Chapter 20 The Market for Corporate Stock. Learning Objectives To learn about the characteristics of common and preferred corporate stock. To.

Chapter 20Chapter 20

The Market for Corporate StockThe Market for Corporate Stock

Learning Objectives Learning Objectives

To learn about the characteristics of To learn about the characteristics of common and preferred corporate stock.common and preferred corporate stock.

To identify the principal investors in To identify the principal investors in corporate stock.corporate stock.

To understand the role equities play in To understand the role equities play in financing business investment.financing business investment.

20-2

Learning Objectives Learning Objectives

To compare and contrast the roles To compare and contrast the roles and functions of organized stock and functions of organized stock exchanges and the over-the-counter exchanges and the over-the-counter market.market.

To explore the issue of market To explore the issue of market efficiency and examine the evidence efficiency and examine the evidence regarding stock market efficiency.regarding stock market efficiency.

20-3

IntroductionIntroduction

Equity is a certificate representing Equity is a certificate representing ownership of a corporation. It grants the ownership of a corporation. It grants the right to share in the firm’s assets and right to share in the firm’s assets and earnings, if any.earnings, if any.

Stock market activity involves mainly the Stock market activity involves mainly the trading of issued securities rather than the trading of issued securities rather than the exchange of financial claims for new exchange of financial claims for new capital.capital.

Nevertheless, the stock market has a Nevertheless, the stock market has a significant impact on the expectations of significant impact on the expectations of businesses when planning investments.businesses when planning investments.

20-4

Characteristics of Corporate StockCharacteristics of Corporate Stock

Corporate stock Corporate stock Ownership interest in a corporationOwnership interest in a corporation A number of rights as well as risksA number of rights as well as risks Common stock is the most important formCommon stock is the most important form

Represents a residual claim against the assets Represents a residual claim against the assets of the issuing firmof the issuing firm

Entitling the owner to share in the net earnings Entitling the owner to share in the net earnings of the firm when it is profitable of the firm when it is profitable

Share in the net market value (after all debts Share in the net market value (after all debts are paid) of the company’s assets if it is are paid) of the company’s assets if it is liquidatedliquidated

20-5


Rights of common stock holdersRights of common stock holders Elect the company’s board of directorsElect the company’s board of directors Preemptive rightsPreemptive rights Right of access to meeting minutes and Right of access to meeting minutes and

lists of existing shareholderslists of existing shareholders Right to vote on issues that affect the Right to vote on issues that affect the

firm’s property as a wholefirm’s property as a whole

20-6


Preferred stock Preferred stock Carries a stated annual dividend expressed Carries a stated annual dividend expressed

as a percent of the stock’s par valueas a percent of the stock’s par value A prior claim over the firm’s assets and A prior claim over the firm’s assets and

earnings relative common stockholdersearnings relative common stockholders Creditors must still be paid firstCreditors must still be paid first Less income than common stockLess income than common stock Also less risky than common stockAlso less risky than common stock

20-7


However preferred have some limitationsHowever preferred have some limitations Generally no votes for the board of directorsGenerally no votes for the board of directors Dividends are not tax-deductibleDividends are not tax-deductible

Shares have a range of characteristics Shares have a range of characteristics Cumulative shares is where, when a dividend is Cumulative shares is where, when a dividend is

missed, the liability accruesmissed, the liability accrues Participating means shareholders share in Participating means shareholders share in

residual earningsresidual earnings Many carry call provisionsMany carry call provisions Some issues are convertibleSome issues are convertible

20-8

Stock Market InvestorsStock Market Investors

Corporate stock is a very widely held Corporate stock is a very widely held financial assetfinancial asset Direct holdings by households represent Direct holdings by households represent

the largest portion of U.S. stock holdingsthe largest portion of U.S. stock holdings There is a phenomenal growth in other There is a phenomenal growth in other

holdingsholdings Investments by pension fundsInvestments by pension funds Mutual fundsMutual funds Foreign investorsForeign investors

20-9


20-10


20-11


In Chapter 6, we learned that the price of In Chapter 6, we learned that the price of stock sharesstock shares Reflect the present value of the stock’s Reflect the present value of the stock’s

expected future dividendsexpected future dividends Factors that impact investor expectations Factors that impact investor expectations

about those future dividends will tend to about those future dividends will tend to change stock priceschange stock prices

Other factors also impact share priceOther factors also impact share price Interest ratesInterest rates InflationInflation Changes in riskChanges in risk

20-12

Equity as a Source of FundingEquity as a Source of Funding

Equity is one potential source of Equity is one potential source of funding physical and financial assetsfunding physical and financial assets Most corporations rely primarily on retained Most corporations rely primarily on retained

earningsearnings When that is insufficient retained earningsWhen that is insufficient retained earnings

Cut dividends generally avoidedCut dividends generally avoided Raise debtRaise debt Raise equityRaise equity

How to choose between debt and equityHow to choose between debt and equity

20-13


Tax treatment is a critical decision Tax treatment is a critical decision factorfactor Differential tax treatment of expensesDifferential tax treatment of expenses

Interest is tax-deductibleInterest is tax-deductible Dividends are not tax deductibleDividends are not tax deductible

A firm acting in the interest of its A firm acting in the interest of its shareholders will tend to minimize the shareholders will tend to minimize the number of shares outstandingnumber of shares outstanding

Over reliance on debt increases firm riskOver reliance on debt increases firm risk So a firm will choose a mix of debt and So a firm will choose a mix of debt and

equity when exhaust retained earningsequity when exhaust retained earnings20-14


Some times corporations buy back sharesSome times corporations buy back shares Often accompanied by a boost in stock priceOften accompanied by a boost in stock price

Expectation is for an improvement in a firm’s Expectation is for an improvement in a firm’s financial ratiofinancial ratio

Reduces the number of shares so, all else Reduces the number of shares so, all else equal, the EPS would riseequal, the EPS would rise

May need May need treasury sharestreasury shares Minimize Minimize dilutiondilution from the creation of an from the creation of an

employee stock option planemployee stock option plan Tax benefits from avoiding taxes on dividendsTax benefits from avoiding taxes on dividends

20-15

The Process of Price Discovery The Process of Price Discovery in the Equity Marketsin the Equity Markets

Price discovery is the means by Price discovery is the means by which a value is placed on an assetwhich a value is placed on an asset Trades taking place in competitive Trades taking place in competitive

markets should reflect the true market markets should reflect the true market value of a stockvalue of a stock

Processes of the last decade has Processes of the last decade has altered the price discovery processaltered the price discovery process Information technology revolutionInformation technology revolution Drive to enhance speed and accuracyDrive to enhance speed and accuracy

20-16

The Process of Price Discovery The Process of Price Discovery in the Equity Marketsin the Equity Markets

There are two main branches of There are two main branches of the market for trading corporate the market for trading corporate stockstockOrganized exchanges Organized exchanges Over-the-counter (OTC) marketOver-the-counter (OTC) market

20-17

Organized ExchangesOrganized Exchanges

The organized exchangeThe organized exchange Governed by regulations and procedures Governed by regulations and procedures Designed to ensure competitive pricingDesigned to ensure competitive pricing Ensure an active market for the traded stocksEnsure an active market for the traded stocks

Active participantsActive participants Floor traders – buy and sell for own accountFloor traders – buy and sell for own account Commission brokers – employed by brokerage to Commission brokers – employed by brokerage to

represent customersrepresent customers Specialists oversee the trading in each stockSpecialists oversee the trading in each stock Odd-lot traders specialize in trading shares in Odd-lot traders specialize in trading shares in

numbers not rounded to 100 sharesnumbers not rounded to 100 shares20-18


20-19


The New York Stock Exchange (NYSE) The New York Stock Exchange (NYSE) and the American Stock Exchange and the American Stock Exchange (AMEX) are organized exchanges(AMEX) are organized exchanges A physical location for tradingA physical location for trading Trading postsTrading posts Formal trading rulesFormal trading rules Listing requirementsListing requirements A board of directorsA board of directors Member firms and seatsMember firms and seats

20-20


Stock exchanges have emerged in every Stock exchanges have emerged in every region of the globeregion of the globe AsiaAsia EuropeEurope The AmericasThe Americas

Japanese exchangesJapanese exchanges Among the most interesting of the exchanges Among the most interesting of the exchanges

outside the U.S. outside the U.S. Have recently swung to some signs of recovery Have recently swung to some signs of recovery Are receiving renewed interest from the rest of Are receiving renewed interest from the rest of

the worldthe world20-21


Exchanges provide a continuous marketExchanges provide a continuous market Centered in an established location Centered in an established location Rigid rules to ensure fairness in tradingRigid rules to ensure fairness in trading

Exchange brings together buyers and Exchange brings together buyers and sellers sellers Appear to make stock a more liquid Appear to make stock a more liquid

investmentinvestment Promote efficient pricing of securitiesPromote efficient pricing of securities Make possible the placement of huge Make possible the placement of huge

amounts of financial capitalamounts of financial capital20-22

The Over-the-Counter MarketThe Over-the-Counter Market

OTC marketOTC market No central trading location No central trading location Only an electronic Only an electronic

communications networkcommunications network E.g. National Association of Security E.g. National Association of Security

Dealers (NASD)Dealers (NASD) Most trading of stock in the world is OTCMost trading of stock in the world is OTC

20-23


Many traders also act as principalsMany traders also act as principals Taking “positions of risk”Taking “positions of risk”

Buying securities outright for their own Buying securities outright for their own portfolios portfolios

Also buys for portfolios of their Also buys for portfolios of their customerscustomers

Prices are determined by negotiationPrices are determined by negotiation Buy at the Buy at the bid bid priceprice Sell at the Sell at the askedasked price price

20-24


The U.S. OTC is regulated by a code of The U.S. OTC is regulated by a code of ethicsethics Developed by the National Association of Developed by the National Association of

Security Dealers (NASD)Security Dealers (NASD) Private organization encouraging ethicsPrivate organization encouraging ethics Registers and supervises over 5,000 Registers and supervises over 5,000

brokerages and 650,000 securities brokerages and 650,000 securities representativesrepresentatives

Breaking the rules may lead to fines, Breaking the rules may lead to fines, suspension or expulsionsuspension or expulsion

20-25

Evolving Trading PlatformsEvolving Trading Platforms

Exchange ListingExchange Listing Subject to requirementsSubject to requirements Requirements vary across platformsRequirements vary across platforms IntentIntent

Ensure the listed firm’s stocks can support an Ensure the listed firm’s stocks can support an ongoing marketongoing market

Ensure sufficient disclosureEnsure sufficient disclosureMust be approved for admission Must be approved for admission Under certain conditions, a firm may be Under certain conditions, a firm may be

delisted delisted

20-26

Evolving Trading PlatformsEvolving Trading Platforms

In the past, listing on one exchange is In the past, listing on one exchange is exclusionaryexclusionary

Now many assets have multiple listingsNow many assets have multiple listingsNew trading platforms are evolving New trading platforms are evolving

rapidlyrapidlyElectronic Communication Network (ECN) Electronic Communication Network (ECN)

taking a larger segment of the markettaking a larger segment of the market ArchipelagoArchipelago InstinetInstinet Exchanges are creating their own ECNsExchanges are creating their own ECNs

20-27

The Third MarketThe Third Market

Third marketThird market Market for securities listed on a stock exchange Market for securities listed on a stock exchange

but traded over the counter but traded over the counter Broker and dealer firms that are not exchange Broker and dealer firms that are not exchange

members are active in this marketmembers are active in this market Set up to supply large numbers of shares to Set up to supply large numbers of shares to

institutional investorsinstitutional investors A catalyst in reducing brokerage fees A catalyst in reducing brokerage fees Helps promote trading efficiencyHelps promote trading efficiency

20-28

The Private Equity MarketThe Private Equity Market

Many different organizations can sell Many different organizations can sell stock into the private equity marketstock into the private equity market New businessesNew businesses Privately held companies and partnershipsPrivately held companies and partnerships Troubled firmsTroubled firms Larger publicly traded companies Larger publicly traded companies

To finance out-of-the-ordinary financial To finance out-of-the-ordinary financial transactionstransactions

20-29

Investment Banking and the Investment Banking and the Sale of New StockSale of New Stock

Majority of new stock issues are sold Majority of new stock issues are sold today through investment bankerstoday through investment bankers If offered in the private equity market If offered in the private equity market Also for issues to the public marketAlso for issues to the public market

These investment bankersThese investment bankers Advise their corporate customers on the Advise their corporate customers on the

proper timing for issuing new stock (initial proper timing for issuing new stock (initial public offerings)public offerings)

Frequently purchase (underwrite) newly Frequently purchase (underwrite) newly issued shares for resale to their investor issued shares for resale to their investor clientsclients

20-30

The Development of A Unified The Development of A Unified International Market for StockInternational Market for Stock

Movement toward integrated stock Movement toward integrated stock marketsmarkets One of the most significant changes in past One of the most significant changes in past

yearsyears Provide a single market for all traders and Provide a single market for all traders and

investorsinvestorsThe 1975 Securities Act Amendments The 1975 Securities Act Amendments

Instructed the Securities and Exchange Instructed the Securities and Exchange Commission (SEC) Commission (SEC)

To “facilitate the establishment of a national To “facilitate the establishment of a national market system for securities.”market system for securities.”

20-31


Intermarket Trading System (ITS) Intermarket Trading System (ITS) Designed for brokers and specialistsDesigned for brokers and specialists Allow to compare bid and ask prices on all Allow to compare bid and ask prices on all

major U.S. exchanges major U.S. exchanges Covers about 700 stocksCovers about 700 stocks

The National Association of Security The National Association of Security Dealers (NASD) Dealers (NASD) Moved to promote a broader market systemMoved to promote a broader market system Further automating price quotations on OTC Further automating price quotations on OTC

stockstock20-32


The 1982 Shelf Registration Rule The 1982 Shelf Registration Rule Allowed many large firms to sell new stocks Allowed many large firms to sell new stocks

and bonds and bonds Any time during the two years after the Any time during the two years after the

issue has been registered with the SECissue has been registered with the SEC

20-33


Cross-listing of stocks on various Cross-listing of stocks on various exchanges exchanges A major growth areaA major growth area Around the globe across different time Around the globe across different time

zoneszones

In response, U.S. exchanges have In response, U.S. exchanges have announced plansannounced plans Extended trading hours Extended trading hours After-hours tradingAfter-hours trading

20-34


The development of international The development of international financial instruments financial instruments Strengthened the links between U.S. and Strengthened the links between U.S. and

foreign stock marketsforeign stock markets Example is American Depository Receipts Example is American Depository Receipts

(ADRs) (ADRs) ADRs ADRs

Dollar-denominated claims on foreign Dollar-denominated claims on foreign shares of stock shares of stock

Kept in safekeeping by U.S. financial Kept in safekeeping by U.S. financial institutionsinstitutions

20-35

Valuing Stocks: Alternative Valuing Stocks: Alternative ApproachesApproaches

Competition among professional Competition among professional investors tends to lead to an efficient investors tends to lead to an efficient market market Valuable information is quickly Valuable information is quickly

incorporated into pricesincorporated into prices Through the trading activities of Through the trading activities of

professional investorsprofessional investorsThis information arrives randomly in the This information arrives randomly in the

marketmarket Stock prices themselves move similarlyStock prices themselves move similarly In a nearly random fashionIn a nearly random fashion

20-36

Valuing Stocks: Alternative Valuing Stocks: Alternative ApproachesApproaches

If stock prices follow a random walkIf stock prices follow a random walk Successive changes in stock prices are Successive changes in stock prices are

unpredictableunpredictable Even the best-informed financial analyst no Even the best-informed financial analyst no

greater ability to predict the future direction of greater ability to predict the future direction of stocks than does the average small investorstocks than does the average small investor

This “leveling out” of the investor playing field This “leveling out” of the investor playing field Result of the collective efforts of Result of the collective efforts of

professionalsprofessionals Striving to correctly process all the relevant Striving to correctly process all the relevant

informationinformation20-37

Technical and Technical and Fundamental AnalysisFundamental Analysis

Technical analysts focus on patterns Technical analysts focus on patterns that emerge in past data that emerge in past data Draw charts reflecting prior upswings and Draw charts reflecting prior upswings and

downdrafts in stock pricesdowndrafts in stock prices Attempt to identify “resistance levels” – Attempt to identify “resistance levels” –

Upper or lower barriersUpper or lower barriers Stock prices have not been able to Stock prices have not been able to

penetrate easily in the pastpenetrate easily in the past

20-38

Technical and Technical and Fundamental AnalysisFundamental Analysis

Fundamental analysts focus on the Fundamental analysts focus on the financial performance of individual financial performance of individual companiescompanies Tries to understand how well these Tries to understand how well these

companies are likely to perform in the companies are likely to perform in the current environmentcurrent environment

Attempt to identify firms with strong balance Attempt to identify firms with strong balance sheetssheets Assets of the firm have good market valueAssets of the firm have good market value Assets are not overly diluted by the firm’s Assets are not overly diluted by the firm’s

liability and capital structureliability and capital structure20-39

Private InformationPrivate Information

Many studies examining the degree of Many studies examining the degree of efficiency of the stock marketefficiency of the stock market Most have concluded it is very difficult to Most have concluded it is very difficult to

systematically exploit publicly available systematically exploit publicly available information for profitinformation for profit

There are, however, some anomaliesThere are, however, some anomalies January effectJanuary effect Private information & insider tradingPrivate information & insider trading

20-40

Markets on the NetMarkets on the Net

About.com at About.com at about.comabout.comAmerican Stock Exchange at American Stock Exchange at

www.amex.comwww.amex.comCNNMoney.com at CNNMoney.com at money.cnn.commoney.cnn.comCorporate Financials Online at Corporate Financials Online at

cfonews.comcfonews.comFederation of European Securities Federation of European Securities

Exchanges at Exchanges at www.fese.bewww.fese.be

20-41


FitchRatings at FitchRatings at fitchratings.comfitchratings.comLearn to Invest at Learn to Invest at greekshares.comgreekshares.comMorningstar at Morningstar at www.morningstar.comwww.morningstar.comNational Association of Security National Association of Security

Dealers at Dealers at www.nasd.comwww.nasd.comNational Center for Employee National Center for Employee

Ownership at Ownership at nceo.orgnceo.orgNASDAQ at NASDAQ at www.nasdaq.comwww.nasdaq.comNew York Stock Exchange at New York Stock Exchange at

www.nyse.comwww.nyse.com

20-42


QuantumOnline.com at QuantumOnline.com at quantumonline.comquantumonline.comQuote.com at Quote.com at new.quote.comnew.quote.comSecurities and Exchange Commission at Securities and Exchange Commission at

sec.govsec.govTechnical Analysis Market Timing at Technical Analysis Market Timing at

tradersfloor.comtradersfloor.comThisMatter at ThisMatter at thismatter.comthismatter.comThomson Investors Network at Thomson Investors Network at

www.thomsoninvest.netwww.thomsoninvest.net

20-43

Chapter ReviewChapter Review

Introduction to the stock marketIntroduction to the stock marketCharacteristics of corporate stockCharacteristics of corporate stock

Common stockCommon stock Preferred stockPreferred stock

Stock market investorsStock market investors Explaining stock valuesExplaining stock values

20-44


Characteristics of the corporate stock Characteristics of the corporate stock marketmarket The major organized exchangesThe major organized exchanges The over-the-counter marketThe over-the-counter market

The third market: Trading in listed The third market: Trading in listed securities off the exchanges securities off the exchanges

The private equity marketThe private equity market Investment banking and the sale of new Investment banking and the sale of new

stockstock

20-45


The development of a unified The development of a unified international market for stockinternational market for stock The national market systemThe national market system NASD and automated price quotationsNASD and automated price quotations The advent of shelf registrationThe advent of shelf registration Global trading in equitiesGlobal trading in equities The development of ADRsThe development of ADRs

20-46


Valuing stocks: Alternative approachesValuing stocks: Alternative approaches Technical and fundamental analysisTechnical and fundamental analysis Private informationPrivate information

20-47

Chapter 20 The Market for Corporate Stock. Learning Objectives To learn about the characteristics of common and preferred corporate stock. To.

Documents

stock market investors20

stock market efficiency

stock market activity

riskscommon stock

stock holdingsthere

preferred corporate

stock pricesother factors

price of stock sharesreflect