CHAPTER 4: EQUITY MARKET
Chapter 13: The Stock Market
I.
Investing in Stocks (p.334)
A share of stock in a firm represents ownership. A stockholder owns a percentage interest
in a firm, consistent with the percentage of outstanding stock held. Investors can earn a
return from stock in one of two ways. Either the price of the stock rises over time or the
firm pays the stockholder dividends. Frequently, investors earn a return from both
sources. Stock is riskier than bonds because stockholders have a lower priority than
bondholders when the firm is in trouble, dividends are less assured, and stock price
increases are not guaranteed. Despite these risks, it is possible to make a great deal of
money by investing in stock, whereas that is very unlikely by investing in bonds.
Another distinction between stock and bonds is that stock does not mature.
Ownership of stock gives the stockholder certain rights regarding the firm. One is the
right of a residual claimant: Stockholders have a claim on all assets and income left over
after all other claimants have been satisfied. If nothing is left over, they get nothing. As
noted, however, it is possible to get rich as a stockholder if the firm does well.
Most stockholders have the right to vote for directors and on certain issues, such as
amendments to the corporate charter and whether new shares should be issued.
1. Common Stock vs. Preferred Stock
There are two types of stock, common and preferred. A share of common stock in a firm
represents an ownership interest in that firm. Common stockholders vote, receive
dividends, and hope that the price of their stock will rise. There are various classes of
common stock, usually denoted type A, type B, and so on. Unfortunately, the type does
not have any meaning that is standard across all companies. The differences among the
types usually involve either the distribution of dividends or voting rights. It is important
for an investor in stocks to know exactly what rights go along with the shares of stock
being contemplated. The owners of small companies also tend to be the managers. In
publicly traded firms, however, most of the shareholders are not managers. Thus they
must rely on the firm’s managers to serve as agents and to make decisions in the
shareholders’ best interests.
Preferred stock is a form of equity from a legal and tax standpoint. However, it differs
from common stock in several important ways. First, because preferred stockholders
receive a fixed dividend that never changes, a share of preferred stock is as much like a
bond as it is like common stock. Second, because the dividend does not change, the price
of preferred stock is relatively stable. Third, preferred stockholders do not usually vote
unless the firm has failed to pay the promised dividend. Finally, preferred stockholders
hold a claim on assets that has priority over the claims of common shareholders but after
that of creditors such as bondholders.
Preferred shareholders technically share the ownership of the firm with common
shareholders and are therefore compensated only when earnings have been generated.
Thus, if the firm does not have sufficient earnings from which to pay the preferred stock
dividends, it may omit the dividend without fear of being forced into bankruptcy.
Because the dividends on preferred stock can be omitted, a firm assumes less risk when
issuing it than when issuing bonds. A cumulative provision on most preferred stock
prevents dividends from being paid on common stock until all preferred stock dividends
(both current and those previously omitted) have been paid.
Less than 25% of new equity issues are preferred stock, and only about 5% of all capital
is raised using preferred stock. This may be because preferred dividends are not taxdeductible to the firm like bond interest payments. Consequently, preferred stock usually
has a higher cost than debt, even though it shares many of the characteristics of a bond.
2. How Stocks Are Sold
Literally billions of shares of stock are sold each business day in the United States. The
orderly flow of information, stock ownership, and funds through the stock markets is a
critical feature of well-developed and efficient markets. This efficiency encourages
investors to buy stocks and to provide equity capital to businesses with valuable growth
opportunities. We traditionally discuss stocks as trading either on an organized exchange
or over the counter. Recently, this distinction is blurring as electronic trading grows in
both volume and influence.
Organized Securities Exchanges Historically, the New York Stock Exchange (NYSE)
has been the best known of the organized exchanges. The NYSE first began trading in
1792, when 24 brokers began trading a few stocks on Wall Street. The NYSE is still the
world’s largest and most liquid equities exchange. The traditional definition of an
organized exchange is that there is a specified location where buyers and sellers meet
on a regular basis to trade securities using an open-outcry auction model. As more
sophisticated technology has been adapted to securities trading, this model is becoming
less frequently used. The NYSE currently advertises itself as a hybrid market that
combines aspects of electronic trading and traditional auctionmarket trading. In March
of 2006, the NYSE merged with Archipelago, an Electronic Communication Network
(ECN) firm. On April 4, 2007, the NYSE Euronext was created by the combination of
the NYSE Group and Euronext N.V. NYSE Euronext completed acquisition of the
American stock exchange in 2009. In November 2013, Intercontinental Exchange (ICE)
purchased NYSE Euronext for about $8.2 billion.
The NYSE has a trading floor where trades can be executed. It has two broad types of
members: floor brokers and specialists. Floor brokers are either commission brokers or
independent brokers. Commission brokers are employed by brokerage firms and execute
orders for clients on the floor of the NYSE. Independent brokers trade for their own
account and are not employed by any particular brokerage firm. However, they
sometimes handle the overflow for brokerage firms and handle orders for brokerage
firms that do not employ full-time brokers. The fee that independent brokers receive
depends on the size and liquidity of the order they trade.
Specialists can match orders of buyers and sellers. In addition, they can buy or sell stock
for their own account and thereby create more liquidity for the stock.
There are also major organized stock exchanges around the world. The most active
exchange in the world is the Nikkei in Tokyo. Other major exchanges include the
London Stock Exchange in England, the DAX in Germany, and the Toronto Stock
Exchange in Canada. To have a stock listed for trading on one of the organized
exchanges, a firm must file an application and meet certain criteria set by the exchange
designed to enhance trading. For example, the NYSE encourages only the largest firms
to list so that transaction volume will be high. There are several ways to meet the
minimum listing requirements. Generally, the firm must have substantial earnings and
market value (greater than $10 million per year and $100 million market value).
Over 8,000 companies around the world list their shares on the NYSE Euronext. The
average firm on the exchange has a market value of $19.6 billion. On October 28, 1998,
the NYSE volume topped 1 billion shares for the first time.1 By 2016, daily volume was
usually in excess of 4 billion shares with more than 10 billion shares being traded on
peak days.
Regional exchanges, such as the Philadelphia, are even easier to list on. Some firms
choose to list on more than one exchange, believing that more exposure will increase
the demand for their stock and hence its price. Many firms also believe that there is a
certain amount of prestige in being listed on one of the major exchanges. They may even
include this fact in their advertising. There is little conclusive research to support this
belief, however. Microsoft, for example, is not listed on any organized exchange, yet its
stock had a total market value of around $400 billion in 2016.
Over-the-Counter Markets If Microsoft’s stock is not traded on any of the organized
stock exchanges, where does it sell its stock? Securities not listed on one of the
exchanges trade in the over-the-counter (OTC) market. This market is not organized in
the sense of having a building where trading takes place. Instead, trading occurs over
sophisticated telecommunications networks. One such network is called the National
Association of Securities Dealers Automated Quotation System (NASDAQ). This
system, introduced in 1971, provides current bid and ask prices on about 3,000 actively
traded securities. Dealers “make a market” in these stocks by buying for inventory when
investors want to sell and selling from inventory when investors want to buy. These
dealers provide small stocks with the liquidity that is essential to their acceptance in the
market. Total volume on the NASDAQ is usually slightly lower than on the NYSE;
however, NASDAQ volume has been growing and occasionally exceeds NYSE volume.
Not all publicly traded stocks list on one of the organized exchanges or on NASDAQ.
Securities that trade very infrequently or trade primarily in one region of the country are
usually handled by the regional offices of various brokerage houses. These offices often
maintain small inventories of regionally popular securities. Dealers that make a market
for stocks that trade in low volume are very important to the success of the over-thecounter market. Without these dealers standing ready to buy or sell shares, investors
would be reluctant to buy shares of stock in regional or unknown firms, and it would be
very difficult for start-up firms to raise needed capital. Recall from Chapter 4 that the
more liquid an asset is, the greater its quantity demanded. By providing liquidity
intervention, dealers increase demand for thinly traded securities.
Organized vs. Over-the-Counter Trading There is a significant difference between
how organized and OTC exchanges operate. Organized exchanges are characterized as
auction markets that use floor traders who specialize in particular stocks. These
specialists oversee and facilitate trading in a group of stocks. Floor traders, representing
various brokerage firms with buy and sell orders, meet at the trading post on the
exchange and learn about current bid and ask prices. These quotes are called out loud.
In about 90% of trades, the specialist matches buyers with sellers. In the other 10%, the
specialists may intervene by taking ownership of the stock themselves or by selling stock
from inventory. It is the specialist’s duty to maintain an orderly market in the stock even
if that means buying stock in a declining market.
Few orders on the New York Stock Exchange are filled by floor traders personally
approaching the specialist on the exchange. Most orders are filled electronically via the
super display book (SDBK). This system bypasses the floor trader and routes the order
to the specialist directly. The system will automatically match buy orders with sell orders
without intervention. Only complex institutional orders continue to be executed by floor
traders on the exchange. This system allows for rapid execution of the high volume of
trades made daily.
Whereas organized exchanges have specialists who facilitate trading, over-thecounter
markets have market makers. Rather than trade stocks in an auction format, they trade
on an electronic network where bid and ask prices are set by the market makers. There
are usually multiple market makers for any particular stock. They each enter their bid
and ask quotes. Once this is done, they are obligated to buy or sell at least 1,000
securities at that price. Once a trade has been executed, they may enter a new bid and
ask quote. Market makers are important to the economy in that they ensure there is
continuous liquidity for every stock, even those with little transaction volume. Market
makers are compensated by the spread between the bid price (the price they pay for
stocks) and ask price (the price they sell the stocks for). They also receive commissions
on trades.
Although NASDAQ, the NYSE, and the other exchanges are heavily regulated, they are
still public for-profit businesses. They have shareholders, directors, and officers who are
interested in market share and generating profits. This means that the NYSE is
vigorously competing with NASDAQ for the high-volume stocks that generate the big
fees. For example, the NYSE has been trying to entice Microsoft to leave the NASDAQ
and list with them for many years.
10-3 INITIAL PUBLIC OFFERINGS
A corporation first decides to issue stock to the public in order to raise funds. It engages
in an initial public offering (IPO), which is a first-time offering of shares by a specific
firm to the public. An IPO is commonly used not only to obtain new funding but also to
offer some founders and VC funds a way to cash out their investment. A typical IPO is
for at least $50 million, since this would be the minimum size needed to ensure adequate
liquidity in the secondary market if investors wish to sell their shares.
10-4a Secondary Stock Offerings
A firm may need to raise additional equity to support its growth or to expand its
operations. A secondary stock offering is a new stock offering by a specific firm whose
stock is already publicly traded. Some firms have engaged in several secondary offerings
to support their expansion. A firm that wants to engage in a secondary stock offering
must file the offering with the SEC. It will likely hire a securities firm to advise on the
number of shares it can sell, to help develop the prospectus submitted to the SEC, and
to place the new shares with investors.
Because there is already a market price for the stock of a firm that engages in a secondary
offering, the firm hopes that it can issue shares at the existing market price. But given
that a secondary offering may involve millions of shares, there may not be sufficient
demand by investors at the prevailing market price. In this case, the underwriter will
have to reduce the price so that it can sell all the new shares. Many secondary offerings
cause the market price to decline by 1 to 4 percent on the day of the offering, which
reflects the new price at which the increased supply of shares in the market is equal to
the demand for those shares. Because of the potential for a decline in the equilibrium
price of all of its shares, a firm considering a secondary stock offering commonly
monitors stock market movements. It prefers to issue new stock when the market price
of its outstanding shares is relatively high and when the general outlook for the firm is
favorable. Under these conditions, it can issue new shares at a relatively high price,
which will generate more funds for a given amount of shares issued.
Corporations sometimes direct their sales of stock toward a particular group, such as
their existing shareholders, by giving them preemptive rights (first priority) to purchase
the new stock. By placing newly issued stock with existing shareholders, the firm avoids
diluting ownership. Preemptive rights are exercised by purchasing new shares during
the subscription period (which normally lasts a month or less) at the price specified by
the rights. Alternatively, the rights can be sold to someone else.