CHAPTER 10 EQUITY MARKETS Copyright© 2012 John Wiley & Sons, Inc

Ownership in a corporation. One vote per share. Common Stock Ownership in a corporation. One vote per share. A residual (last) claim on income and assets in liquidation, thus a riskier position than bonds and preferred stockholders. Shareholders’ liability for the debts of the corporation is limited to their investment in the common stock. Copyright© 2012 John Wiley & Sons, Inc

Common Stock (continued) Shareholders’ return is derived from dividends and from appreciation in stock’s market value. Common shareholders may vote with their shares to elect the members of the board of directors. Board of directors can be elected by cumulative voting or straight voting. Copyright© 2012 John Wiley & Sons, Inc

Dividends paid ahead of common. Preferred Stock A preferred or prior claim on earnings and assets compared to common stock. Dividends paid ahead of common. Cumulative provision - arrearage plus current dividends must be paid before any payment made to common shareholders. Non-participating preferred receive a fixed level of dividends, thus not participating in possible high earnings level of the corporation. Adjustable-rate preferred, indexed to market rates, varying with the index. Copyright© 2012 John Wiley & Sons, Inc

Preferred Stock (continued) Preferred stockholders are usually excluded from voting for board of directors and shareholder issues. Many corporations buy preferred stock. A high percentage (70%), depending on the extent of ownership, of dividends received from one corporation by another corporation are federally tax exempt. Investors are concerned about after-tax return. Copyright© 2012 John Wiley & Sons, Inc

Convertible Securities Convertible preferred stock - convertible to common stock at specific common price or number of shares (conversion ratio). Dividends received until conversion. Investor may participate in growth of firm. Convertible bonds - convertible to common stock at specific common price or number of shares (conversion ratio). Pays fixed bond rate until conversion. Provides potential for higher returns for investors. Convertibles are mostly subordinated debt and hence have a higher risk. Issuing firm is essentially “selling” the company’s stock at a higher future price. Copyright© 2012 John Wiley & Sons, Inc

Equity Owners Copyright© 2012 John Wiley & Sons, Inc

Primary Market for Equities Unseasoned or initial public offering (IPO): The first time shares are sold in the market. Seasoned offering: When additional shares are sold later. Equities may be: Sold directly to investors by the firm. Purchased and sold at a higher price (underwriter’s spread) by investment bankers in an underwritten offering. The size of the underwriter’s spread depends on the underwriter’s level of uncertainty concerning the shares’ market price. Sold to existing shareholders in a rights offering. Copyright© 2012 John Wiley & Sons, Inc

The Secondary Market for Equity Securities Subsequent trading in securities after primary issue. Stock may trade on: Exchanges. Over the counter. Provides investor liquidity. Copyright© 2012 John Wiley & Sons, Inc

The Secondary Market (continued) Stable prices are related to the extent of: Breadth of the market – the number of varied traders of the stock. Depth of the market – the extent to which there are conditional orders to buy and sell below and above the current price. Resilience of the market – the ability of the market to attract buyers/sellers when the stock prices decrease/increase, respectively, due to order imbalances. Copyright© 2012 John Wiley & Sons, Inc

Four ways to bring buyers/sellers together: Secondary Markets Four ways to bring buyers/sellers together: A buyer may incur search costs and find a seller on their own, called a direct search. A broker may bring buyer and seller together, charging a commission. A dealer may sell/buy (bid/ask) securities from an inventory of securities, reducing search costs. The dealer’s return is the bid/ask spread. An auction market allocates the selling shares to the highest bidder, providing a buyer/seller. Copyright© 2012 John Wiley & Sons, Inc

Dealer Bid/Ask Spreads: Bid-ask spread is: proportionately wider for low priced stocks due to fixed costs of operations. wider for trades of a few shares. wider for a large block trade; a liquidity service is performed. narrower with more frequent trading, where the costs of providing liquidity are less. wider with traders with insider information, where the dealer may have to incur the cost of price discovery, or buying high and selling low! Copyright© 2012 John Wiley & Sons, Inc

Equity Trading Over-the-counter market (OTC) Securities not listed are traded over-the-counter (OTC). The reasons for not listing a stock include: little investor interest. small issue size. insufficient order flow. The OTC market is a dealer market, which includes a large number of relatively small OTC dealers. Brokers seek favorable prices from a variety of dealers. Copyright© 2012 John Wiley & Sons, Inc

NASDAQ National Association of Securities Dealers Automated Quotation (NASDAQ) Before 1971 daily "pink sheet" information of the National Quotation Bureau listed stocks and associated dealers. After 1971 the National Association of Securities Dealers (NASD) initiated the NASDAQ, the NASD automated quotation system, providing continuous bid/ask information. NASDAQ is an electronic pink sheet. NASDAQ is available to: Level 3 terminals are available only to dealers who enter bid/ask quotes into the system. Level 2 terminals display price information and are available to brokers and institutions. Level 1 terminals provide the best bid/ask quote for a given stock. NASDAQ accelerated disclosure of dealer quotes to brokers, reducing search time and enhancing ability to find the best price. Copyright© 2012 John Wiley & Sons, Inc

The New York Stock Exchange is the largest U.S. stock exchange. Stock Exchanges Exchanges are physical places or electronically connected markets where listed stocks are traded by members of the exchange. The New York Stock Exchange is the largest U.S. stock exchange. Stocks are traded on an auction basis at specific locations on the trading floor (posts). All bid/ask information is in a single place. Copyright© 2012 John Wiley & Sons, Inc

NYSE vs. NASDAQ Copyright© 2012 John Wiley & Sons, Inc

Stock Exchanges (continued) Three major sources of bids and offerings: floor brokers handling customer orders. limit price orders. the specialist in the stock buying and selling for his/her own account, making a continuous market for the stock. Buy/sell orders include: market orders - to buy or sell at the available price limit orders - to buy or sell at a designated price stop orders – to sell only if the price drops to the stop price and buy if the price increases to the stop price Short sale: An investor who believes a stock’s price is going to fall can borrow shares from a broker and sell them today. Copyright© 2012 John Wiley & Sons, Inc

Globalization of the Equity Markets Electronically linking equity dealer and exchange markets is slowly leading toward a national market system. Electronically linking international markets has created 24-hour trading opportunities for some stocks. U.S. stock exchanges have introduced after hours trading when shares are traded electronically, linking U.S. with the hours of international markets. Investors’ ability to invest in foreign stocks is enhanced by American Depository Receipts (ADRs). An ADR is a negotiable instrument issued by U.S. financial intermediaries (FIs) against shares in foreign companies, with the shares held in custody by the FIs for investors. ADRs are issued in the U.S. and are denominated in U.S. dollars. All cash flows to the investor are in dollars. Copyright© 2012 John Wiley & Sons, Inc

Globalization of the Equity Markets (continued) Global Depository Receipts (GDRs) are negotiable receipts issued by financial intermediaries in developed countries other than the U.S. against shares in foreign companies that are held in custody for investors. ADRs and GDRs allow investors to diversify their portfolio globally by reducing both transaction costs and risk for investors. Enhances a company’s visibility, status, and profile in the U.S. and internationally among investors, consumers, and customers. Establishes/increases the foreign firm’s U.S. liquidity (and potentially total global issuer liquidity) by attracting new investors. Copyright© 2012 John Wiley & Sons, Inc

Regulation of Equity Markets Securities Act of 1933 requires full disclosure of relevant information related to a primary issue of securities. requires registration of publicly traded securities across state lines. requires issuance of prospectus, a summary of registration statement, to interested investors. Securities Exchange Act of 1934 Established the SEC. SEC administers the Securities Act of 1933. SEC registers and regulates securities exchanges, OTC trading, brokers, and dealers. SEC has broad powers over securities industry. Copyright© 2012 John Wiley & Sons, Inc

Equity Valuation Basics The value of a security is the present value of expected cash flows, discounted at the required rate of return. Identify the size and timing of relevant future cash flows. Select the appropriate discount rate. Calculate the present value by discounting the cash flows at the discount rate. Copyright© 2012 John Wiley & Sons, Inc

Common Stock Valuation The analyst must approximate the future cash flow stream and select an appropriate discounting equation. The value of a stock held for a long time is the present value of the dividend stream discounted at the required rate of return, a perpetuity similar to the preferred stock. Copyright© 2012 John Wiley & Sons, Inc

Common Stock Valuation The value of a stock to be held for a determined period of time is the present value of the dividend stream plus the PV of the expected selling price of the stock. The present value, now in period zero, of a steadily increasing stream of cash flow is the value of the cash flow in the first year divided by the difference between the discount rate and the rate of growth: Copyright© 2012 John Wiley & Sons, Inc

Preferred Stock Valuation Discount the expected dividend stream at the required rate of return to determine its value. A fixed-rate preferred stock approximates a perpetuity and the value can be found by dividing the annual dividends by the discount rate: P0 = D/r The preferred stock price varies as rates of return change. Copyright© 2012 John Wiley & Sons, Inc

The Total Risk of a Security Comprised of the Systematic (Market or Undiversifiable) Risk and the Unsystematic (Diversifiable) Risk. Proper diversification can reduce unsystematic (i.e., unique, security-specific) risk. Diversification across different securities helps reduce total risk, resulting in portfolio returns being less volatile than the average of individual securities’ returns. Copyright© 2012 John Wiley & Sons, Inc

The Total Risk of a Security Diversification occurs when securities whose historic returns have correlation coefficients less than +1 are assembled in a portfolio. Unsystematic or diversifiable risks of individual stocks offset one another. The systematic risk of the portfolio cannot be diversified away by adding more securities. Copyright© 2012 John Wiley & Sons, Inc

Effect of Diversification on Portfolio Risk Copyright© 2012 John Wiley & Sons, Inc

Measuring Systematic Risk: Beta Investors are assumed to hold securities in a diversified portfolio with only systematic or market risk to analyze. The relevant risk of a security is how it correlates with the portfolio. The extent to which stock returns vary with a broad-based market portfolio is called the beta of the stock. It is a measure of relative risk of a security. Copyright© 2012 John Wiley & Sons, Inc

Measuring Systematic Risk: Beta (continued) If a stock varies as the market portfolio does, the beta is 1.0 and the stock has a risk level matching the market portfolio such as the S&P 500. A beta greater than one is riskier (aggressive stock) than the market while a beta less than one is not as risky as the market (defensive stock). Betas calculated for securities identify their relative historic riskiness. Copyright© 2012 John Wiley & Sons, Inc

Selected Betas (July 12, 2010) Copyright© 2012 John Wiley & Sons, Inc

Security Market Line (SML) SML depicts the offsetting returns demanded for increased increments of risk, the classic risk/return tradeoff. SML enables us to conceptualize the risk of a stock as the sum of the risk free-rate plus the market risk premium adjusted for the relative risk of the stock (beta): Copyright© 2012 John Wiley & Sons, Inc

The Security Market Line Copyright© 2012 John Wiley & Sons, Inc

Stock Market Indexes Stock market indexes are useful to assess the performance of various portfolios of securities. An index is constructed by selecting a starting point and a portfolio of securities, establishing a date and the initial (base) value. With time the relative value of the index moves away from the base; the base serves as a reference point. Copyright© 2012 John Wiley & Sons, Inc

Stock Market Indexes (continued) Each stock is assigned a relative weight in the portfolio. A price-weighted index (e.g., Dow Jones) is computed by summing the prices of the individual stocks, then dividing by a divisor to determine the base index value. The divisor, such as 100, relates the starting value and is adjusted as stocks split or composition of the index is changed. A market value-weighted index (e.g., S&P 500) is calculated by summing the total market value of the firms in the index. The percentage change in the total market value of the firms is the return on the index. Both composition and weighting affect the value of an index over time. Copyright© 2012 John Wiley & Sons, Inc

The Stock Market As a Predictor of Economic Activity The stock market value changes may predict real economic activity because: Stock prices are thought to represent the present value of expected cash flows. If a recession is coming with lower earnings and dividends, the market should reflect those expectations with lower prices. Stock price declines reduce wealth and may reduce consumption, and negative business expectations should curtail investment spending. Evidence indicates that the stock market is not very successful in predicting economic activity. Copyright© 2012 John Wiley & Sons, Inc