Chapter 20 The Market for Corporate Stock

 Learning Objectives   To learn about the characteristics of common and preferred corporate stock.  To identify the principal investors in corporate stock.  To understand the role equities play in financing business investment. 20-2

 Learning Objectives   To compare and contrast the roles and functions of organized stock exchanges and the over-the-counter market.  To explore the issue of market efficiency and examine the evidence regarding stock market efficiency. 20-3

Introduction  Equity is a certificate representing ownership of a corporation. It grants the right to share in the firm’s assets and earnings, if any.  Stock market activity involves mainly the trading of issued securities rather than the exchange of financial claims for new capital.  Nevertheless, the stock market has a significant impact on the expectations of businesses when planning investments. 20-4

Characteristics of Corporate Stock  Corporate stock  Ownership interest in a corporation  A number of rights as well as risks  Common stock is the most important form  Represents a residual claim against the assets of the issuing firm  Entitling the owner to share in the net earnings of the firm when it is profitable  Share in the net market value (after all debts are paid) of the company’s assets if it is liquidated 20-5

Characteristics of Corporate Stock  Rights of common stock holders  Elect the company’s board of directors  Preemptive rights  Right of access to meeting minutes and lists of existing shareholders  Right to vote on issues that affect the firm’s property as a whole 20-6

Characteristics of Corporate Stock  Preferred stock  Carries a stated annual dividend expressed as a percent of the stock’s par value  A prior claim over the firm’s assets and earnings relative common stockholders  Creditors must still be paid first  Less income than common stock  Also less risky than common stock 20-7

Characteristics of Corporate Stock  However preferred have some limitations  Generally no votes for the board of directors  Dividends are not tax-deductible  Shares have a range of characteristics  Cumulative shares is where, when a dividend is missed, the liability accrues  Participating means shareholders share in residual earnings  Many carry call provisions  Some issues are convertible 20-8

Stock Market Investors  Corporate stock is a very widely held financial asset  Direct holdings by households represent the largest portion of U.S. stock holdings  There is a phenomenal growth in other holdings  Investments by pension funds  Mutual funds  Foreign investors 20-9

Stock Market Investors 20-10

Stock Market Investors 20-11

Stock Market Investors  In Chapter 6, we learned that the price of stock shares  Reflect the present value of the stock’s expected future dividends  Factors that impact investor expectations about those future dividends will tend to change stock prices  Other factors also impact share price  Interest rates  Inflation  Changes in risk 20-12

Equity as a Source of Funding  Equity is one potential source of funding physical and financial assets  Most corporations rely primarily on retained earnings  When that is insufficient retained earnings  Cut dividends generally avoided  Raise debt  Raise equity  How to choose between debt and equity 20-13

Equity as a Source of Funding  Tax treatment is a critical decision factor  Differential tax treatment of expenses  Interest is tax-deductible  Dividends are not tax deductible  A firm acting in the interest of its shareholders will tend to minimize the number of shares outstanding  Over reliance on debt increases firm risk  So a firm will choose a mix of debt and equity when exhaust retained earnings 20-14

Equity as a Source of Funding  Some times corporations buy back shares  Often accompanied by a boost in stock price  Expectation is for an improvement in a firm’s financial ratio  Reduces the number of shares so, all else equal, the EPS would rise  May need treasury shares  Minimize dilution from the creation of an employee stock option plan  Tax benefits from avoiding taxes on dividends 20-15

The Process of Price Discovery in the Equity Markets  Price discovery is the means by which a value is placed on an asset  Trades taking place in competitive markets should reflect the true market value of a stock  Processes of the last decade has altered the price discovery process  Information technology revolution  Drive to enhance speed and accuracy 20-16

The Process of Price Discovery in the Equity Markets  There are two main branches of the market for trading corporate stock  Organized exchanges  Over-the-counter (OTC) market 20-17

Organized Exchanges  The organized exchange  Governed by regulations and procedures  Designed to ensure competitive pricing  Ensure an active market for the traded stocks  Active participants  Floor traders – buy and sell for own account  Commission brokers – employed by brokerage to represent customers  Specialists oversee the trading in each stock  Odd-lot traders specialize in trading shares in numbers not rounded to 100 shares 20-18

Organized Exchanges 20-19

Organized Exchanges  The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) are organized exchanges  A physical location for trading  Trading posts  Formal trading rules  Listing requirements  A board of directors  Member firms and seats 20-20

Organized Exchanges  Stock exchanges have emerged in every region of the globe  Asia  Europe  The Americas  Japanese exchanges  Among the most interesting of the exchanges outside the U.S.  Have recently swung to some signs of recovery  Are receiving renewed interest from the rest of the world 20-21

Organized Exchanges  Exchanges provide a continuous market  Centered in an established location  Rigid rules to ensure fairness in trading  Exchange brings together buyers and sellers  Appear to make stock a more liquid investment  Promote efficient pricing of securities  Make possible the placement of huge amounts of financial capital 20-22

The Over-the-Counter Market  OTC market  No central trading location  Only an electronic communications network  E.g. National Association of Security Dealers (NASD)  Most trading of stock in the world is OTC 20-23

The Over-the-Counter Market  Many traders also act as principals  Taking “positions of risk”  Buying securities outright for their own portfolios  Also buys for portfolios of their customers  Prices are determined by negotiation  Buy at the bid price  Sell at the asked price 20-24

The Over-the-Counter Market  The U.S. OTC is regulated by a code of ethics  Developed by the National Association of Security Dealers (NASD)  Private organization encouraging ethics  Registers and supervises over 5,000 brokerages and 650,000 securities representatives  Breaking the rules may lead to fines, suspension or expulsion 20-25

Evolving Trading Platforms  Exchange Listing  Subject to requirements  Requirements vary across platforms  Intent  Ensure the listed firm’s stocks can support an ongoing market  Ensure sufficient disclosure  Must be approved for admission  Under certain conditions, a firm may be delisted 20-26

Evolving Trading Platforms  In the past, listing on one exchange is exclusionary  Now many assets have multiple listings  New trading platforms are evolving rapidly  Electronic Communication Network (ECN) taking a larger segment of the market  Archipelago  Instinet  Exchanges are creating their own ECNs 20-27

The Third Market  Third market  Market for securities listed on a stock exchange but traded over the counter  Broker and dealer firms that are not exchange members are active in this market  Set up to supply large numbers of shares to institutional investors  A catalyst in reducing brokerage fees  Helps promote trading efficiency 20-28

The Private Equity Market  Many different organizations can sell stock into the private equity market  New businesses  Privately held companies and partnerships  Troubled firms  Larger publicly traded companies  To finance out-of-the-ordinary financial transactions 20-29

Investment Banking and the Sale of New Stock  Majority of new stock issues are sold today through investment bankers  If offered in the private equity market  Also for issues to the public market  These investment bankers  Advise their corporate customers on the proper timing for issuing new stock (initial public offerings)  Frequently purchase (underwrite) newly issued shares for resale to their investor clients 20-30

The Development of A Unified International Market for Stock  Movement toward integrated stock markets  One of the most significant changes in past years  Provide a single market for all traders and investors  The 1975 Securities Act Amendments  Instructed the Securities and Exchange Commission (SEC)  To “facilitate the establishment of a national market system for securities.” 20-31

The Development of A Unified International Market for Stock  Intermarket Trading System (ITS)  Designed for brokers and specialists  Allow to compare bid and ask prices on all major U.S. exchanges  Covers about 700 stocks  The National Association of Security Dealers (NASD)  Moved to promote a broader market system  Further automating price quotations on OTC stock 20-32

The Development of A Unified International Market for Stock  The 1982 Shelf Registration Rule  Allowed many large firms to sell new stocks and bonds  Any time during the two years after the issue has been registered with the SEC 20-33

The Development of A Unified International Market for Stock  Cross-listing of stocks on various exchanges  A major growth area  Around the globe across different time zones  In response, U.S. exchanges have announced plans  Extended trading hours  After-hours trading 20-34

The Development of A Unified International Market for Stock  The development of international financial instruments  Strengthened the links between U.S. and foreign stock markets  Example is American Depository Receipts (ADRs)  ADRs  Dollar-denominated claims on foreign shares of stock  Kept in safekeeping by U.S. financial institutions 20-35

Valuing Stocks: Alternative Approaches  Competition among professional investors tends to lead to an efficient market  Valuable information is quickly incorporated into prices  Through the trading activities of professional investors  This information arrives randomly in the market  Stock prices themselves move similarly  In a nearly random fashion 20-36

Valuing Stocks: Alternative Approaches  If stock prices follow a random walk  Successive changes in stock prices are unpredictable  Even the best-informed financial analyst no greater ability to predict the future direction of stocks than does the average small investor  This “leveling out” of the investor playing field  Result of the collective efforts of professionals  Striving to correctly process all the relevant information 20-37

Technical and Fundamental Analysis  Technical analysts focus on patterns that emerge in past data  Draw charts reflecting prior upswings and downdrafts in stock prices  Attempt to identify “resistance levels” –  Upper or lower barriers  Stock prices have not been able to penetrate easily in the past 20-38

Technical and Fundamental Analysis  Fundamental analysts focus on the financial performance of individual companies  Tries to understand how well these companies are likely to perform in the current environment  Attempt to identify firms with strong balance sheets  Assets of the firm have good market value  Assets are not overly diluted by the firm’s liability and capital structure 20-39

Private Information  Many studies examining the degree of efficiency of the stock market  Most have concluded it is very difficult to systematically exploit publicly available information for profit  There are, however, some anomalies  January effect  Private information & insider trading 20-40

Markets on the Net  About.com at about.com about.com  American Stock Exchange at  CNNMoney.com at money.cnn.com money.cnn.com  Corporate Financials Online at cfonews.com cfonews.com  Federation of European Securities Exchanges at

Markets on the Net  FitchRatings at fitchratings.com fitchratings.com  Learn to Invest at greekshares.com greekshares.com  Morningstar at  National Association of Security Dealers at  National Center for Employee Ownership at nceo.org nceo.org  NASDAQ at  New York Stock Exchange at

Markets on the Net  QuantumOnline.com at quantumonline.com quantumonline.com  Quote.com at new.quote.com new.quote.com  Securities and Exchange Commission at sec.gov sec.gov  Technical Analysis Market Timing at tradersfloor.com tradersfloor.com  ThisMatter at thismatter.com thismatter.com  Thomson Investors Network at

Chapter Review  Introduction to the stock market  Characteristics of corporate stock  Common stock  Preferred stock  Stock market investors  Explaining stock values 20-44

Chapter Review  Characteristics of the corporate stock market  The major organized exchanges  The over-the-counter market  The third market: Trading in listed securities off the exchanges  The private equity market  Investment banking and the sale of new stock 20-45

Chapter Review  The development of a unified international market for stock  The national market system  NASD and automated price quotations  The advent of shelf registration  Global trading in equities  The development of ADRs 20-46

Chapter Review  Valuing stocks: Alternative approaches  Technical and fundamental analysis  Private information 20-47