CHAPTER 1

EQUITY MARKETS
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Chapter Objectives
This chapter discusses;

1. Introduction to financial markets

2. Introduction to equity markets
3. The role of equity markets in economies
4. Primary and secondary equity markets
5. Valuation and analysis process for investors
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What is a Market
• Market is a place that facilitates a transaction between two parties for the
exchange of tangible goods and services.

• Characteristics
• Not to have physical location
• Not necessarily own the goods and services
• Deal in variety of goods and services

• Financial market is a market for trading financial assets or investments

such as stocks, bonds, options, and futures.
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Organization of Financial Markets

• Primary Markets
• Market where new securities are sold and funds go to issuing unit.
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Organization of Financial Markets
• Primary Markets
• Government Bond Issues
• Treasury bills, Treasury notes, Treasury bonds

• Municipal Bond Issues

• Competitive bids - sealed bids
• Negotiated sales - contractual agreements
• Private placements - bond issue directly to an investor.

• Corporate Bond Issues

• Corporate Stock Issues
• Secondary equity issues
• Initial public offerings (IPOs)
• New issues
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Organization of Financial Markets
• Secondary Markets
• Market where outstanding securities are bought and sold by investors.
The issuing unit does not receive any funds in a secondary market
transaction
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Organization of Financial Markets
• Secondary Markets
• Secondary Markets for U.S. Government and Municipal Bonds
• Major market makers in the secondary municipal bond market are
banks and investment firms

• Secondary Corporate Bond Markets

• Large investment banking firms. JPMorgan, Barclay Capital, and
Morgan Stanley
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Equity Markets
• What is an equity market, and why is it important?

• An equity market is a market in which firms issue stocks/shares to fund

their operations.
• After issuance, investors trade shares on exchanges and over-the-
counter (OTC) markets.

Functions
• Support the growth of business and industry by channeling funds from
savers to firms.
• Provide an opportunity to access capital
• Raise funds to grow their business but also give investors a chance to
become shareholders.
• Provides a common place to buy and sell stocks.
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Equity Market
• Secondary Equity Markets
• Secondary equity markets in the United States and around the world
were divided into three segments:

• National stock exchanges,

• Regional stock exchanges,
• Over-the-counter (OTC) markets for stocks not on an exchange

• Bursa Malaysia
• Main market
• ACE market
• LEAP market
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Types of Equities
• Common Equity
• Preferred Equity

• Common Equity

• Common equity gives holders the right to vote on specific corporate

issues, including the election of the board of directors, corporate
objectives and policy, and acquisitions and divestitures.

• In the event of liquidation, the common equity holders will receive only
the remainder of funds.
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Types of Equities
• Preferred Equity
• Preferred stock is a hybrid security that typically lacks voting rights but
gives its shareholders a prior claim to receiving dividends before
common stockholders.

• Preferred equity has a more senior claim, relative to common equity, on

the company’s assets and receives priority when the company declares
and pays dividends

• Task: Discuss 5 (FIVE) differences between common stocks and

preferred stocks.
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Market Index
• Market changes over time can be tracked by using market indices.

• Market Index
• A market index is a weighted average of many stocks, which is computed
using the prices of the stocks included in the index.

• The oldest U.S. stock market index – the Dow Jones Industrial Average
(DJIA) – originated in 1885 as the Dow Averages. The DJIA consists of 30
large, influential U.S. companies.

• Another widely used market index – the Standard & Poor’s 500 index –
represents 500 large U.S. stocks. Investors can use these stock indices, as
well as many others, to follow market trends and compare their portfolio
performance.
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Market Indices
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Market Indices
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Role of Equity Markets in Economies

• World equity markets have grown steadily since the 1980s.

• World market capitalization of listed companies reached $79.121 trillion in

2017 from a low of $2.501 trillion in 1980 (World Bank 2018).

• During this period, it fluctuated dramatically, declining almost 50 percent

during the global financial crisis of 2007–2008.
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Role of Equity Markets in Economies
• 81 percent is accounted for by the market capitalization of the major equity
markets from 29 developed countries.

• The other 19% is accounted for by the market capitalization of developing

countries in “emerging markets”.

• Latin America
• Asia
• Eastern Europe
• Mideast/Africa
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Role of Equity Markets in Economies
• There are approximately 80 major national stock markets.

• Western and Eastern Europe once had more than 20 national stock
exchanges.

• Today, stock markets around the world are under pressure from clients to
combine or buy stakes in one other to trade shares of companies anywhere,
at a faster pace.
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Factors Affecting Equity Returns
• Macroeconomic Factors
• Exchange Rates, interest rate differentials, inflation
• Market Structure
• Trading practices and costs
• Market Liquidity
• Stock Market Concentration
• Size of largest firms in relation to the industry as whole.
• Example: A low concentration ratio in an industry would indicate
greater competition among the firms in that industry.
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Equity Valuation and Analysis Process
• Knowledge
• Investors are required to have good understanding of market and
industry.
• The purpose is to determine the opportunities available regarding
developing and improving the products and services as per need of
customers.
• Industry analysis helps investor to explore potential opportunities for
the firms by analyzing external and internal factors.
• An expanding industry provides ample opportunity to improve
firm position.
• A declining industry would force firms to search for opportunities.
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Equity Valuation and Analysis Process
• Valuation Techniques
• Dividend discount method
• Uses the present value of future dividend payments to compute the stock
fundamental value.
• Free cash flow method
• If a firms does not pay dividend, investors evaluate firms’ cash flow. For
investors, positive cash is always desirable. However, negative cash flow is not
necessarily an unfavorable signal as it may indicate that firm is making
significant investments.
• Comparable method
• Investors may compare similar businesses to value firm’s stock based on
business types, transaction or industry averages.
• Other valuation methods
• Residual income valuation and technical analysis
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Equity Valuation and Analysis Process
• An investor may choose active investing and try to time the market with an
objective of short-term gains.

• A passive investor may choose to invest for the long term by tracking an
index. This strategy reduces the risk through diversification.

• Investors can strategically focus on certain types of stocks.

• For example, one may choose to invest in stocks whose earnings are
expected to grow faster than others (growth strategy) or may look for
undervalued stocks that are expected to increase in value (value
strategy).
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Summary

• This chapter discussed

• Introduction to financial markets,
• Equity markets
• Types of Equities
• Market Index
• Role of equity markets in economies
• Factors affecting equity returns
• Stock valuation and analysis process