The Stock Market
I. Introduction
The stock market of a country can be divided into two large interrelated markets: (1) the primary market, where newly issued shares are sold; and (2) the secondary market, where outstanding shares are traded
In the primary market, a company needing funds can sell newly issued shares by using an underwriter (usually a large brokerage firm). The primary market is a global market, since newly issued shares can be sold anywhere the underwriter has a branch office. The underwriter performs an important middleman service, since the issuing company would generally not be able to sell its shares over such a large geographic area. If the company is issuing a large amount of shares, then it may want to use a large number of different security firms to underwrite these securities. Information regarding the issuance will be contained in a prospectus, which can be obtained from the underwriters.
Newly issued stock generally has a par or face value. However, when sold in the primary market, it will have a price determined by supply and demand. Therefore, except for some accounting relations, the par value is not of great importance. The stock that is issued can be either common stock or preferred stock. Common stock gives the owner voting rights in the stockholder meetings; however, it does not have a fixed dividend like preferred stock. Moreover, preferred stock dividends must be paid before any common stock dividends can be paid.
The importance of corporate stock is that it carries limited liability. If the company amasses debts, the personal assets of the stockholders cannot be taken to pay these debts. The stockholder is liable only for the money he or she has invested in the stock.
After the stock has been issued and bought by investors, it becomes stock outstanding. If the company buys back some of its stock previously issued, then the stock outstanding will decrease. However, the total number of shares will not decrease. Shares repurchased in a stock buyback plan are called treasury stock. The number of shares outstanding is very important in calculating certain financial ratios (e.g., the P/E ratio).
Outstanding shares in corporations are often traded in organized secondary markets. Such companies are what we call listed corporations. The secondary markets mainly consist of various stock exchanges and the over-the-counter (OTC) market. Listings on stock exchanges or the OTC are very important because they increase the liquidity of the stock. Very few people would be willing to purchase stock if they thought they could not sell it when necessary. Liquidity is a measure of how quickly an asset can be sold for cash without a large reduction in its price. A strong secondary market raises the liquidity of the stock and thus its value to investors.
The largest and most famous secondary market for stock is the New York Stock Exchange (NYSE). in addition, many major American corporations are listed on the American Stock Exchange (AMEX). Less well known corporations are listed on other exchanges and the OTC. Foreign companies can also sometimes obtain listings on these exchanges.
II. Understanding Stock Quotations in the Wall Street Journal
The most important source for understanding current developments in stock markets is the Wall Street Journal (WSJ). In addition to providing quotations on the previous trading day's closing session, it also contains valuable information on specific companies, industries, as well as useful macroeconomic news. There are European and Asian editions of the WSJ, which focus more on regional markets and developments. The editorial pages are usually devoted to important issues affecting politics and economics. The views expressed there are usually pro-business and very conservative, but occasionally contributed pieces can be quite liberal.
The stock quotations found in the WSJ provide only a limited number of financial indicators. For each stock, the high and low price for the past 52 weeks is given. Next, the name of the company and its abbreviation appears. If the stock is preferred, this will also be indicated. The last quarterly dividend per share, expressed on an annualized basis, is reported. After this, the current yield of the stock is given, and is computed by dividing the dividend by the current price. The P/E ratio comes next, and refers to the current price divided by the most recent yearly earnings per share ratio. The volume of shares traded during the day is shown next, and is expressed in terms of 100s of shares. Finally, the high, low, and closing price for the day are presented, along with the net change in price from the last trading session.
On any single day, the above information is not likely to be very helpful. However, if one follows these quotations over time, it is possible to get some understanding of the market's valuation of the equity. Each piece of information provides a different facet of the stock's financial condition. Unfortunately, the quotations by themselves, cannot provide sufficient information for adjusting one's portfolio. To truly understand a particular stock, one must consider other sources of information about the companies.
III.Balance Sheets and Income Statements
To clearly understand the financial condition of a corporation, one needs to study both the balance sheets and income statements of the company.
An annual balance sheet lists the assets, liabilities and owners' equity of a corporation. By definition, owners' equity is equal to all assets minus all liabilities. The basic assets of a company include such things as cash, accounts receivable, inventory, and plant and equipment. These assets are used to produce revenue for the company. Total liabilities consist of mainly bank loans, accounts payable, and corporate bonds outstanding. Each of these will require future payments of money by the company. Owners' equity (or net worth) is composed of stock outstanding and retained earnings. It is important to note that the balance sheet shows the above information for one point in time, usually the last day of the year.
By contrast, the quarterly income statement shows the revenues and expenditures made by the corporation during the past three months, usually compared with the same period in the previous year. The income statement gives a concise picture of how profits were made, income taxes were paid, and typically shows the earnings per share of common stock. Often it is important to understand how net earnings were made and not just how large they were.
Careful analysis of the balance sheets and income statements can help one determine such things as whether a stock is currently undervalued, whether it may become the target of a hostile takeover, or even whether current earnings have been manipulated through clever accounting tricks.
IV. Stock Indexes and Selling Short
The NYSE has thousands of listed stocks, so it can often be difficult to judge the overall direction of the market. To judge general movements in the market, we must rely on a stock index. The most popular indexes are the three Dow Jones indexes: one each for industrials, transportation companies, and utilities. There is also a very broad based index called the NYSE Composite Index which considers the whole market. In addition, there is the S&P 500 index which covers the top 500 corporations. The NASDAQ index gives an average of a particular set of stocks trading OTC.
Over a period of a year, the stock index will be affected by the health of the economy. Over shorter periods of time, there are many factors which affect the index, such as changes in interest rates, money supply, earnings reports, trade and budget deficits, and important political developments.
When the index rises steadily, we call it a bull market. By contrast, when most stockholders and investors are wanting to sell their stock, we call it a bear market. Sometimes, the market will rise too far and then suddenly drop. This is called a market correction since the index was unrealistically high. We often say that the market fell because of profit-taking.
Sometimes an investor feels that the market is going lower. He may choose to short a particular stock. Selling stock short means that the investor borrows stock from a broker and sells it now, with the intention of buying the same stock back at a lower price. The investor must maintain a margin account with the broker. If the stock the investor is shorting rises in price, he is required to increase the deposit in his margin account. Shorting stock creates a risk of unlimited losses for the investor, since the stock he is shorting can theoretically experience an unlimited rise in price. Short sellers can limit this risk by hedging with call options, which we will discuss later.
Discussion Questions:
#1. What is the difference between the primary and secondary market for stock?
#2. Who are underwriters and why are they important?
#3. What is meant by limited liability?
#4. What is the definition of liquidity?
#5. What is the difference between common and preferred stock?
#6. What information is given in the NYSE stock quotations in the WSJ?
#7. What are balance sheets and income statements?
#8. What are some US stock indexes?
#9. What is meant by bull and bear markets?
#10. What does it mean to sell stock short?