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Chapter 20

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.

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Chapter 20

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  1. Chapter 20 The Market for Corporate Stock

  2.  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

  3.  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

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. Stock Market Investors 20-10

  11. Stock Market Investors 20-11

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. Organized Exchanges 20-19

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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

  30. 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

  31. 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

  32. 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

  33. 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

  34. 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

  35. 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

  36. 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

  37. 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

  38. 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

  39. 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

  40. 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

  41. Markets on the Net • About.com at about.com • American Stock Exchange at www.amex.com • CNNMoney.com at money.cnn.com • Corporate Financials Online at cfonews.com • Federation of European Securities Exchanges at www.fese.be 20-41

  42. Markets on the Net • FitchRatings at fitchratings.com • Learn to Invest at greekshares.com • Morningstar at www.morningstar.com • National Association of Security Dealers at www.nasd.com • National Center for Employee Ownership at nceo.org • NASDAQ at www.nasdaq.com • New York Stock Exchange at www.nyse.com 20-42

  43. Markets on the Net • QuantumOnline.com at quantumonline.com • Quote.com at new.quote.com • Securities and Exchange Commission at sec.gov • Technical Analysis Market Timing at tradersfloor.com • ThisMatter at thismatter.com • Thomson Investors Network at www.thomsoninvest.net 20-43

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

  45. 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

  46. 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

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

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