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Chapter 6

The Stock Market

Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

116.pdf

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

Take stock in yourself. Make sure you
have a good understanding of:

The difference between private and public equity and primary and secondary stock markets.

The workings of the New York Stock Exchange.

The workings of the Toronto Stock Exchange.

How NASDAQ operates.

How to calculate index returns.

Our goal in this chapter is to provide 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.

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

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

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 companies 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
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 company or goes public.
Either way, investment bankers are often involved in the process.

Many small, regional private equity funds concentrate their investments in “middle market” companies.
ongoing concerns (i.e., not start-ups)
known performance history
typically, small and family owned and operated.

Reasons middle market companies seek more capital
Expansion beyond their existing region
Founder wants to “cash out”

A private equity fund might purchase a portion of the business so that others can now manage the company.

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.

The primary market is the market where investors purchase newly issued securities.
Initial public offering (IPO): An IPO occurs when a company offers stock for sale to the public for the first time.
Seasoned equity offering (SEO): If a company already has public shares, an SEO occurs when a company raises more equity.

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.

Primary Market: “New-car with sticker still in window”; Secondary Market: “Used car market”

An IPO (and an SEO) involves several steps.
Company appoints an investment banking firm to arrange financing.
Investment banker designs the stock issue and arranges for fixed commitment or best effort underwriting.
Company prepares a prospectus (usually with outside help) and submits it to the Securities and Exchange Commission (SEC) for approval. Investment banker circulates preliminary prospectus (red herring).
Upon obtaining SEC approval, company finalizes prospectus.
Underwriters place announcements (tombstones) in newspapers and begin selling shares.

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.

Important concepts:
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 the spread.

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 the early 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
Naturally, NYX stock is listed on the NYSE

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 on the exchange floor 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 set you back a cool $40,000—per year.
Having a license entitles the holder to buy and sell securities on the floor of the exchange.

For a long time, most securities listed at the NYSE were divided among specialists—an exclusive dealer, or intermediary, for a set of securities.

Specialists:
posted bid prices and ask prices for each security assigned to them.
were obligated to make and maintain a fair, orderly market
Specialists stood ready to buy at bid prices and sell at ask prices when outside sell and buy order flows were unequal
Specialists had an exclusive, advance look at incoming orders flowing to the display book.
Because of this advance look, specialists had an information advantage when they were making quotes and matching orders.
Under this system, specialists, however, could “work” orders, that is, try to improve trading prices for customers.

In 2009, aiming to stay competitive, the NYSE replaced the role of specialists with two classes of market makers:
designated market makers (DMMs)
and supplemental liquidity providers (SLPs).
What were specialists are now the DMMs.
The DMMs are assigned a set of securities and are
obligated to maintain a fair and orderly market in these stocks

Differences between the Specialist Role and the DMM Role
DDMs can compete against other exchange members for trades.
Specialists had to step back from a trade if a floor broker order had the same price.
Unlike the former specialist system, however, DMMs do not receive an advance look at incoming orders.

DMMs do not have an exclusive right to make markets in their assigned securities.

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.

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

The Toronto Stock Exchange (TSX), unlike the NYSE, is a computerized exchange.
In 2002, the Toronto Stock Exchange 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 Toronto Stock Exchange experienced solid growth and became the third largest North American exchange in the 1940s.
By 1955 a membership seat cost $100,000 and trading volume reached 1 billion shares.
In 1977, the Toronto Stock Exchange 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.
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 302new 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 are listed at the TSX and TSXV. The total number of the listed companies is 1531. In 2010, the trading volume related to mining industry exceeded 91 billion Canadian Dollar.
In February 2011, the TMX announced that they are evaluating a merger with the London Stock Exchange. If the merger would have been approved by the authorities the new exchange would have become the third largest exchange in the world. However, later in the year the group rejected the offer and began negotiating an offer by the Maple Group( a group of Canadian banks and the firms.
Today the TSX has over 100 participating organizations and member firms. These organizations help companies in underwriting their new issues, in listing and in providing corporate financial services. Different customer orders (market, limit or stop orders) are entered into the system by these organizations.

The name “NASDAQ” is derived from the acronym NASDAQ, which stands for National Association of Securities Dealers Automated Quotations system.

NASDAQ is now a proper name in its own right.

Introduced in 1971, the NASDAQ market is a computer network of securities dealers who disseminate timely security price quotes to NASDAQ subscribers.
The NASDAQ has more companies listed than the NYSE.

On most days, volume on the NASDAQ exceeds the NYSE volume.

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.

There are essentially four differences between the stock indexes them: (1) the market covered; (2) the types of stocks included; (3) how many stocks are included; and (4) how the index is calculated.

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.
How stock market indexes are computed is not quite so straightforward, but it is important to understand. There are two major types of stock market index: price-weighted and value-weighted.

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.

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).
Stocks that do not trade during a time period cause index staleness over that time period.
That is, we do not know the "true" index level if all the stock prices are not updated, i.e., fresh.

For a value-weighted index (i.e., the S&P 500, S&P/TSX Composite), 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.
Note: As of April 12, 2010, the DJIA divisor was a nice “round” 0.132319125!

Note: Shares = $1,000,000 / 131.130 = 7,626

Sheet1

		Price	Shares
Company	Price	Weight	to Buy
Boeing	67.50	0.5148	7,626
Nordstrom	41.93	0.3198	7,626
Lowe's	21.70	0.1655	7,626
	131.130	1.000	7,626

What would have happened to the divisor if Home Depot shares were selling at $65.72 per share instead of $32.90?

Sheet1

Day 1 of Index:	Company	Price
	Boeing	67.50
	Nordstrom	41.93
	Lowe's	21.70
	Sum:	131.13
	Index:	43.71	(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., 43.71:
	Boeing	67.50
	Nordstrom	41.93
	Home Depot	32.90
	Sum:	142.33
142.33 / Divisor = 43.71, if Divisor is:		3.2562342713

Note: Shares to Buy = $1,000,000*Weight / Price

Sheet1


		Total	Market	Market-	Market-
		Shares	Capitalization	Value	Shares
Company	Price	(millions)	(millions)	Weight	to Buy
Boeing	67.50	732.74	49,460.0	0.5550	8,223
Nordstrom	41.93	219.65	9,210.0	0.1034	2,465
Lowe's	21.70	1,402.76	30,440.0	0.3416	15,742
Total:	131.130	Total:	89,110.0	1.0000	26,430

Using the Portfolio from Example III:

Sheet1

			Total Shares	Market Capitalization
Day 1:	Company	Price	(millions)	(millions)
	Boeing	67.50	732.74	49,460
	Nordstrom	41.93	219.65	9,210
	Lowe's	21.70	1402.76	30,440
			Total MV(1):	89,110
			Divisor (Set by Vendor):	89.11
			Day 1 Index Level:	1,000.00
			Total Shares	Market Capitalization
Day 2:	Company	Price	(millions)	(millions)
	Boeing	69.00	732.74	50,559
	Nordstrom	41.93	219.65	9,210
	Lowe's	21.70	1402.76	30,440
			Total MV(2):	90,209
			Day 2 Index Level:	1,012.33

Sheet1

			Total Shares	Market Capitalization
Day 3:	Company	Price	(millions)	(millions)
	Boeing	71.10	732.740	52,098
	Nordstrom	41.93	219.650	9,210
	Lowe's	21.70	1,402.760	30,440
			Total MV(3):	91,748
			Total MV(2):	90,209
			Day 2 Index Level:	1,012.33
			Day 3 Index Level:	1,029.60
			Total MV(1):	89,110
			Day 3 Index Level:	1,029.60

www.hoovers.com (information on Initial Public Offerings, or IPOs)
www.nyse.com (website for the New York Stock Exchange)
www.tmx.com (website for the Toronto 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.standardandpoors.com (website for S&P 500)
www.nni.nikkei.co.jp (website for Japan’s Nikkei 225 index)

Private and Public Equity
Private Equity Funds

The Primary and Secondary Stock Markets
The Primary Market for Common Stock
The Secondary Market for Common Stock
Dealers and Brokers
The New York Stock Exchange
NYSE-Listed Stocks

Toronto and Toronto Venture Exchange
NYSE and NASDAQ Competitors
Stock Market Information
Stock Market Indexes
More on Price-Weighted Indexes
Value-Weighted Indexes

PriceShares

CompanyPriceWeightto Buy

Boeing67.500.51487,626

Nordstrom41.930.31987,626

Lowe's21.700.16557,626

131.1301.0007,626

Day 1 of Index:CompanyPrice

Boeing67.50

Nordstrom41.93

Lowe's21.70

Sum:131.13

Index:

43.71

(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., 43.71:

Boeing67.50

Nordstrom41.93

Home Depot32.90

Sum:142.33

142.33 / Divisor = 43.71, if Divisor is:3.256234271

SharesCapitalizationValueShares

CompanyPrice(millions)(millions)Weightto Buy

Boeing67.50732.7449,460.00.55508,223

Nordstrom41.93219.659,210.00.10342,465

Lowe's21.701,402.7630,440.00.341615,742

Total:131.130Total:89,110.01.000026,430

Lowe's21.701402.7630,440

Total MV(1):89,110

Divisor (Set by Vendor):89.11

Day 1 Index Level:1,000.00

Total SharesMarket Capitalization

Day 2:CompanyPrice(millions)(millions)

Boeing69.00732.7450,559

Nordstrom41.93219.659,210

Lowe's21.701402.7630,440

Total MV(2):90,209

Day 2 Index Level:1,012.33

Total SharesMarket Capitalization

Day 3:CompanyPrice(millions)(millions)

Boeing71.10732.74052,098

Nordstrom41.93219.6509,210

Lowe's21.701,402.76030,440

Total MV(3):91,748

Total MV(2):90,209

Day 2 Index Level:1,012.33

Day 3 Index Level:1,029.60

Total MV(1):89,110

Day 3 Index Level:1,029.60

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