Chapter four

EQUITY MARKET

4.1 Introduction

Equity represents basic ownership claim in a corporation owners expect capital gains and
possibly dividends and Value based on expected future cash flows.

A stock market or (equity market) is private or public market for the trading of the
company stock and derivatives of the company stock at an agreed price. The expression
equity market refers to the market enables the trading of company stocks (collective
share), othersecurity. Participant in stock market range from small individual stock
investor to large huge fundtraders, who can be based in anywhere located. Their orders
usually end up with a professional at the stock exchange, who executes the order. Some
exchange is physical location where transaction are carried out on trading floor, by a
method known as open outcry. This type of auction is used in stock exchanges and
commodity exchange where trader may enter verbal bids and offers simultaneously. The
other kind of exchange is virtual kind, composed of computer network where trade
ismade electronically via traders.

Actual trading are based on an auction market paradigm where a potential buyer bids a
specific price for stock and potential seller ask a specific price for the stock .(buying or
selling at market meansyou will accepts any ask price or bid price for the stock,
respectively.)when the bid and ask price match, a sale take place on first come first
served basis if there are multiple bidder or askers at given price. The purpose of stock
exchange is to facilitate the exchange of security between the buyer and sellers those
providing a market place virtual or real. The exchanges provide real time trading
information on the listed securities, facilitating price discovery.

Common stock Vs. Preferred stock

There are two classes of stock that the company offer I.e. common and preferred. These
come with different financial terms and offer different rights in relation to the governance
of the company. Here are the key differences between these two types of stockand the
implication how each type is used.

Common Stock

The holders of the common stock can reap two main benefits from issuing company.

 Capital appreciation and

 Dividends.

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Capital appreciation occurs when a stock’s value increases over the amount initially paid
for it. The stock holder makes profit when he or she sells the stock at its current market
value after capital appreciation.

Dividend which are taxable payments are paid to company shareholders from its current
earnings. Typically dividend is paid to the stock holder on a quarterly basis.
Thesepayments are usually kept in the form of cash, but other property or stock can also
give as dividends.Common stock ownership has additional benefit of enabling its holder
to vote on company issues and in the elections of the organization leadership team.
Usually, one share of common stocks equities to one vote.

Common Stock Features

 Control of the firm – the right to elect directors who appoint officers to manage
the business.
 Preemptive Right – a provision the gives common stockholders the right to
purchase new issues of common stock.

Preferred Stock

Preferred stock does not offer the same potential for the profit as common stock, but it is
more stable investment vehicle because it guarantees a regular dividend that is not
directly tied to the markets like the price of common stock. This types of stock
guaranteesdividend which common stock does not. The price of preferred stock is tied to
interest rates levels, and tends to go down if interest rates go up and to increase if interest
rates fall.Preferred stock holder is a win- win situation over the common stockholders,
since the preferred will receive reimbursement back from their investments from the
common stock holders, especially the company is liquidates or ‘’goes out of business.
“Preferred stock holders however havecons, which include fixed income reimbursements.
This is the set rate of returns which common stock and preferred stock seekers should
explore.

Characteristics of preferred stock

 They look like stocks, behave like bonds.

 Their dividend never changed
 Some preferred shares have special voting rights to approve certain extraordinary
events (such as the issuance of new share or the approval of the acquisition of the
company) or to elect directors, but most preferred shares provide no voting rights
associated with them.
 If the company fails, preferred share holder stands in line before common
shareholdersfor any proceeds, but behind all creditors and bond holder.

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  Companies can postpone paying promised dividends for up to 5 years, but you
have to pay income taxes on the accumulation.
 Since the dividend is based on the original par value, if the stock trade at the
lower price, the current yielding for the new investor is higher. If the stock trade
at higher than par value price, the current yielding for the new stock purchased is
lower.

Common types of preferred stock

There are various types of preferred stocks that are common to many corporations.

 Cumulative preferred stock-if the dividend is not paid, it will

accumulate for future payment.
 Noncumulative preferred stock-dividend for this type of preferred stock
will not be accumulated if it is unpaid.
 Convertible preferred stock-This type of preferred stock carry the
option of converting in to common stock at the prescribed price.
 Exchangeable preferred stock- this type of preferred stock carries the
option to be exchanged for other security upon certain condition.
 Participating preferred stock-these types of preferred stock allows the
possibility of additional dividend above the stated amount under certain
Condition.

Expenses, costs and risk in equity market

Trading activity are not free; they have considerable high level of risk, uncertainty and
complexity, especially for unwise and inexperienced stock traders/investor seeking for an
easy way to make money quickly.In addition stock trader/investor facedseveral; costs
such as commission, taxes, fees to be paid for the brokerages and other services, like
buying and selling order placed at stock exchange. According to each national or state
legislation, a large array offiscal obligation must be respected, and taxes are charged by
the state over the transactions, dividends and capital gains.

3. Stock Exchanges

Stock exchanges are formal organizations approved and regulated by the security and
exchange commission (SEC).These exchange are physical locations and are made up of
“members” that uses the exchange facility and system to exchange or trade listed stocks.
Stocks traded on exchange are said to be listed stocks. To be listed the company must
apply and satisfy the requirements established by the exchange for a minimum
capitalization, shareholder equity, average closing share price, and other criteria. Even

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after being listed, exchanges may delist a company stock if it no longer meets the
exchange requirements. The right to trade security or make market in exchange floor is
granted to a firm or individual who becomes a member of exchange by buying a seat on
the exchange.

The role of stock exchanges

1. Raising capital for the businesses: the stock exchange provides a company with
a facility to raise capital for the expansion through selling share to the investing
public.
2. Mobilizing saving for investment: when people draw their saving and invest in
shares, it leads to more rational allocation of resource because funds, which could
have been consumed or kept in idle deposit with banks, are mobilized and
redirected to promote business activity with benefits for several economic sectors
such as agricultural, commerce and industry, resulting in a strong economic
growth and higher productivity levels and firms.
3. Facilitating company growth: companies view acquisitions as an opportunity to
expand product lines, increase distribution channels, increases its market share, or
acquire other necessary business assets. A takeover bid or a merger agreement
through the stock market is one of the simplest and most common ways for a
company to grow by the acquisition or fusion.
4. Redistribution of wealth: stocks exchanges do not exist to redistribute wealth
.However both causal and professional stock investors, through dividends and
stock price increases that may result in capital gains,will share in wealth of
profitable businesses.
5. Creating investment opportunity for small investors: as opposed to other
businesses that require huge capital outlay, investing in shares is open to both
large and small stock investors because a person buys the number of shares they
can afford. Therefore the stock exchange provides the opportunity for the small
investors to ownshares of the same company as large investors.
6. Government capital rising for the development projects: government at
various levels may decide to borrow money in order to finance infrastructure
project such as housing estate, sewage and water treatment works by selling
another category of security known as bonds. This bond can be raised through the
stock exchange whereby member of the public buy them, thus loaning money to
the government.
7. Barometer of the economy: at the stock exchange, share price rise and falling
depending, largely on market forces. Share price tend to rise or remain stable
when company and economy in general show sign of stability and growth. An
economic recession, depression or financial crises could eventually lead to a stock

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 market crash. Therefore the movement of shares prices in general of stock index
can be the indicator of the general trend in the economy.

The major organized stock exchange market include

 New York stock exchange

 London stock exchange
 Tokyo stock exchange
 Hong Kong stock exchange
 Stockholm stock Exchange
 Brussels stock exchange
 Johannes burg stock exchange

Over the Counter Markets

The majority of securities bought and sold around the globe are traded over the counter
not on organized exchanges. There is no central location, but only an electronic
communications network. Thecustomer places a buy or sells order with the broker or
dealer that is relayed via telephone, wire or computer terminal to the dealer or broker
with securities to sell or an order to buy. In this system of electronically linked market
makers, brokers and dealers seek the best possible price, and resulting competition to
find the best deal brings together traders located hundreds or thousands of miles
apart.The prices of actively traded security traded security quickly respond to the
changing force of demand and supply.

The Third Market

The market for securities listed on exchange but traded over the counter is known as the
third market. Broker and dealer firm are not the member of an organized exchange active
in this market. Theoriginal purpose of the third market was to supply large blocks of
shares to institutional investors. This investor engage mainly in block trades, defined as
transaction involving 1,000 shares or more .Presumably, block traders possess the
technical know how to make informed investment decision and then carry out
transaction without assistance from the stock exchange. By trading with third market
broker and dealer firms, who in effect, compute directly with specialists on the
exchanges, the large institutional investor frequently can lower transactions costs and
trade securities faster.

The fourth market; Alternative trading system

It is not necessary for two parties to a transaction (buy and sell stock) to use an
intermediary; that is, the services of a broker or dealer are not required to execute a trade,

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The directtrading of Stocks between the buyer and seller of the stock without the use of a
broker is called the fourth market .This market grow as the same reason as third market
because of excessive high minimum commission.

Trading Mechanics
Types of Orders – price and conditions of an order.

 Market order – an order to buy or sell stock at the best price available when the
order is placed.
 Limit order – an order to buy at or below a specified price. Or, sell at or above a
specified price.
 Stop-loss order – an order to sell a stock when its price reaches or drops below a
specified level.
Stock Valuation
Common Stock Valuation

Common Stock – Valued the same as any other asset – by discounting all expected future
cash flows. The cash flow comes in two forms: Dividends and Capital Gains

Cash Flows – the basic stock valuation equation

Value of stock = P0 = PV of future dividends

Zero Growth – a common stock whose future dividends are no expected to grow at all.

P0 = D/k

Constant Growth – a common stock whose growth is expected to continue into the
foreseeable future at a constant rate.

Constant Growth Model – a model used to find the value of a constant growth stock.
Total return is comprised of a capital gains return and a dividend return.

P0 = D1/(k – g)

Non constant (supernormal) Growth – a company which grows much faster for a
specified period of time.

• Find the PV of the dividends during period of rapid growth.

• Find the price of the stock at the end of the non-constant growth period using the
dividend growth model.

• Add these two components to find the intrinsic value of the stock.

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Capital Asset Pricing Model (CAPM) – theory where the expected return of a security
equals its beta times the market risk premium.

Expected rates of return depend on two things:

1. Compensation for the time value of money.

2. A risk premium, which depends on beta and the market risk premium.

Expected return = risk-free rate + risk premium

ks = kRF + âs(kM – kRF)