Chapter 3: Stock Markets

Introduction

Investors have several options to invest their money.

This chapter consists of four sections. In the first section, basic definitions of stocks and the rights and liabilities of stockholders are given. The second section focuses on types of stocks and features of these stocks. In the third section, stock valuation models and examples regarding these models are presented. The final section provides an overview of stock markets.

Definition and Properties of Stocks

Stock is a financial instrument that companies issue to raise capital in order to satisfy their financing needs.

Motivations of stockholders may be different. Some of them buy stocks in order to receive dividends and some of them buy to gain from the difference between buying and selling prices.

Stock investments provide two types of return:

1. Dividend Gain.
2. Capital Gain

There are many factors affecting the return that will be gained from stock investments;

• Inflation
• Interest Rates
• Macroeconomic Factors

Rights and Liabilities of Stockholders

Owing stocks imposes some obligations on investors. These rights and liabilities can be listed as follows:

• Right to dividend,
• Right to preemption,
• Right to liquidation surplus,
• Right to vote and right to participate in management,
• Right to demand information, Secrecy liability,
• Capital liability.

Right to Dividend

Companies may prefer not to distribute dividends. They may use this fund to finance the new investments of the company that is expected to increase the value of the company.

Right to Preemption

The right to preemption is important for the stockholders to keep the management of the company. For this reason, the stockholders of small companies may be granted preemption rights.

Right to Liquidation Surplus

This means that the portion of the assets remaining after the debts are paid is distributed to the stockholders in proportion to their shares in the capital of the company in case of liquidation of the company.

Right to Vote and Right to Participate in Management

Voting rights can be transferred to the second persons by proxy. Therefore, stockholders may try to change the management through the proxy if they are dissatisfied with the operations and the management of the company.

Right to Demand Information:

Stockholders have the right to review the profit and loss situation, annual reports and balance sheet within the one year following the general assembly meeting. However, none of the stockholders has the right to learn the company’s trade secrets.

Secrecy Liability

Under any circumstances, the stockholders are obligated to keep the company’s business secrets, even if they leave the partnership.

Capital Liability

Stocks impose liabilities to the owners besides providing some rights. One of the most important liabilities is to pay the capital that stockholders committed, both in new establishment and in capital increase.

Stock Value Definitions

The value of a stock can be measured for different purposes and in different ways.

Par (Face) Value: Par or face value is a legal term and refers to the minimum amount of money that the stockholders have to pay per share.

Book Value: It is the sum of par value, paid in capital and retained earnings, but firms generally report it on a per share basis.

Going Concern Value: This value is estimated based on the assumption that the company will continue its operations into the foreseeable future.

Liquidation Value: Liquidation value is the value that remains after all the assets of the company are sold, and the liabilities including preferred stocks are paid off.

Issuance Value: Issuance value refers to the price at which stocks are issued.

Market Value: The market value of a stock is the price that stock is traded in the market.

Intrinsic (Real) Value: The intrinsic value is obtained by discounting the cash flows that the investor expects to get from the investment in a specified period.

Types of Stocks

Investors invest in alternative types of stocks based on their attitude towards risk and return expectation.

Common Stocks

Common stock is the basic type and the most traded one in the financial markets. They are issued to satisfy the company’s financing needs.

Preferred Stocks

Preferred stocks are suitable especially for investors who do not want to undertake a high risk. Since they are less risky than common stocks, their return is lower to the common stocks.

Non-Voting Stocks

Non-voting stock is a security that provides its holder the rights of other stocks with the exception of voting right.

Stock Valuation

Macroeconomic factors such as inflation, interest rate, growth and company based factors such as dividend, profitability and capital structure affect the supply and demand of stocks.

In the valuation process, there are three key elements; expected cash flows, timing of the cash flows and the discount rate. There are models in the financial literature developed to calculate the real value of stocks.

The Discounted Dividend Model

In this technique, the present value of a stock is calculated by discounting the future dividends or net cash flows obtained from operations of the company (Korkmaz and Ceylan, 2007, p. 250).

The Constant Dividend Model

In the constant dividend model, it is assumed that the growth is provided by internal funds of the company, and therefore the dividends paid to the stockholders does not change over the time (Dt = D) (Kasper, 1997, p. 38).

Constant Growth (Gordon) Dividend Discount Model

In the dividend discount model, dividends must be estimated for each future year. In Gordon model, it is assumed that dividends grow forever with a constant rate (g), and the expected return per share is equal to the sum of dividend return and the expected growth rate of the dividend (Bodie, Merton, and Cleeton, 2000, p. 247).

Price-Earnings Ratio Model

Price-earnings (P/E) ratio is one of the most used and best known models in stock valuation in the last decades. It gives an idea to the investor if the stock is fairly valued or not.

Market to Book Value Model

Similar to the price-earnings ratio, market to book value (MV/BV) ratio can be used in stock valuation as a starting point. While P/E ratio uses income statement for per-share earnings in the formula, market to book value ratio uses balance sheet for book value.

Regression Model

In regression models one of the two or more variables is considered as the dependent variable and the relationships between the dependent and various independent variables are given mathematically.

Stock Indices

The main function of stock markets is to bring the companies and the investors together.

Indices are used as measurement tools in many areas and considered as indicators especially in the field of economy and finance.

Stock indices also allow the market trend to be compared with past trends and other markets.

Stock indices are considered as the leading indicators in evaluating economic and financial activities. The sharp declines in these indices may indicate a crisis particularly for developing countries.

Since the indices are well diversified portfolios, index investing is quite popular for the investors especially those who do not have sufficient information about stock investing.

Major Stock Markets

Stock markets are one of the most important parts of the financial markets. They provide a link between the buyers and sellers of stocks and contribute to price formation. Stock markets are important for several reasons, and they perform different functions in the economy.

Stock markets contribute to price formation for the financial assets by bringing together a large number of buyers and sellers. The prices in the stock markets are references for many decisions.

The Hong Kong Stock Exchange is one of largest stock markets located in Asia. Although Hong Kong is a Special Administrative Region (SAR) of China, it has a free market economy and foreign investors can invest in HKG.

Volatility and Volatility Spillover

Volatility is a statistical measure of variability in price or return of a financial variable. Volatility of financial instruments or markets is important because it reflects the risk of the instrument or the market. Volatility is caused by many factors such as new public information, changes in investor behaviors and economic and political developments (Stoll and Whaley, 1990, p. 4).

One of the main reasons for increases in the volatility of a stock market is the volatility in related markets. Hence, volatility spills over to other markets through financial and economic channels