5: Valuing SharesOf the three business lines, corporate finance enjoys the highest visibility, and includes activities such as
merger and acquisitions (M&A) advisory work and new security issues. Corporate finance tends to be the
most profitable line of business, especially for large banks such as Macquarie Bank or Goldman Sachs,
which can charge the highest underwriting and advisory fees. Investment banks earn revenue from
trading debt and equity securities, either by acting as dealers, by facilitating trade between unrelated
parties or by holding inventories of securities that can make or lose money for the bank as inventory
values fluctuate. Finally, asset management encompasses several different activities, including managing
money for individuals with high net worth, operating and advising mutual funds and managing pension
funds.
When they advise corporations that want to issue ordinary shares in the public markets, investment
banks play several different roles. The complexity of the investment banker’s job depends on: (1) whether
a company is selling equity for the first time, and in the process, converting from private to public
ownership; and (2) whether the company has previously issued shares and is simply going back to the
equity market to raise money. The first type of transaction is much more complex and is called an
initial public offering (IPO). The second type is known as a seasoned equity offering (SEO), implying that the
shares offered for sale have previously been seasoned in the market. Usually, companies hire investment
bankers through a process known as a negotiated offer, where, as the name implies, the issuing company
negotiates the terms of the offer directly with one investment bank.^13 Companies issuing securities often
enlist the services of more than one investment bank. In these cases, it is typical for one of the banks to
be named the lead underwriter, and the other participating banks are known as co-managers.
In most equity deals, the investment bank agrees to underwrite the issue in a firm-commitment offering,
which means that the bank actually purchases the shares from the company and resells them to investors.
In firm-commitment offerings, investment banks receive compensation for their services via the
underwriting spread, the difference between the price at which the banks purchase shares from companies
(the net price) and the price at which they sell the shares to institutional and individual investors (the
offer price). Underwriting fees can be quite substantial, especially for companies issuing equity for the
first time. Underwriting spreads vary in value, reaching as high as 10% for particular organisations. As
an example, suppose a company conducting an IPO wants to sell shares worth $100 million. If the
underwriting spread is 7%, it will receive $93 million in proceeds from the offer. The underwriter earns
the gross spread of $7 million as long as it can sell the shares on to the market for a total value of $100
million. At the other extreme, large debt offerings of well-known issuers have underwriting spreads in
the 0.5% range.
Just what do investment banks do to earn their fees? Investment banks perform a wide variety of
services, ranging from carrying out the analytical work required to price a new security offering, to
assisting the company with regulatory compliance, marketing the new issues and developing an orderly
market for the company’s securities once they begin trading.
Early in the process of preparing for an equity offering, an investment bank helps file the necessary
documents with regulators, starting with the registration statement, which provides information about the
securities being offered. Securities that are sold in Australian capital markets must be registered with the
Australian Securities and Investments Commission (ASIC), and because shares are a form of security,
an issue of public shares must be registered with ASIC. When a company files documents with ASIC,
it must take great pains to be sure that the information provided is timely and accurate. The investment
13 Less common is a competitively bid offer in which the company issuing securities announces the terms of its intended sale, and investment
banks bid for the business.
initial public offering
(IPO)
A corporation offers its shares
for sale to the public for the
first time
seasoned equity offering
(SEO)
An equity issue by a company
that already has ordinary
shares outstanding
negotiated offer
A process used by an issuer
to hire an investment banker
with whom it directly
negotiates the terms of the
offer
lead underwriter
The investment bank that
takes the primary role in
assisting a company in a
public offering of securities
underwrite
The investment banker
purchases shares from a
company and resells them to
investors
firm-commitment offering
An offering in which the
investment bank agrees to
underwrite the company’s
securities, thereby
guaranteeing that the
company will successfully
complete its sale of securities
underwriting spread
The difference between the
net price and the offer price of
an underwritten security issue