Chapter 20

The Market for Corporate Stock

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Learning Objectives

To learn about the characteristics of common and preferred corporate stock. To compare and contrast the roles and functions of the organized stock exchanges and the over-the-counter market. To explore the issue of market efficiency.

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Introduction to the Stock Market

Equity is a certificate representing ownership of a corporation. It grants the right to share in the firms 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 future investments.

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Characteristics of Corporate Stock

All corporate stock represents an ownership interest in a corporation, conferring on the holder a number of rights as well as risks. Common stock 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 and to share in the net market value (after all debts are paid) of the companys assets if it is liquidated.

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Characteristics of Corporate Stock

Preferred stock carries a stated annual dividend expressed as a percent of the stocks par value. Preferred stockholders have a prior claim over the firms assets and earnings relative to the claims of common stockholders, although creditors must still be paid first. Preferred shares generally provide less income but are less risky than common stock.

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Stock Market Investors

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Stock Market Investors

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Explaining Stock Values

Recent research suggests that much of the variability in stock prices, though not all, can be explained by a relatively simple valuation model:

S0 E(Dt) r k

= todays market price per share of stock = expected future dividend flows per share = the default-free rate of interest = the premium for bearing equity risk
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Explaining Stock Values

If a corporations dividend payments are expected to grow at a constant rate, g, in the future, then S0 = D1/(r + k g).

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Explaining Stock Values

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Characteristics of the Corporate Stock Market

There are two main branches of the market for trading corporate stock. Organized exchanges Trading is governed by regulations and formal procedures designed to ensure competitive pricing and an active market for the stock of the largest firms. Over-the-counter (OTC) market This more informal market involves the trading of stock through brokers.

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Characteristics of the Corporate Stock Market

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The Major Organized Exchanges

The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) are organized exchanges. They have:
a physical location for trading trading posts formal trading rules listing requirements a board of directors member firms and seats

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The Major Organized Exchanges

Stock exchanges have emerged in every region of the globe, especially in Asia, Europe, and the Americas. Among the most interesting of the exchanges outside the U.S. are those in Japan, which have recently swung from more than a decade of economic and financial disaster to some signs of recovery and are receiving renewed interest from the rest of the world.

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The Major Organized Exchanges

Exchanges provide a continuous market centered in an established location with rigid rules to ensure fairness in trading. By bringing together buyers and sellers, the exchanges appear to make stock a more liquid investment, promote efficient pricing of securities, and make possible the placement of huge amounts of financial capital.

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The Over-the-Counter Market

There is no central trading location for the OTC market, but only an electronic communications network.

Many traders also act as principals, taking positions of risk by buying securities outright for their own portfolios in addition to the portfolios of their customers.

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The Third Market

The market for securities listed on a stock exchange but traded over the counter is known as the third market. Broker and dealer firms that are not exchange members are active in this market. The third market was set up to supply large blocks of shares to institutional investors, and it has been a catalyst in reducing brokerage fees and promoting trading efficiency.

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The Private Equity Market

New businesses, privately held companies and partnerships, troubled firms, and even larger publicly traded companies can conduct a private sale of stock in the private equity market to finance their acquisitions and other investments, as well as to support out-of-the-ordinary financial transactions.

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Investment Banking and the Sale of New Stock

Whether offered in the private equity market or in the public market, the majority of new stock issues are sold today through investment bankers. These firms advise their corporate customers on the proper timing for issuing new stock (initial public offerings) and frequently purchase (underwrite) newly issued shares for resale to their investor clients.

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The Development of A Unified International Market for Stock

One of the most significant developments in recent decades has been a movement to weld all parts of the equities market together into 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.

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The Development of A Unified International Market for Stock

The development of the Intermarket Trading System (ITS) enabled brokers and specialists to compare bid and ask prices on all the major U.S. exchanges for about 700 stocks. The National Association of Security Dealers (NASD) also moved to promote a broader market system by further automating price quotations on OTC stock.

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The Development of A Unified International Market for Stock

The 1982 Shelf Registration Rule allowed many large firms to sell new corporate stocks and bonds any time during the two years after the issue has been registered with the SEC.

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The Development of A Unified International Market for Stock

A rapid growth area in the internationalization of the stock market is the cross-listing of stocks on various exchanges around the globe across different time zones. In response, U.S. exchanges have announced plans for extended trading hours as well as after-hours trading.

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The Development of A Unified International Market for Stock

The development of international financial instruments like the American depository receipts (ADRs) has also strengthened the links between U.S. and foreign stock markets. ADRs are dollar-denominated claims on foreign shares of stock that are kept in safekeeping by U.S. financial institutions.

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Valuing Stocks: Alternative Approaches

Competition among professional investors results in an efficient market.

- Information that has value in terms of its ability to help forecast future stock price movements is quickly incorporated into those prices through the trading activities of professional investors.

Because this information arrives randomly in the market, stock prices themselves also tend to behave in a nearly random fashion.

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Valuing Stocks: Alternative Approaches

When stock prices follow a random walk, successive changes in stock prices are unpredictable.
- Even the best-informed financial analyst has no greater ability to predict the future direction of stocks than does the average small investor. - However, remember that this leveling out of the investor playing field is the result of the collective efforts of professionals who strive to correctly process all the relevant information in the market.

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Technical and Fundamental Analysis

Technical analysts focus on patterns that emerge in past data. They draw charts reflecting prior upswings and downdrafts in stock prices and attempt to identify resistance levels upper or lower barriers that stock prices have not been able to penetrate easily in the past.

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Technical and Fundamental Analysis

Fundamental analysts focus on the financial performance of individual companies and try to understand how well these companies are likely to perform in the current environment. Their task is to identify firms with strong balance sheets, meaning that the assets of the firm have good market value and are not overly diluted by the firms liability and capital structure.

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Private Information

Most studies examining how efficient the stock market is have concluded that it is very difficult to systematically exploit publicly available information for profit. There are, however, some anomalies.
- January effect - private information & insider trading

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Markets on the Net

American Stock Exchange at www.amex.com Federation of European Securities Exchanges at www.fese.be Morningstar at www.morningstar.com National Association of Security Dealers at www.nasd.com NASDAQ at www.nasdaq.com

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Markets on the Net

New York Stock Exchange at www.nyse.com Pacific Stock Exchange at www.pacificex.com Thomson Investors Network at www.thomsoninvest.net

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Chapter Review

Introduction to the Stock Market Characteristics of Corporate Stock

- Common Stock - Preferred Stock

Stock Market Investors

- Explaining Stock Values

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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

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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

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Chapter Review

Valuing Stocks: Alternative Approaches

- Technical and Fundamental Analysis - Private Information

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