Lecture 9: Corporate Stocks

What this lecture covers

Shiller opens with his own experience co-founding Case Shiller Weiss Inc. to motivate a broader discussion of what a corporation is, how shares are allocated and traded, and why stock markets matter less to household wealth than people assume. He then works through the mechanics of corporate structure: shareholders, boards of directors, dividends, share repurchases, dilution, and the choice between equity and debt financing, before testing the "pecking order" theory of how companies actually raise money. He closes by reading real balance sheets from Xerox and Microsoft to show how shareholders' equity, market capitalization and a company's history relate to each other.

This lecture continues the course's asset-class survey after earlier sessions on debt and interest rates, and sets up the following lecture on real estate. After watching, you should be able to explain the roles of shareholders, boards and CEOs, distinguish common from preferred stock, describe what dividends, dilution and share repurchases do to shareholder value, and read the basic structure of a corporate balance sheet.

Key ideas

• Corporation: a legal "artificial person" owned by shareholders, who elect a board of directors that in turn hires and oversees a chief executive officer; the concept dates to the Dutch East India Company in 1602 and became widespread in the 19th century.
• Common vs. preferred stock: common shares carry voting rights and a residual claim on profits with no fixed payout; preferred shares get a set dividend that must be paid before common dividends, but usually carry no vote and less upside, illustrated by the U.S. government's use of preferred shares in the General Motors bailout.
• Dividends: profit distributions decided at the board's discretion; John Lintner's research found boards target a stable payout ratio of earnings and strongly resist cutting dividends once started, which explains why dividends adjust smoothly rather than tracking earnings exactly.
• Dilution and repurchase: issuing new shares dilutes existing shareholders' ownership fraction but can raise capital worth more than the dilution costs; repurchasing shares does the reverse and has historically been used partly for tax reasons.
• Equity vs. debt financing: equity financing sells ownership stakes and shares risk with new investors, while debt (bank loans or bonds) is a fixed obligation that leverages shareholder risk since shareholders are paid only after debt holders.
• Pecking order theory: Stewart Myers's 1984 finding that most corporate financing comes from retained earnings rather than new share issuance; Fama and French's 2005 rebuttal shows most companies do issue new shares regularly, so equity markets still matter for price discovery.
• Shareholders' equity vs. market capitalization: shareholders' equity (assets minus liabilities) is roughly a company's liquidation value on the books, while market capitalization reflects what investors think the ongoing business is worth; a market cap persistently below shareholders' equity can make a company a takeover-and-liquidation target.
• Balance sheet structure: public companies file quarterly balance sheets with the SEC listing assets (cash, receivables, inventory, property) against liabilities (debt, taxes owed, and finally shareholders' equity as the residual).

Walkthrough

Founding a corporation and the scale of stock markets (1:01)

Shiller recounts co-founding Case Shiller Weiss Inc. in 1991 with colleagues who contributed time rather than money, describing how the founders divided shares and later used additional share grants to resolve disputes over unequal effort. He then uses World Bank data to show the U.S. has by far the largest stock market in the world by value and as a share of GDP, but argues people overstate how much stock market wealth matters to typical households: the roughly $40,000 per-capita value of the U.S. market is smaller than average household real estate holdings, and redistributing all stock wealth equally would not meaningfully solve poverty.

What a corporation is and how it's governed (15:31)

Shiller explains the corporation as a legal "artificial person" owned by shareholders who vote by share (not by person) to elect a board of directors, who in turn hire and oversee a CEO. He describes the board's duty of loyalty to shareholders, why board members are typically unpaid or lightly paid, and how an activist investor like Carl Icahn can buy enough shares to gain board influence and push out an underperforming CEO. He contrasts for-profit corporations with nonprofits like Yale, noting that nonprofits have boards but no shareholders and reinvest surplus into their mission rather than distributing it.

Dividends, dilution and share repurchase (28:56)

Shiller defines market capitalization as share price times shares outstanding, then explains that dividends are a discretionary board decision and that a company's share price mechanically falls by the dividend amount on the ex-dividend date, which is not a sign of bad news. He introduces dilution, where issuing new shares reduces existing owners' proportional stake unless the new capital raised is worth at least as much as what's given up, and its opposite, share repurchase, which increases remaining shareholders' proportional ownership. He briefly covers preferred stock as a hybrid instrument with a fixed dividend and typically no vote, illustrated by the U.S. government's preferred-share investment in General Motors during its bailout.

Equity financing and the pecking order debate (37:04)

Shiller distinguishes equity financing (selling shares) from debt financing (bank loans or bonds), noting that debt leverages shareholder risk since shareholders are paid only after debt holders. He presents Stewart Myers's 1984 finding that most 1973-1982 corporate financing came from retained earnings (62%) with equity issuance a minor source (6%), which Myers used to argue for a "pecking order" where companies avoid issuing new shares. He then presents Fama and French's 2005 rebuttal, showing that Myers's aggregate net-issuance figures obscured the fact that a large majority of individual companies issue new shares in a given year, concluding that equity markets remain functionally important even for large, established firms.

Reading Xerox's balance sheet (1:02:39)

Using Xerox's SEC-filed balance sheets from 1999 and 2010, Shiller walks through assets (cash, receivables, inventory, buildings) and liabilities (short- and long-term debt, preferred stock, other obligations), arriving at shareholders' equity as the residual. He explains that Xerox nearly collapsed in the 1990s when digital copiers displaced its dry-copier technology, but was stabilized under CEO Anne Mulcahy, and that by 2010 its market capitalization of about $16.4 billion exceeded its shareholders' equity of about $11.9 billion, a sign the company was worth more as a going concern than as a liquidation.

Reading Microsoft's balance sheet (1:10:56)

Shiller contrasts Xerox with Microsoft, founded by Bill Gates and Paul Allen in 1975, which held large cash and short-term investment balances, modest real estate, and no long-standing debt, and did not pay a dividend for years despite strong profitability, consistent with retaining earnings for reinvestment. By 2010, Microsoft's shareholders' equity of about $48 billion was far exceeded by its roughly $221 billion market capitalization, a gap Shiller attributes to the market valuing growth prospects well beyond the liquidation value implied by the balance sheet, illustrated by Microsoft's dramatic share-price run-up before 2000 followed by a long plateau.

Before you watch

• Familiarity with the earlier lecture on debt and interest rates helps when Shiller contrasts equity financing with debt financing.
• A basic sense of what a balance sheet's two sides (assets and liabilities) represent will make the Xerox and Microsoft sections easier to follow.

Check your understanding

1. Why does Shiller argue that the total value of the U.S. stock market is smaller relative to household wealth than most people assume?
2. What is the difference between common and preferred stock, and why did the U.S. government choose preferred shares when it invested in General Motors?
3. How does issuing new shares dilute existing shareholders, and under what condition is dilution still a good deal for them?
4. What did Stewart Myers's Pecking Order Theory claim about how companies finance themselves, and how did Fama and French's later research complicate that claim?
5. Why was Microsoft's market capitalization so much higher than its shareholders' equity in 2010, while Xerox's gap between the two was much smaller?