CHAPTER 10

EQUITY MARKETS

CHAPTER OVERVIEW AND LEARNING OBJECTIVES

 In this second capital markets chapter we shift from the debt market to the equity market.Capital markets and their instruments, bonds, mortgages, and equities develop only where there is prospect for political stability and economic development.

 The world comes to U.S. financial centers (and increasingly, European and Asian) to finance long-term capital projects.As you study this chapter, note the need for a viable secondary market in order to bring new issues to market (underwriting).With secondary markets, investors can alter their portfolio as their "real" conditions change (retirement, college tuition, etc.).

 As the number of market participants increases, and as technology improves, efficiency increases.

 When finished, review the Flow of Funds tables noting the credit flows (transactions) in the equity capital markets over the last several years.

CAREER PLANNING NOTE:TAKE A TRIP TO A FINANCIAL CENTER

Most campuses and homes of most students in this course are miles away from "financial centers" such as New York, Boston, Chicago, San Francisco, and regional centers such as Houston, Denver, and Cleveland.For those of you with a "finance" career on your mind, take the time to check out the Big Apple or other centers where there is a concentration of financial activity.Don't be concerned if you do not know anyone there!They (financial center employers) are expecting you!Book a tour (campus, organization, or private) or go with a friend.Take advantage of discount fares, coupon book room discounts, and the tours available from exchanges and others.Talk to your professors or alumni about people to meet and places to hit!Read the want ads in the city's newspaper before you go.Check out the universities and MBA degrees offered in the "money-center" area.Some students "get" to the right job and the city by relocating for prior MBA work.Look over the options and your strategy.Don't worry about leaving home.If you want, you can come home later – with "financial center" experience!Don't sit on your assets!Get that career plan going!

READING THE WALL STREET JOURNAL: PREDICTING THE MARKET

The “Ahead of the Tape” column on page C1 tries to make sense of what will happen in the market on a given day. If there is a meeting of the Federal Open Market Committee on a given day, you can be sure that the “Ahead of the Tape” column will discuss the likely outcome of the meeting and how it will affect markets. Likewise, if important economic data is to be released, the “Ahead of the Tape” column will give you a heads up about it.

TOPIC OUTLINE AND KEY TERMS

I.What Are Equity Securities?

A.Common Stock - Basic Ownership in a Corporation

1.One vote per share.

2.Board of directors declares dividends.

3.Residual (last) claim on income and assets in liquidation, thus a riskier position than bondholders and preferred stockholders.

4.Shareholders' liability for the debts of the corporation is limited to their investment in the common stock.

5.Shareholders' return is derived from dividends declared by the board of directorsand from appreciation of the stock’s market value.

6.Common shareholders may vote their shares to elect the members of the board of directors.

7.A shareholder may proxy their votes so that others, usually management, may vote the shares at shareholders' meetings.

8.Dual-class stock provides voting for one class of stock and limits or excludes voting for another class of common stock.

9.With cumulative voting, voting for the board is made in one ballot, permitting shareholders the opportunity to aggregate their votes and cast them together.The largest block of votes may appoint the first director, etc.Minority shareholder interests may be represented on the board.Majority or straight voting permits a majority or plurality to win all contested board seats, for each board seat is a separate election and the majority will win all.

B.Preferred Stock- Preferred claim on earnings and assets compared to common stock.

1.Preferred dividends are paid ahead of common if declared.

a.Cumulative– arrearage plus current dividends must be paid before any payment can be made to common shareholders.

b.Non-participating– preferred stockholders receive fixed dividends, thus not participating in possible high earnings of the corporation.

c.Adjustable-rate preferred, indexed to market rates, has dividend levels varying with the index interest rate.

2.Preferred stockholders are usually excluded from voting for board of directors and shareholder issues.

3.Many corporations (e.g., casualty insurance companies) buy preferred stock.

a.A high percent (70%), depending on the extent of ownership, of dividends received from one corporation by another are federally tax-exempt.

b.Investors are concerned about after-tax return.

c.As firm’s common stock price increases, so does the value of the preferred stock.

C.Convertible Securities

1.Convertible preferred stock- convertible to common stock at specific common price or number of shares (conversion ratio).

a.Dividends received until conversion.

b.Investor may participate in growth of firm.

2.Convertible bonds- convertible to a specific number of shares of common stock at a specific price.

a.Pays fixed bond coupon rate until conversion.

b.Provides potential for higher returns for investors.

c.Convertibles are mostly subordinated debt and hence have a higher risk.

d.Issuing firm is essentially “selling” the company’s stock at a higher future price.

II.The Market for Equity Securities

A.Shareholder Ownership

1.Households dominate direct holdings of equity securities.

a.May own directly or,

b.Households hold many indirect claims on stock through mutual funds.

2.Mutual funds rank number one in institutional ownership, followed by foreign investorsand pension funds.

B.Primary Market for Equities

1.Primary market transactions refer to the first sale of shares in the market an initial public offering (IPO) as well as additional shares sold later in a seasoned offering.

2.They may be:

a.sold directly to investors by the firm.

b.purchased and sold at a higher price ( the difference is the underwriter's spread) by investment bankers in an underwritten offering.

c.sold to existing shareholders in a rights offering.

3.Regulation and adequate disclosure are required by the Securities and Exchange Commission (federal) and securities offices of fifty states where they are sold.

a.Securities and Exchange Commission enforces the Securities Act of 1933 and the SEC Act of 1934.

b.Firms traditionally registered each new publicly distributed issue with the SEC just prior to distribution.

c.Qualified firms may now "shelf" register or register and then delay issuance (keep issue on the shelf) until the appropriate time to issue (within a two year period).

4.The size of the underwriter's spread is:

a.inversely related to the size of the primary offering.

b.directly related to risk of the offering, or potential variability of the stock price.

c.smaller with shelf registrations (usually larger, well known companies).

C.The Secondary Market for Equity Securities - Subsequent Trading in Securities

1.Largest dollar volume traded of any security.

2.Stock does not mature - must be traded.

3.Stock may trade on:

a.Exchanges.

(1)Listed

(2)Traded by exchange members

b.Over-the-counter (OTC).

(1)Dealers hold inventory

(2)Sell on bid/ask basis

4. Stable prices are related to the extent of:

a.Breadth of the market or the number of varied traders of the stock.

b.Depth of the market or the extent to which there are conditional orders to buy and sell below and above the current price, respectively.

c.Resiliency of the market or the ability of the market to attract buyers/sellers when the stock prices decrease/increase, respectively.

5.Secondary markets bring buyers/sellers together in four ways:

a.A buyer may incur search costs and find a seller on their own, called a direct search.

b.A broker may bring buyers and sellers together, charging a commission.

c.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.

d.An auction market allocates the selling shares to the highest bidder, providing a buyer/seller.

6.The size of a dealer’s bid/ask spread

a.is proportionally higher for low-priced stocks due to fixed costs of operations.

b.is higher for trades of a few shares.

c.is higher for large block trades, for a liquidity service is performed.

d.is narrower for more frequently traded stocks, where the costs of providing liquidity are less.

e.is wider with traders with insider information, where the dealer may have to incur the cost of price discovery, or buying high and selling low!

III.Equity Trading

A.Over-the-counter market (OTC)

1.Securities not listed on exchanges are traded over-the-counter (OTC).The reasons for not listing a stock include:

a.little investor interest.

b.small issue size.

c.insufficient order flow.

2.The OTC market is a dealer market, which includes a large number of relatively small dealers.

3.Brokers seek favorable prices from a variety of dealers.

B.National Association of Securities Dealers Automated Quotation (NASDAQ)

1.Before 1971 daily "pink sheet" information of the National Quotation Bureau listed stocks and associated dealers.

2."Pink sheets" had late price information.

3.After 1971 the National Association of Securities Dealers (NASD) initiated the NASDAQ, the NASD automated quotation system, providing continuous bid/ask information.

4.NASDAQ is an electronic pink sheet.

5.NASDAQ is available to:

a.Level 3 terminals are available only to dealers who enter bid/ask quotes into the system.

b.Level 2 terminals display price information and are available to brokers and institutions.

c.Level 1 terminals provide the best bid/ask quote for a given stock.

6.NASDAQ accelerated the disclosure of dealer quotes to brokers, reducing search time and enhancing the ability to find the best price.

C.Stock Exchanges

1.Exchanges are physical places or electronically connected markets where listed stocks are traded by members of the exchange.

2.The New York Stock Exchange is the largest of the U.S. stock exchanges.

a.Stocks are traded on an auction basis at specific locations on the trading floor, called posts.

b.All bid/ask information is at a single place.

3.Three major sources of active bids and offerings are located at each trading post.

a.floor brokers handling customer orders.

b.limit price orders.

c.the specialist in the stock buying and selling for his/her own account, making a continuous market for the stock.

4.Buy/ sell orders include

a.market orders to buy or sell at the available price and limit orders to sell at a designated price are sent by brokers to members trading on the floor of the NYSE.

b.limit orders (order to buy or sell at a designated price) are held by the specialists.

D.Merger of American Stock Exchange and NASDAQ

1.National Association of Securities Dealers (NASD) and American StockExchange announced it on 10/30/98.

2.First combination of central auction specialists (AMEX) and multiplemarket-makers (NASD).

3.Operated separately but attempt to provide combination of services to customers.

4.Use of electronic limit order book, allowing investors/traders toexecute orders on or off the physical trading floor of the AMEX.Limit order book is visible to investors.

E.Globalization of the Equity Markets

1.Electronically linking equity dealer and exchangemarkets is slowly leading toward a nationalmarket system.

2.Electronically linking international markets hascreated 24 hour trading opportunities for some stocks.

3.U. S. stock exchanges have extended (after hours)their normal trading hours in which shares aretraded electronically, linking U.S. with the hours of international markets.

4.Investors’ ability to invest in foreign stocks is enhanced by American Depository Receipts (ADRs)

a.An American Depository Receipt (ADR) is a negotiable issued by the U.S. financial intermediaries (FIs) against shares in foreign companies, with the shares held in custody by the FIs for investors.

b.ADRs are issued in the U.S. and are denominated in U.S. dollars. All cash flows to the investor are in dollars.

c.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.

d.ADRs and GDRs allow investors to diversify their portfolio globally by reducing both transaction costs and risk for investors.

e.Enhances a company’s visibility, status and profile in the U.S. and internationally among investors, consumers and customers.

f.Establishes/increases the foreign firm’s U.S. liquidity (and potentially total global issuer liquidity) by attracting new investors.

g.As of December 2006 there were 450 listed ADRs representing over $1.9 trillion of equity in companies from 76 countries.

h.In 2006, ADR dollar trading volume in the U.S. totaled $1.58trillion, up from $953 billion in 2005.

IV.Regulation of Equity Markets

A.Trading in securities markets in the U.S. are regulated by several federal laws and many state laws.

1.Securities Act of 1933

a.requires full disclosure of relevant information related to a primary issue of securities.

b.requires registration of publicly traded securities across state lines.

c.requires issuance of prospectus, a summary of registration statement, to interested investors.

2.Securities Exchange Act of 1934

a.Established the SEC.

b.SEC administers the Securities Act of 1933

c.SEC registers and regulates securities exchanges, OTC trading, brokers, and dealers.

d.SEC has broad powers over securities industry.

V.Equity Valuation Basics

A.The value of a security is the present value of expected cash flows, discounted at the required rate of return.

1.Identify the relevant future cash flows and their timing.

2.Select the appropriate discount rate.

3.Calculate the present value found by discounting the cash flows at the discount rate, recognizing the timing of cash flows.

B. Preferred stock valuation

1.Discount the expected dividend stream at the required rate of return to determine its value.

2.A fixed-rate preferred stock approximates a perpetuity, and the value can be found by dividing the annual dividends by the discount rate. [See Equation 10.2]

3.The preferred stock price varies to give the going rate of return to the new investor.

C.Common Stock Valuation

1.The analyst must approximate the future cash flow stream and select an appropriate discounting equation that approximates the cash flows of the stock.

2.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 above.

3.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.

4.The present value, now in period zero, of a steadily increasing stream of cash flows is the value of the cash flow in the first year divided by the difference between the discount rate and the (constant) rate of growth.This expression is a math expression of a steadily growing perpetuity. [See Equation 10.9]

5.The valuation of a stock growing at varied assumed growth rates in the future is calculated in several steps:

a.first, calculate the dividends expected in the first few years of the supernormal growth.

b.Calculate the price or present value of the stock at the end of the supernormal growth period.

c.Combine the assumed new perpetual growth rate with the cash flows computed above in the following equation: [See Equation 10.11]

VI.Equity Risk

A.Systematic & Unsystematic Risk

1.The total risk of a security is comprised of the systematic (market or non-diversifiable) risk and the unsystematic risk (diversifiable) risk.

2.Proper diversification can reduce unsystematic, or security-specific risk.

3.A portfolio of selected securities can result in diversification, the reduction of total risk or the variability of returns (portfolio) below that of holding individual securities.

4.Diversification occurs when securities whose historic returns are less than perfectly positively correlated are assembled in a portfolio.Unsystematic or diversifiable risks of different firms offset one another to some extent.

5.Adding properly selected securities to a portfolio has a limit as the systematic risk of the portfolio cannot be diversified away.

B.Measuring Systematic Risk:Beta

1.Investors are assumed to hold securities in a diversified portfolio with only systematic or market risk to analyze.

2.The relevant risk of a security is how it correlates with the market portfolio.

3.The extent to which the variability of returns (risk) of a stock relates to the risk of a broad-based market portfolio is called the beta of the stock.It is a measure of market (systematic) risk of a security.

4.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.

5.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 and are called defensive stocks.

6.Betas calculated for securities identify their relative historic riskiness.

C.The Security Market Line (SML)

1.The security market line depicts the returns demanded for increased increments of risk, the classic risk/return tradeoff.

2.The security market line is part of the capital asset pricing model (CAPM), which explains the risk/return tradeoff.

3.The security market line enables one 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).

4.The equation for the SML is expressed asthe risk premium of a stock is the sum of the risk-free rate plus the market risk premium over the risk free rate times the beta. (Equation 10.12a)