and as a shareholder if the company wants to send me a dividend I say fine I've got money if the company

Says I want to buy some of your shares back you say fine I've got money I don't care right and so if they buy back five percent of all their shares then the total number of shares goes down my fraction of the company is the same

Right and I've got money it's the same as getting a dividend so you can be confused by these things dilution and repurchase are neither good nor bad it depends on circumstances and you have to look at the business and what's being

Done with the money and I wanted to mention there's another kind of share called preferred there's – well I really – I've been talking here about common stock common stock is the real ownership in the company there's another thing in

Other words you take all the profits they're the ultimate owners of the company they nobody is above them in the in the hierarchy but there's something close is considered close but different it's called preferred stock and

Preferred stock pays a it has a set dividend instead and it but the the contract says that the dividend is so many dollars per year and the board doesn't have to pay it but if they they cannot typically the contract says they

Cannot pay a dividend to the common steyr holders until all the dividends to the preferred shareholders are paid up and the preferred shareholders typically don't have a vote okay so this is it so you could buy preferred stock in some

Company and then you would know exactly what your dividend usually they just pay a dividend it's like owning a bond and it's always the same amount so you're not betting company doing better or worse generally

But if it does badly you might lose your dividend for a while if the company goes bankrupt well then you're out but if the company starts doing well again they've got to go back and make up for all the dividends they missed so preferred

Shares are safer than common shares but they lack the upside potential they're not as exciting as common shares so when General Motors got into a crisis the US government bailed out General Motors what they did was to buy preferred

Shares in General Motors so the US government was a preferred stockholder in General Motors why did the US government do that why did they buy preferred shares rather than Cantwell they now do have common shares as well I

Think the government wanted to not be a stockholder not to be a voter in GM they wanted to keep their distance because this is America the capitalist country if the us bought common shares in General Motors

It's like nationalizing the company right the government would be on the board they would have the votes they just didn't want to go that far so they bought preferred shares in General Motors later General Motors got its on

Its feet again and and bought back the government's preferred shares so the government is no longer a preferred shareholder in General Motors common is much more important than preferred okay now I'm going to talk a little bit about

Dividends what determines whether a firm pays dividends there's a famous article by John Lintner John Lintner was a professor at the Harvard Business School and also one of the inventors of the capital asset pricing model he wrote

An article in when was it it was a long time ago about why firms pay dividends and he said remember it's a judgment call by the by the Board of Directors so he interviewed people who were involved in those judgments and asked them why

Did you why do you pay dividends why did you decide to pay a dividend of a certain amount and he wrote a long article about this and he found out that it was impossible to summarize everything they said they said so many

Different things that you know corporations are very complex and there's a lot of different people who have different feelings and we're trying to keep people happy and you want you want the company to do well and be

Perceived well so you know but one thing he learned is that companies like they think that that's our job is to pay dividends but when we're young just like you don't you don't have to earn an income now you're young right eventually

You know people are going to get fed up with you if you don't earn an income so it's the same thing as a company matures it's part of life's passage you start paying dividends and you take pride that you're paying dividends and people are

Getting money out of you they heard a lot of generalities like that but what really decides and one thing he learned from them is they told him you know one thing we don't ever want to do is cut our dividends once we start paying a

Dividend if we stop it'll get a lot of attention right well it's like for you right your young people you don't have a job nobody's complaining you could go for a while like this and stay you're still

Young but once you start in a job and then you quit and become a looks bad right if you're 40 years old and you say I'm just dropping out looks worse than if you do it at your age it's the same for companies once they start paying a

Dividend we've got to keep paying it otherwise people get angry so that was one theme but Lintner said even that doesn't tell the whole story so he tried to build a mathematical model of of dividends and the model that

He came up with which he then fit to the data and found that it worked very well was that these boards of directors have a target payout ratio of earnings basically this is the the bottom line that they think they should pay out a

Certain fraction of their earnings because this chair holders will get mad if we're making a lot of money and we're not sharing it with you the men will pay out half of our knees and the other half will keep as retained earnings so that

We don't have to go on issue new equity or borrow money it all sounds reasonable and then because they don't like to cut a dividend they don't want to adjust upward quickly if earnings shoot up

Because if they go up I raised their dividend and they might have to cut it if earnings go back down so the model that that so this is the Lintner model and it is that the dividends the dividends at time t year t let's say

Minus dividends at year t minus 1 equals Rho times a number tau it's the Greek letter tau times earnings per share – dividend per share at time t minus 1 well plus noise so n tau is between 0 and 1

So they have some fraction of earnings that they want to pay out and if earnings per share rise above rise so that tau times earnings per share is greater than dividends then they increase their

Dividends and Rho is between 0 and 1 that's the linear model and he showed with the data that it pretty much summarizes what firms are doing so they have a payout ratio out of earnings they think that in the payout ratio has been

Declining over the last century it used to be typically 60 70 percent in nineteen hundred shares were impatient with company wanted to see the money but they let them keep 30 or 40 percent but now you know we've come more and

More believers in the stock market and we allow companies to do better things so I said I would talk about some examples so let me examples of specific companies let me get back to my slides here I wanted to start with Xerox Xerox

Corporation you heard of it in front of Xerox it's still there exist Xerox Corporation was founded in 1906 1906 wasn't called Xerox it was called the halide photographic company and they produced photographic equipment but they

Had a big impetus forward when they met Chester Carlson who was an inventor and what Chester Carlson invented was a copying machine that used plain paper that they used to have copying machines going all the way back to 1906 but they

Were very expensive it would cost you to get a copy of something a photographic copy it cost you maybe a dollar or a page it's extremely expensive for that time but what Carlson invented was a dry copier it used to be that what they had

To do was take a photograph of the document that you wanted a copy of and then process it through the different chemicals that they use comes out wet and you have to hang it out that was expensive and inconvenient but they did

Have copying machines it just didn't work very well but he invented this process that you could take any paper and put it through plain paper and we'd come out hot and dry then and cheap so Xerox became an overnight success

Because they had a patent on Carlson's thing and it became the glamour company of the 1960s and 1970s so it was one of the nifty 50 people were very impressed with Xerox in its day

So Xerox means dry in Greek if it's dry copier and it was considered a high-tech company and moving forward rapidly but then it suffered a problem you know what the problem was it was doing really well until sometime in the 1990s when another

Invention came and it wasn't Xerox ISM is called digital copying machines where they would scan in the machine would have like a computer that would scan in the document and then produce a copy and it had a lot of advantages over the

Xerox copier so the company almost went under so I have what I got here is the balance sheet from Xerox company this comes from a website secgov and I got this from the 10-q report Xerox is a public company not a private company

It's traded on stock exchanges so US law says any public company must file a quarterly report with the Securities and Exchange Commission and they put it up on their website this is the website so any public company's balance sheet is on

On the WebEx they're updated every three months and I've got a couple of them here I've got 1999 and 2010 in my little company Case Shiller Weiss incorporated it was not public so our balance sheet was never up there on the SCC gov that's

One of the disadvantages many people say of becoming public if you start out as a private company then you want to get listed on the stock exchange that's called going public when you go public the SEC is on your back and you say you

Now have to file those quarterly balance sheets so this is what I've got so this is Z rock and it's all up there on sec gov and I've got it for $1999 right at this was right at the time when they were

Really in trouble because the digital revolution was killing Xerox and I just wanted to show a balance sheet of a company because it it's a there's two sides to the balance sheet there's assets and liabilities assets are things

The company owns liabilities are debts the company has so this is one side of the balance sheet but I've got it for two years and it's everything is in millions so in what Xerox had one hundred and twenty six million dollars

In cash in in 1999 and they they picked up they they the company was dying in 1999 in 2001 they hired a new CEO and mulcahey and she is credited with saving Xerox turning the company around so by 2010 at least in terms of cash they were

Doing better but maybe not a lot better she saved it from extinction but she didn't save it didn't move it back onto the nifty 50 so I just wanted to look at what a company owns and this is just an example of a balance sheet so there are

Owned 15 billion dollars of receivables in 1999 it was much lower number in 2010 I don't know it might reflect time of the year or something receivables is money that's owed to them right they ship a copying machine to someone the

Guy says I'll pay you in three months that's a receivable and they had inventories that means probably copying machines ready to be sent out and and they own buildings the building was like he went down under

Okay he went down from 24 billion to 16 billion and then there's a lot of other things I saw the value of everything that the company owns wasn't much changed 28 billion twenty-eight point eight billion

What went went up to thirty billion so at least she stopped the company from failing but now that's only half of the balance sheet I have to go to the other half and these are the liabilities this is what the company owned what it oh so

It has short term debt let's talk about 2010 16 billion long term debt of seven point eight billion deferred taxes that means taxes that they know they have to pay that they haven't paid it they didn't have any in 2010 and preferred

Stock they own they said they they did have a small amount of preferred stock outstanding which counts as a liability all right and so there's and other liabilities I put them all into one category now okay

Those are all the light now this last liability is unique because it's the it's the residual it's called shareholders equity and what they did this number the total liabilities has to equal the total assets this is the same

Number that I showed you on the preceding page what's the difference it's the shareholders equity okay so it's eleven point nine billion in 2010 up from four point nine million so it's by this measure it's a success

Now why is shareholders equity it is this the value of the company no it's the value of the company on the books so according to their books I'll go back to the they have all these assets right including buildings and equipment where

Do they come up with this number how do they know what their buildings and equipment are worth it's an estimate okay because who knows what they could sell them for so in principle this shareholders equity is what the shares

Are worth all of the shares eleven point nine billion because if you bought the company and you sold all the assets and paid off all the debts that's what would be left so you divide that by the number of shares and

You can get an estimate of the value of a share but I say an estimate it's not the same as the market value in 2010 there were 14 billion shares outstanding in Xerox the price per share of a Xerox common share in 2010 was

$1180 so if I multiply the number of shares by the price per share the market cap for Xerox is sixteen point four billion dollars compare that with the shareholders equity of eleven point nine

Billion so the company is worth more than its shareholders equity and you might ask why would that be okay well I think the answer is you wouldn't buy this company to shut it down right you could buy the company for sixteen

Billion and then shut it down sell off all the assets pay off all the debts and you'd have eleven billion so your that that's a sign of an mo hey he's success her company is not going to be shut down if the stock price falls below the

Shareholders equity it becomes at risk for being shut down somebody buys the company and shuts it down because I can make money if the company we're selling for five billion I might do that well not me somebody who arranges these

Things could do that so I buy the company for five billion I tell everybody you're all fired we're going out of business I sell it I get eleven point nine billion I've doubled my money alright now our company can sell for

Less than the shareholders equity because the shareholders equity is kind of a funny number it's also called stockholders equity by some people same thing it's a funny number because it involves

All kinds of estimates and you really try to sell that real estate for what it says here you might find so the value the market cap can fall below the market capitalization can fall below shareholders equity but probably

Not too far below and this is what worries boards and CEOs they're they watch their stock price every day and they've got in their mind that shareholders equity and if the stock is falling below that then they're in

Danger of liquidation so they worry and that's why every morning if you are a CEO you don't realize that if you're a CEO of a public company you will be watching your market cap every day and comparing that with shareholders equity

So we chose Eric's is an example of a company that's doing all right now I'll show you what's price I don't have it all the way back to 1906 but this is the Xerox price per share and it's corrected for splits and other special factors

From 1977 to 2001 and you can see the incredible trash they took after digital copying came in they were in the 1990s they were soaring it they look great they must have been doing something right but they had their heyday and it's

Over so Anne Mulcahy came in when the company was utterly collapsing and I guess she's a success because it's but it's not it's not its former self its limping along I wanted to tell you now about about Microsoft so that was

Founded in 1975 by two people your age I guess and as of 2000 it had assets totaling 52 billion and in the last 10 years it's doubled almost doubled it so its assets are 92 billion what is it owned well it has cash of about 4 or 5

Billion short term investments a lot of short-term investments 37 billion dollars of short-term use but this is a company that's doing well it's not on the on the end of end of its life and it has

Property they have this nice campus in Redmond Washington they call it a campus it's fun fun place it's so anyway it's not that expensive it's only all their real estate now is only about eight billion dollars that's all of their

Computers and equipment and then they own stock they don't just own this is really different from the Xerox doesn't own any stock there they're trying to limp by they're trying to get back in stride

Maybe they have gotten back and stride but they've got ten billion dollars in the stock market other companies they own so they own all sorts of stuff this is a company that didn't pay a dividend until recently and it's you know Bill

Gates and Paul Allen was still there running it and it's it maybe it's a little bit of truth in this pecking order model they just wanted to save their own money and they thought their shareholders would understand Microsoft

Is doing so well are you really expecting us to pay your dividend out you know we have all these opportunities so we'll keep the money and people had enough faith in in in these guys to let them do it

So by this account the total assets of the company were 92 billion but we have to look at liabilities remember the shareholders equity subtract off liabilities so here are their liabilities they have but they have some

Income taxes that have to be paid but this is just it's only a billion dollars that's like small change right it's because of some timing affects accounts payable this is some money that they owe they do owe money because every company

Delay is paying their bills for a little while anyway so they have something unearned revenue is revenue that they they've typical cases they've sold a a Windows system they've got the money but they really haven't completely

Earned it yet because you're going to be calling up with complaints and they're going to have to feel they're going to have to do things in the future for the revenue that they've already earned so they count that as a liability they

Didn't have any debt in 2000 this is strange right but I think they were making so much money why should they borrow for some reason it's back it's now up to about 10 billion dollars according to I can't explain that and so

All right then you add all these up and subtract them from 92 billion and their shareholders equity is 48 billion so they're doing pretty well they're much bigger and but is that the way to measure Microsoft okay this is a measure

Of the value of market it's really the liquidation value of Microsoft so you could imagine buying Microsoft and then selling all those assets shutting it down firing everybody would that be a smart thing to do you fire everybody you

Sell the Redmond campus you sell all of their computers and what do you end up with 48 billion dollars well let's compare that with the market cap of Microsoft they have eight billion four hundred and ninety seven million shares

Outstanding and the price per share at the end of 2010 was $26 so the market cap is 221 billion so that's over five times their shareholders equity that means that they have some other value I think I'm running out of time this is a

Lot of interesting what happens in the world this is my last I'll stop with this but this is the price per share of Microsoft I should disclose I'm now a shareholder I wish I were a shareholder back then nobody believed it this all

Goes back to 86 but the company maybe it was private I forget when it went public so we don't have prices but then we have prices in 86 it really had a run until 2000 and then something broke with Microsoft as well

Looks a little bit like Xerox doesn't I think it was the end of the high tech bubble this was the this was a bubble in tech prices and Microsoft Road the bubble but it's still doing very well this is not going up lately anyway this

Is an example we're going to talk about real estate the other asset class that I mentioned is even bigger than the stock market in our next lecture on Wednesday

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