Some terms in Stulz's chapter of foundation

[Patrick Pan]

Hi David,

I feel a little bit confused about the several terms used in Stulz's chapter 2.

1. Shareholder and invester, do they mean the same thing? Can I interpret that shareholders are pure stock holder but investers could buy other asset like derivatives?

2. Firm , does this word refere to an invester (such as mutual fund) or a corpration (like IBM) which issues the asset?
Then can I say the firm's value is the value of portfolio if the firm really means buyer of asset?

Thanks
Patrick

 

[David Harper CFA FRM]

Hi Patrick,

1. In the first part of book, Stulz is never really beyond a simple capital structure (classic Merton model) with two investor classes: equity and debt. So, shareholder are owners of common equity; investors include shareholders who (under classic theory) likely own diversified portfolios, including other common shares, maybe debt too, and as you say, maybe they own derivatives too. So, a shareholders implies an investor; but the converse depends on whether the sharedholder is diversified. Note shareholder is subclass of broader stakeholder. So, yes, I agree exactly with your parsing: "shareholders" is from the perspective of the firm's capital structure (the group that owns the common equity); "investors" is *not* from the firm perspective.

2. Right, well, IMO your confusion is warranted. Stulz' imprecision (and very difficult prose) has given challenge each year (I recommended GARP drop these Chapters b/c they are constantly causing confusion. GARP accepted many of my recommendations, but not this one...). I hesitate to infer Stulz' exact meaning of "firm" because frankly I don't think he is precise like, say, Jorion in precise. In regard to the eary chapters, you can trust Stulz is always operating from the simple two-class capital structure that underlies classic Merton. In this respect, "firm" refers to what we tend to call in valuation "entity;" e.g., corporation. Entity includes corporation, but reminds us we are not venturing into legal structures. And so,

firm (entity) value = market value of common + market value of debt [under simple two-class capital structure]

the framework he is using is assets = debt + equity, so by "firm" i think he means the entity characterized by this balance sheet. But I don't *think* he is precise about this entity. Put another way, I think trying to parse him on "firm" is more precision than he is giving, rather maybe think about this all in terms of a balance sheet.

Hope that helps, David