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Chapter 6 The Stock

Market

The primary and secondary stock markets

The New York Stock Exchange The Toronto Stock Exchange

and TSX Venture Exchange Third and Fourth Market Stock Market Information

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© 2009 McGraw-Hill Ryerson Limited 6-2

The Stock Market

Our goal in this chapter is to get 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

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Private Equity

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

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The Structure of Private Equity Funds

Types of Private Equity Funds: Venture Capital

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 compan ies 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 or 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. 5

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Types of Private Equity Funds: Leveraged Buyouts

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.

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The Primary Stock Markets The Primary market is the market where investors purchase newly

issued securities. Initial public offering (IPO): An initial public offer occurs when

a company offers stock for sale to the public for the first time.

The Secondary Stock Markets 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.

Selling Securities to the Public

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The 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 firm

commitment or best effort underwriting. Company prepares a prospectus (usually with outside help) and

submits it to securities and exchange commissions for approval. Investment banker circulates preliminary prospectus (red

herring).

Upon obtaining approval, company finalizes prospectus. Underwriters place announcements (tombstones) in

newspapers and begin selling shares.

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IPO Tombstone

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The Secondary Market

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.

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.

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The 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 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) 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 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 cost $40,000—per year. Having a license entitles the holder to buy and sell securities on the floor.

Other NYSE Participants 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.

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NYSE Listed Stocks 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

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The Toronto Stock Exchange The Toronto Stock Exchange (TSX), unlike the NYSE, is a computerized

exchange. In 2002, the TSX 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 TSX experienced solid growth and became the third largest North American exchange in the 1940s.

In 1977, the TSX 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 302 new 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 (1531) are listed at the TSX and TSXV. In 2010, the trading volume related to mining industry exceeded $91 billion.

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TMX Group And TSX Venture Exchange

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Stock Market Order Types

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Trading on the Web

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Third and Fourth Market

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.

© 2009 McGraw-Hill Ryerson Limited 6-19

Stock Market Information

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.

The S&P/TSX is a capitalization weighted index of 220 Canadian companies.

© 2009 McGraw-Hill Ryerson Limited 6-20

S&P/TSX CompositeFigure 6.3

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Stock Market Indexes 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) 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.

© 2009 McGraw-Hill Ryerson Limited 6-22

Stock Market Indexes

For a value-weighted index (i.e., the S&P 500), 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.

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Stock Market Major Indexes

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Example I: $1,000,000 to Invest, Price-Weighted Portfolio

Price Shares

Company Price Weight to Buy

GM 40.56 0.3376 8,323

Nordstrom 25.91 0.2156 8,323

Lowe's 53.68 0.4468 8,323

120.150 1.000 8,323

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Example II: Changing the Divisor

Day 1 of Index: Company Price

GM 40.56Nordstrom 25.91Lowe's 53.68Sum: 120.15

Index: 40.05 (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., 40.05:

GM 40.560Nordstrom 25.910Home Depot 32.90Sum: 99.370

Sum / Divisor = 40.05, if Divisor is: 2.481148564

© 2009 McGraw-Hill Ryerson Limited 6-26

Example III: $1,000,000 to Invest, Value-Weighted Portfolio

Shares Capitalization Value Shares

Company Price (millions) (millions) Weight to Buy

GM 40.56 560.72 22,742.8 0.3323 8,192

Nordstrom 25.91 136.07 3,525.6 0.0515 1,988

Lowe's 53.68 785.75 42,179.1 0.6162 11,480

Total: 120.150 Total: 68,447.4 1.0000 21,660

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

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Example IV: How Does the Value-Weighted Index Change?

Total Shares Market CapitalizationDay 1: Company Price (millions) (millions)

GM 40.56 560.72 22,743Nordstrom 25.91 136.07 3,526Home Depot 32.90 2370.00 77,973

Total MV(1): 104,241

Divisor (Set by Vendor): 104.2413769

Day 1 Index Level: 1000.00

Total Shares Market CapitalizationDay 2: Company Price (millions) (millions)

GM 44.21 560.72 24,789Nordstrom 27.25 136.07 3,708Home Depot 33.50 2370.00 79,395

Total MV(2): 107,892

Day 2 Index Level: 1035.02

Using the Index from Example II:

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The Day 3 Index Can be Calculated in Two Ways:

Total Shares Market Capitalization

Day 3: Company Price (millions) (millions)

GM 43.250 560.720 24,251.1Nordstrom 23.210 136.070 3,158.2Home Depot 34.100 2,370.000 80,817.0

Total MV(3): 108,226.3

Total MV(2): 107,892.0

Day 2 Index Level: 1035.02

Day 3 Index Level: 1038.23

Total MV(1): 104,241.0

Day 3 Index Level: 1038.23

1Day LevelIndex 1Day ValueMarket

3Day ValueMarketIndex 3Day

or

2Day LevelIndex 2Day ValueMarket

3Day ValueMarketIndex 3Day

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Useful Internet Sites www.hoovers.com (reference for more on Initial

Public Offerings, IPOs) www.nyse.com (website for the New York Stock

Exchange) www.tsx.com (website for the Toronto Stock

Exchange) www.nasdaq.com (website for the Nasdaq) averages.dowjones.com (reference for more

information on the DJIA)