Chapter 6
The Stock
Market





•Ayşe Yüce
The primary and secondary
stock markets
The New York Stock Exchange
The Toronto Stock Exchange
and TSX Venture Exchange
Third and Fourth Market
Stock Market Information
Copyright © 2012
McGraw-Hill Ryerson
6-1
The Stock Market

Our goal in this chapter is to get a “big
picture” overview of:



Who owns stocks
How a stock exchange works, and
How to read and understand the stock market
information reported in the financial press.
© 2009 McGraw-Hill Ryerson
Limited
6-2
Private Equity



Private Equity is used in the rapidly growing area of equity financing for
nonpublic companies.
Banks are generally not interested in making loans to start-up companies,
especially ones :
 with no assets (other than an idea).
 run by fledgling entrepreneurs with no track record.
 Firms with this profile search for venture capital (VC), an
important part of the private equity markets.
Firms other than start-ups might also need financing.
Private equity also includes:
 middle-market firms
 large leveraged buyouts
3
The Structure of Private Equity Funds

Private equity funds and hedge funds are two types of
investment companies. Both






are set up as limited partnerships.
pool money from investors.
invest this money on behalf of these investors.
use, typically, a 2/20 fee structure (i.e., a 2 percent annual
management fee and 20 percent of profits).
have built-in constraints to prevent managers from taking
excessive compensation.
Private equity funds generally have:


a high-water-mark provision
a “clawback” provision
4
Types of Private Equity Funds: Venture Capital








Venture Capital refers to 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.
Venture capitalists know that many new companies will fail. The compan
ies that succeed can provide enormous profits. 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 or Mezzanine Level financing
At each stage of financing, the value of the founder’s stake grows and the
probability of success rises.
If goals are not met, the venture capitalists withhold further financing.
If a start-up succeeds:
 The big payoff frequently comes when the company is sold to another
5
company or goes public.
Types of Private Equity Funds: Leveraged Buyouts




Suppose a company (or someone else) purchases all the shares of
the company held by the public at large?
This process is called “taking the company private.”
The cost of going private is often high.
 A manager or investor who wants to take a company private
probably needs to borrow a significant amount of money.
 Taking a company private is called a leveraged buyout (LBO).
LBO market activity levels depend on credit markets.
 Around 2005, the LBO market was quite active.
 Activity in the LBO market came to a standstill after the crash of
2008.
Ayşe Yüce Copyright © 2012
McGraw-Hill Ryerson
6
Selling Securities to the Public
The Primary Stock Markets

The Primary market is the market where investors purchase newly
issued securities.
 Initial public offering (IPO): An initial public offer occurs when
a company offers stock for sale to the public for the first time.
The Secondary Stock Markets

The Secondary market is the market where investors trade
previously issued securities. An investor can trade:



Directly with other investors.
Indirectly through a broker who arranges transactions for others.
Directly with a dealer who buys and sells securities from inventory.
6-7
The Primary Market for Common Stock

An IPO (and an SEO) involves several steps.
Company appoints investment banking firm to arrange
financing.



Investment banker designs the stock issue and arranges for firm
commitment or best effort underwriting.
Company prepares a prospectus (usually with outside help) and
submits it to securities and exchange commissions for approval.
Investment banker circulates preliminary prospectus (red
herring).

Upon obtaining approval, company finalizes prospectus.

Underwriters place announcements (tombstones) in
newspapers and begin selling shares.
6-8
IPO Tombstone
6-9
The Secondary Market





The goal of a secondary market is to match investors wishing
to buy stocks with investors wishing to sell stocks.
Common stock trading typically occurs on either an organized
stock exchange or a trading network.
The bid price:
 The price dealers pay investors.
 The price investors receive from dealers.
The ask price:
 The price dealers receive from investors.
 The price investors pay dealers.
The difference between the bid and ask prices is called the
bid-ask spread, or simply spread.
6-10
© 2009 McGraw-Hill Ryerson
Limited
6-11
The New York Stock Exchange






The New York Stock Exchange (NYSE), popularly known as the Big
Board, celebrated its bicentennial in 1992.
The NYSE has occupied its current building on Wall Street since 1900’s.
For 200 years, the NYSE was a not-for-profit New York State corporation.
The NYSE went public in 2006 (NYSE Group, Inc., ticker: NYX)
In 2007, NYSE Group merged with Euronext to form NYSE Euronext, the
world’s largest exchange.
Historically, the NYSE had 1,366 exchange members. These members:





Were said to own “seats” on the exchange.
Collectively owned the exchange, although professionals managed the exchange.
Regularly bought and sold seats (Record seat price: $3 million in 2005)
Seat holders could buy and sell securities without paying commissions.
In 2006, all of this changed when the NYSE went public.


Instead of purchasing seats, exchange members purchase trading licenses:
 number limited to 1,500; In 2010, a license would cost $40,000—per year.
Having a license entitles the holder to buy and sell securities on the floor.
6-12









Other NYSE Participants
The largest number of NYSE members are registered as commission
brokers.
Commission brokers execute customer orders to buy and sell stocks.
When commission brokers are too busy, they may delegate some orders to
floor brokers, or two-dollar brokers, for execution.
A small number of NYSE members are floor traders, who independently
trade for their own accounts.
NYSE Listed Stocks
In 2008, the total number of companies listed on the NYSE represented a
total global market value of about $16.7 trillion.
Initial and annual listing fees are charged based on the number of shares.
To apply for listing, companies have to meet certain minimum requirements
with respect to:
 The number of shareholders
 Trading activity
 The number and value of shares held in public hands
 Annual earnings
13
The Toronto Stock Exchange







The Toronto Stock Exchange (TSX), unlike the NYSE, is a computerized
exchange.
In 2002, the TSX celebrated its 150th birthday having started its operations
in 1861 with 18 securities and 14 member firms.
In 1861, approximately twenty-five businessmen decided to form a stock
exchange in Toronto in their meeting at Toronto’s Masonic Temple. At that
time, members paid $250 to purchase a seat.
In 1901, the price of membership had risen to $12,000 and trading volume
became approximately 1 million shares per year.
The TSX experienced solid growth and became the third largest North
American exchange in the 1940s.
In 1977, the TSX introduced the world’s first Computer Assisted Trading
System (CATS) and closed its trading floor to become the largest electronic
North American Exchange.
The Toronto Stock Exchange, with Canadian exchange restructuring in 1999,
became the major stock exchange for trading senior equities.
6-14
TMX Group And TSX Venture Exchange








Canadian derivatives trading were transferred to the Montreal Exchange.
The Vancouver and Alberta Exchanges merged to become the Canadian
Venture Exchange (CDNX).
Later the TSX purchased the CDNX and called it the TSX Venture
Exchange.
In 2008, the shareholders of the TSX group decided to change the name of
the company from TSX Group to TMX Group. According to market
capitalization, the TSX group is the third largest exchange in North America
and the seventh largest exchange in the world.
As of 2009, there are 3,640 listed issuers in TSX and TSXV(Toronto Venture
Exchange), and the TMX group is second in the world for number of listed
issuers. There are 281 international issuers and 302 new listings.
Currently the TMX Group is the leader exchange in oil and gas sector.
The TMX group is the global leader in mining industry as well. The highest
number of mining companies (1531) are listed at the TSX and TSXV.
In 2010, the trading volume related to mining industry exceeded $91 billion.
15
Stock Market Order Types
Ayşe Yüce Copyright © 2012
McGraw-Hill Ryerson
16
Trading on the Web
17
Third and Fourth Market

The third market is an off-exchange market for
securities listed on an organized exchange.

The fourth market is for exchange-listed securities
in which investors trade directly with one another,
usually through a computer network.
For dually listed stocks, regional exchanges also
attract substantial trading volume.

© 2009 McGraw-Hill Ryerson
Limited
6-18
Stock Market Information



The most widely followed barometer of day-to-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.
The S&P/TSX is a capitalization weighted index of
220 Canadian companies.
© 2009 McGraw-Hill Ryerson
Limited
6-19
S&P/TSX Composite
Figure 6.3
© 2009 McGraw-Hill Ryerson
Limited
6-20
Stock Market Indexes

Indexes can be distinguished in four ways:
The market covered,
 The types of stocks included,
 How many stocks are included, and
 How the index is calculated (price-weighted, e.g. DJIA,
versus value-weighted, e.g. S&P 500)
The first three differences are straightforward. Some indexes
such as the S&P/TSX Energy Index, focus on specific industries.
Others, such as the S&P/TSX Composite , focus on particular
markets. Some have a small number of stocks, like the S&P/TSX
60 which contains only 60 stocks. Some indexes contain small
companies, like the S&P/TSX Cdn Small Cap.



6-21
Stock Market Indexes

For a value-weighted index (i.e., the S&P 500),
companies with larger market values have higher
weights.

For a price-weighted index (i.e., the DJIA), higher
priced stocks receive higher weights.


This means stock splits cause issues.
But, stock splits can be addressed by adjusting the index
divisor.
© 2009 McGraw-Hill Ryerson
Limited
6-22
Stock Market Major Indexes
6-23
Example I: $1,000,000 to Invest,
Price-Weighted Portfolio
Company
Price
Price
Weight
Shares
to Buy
GM
40.56 0.3376
8,323
Nordstrom
25.91 0.2156
8,323
Lowe's
53.68 0.4468
8,323
120.150
1.000
© 2009 McGraw-Hill Ryerson
Limited
8,323
6-24
Example II: 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 starts, you want to 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:
Sum / Divisor = 40.05, if Divisor is:
40.560
25.910
32.90
99.370
2.481148564
© 2009 McGraw-Hill Ryerson
Limited
6-25
Example III: $1,000,000 to Invest,
Value-Weighted Portfolio
Company
Price
Shares Capitalization Value Shares
(millions)
(millions)
Weight to Buy
GM
40.56
560.72
22,742.8
0.3323
8,192
Nordstrom
25.91
136.07
3,525.6
0.0515
1,988
Lowe's
53.68
785.75
42,179.1
0.6162 11,480
Total: 120.150
Total:
68,447.4 1.0000 21,660
Note: Shares to Buy = $1,000,000*Weight / Price
© 2009 McGraw-Hill Ryerson
Limited
6-26
Example IV: How Does the
Value-Weighted Index Change?
Using the Index from Example II:
Day 1:
Day 2:
Company
GM
Nordstrom
Home Depot
Company
GM
Nordstrom
Home Depot
Price
40.56
25.91
32.90
Total Shares
Market Capitalization
(millions)
(millions)
560.72
22,743
136.07
3,526
2370.00
77,973
Total MV(1):
104,241
Divisor (Set by Vendor):
104.2413769
Day 1 Index Level:
1000.00
Price
44.21
27.25
33.50
Total Shares
Market Capitalization
(millions)
(millions)
560.72
24,789
136.07
3,708
2370.00
79,395
Total MV(2):
107,892
Day 2 Index Level:
1035.02
6-27
The Day 3 Index Can be Calculated in Two
Ways:
Day 3:
Company
GM
Nordstrom
Home Depot
Day 3 Index 
Price
43.250
23.210
34.100
Total Shares
Market Capitalization
(millions)
(millions)
560.720
24,251.1
136.070
3,158.2
2,370.000
80,817.0
Total MV(3):
108,226.3
Total MV(2):
107,892.0
Day 2 Index Level:
1035.02
Day 3 Index Level:
1038.23
Total MV(1):
104,241.0
Day 3 Index Level:
1038.23
Market Value Day 3
 Index Level Day 2
Market Value Day 2
or
Day 3 Index 
Market Value Day 3
 Index Level Day 1
Market Value Day 1
© 2009 McGraw-Hill Ryerson
Limited
6-28
Useful Internet Sites





www.hoovers.com (reference for more on Initial
Public Offerings, IPOs)
www.nyse.com (website for the New York Stock
Exchange)
www.tsx.com (website for the Toronto Stock
Exchange)
www.nasdaq.com (website for the Nasdaq)
averages.dowjones.com (reference for more
information on the DJIA)
© 2009 McGraw-Hill Ryerson
Limited
6-29