5
The Stock Market
1
Learning Objectives
1. How firms raise capital
2. The difference between primary and secondary
stock markets.
3. The workings of the New York Stock Exchange.
4. How NASDAQ operates.
5. How to calculate index returns.
6. How to read and understand the stock market
information reported in the financial press.
5-2
How do firms raise capital?
• Private Funding
• Private equity
• Venture capital
• “First Stage” or “Ground Floor”
• “Second Stage” or “Mezzanine”
• Public Funding
• Primary versus Secondary markets
• Investment banking firms
5-3
Private Equity and Venture Capital
• Private Equity = equity financing for
nonpublic companies.
• Target firms typically:
• Have no assets other than an idea
• Are run by fledgling entrepreneurs with no track
record.
• Venture capital (VC) = important part of the
private equity market
5-4
Venture Capital, I
• Venture Capital = financing new, often high-risk,
start-ups.
• Individual venture capitalists invest their own
money.
• Venture capital firms pool funds from various
sources, like
• Individuals
• Pension funds
• Insurance companies
• Large corporations
• University endowments
• Start-ups that succeed can provide enormous
profits.
5-5
Venture Capital, II
• To limit their risk:
• Venture capitalists generally provide
financing in stages.
• Venture capitalists actively help run the
company.
• At each stage, enough money is
invested to reach the next stage.
• Ground-floor financing
• Mezzanine Level financing
5-6
Venture Capital, II
• At each stage of financing:
• The value of the founder’s stake grows
• The probability of success rises
• If goals are not met, the venture capitalists
withhold further financing.
• If a start-up succeeds:
• Big payoff = sale or IPO
• Either way, investment bankers often
involved.
5-7
Public Funding
• Equity Offerings
• IPOs
• Seasoned Equity Offerings
• Investment banking firms
• Underwriting
• Dutch Auction Underwriting
5-8
The Primary and Secondary
Stock Markets
• Primary market
• Where investors purchase newly issued securities
• Initial public offering (IPO):
• When a company offers stock for sale to the public for the
first time
• Secondary market
• Where investors trade previously issued securities.
An investor can trade:
• Directly with other investors.
• Indirectly through a broker
• Directly with a dealer
5-9
Initial Public Offering
COMPANY

INVESTMENT BANKER
Select Investment banker
Design the stock issue
Arrange underwriting


Prepare preliminary prospectus
(red herring)
Submit prospectus to SEC
Circulate prospectus

SEC approves preliminary prospectus

Finalize prospectus
Tombstones placed
Sell shares

5-10
IPO
Tombstone
5-11
Dutch or Uniform Price Auction
Buyers:
•Bid a price and number of shares
Seller:
•Work down the list of bidders
•Determine the highest price at which
they can sell the desired number of
shares
All successful bidders pay the same
price per share.
5-12
Dutch Price Auction Example
The company wants to sell 1,500 shares of stock.
Bidder
A
B
C
D
E
Quantity
500
400
250
350
200
Bid
$20
18
16
15
12
The firm will sell 1,500 shares at $15 per share.
Bidders A, B, C, and D will get shares.
Bidder
A
B
C
D
E
Quantity
500
400
250
350
200
Bid
$20
18
16
15
12
Σ Qty
500
900
1150
1500
1700
5-13
The Secondary Market for Common Stock
Organized Exchanges & Markets
• NYSE (1792)
• NASDAQ (1971)
• The Regional Exchanges
•
American Stock Exchange (1842; NYSE-Euronext, 2008)
•
Boston Stock Exchange (1834; Nasdaq, 2007)
•
Chicago Stock Exchange (1882)
•
Cincinnati Stock Exchange (1885; NSX, 2003)
•
Pacific Stock Exchange (1882; Arca, 2005; NYSE,2006)
•
Philadelphia Stock Exchange (1790; Nasdaq acquired 2008)
• Electronic Communications Networks (ECNs)
5-14
Brokers vs. Dealers
• Broker
• Brings buyers and sellers together to trade
• Does not hold inventory
• Think “Real Estate Broker”
• Dealer
• Maintains an inventory
• Stands ready to buy or sell based on published
quotes
• Think “Used Car Dealer”
5-15
Bid and Ask Quotes
• Bid price:
• The price a dealer is willing to pay investors for a
security
• Ask price:
• The price at which a dealer is willing to sell a
security
• Bid-ask spread, or spread:
• Difference between the bid and ask prices
• Inside Quotes:
• Highest Bid, Lowest Ask
5-16
The New York Stock Exchange
• NYSE = The “Big Board”
• Physical location exchange
• History:
• Founded in 1792 as a not-for-profit corporation
• In current Wall Street building since early 1900’s
• For-profit, public NY state corporation in 2006
• Merged with Euronext N.V. in 2007
• Launched NYSE Euronext, the largest stock
exchange in the world
5-17
NYSE Seats and Trading Licenses
• Historically, the NYSE had 1,366 exchange
members. These members:
• Were said to own “seats” on the exchange.
• Collectively owned the exchange
• Professionals managed the exchange.
• Regularly bought and sold seats
• Record seat price: $3 million in 2005
• Seat holders could buy and sell securities on
the exchange floor without paying
commissions.
5-18
NYSE Seats and Trading Licenses
• In 2006, NYSE went public
• Instead of purchasing seats, exchange
members purchase trading licenses:
• Number limited to 1,500
• In 2007, a license would set you back a cool
$55,000—per year.
• Having a license entitles the holder to buy and
sell securities on the floor of the exchange.
5-19
NYSE-Listed Stocks
• 2006 Listings:
• Global market value = $25 trillion
• Minimum Listing Requirements
•
•
•
•
Number of shareholders
Trading activity
Number and value of shares held in public hands
Annual earnings
• Listing Fees:
• Initial listing fee and annual listing fees
• Based on the number of shares
5-20
Operation of the NYSE
• The fundamental business of the NYSE is to
attract and process order flow.
• In 2007, the average trading volume on the
NYSE was over 2 billion shares a day.
• Volume breakdown:
• About one-third from individual investors.
• Almost half from institutional investors.
• The remainder represents NYSE-member trading,
mostly from specialists acting as market makers.
5-21
Types of NYSE Members
• Specialists, or market makers:
• Obligated to maintain a “fair and orderly market”
• “The Crowd”
• Commission brokers:
• Execute customer orders to buy and sell stocks
• Floor brokers, or Two-dollar brokers
• Execute orders when commission brokers busy
• Less important due to SuperDOT system (designated
order turnaround)
• Floor traders
• Independently trade for their own accounts
5-22
NYSE Floor Activity
• There are a number of specialist’s posts, each with
a roughly figure-eight shape, on the floor of the
exchange.
• At the telephone booths, commission brokers:
• Receive customer orders.
• Walk out to specialist’s posts where the orders can be
executed,
• Return to confirm order executions, and receive new
customer orders.
• Coat colors indicate the person’s job or position.
5-23
Watching Trading on the Web
5-24
The New York Stock Exchange
Founding date
Physical location/trading floor
Typcially referred to as:
Brokers
Dealers
Market maker per stock
Electronic trading
Signature Index
Listing requirements
NSYE
May 17, 1792
Yes
"The listed market"; "The Big Board"
Yes; specialists
Yes; specialists
1 specialist
SuperDOT System
NYSE Composite
Yes
5-25
NASDAQ
• “National Association of Securities Dealers
Automated Quotations”
• 2nd largest stock market in U.S. in terms of $ volume
• More companies listed than the NYSE.
• Volume usually exceeds NYSE volume
• Computer network
• Disseminates price quotes to subscribers
• No trading floor or physical location
5-26
NASDAQ
• An Over-the-counter (OTC) market:
•
•
•
•
Dealers = “market makers”
Multiple dealers per stock
Competing market makers
Buy and sell from inventory
• Three separate markets:
• The Global Select Market
• The Global Market
• The Capital Market
5-27
The NASDAQ System
• The NASDAQ network provides bid and ask prices
as well as recent transaction information.
• The bid and ask prices for the NASDAQ represent
inside quotes.
• The highest bid
• The lowest ask
• For a small fee, you can have access to “Level II”
quotes.
• Displays all bids and asks
• Frequently displays the market maker identity
5-28
NASDAQ
Founding date
Physical location/trading floor
Typcially referred to as:
Brokers
Dealers
Market maker per stock
Electronic trading
Signature Index
Listing requirements
NASDAQ
1971
No; computer network
"The over-the-counter market"
No
Yes; market makers
Multiple market makers
All electronic
NASDAQ 100
NMS - Yes
5-29
NYSE vs. NASDAQ
Founding date
Physical location
Typcially referred to as:
Brokers
Dealers
Market maker per stock
Electronic trading
Signature Index
Listing requirements
NSYE
May 17, 1792
Yes
"The listed market"
Yes; specialists
Yes; specialists
1 specialist
SuperDOT System
NYSE Composite
Yes
NASDAQ
1971
No; computer network
"The over-the-counter market"
No
Yes; market makers
Multiple market makers
All electronic
NASDAQ 100
NMS - Yes
5-30
Other Market Venues
• The “Third Market”
• Off-exchange trading of exchange-listed securities
• The “Fourth Market”
• Direct trading of both NYSE and NASDAQ stocks among
investors.
• ECNs provide an avenue for fourth market trading.
• ECNs
• Electronic Communications Networks
• The Regional Exchanges
• Chicago, Cincinnati (NSX)
• Dually-listed stocks
5-31
NASDAQ, II.
• In the late 1990s, the NASDAQ system
opened to electronic communications
networks (ECNs)
• ECNs are basically websites that allow
investors to trade directly with one another.
5-32
Stock Market Order Types
5-33
Market and Limit Orders
Buy
Sell
Price
Execution
Price
Execution
Market Order:
Market
Best price available
Immediate
Best price available
Immediate
Limit
Best price; not > limit
Only if limit met
Best price; not < limit
Only if limit met
“Buy 100 shares of IBM at the market”
“Sell 200 shares of GE at the market”
Limit Order:
“Buy 100 shares of IBM at $100 or better”
“Sell 200 shares of GE at $35 or better”
5-34
Stock Market Information
• The most widely followed barometer of dayto-day stock market activity is the Dow Jones
Industrial Average (DJIA), or “Dow” for short.
• The DJIA is an index of the stock prices of 30
large companies representative of American
industry.
5-35
The Dow Jones Industrial Average
5-36
Yields on
DJIA
Component
Stocks
5-37
Stock Market Indexes
• Distinguishing features:
•
•
•
•
Market covered
Types of stocks included
Number of stocks included
Index calculation technique
• Price-weighted
• Value-weighted
5-38
Index Weighting
• Price-Weighted
• Stocks held in proportion to their share price
• Higher priced stock = higher weight
• DJIA (3/08/2008: DJIA divisor = 0.122834016)
• Adjusted for stock splits
• Value-Weighted
• Stocks held in proportion to their total company
market values
• Company with larger market value = higher weight
• S&P 500
5-39
Stock
Market
Indexes,
III.
5-40
Price- vs. Value-Weighted
Price per Share
Shares
Total Market Value
Stock
Outstanding
BOY
EOY
%r
BOY
EOY
%r
ABC
20 million
$50
$52
4%
$1,000
$1,040
4%
XYZ
100 million
$25
$30
20%
$2,500
$3,000
20%
38
41
9%
3500
4040
15%
Price-Weighted Index
Value-Weighted Index
The Price-Weighted Index = Average share price
The Value-Weighted Index = Total Market Value (#
shares x Price)
5-41
Adjusting a Price-Weighted
Divisor
• Initial divisor = number of stocks in index
• Divisor Adjusted:
• For stock splits
• For changes in the composition of the
index
• Closing on Day 1 must = Day 2 opening
5-42
Price-Weighted: Changing the
Divisor
Day 1 of Index:
Company
GM
Nordstrom
Lowe's
Sum:
Index:
Price
40.56
25.91
53.68
120.15
40.05 (Divisor = 3)
Before Day 2: Replace Lowe's with Home Depot, selling at $32.90
To keep the value of the Index the same, i.e., 40.05:
GM
Nordstrom
Home Depot
Sum:
99.37 / Divisor = 40.05, if Divisor is:
40.56
25.91
32.90
99.37
2.481148564
5-43
Adjusting for a Stock Split
Shares
Stock
ABC
XYZ
Price per Share
Outstanding
EOD
20 million
$50
40 million
100 million
Price-Weighted Index
Divisor
BOD
$25
$25
$30
37.50
37.50
2
1.4665
Closing on Day 1 must = Day 2 opening
5-44
Useful Internet Sites
•
•
•
•
•
•
•
•
•
www.hoovers.com (information on Initial Public Offerings, or IPOs)
www.nyse.com (website for the New York Stock Exchange)
www.nasdaq.com (website for the NASDAQ)
averages.dowjones.com (The Dow Jones Industrial Average)
www.russell.com (the Russell Indexes)
www.barra.com (reference for “value” and “growth” indexes)
www.djindexes.com (reference for current divisor for the DIJA)
www.standardpoors.com (website for S&P 500)
www.nni.nikkei.co.jp (website for Japan’s Nikkei 225 index)
5-45