ChapterMcGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.5The Stock Market5-2The Stock Market• 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.5-3Private Equity and Venture Capital• Private Equity is the used for 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.5-4Venture Capital, I• 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.5-5Venture 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• 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.5-6Selling Securities to the Public• 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.5-7The 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 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.5-8IPO Tombstone5-9The Secondary Market for Common Stock, I.• 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. 5-10The Secondary Market for Common Stock, II.• Most common stock trading is directed through an organized stock exchange or trading network.• Whether a stock exchange or trading network, the goal is to match investors wishing to buy stocks with investors wishing to sell stocks.5-11The 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 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.5-12NYSE 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, 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 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.5-13Types of NYSE Members, I.• The largest number of NYSE members are registered as commission brokers. • Commission brokers execute customer orders to buy and sell stocks.• Second in number of NYSE members are specialists, or market makers. • Market makers are obligated to maintain a ―fair and orderly market‖ for the securities assigned to them.5-14Types of NYSE Members, II.• When commission brokers are too busy, they may delegate some orders to floor brokers, or two-dollar brokers, for execution.– Floor brokers have become less important because of the efficient SuperDOT system (designated order turnaround), – SuperDOT allows orders to be transmitted electronically directly to the specialist.• A small number of NYSE members are floor traders, who independently trade for their own accounts.5-15NYSE-Listed Stocks• In 2006, the total number of companies listed on the NYSE represented a total global market value of about $25 trillion.• Initial and annual listing fees are charged based on the number of shares.• To apply for listing, companies have to meet certain minimumrequirements with respect to– The number of shareholders– Trading activity– The number and value of shares held in public hands– Annual earnings5-16Operation of the New York Stock Exchange• The fundamental business of the NYSE is to attract and process order flow.• In 2007, the average trading volume on the NYSE was