STOCK MARKET

Stock or capital stock is the capital raised by a company or corporation through issue and
subscription of shares. Alternatively, stocks are defined as a type of security that signifies
ownership in a corporation and represents a claim on the corporation’s part of assets and
earnings. There are two types of stocks: common stocks and preferred stocks. Preferred stocks
have higher as well as priority claim on a company’s assets and earnings but do not carry any
voting rights for the stockholders. On the other hand, common stocks entitle the holders to vote
their rights. Convertible preferred stocks include the option of converting a fixed number of
preferred shares into common shares at a predetermined date.

Stock markets are the places where stocks are traded. Those who hold stocks in corporations are
called stockholders. They own an interest in the corporation proportional to the percentage of
outstanding shares they own. The ownership right confers upon them the right to vote, and to be
the residual claimant of all funds flowing into the firm; i.e. the stockholders receive whatever
remains all other claims against the firm’s assets have been satisfied. Dividends are the payments
made periodically, usually every quarter, to stockholders. The board of directors of a firm sets
the level of dividend, usually based on the recommendation of the management. The
stockholders also have the right to sell the stock.

Most companies are usually started privately by their promoter(s). However, the promoters’
capital and the borrowings from banks and financial institutions may not be sufficient for setting
up or running the business over a long term. So companies invite the public to contribute towards
the equity and issue shares to individual investors, through a ‘Public Issue’. A public issue is an
offer to the public to subscribe to the share capital of a company. Primarily, issues can be
classified as a Public, Rights or Preferential issues, also known as private placements. When an
unlisted company makes either a fresh issue of securities or an offer for sale of its existing
securities or both for the first time to the public, then it is called Initial Public Offering (IPO).
This paves way for listing and trading of the issuer’s securities. When an already listed company
makes either a fresh issue of securities to the public or an offer for sale of its existing securities
to the public, through an offer document, it is called a follow on public offering (Further
Issue). When a listed company proposes to issue fresh securities to its existing shareholders as
on a record date, it is called Rights Issue.

The rights are normally offered in a particular ratio to the number of securities held prior to the
issue. This route is best suited for companies who would like to raise capital without diluting
stake of its existing shareholders. Rights issues may be particularly useful for companies which
cannot retain earnings, because they distribute essentially all of their realized income and capital
gains each year; therefore, they raise additional capital through rights offerings. As equity issues
are generally preferable to debt issues from the company's viewpoint, companies usually opt for
a rights issue when they have problems raising equity capital from the general public and choose
to ask their existing shareholders to buy more shares. Preferential issue or private placement
or preferential allotment is issue of shares or of convertible securities by listed companies to a
select group of persons under Section 81 of the Companies Act, 1956 which is neither a rights
issue nor a public issue. This is a faster way for a company to raise equity capital. Investors
involved in private placements are usually large banks, mutual funds, insurance companies and
pension funds.

Classification of Issues

The price at which a company's shares are offered initially in the primary market is called as the
issue price. When they begin to be traded, the market price may be above or below the issue
price. Indian primary market ushered in an era of free pricing in 1992. Following this, the
guidelines have provided that the issuer in consultation with Merchant Banker shall decide the
price. There is no price formula stipulated by SEBI. There are two types of issues, one where
company and Lead Merchant Banker (also called the lead underwriter or lead manager) fix a
price (called fixed price) and other, where the company and the Lead Manager (LM) stipulate a
floor price or a price band and leave it to market forces to determine the final price (price
discovery through book building process).

Valuation of Common Stock

People differ on how stock should be valued. Some believe that they can predict changes in a
stock price by studying in its price movements in the past. Because, these people study charts of
stock prices, they are called chartists. Some other determines the value of stocks based on their
perceptions of investors’ psychology and behaviour. They are known as behaviouralists. Still
others estimate stock values based on a detailed study of companies’ financial statements. They
advocate that the value of a firm’s stock depends on its current assets and future profitability,
called fundamentals. Thus, the fundamental value of a stock is based on the timing and
uncertainty of the returns it brings. There are three models to compute the fundamental value of a
stock. We begin with the simplest possible scenario. You buy the stock, hold it for one period to
get a dividend, and then sell the stock. We call this the one-period valuation model. This is
further extended to Generalised Dividend Valuation Model. Another alternative is the Gordon
Growth Model.

The One-Period Valuation Model – if one wants to invest in a one-period stock, then valuation
of the stock’s price needs calculation of its present values of future cash flow and expected
selling price after one year. Suppose, the company announces a dividend of D1 to be paid to the
stockholders in the first year. And, the stock is expected to sell at a price P1 in the next year. If ke
is the investor’s required return on equity, which may differ from individual to individual, then
the current price of the stock would be
𝐷1 𝑃1
𝑃0 = +
1 + 𝑘𝑒 1 + 𝑘𝑒
If P0 turns out to be equal to or larger than the current selling price, then the investor would buy
the stock.

The Generalised Dividend Valuation Model – the one-period valuation model can be
generalised by extending it to any number of periods where the value of stock today is the
present value of all future cash flows plus the selling price of the stock. The generalised multi-
period formula for stock valuation is written as
𝐷1 𝐷2 𝐷𝑛 𝑃𝑛
𝑃0 = + + ⋯ + +
1 + 𝑘𝑒 (1 + 𝑘𝑒 )2 (1 + 𝑘𝑒 )𝑛 (1 + 𝑘𝑒 )𝑛
Therefore, in order to know P0 one must first know Pn. However, if n is a sufficiently long period
then it will not have any traceable impact on P0. Therefore, the generalised model can be
rewritten as
∞
𝐷𝑡
𝑃0 = ∑
(1 + 𝑘𝑒 )𝑡
𝑡=1
Therefore, the generalised dividend valuation model implies that the price of the stock is
determined by only the present value of the dividend. However, it is difficult to have estimates of
an infinite stream of dividends. A simplified alternative is provided by the Gordon growth model
discussed below.

The Gordon Growth Model – many firms strive to increase their dividends at a constant rate
each year. Therefore, the previous model can be rewritten by incorporating an expected constant
growth rate g into the equation.
𝐷0 (1 + 𝑔) 𝐷0 (1 + 𝑔)2 𝐷0 (1 + 𝑔)∞
𝑃0 = + + ⋯ +
1 + 𝑘𝑒 (1 + 𝑘𝑒 )2 (1 + 𝑘𝑒 )∞
Simplifying we obtain
𝐷0 (1 + 𝑔) 𝐷1
𝑃0 = =
𝑘𝑒 − 𝑔 𝑘𝑒 − 𝑔
This is also called Dividend-Discount Model. Note that P0 will be positive only when ke > g
holds. Thus, this theorem is valid under two assumptions:
 Dividends would continue to grow at a constant rate forever.
 The growth rate of dividends should be less than the required return on equity.

Determination of Stock Prices in the Market

Broadly there are two factors that influence stock prices in the market: (1) stock specific and (2)
market specific. The stock-specific factor is related to people’s expectations about the company,
its future earnings capacity, financial health and management, level of technology and marketing
skills. The market specific factor is influenced by the investor’s sentiment towards the stock
market as a whole. This factor depends on the business environment rather than the performance
of a company. Events favourable to an economy, political or regulatory environment like high
economic growth, friendly budget, stable government etc. can fuel euphoria in the investors,
resulting in a boom in the market. On the other hand, unfavourable events like war, economic
crisis, communal riots etc. depress the market irrespective of certain companies performing well.
However, the effect of market-specific factor is generally short-term. Despite ups and downs,
price of a stock in the long run gets stabilized based on the stock specific factors.

To understand how the stock specific factors work, suppose there are three investors in the
market, Mr. A, B and C. Further assume that a stock is expected to grow at 3 percent per annum
indefinitely with D0 = 2. If Mr. A is uncertain about the predictions and wants a 15 percent return
to compensate for the uncertainty then following the Gordon growth model the stock price will
be Rs 17.17. If Mr. B feels more confident about the projected cash flows and requires only a 12
percent return then he would be willing to pay a higher price, Rs 22.89. If further Mr. C has
some additional information about the company so that he is very sure about its future
performance, he will be satisfied with a 10 percent return. Thus, he will offer a price Rs 29.43.
The investor with the lowest perceived risk is ready to pay the highest price for the stock.
Therefore, the market price would be between Rs 22.89 and Rs 29.43. If Mr A already holds the
stock, he will sell it to Mr. C.

Hence, the players in the market bidding against each other establish the market price. When
new information is released about a firm, prices change. New information causes changes in
expectations about the level of future dividends or the risk of those dividends. Consequently,
stock prices are constantly changing.

The price at which a buyer intends to buy a share is called bid while the price at which a seller
offers to sell shares is called the ask price. When the bid price matches with a ask price, the
exchange takes place. A computer screen for quotes of the stock prices of a company looks like
the following.
Bid (buy side) Ask (Sell side)
Quantity Price (Rs.) Quantity Price (Rs.)
1000 50.25 2000 50.35
500 50.10 1000 50.40
550 50.05 1500 50.50
2500 50.00 3000 50.55
1300 49.85 1450 50.65
5850 8950

The best buy order is the order with the highest price and the best sell order is the order with the
lowest sell price. The difference between the prices of the best bid and ask is called the bid-ask
spread and often considered as an indicator of liquidity of a stock. The narrower is the
difference, the more traded or highly liquid is the stock.

The Efficient Market Hypothesis

The efficient market hypothesis is based on the assumption that prices of securities in financial
markets fully reflect all available information. As a result markets adjust immediately and
continuously to changes in the fundamental values. The theory implies that stock price
movements are unpredictable. If they weren’t, you could accurately forecast that the price of a
stock was going to rise tomorrow. You would immediately buy as many shares of the stock as
possible. Your action would increase demand for the stock, driving its price up today.

If the theory of efficient market hypothesis is correct then no one can beat the market average.
This means active portfolio management – buying and selling stocks based on someone’s advice
– will not yield a higher return than that of a broad stock-market index, the market average. For a
formal presentation of the theory recall that the rate of return from holding a stock for one period
is
𝑃𝑡+1 − 𝑃𝑡 + 𝐶
𝑅=
𝑃𝑡
where Pt+1 and Pt are the prices of the security at time t+1 and t, respectively and C is the coupon
or dividend payment. However, the only variable in the definition whose value is uncertain is
Pt+1. Denoting the expected price at the end of holding period by Pt+1e, the expected return would
be
𝑒
𝑒
𝑃𝑡+1 − 𝑃𝑡 + 𝐶
𝑅 =
𝑃𝑡
The efficient market hypothesis views expectations about future prices as equal to optimal
forecasts using all currently available information; i.e. Pt+1e = Pt+1f which in turn implies that the
expected return on the security will equal the optimal forecast of the return, Re = Rf. However,
since neither Re nor Pt+1e is observable, these equations by themselves do not tell us much about
how financial markets behave. Nevertheless, the supply and demand analysis of the bond market
showed us that the expected return on a security will have a tendency to head towards the
equilibrium return that equates the quantity demanded to the quantity supplied. Therefore, the
expected return on a security Re equals the equilibrium return, R*. This also implies Rf = R*.
This equation tell us that current prices in a financial market will be set so that the optimal
forecast of a security’s return using all available information equals the security’s equilibrium
return. Alternatively, it states that in an efficient market, a security’s price fully reflect all
available information.

Suppose, the optimal forecast of returns of a stock deviates from its equilibrium level so that Rf >
R*. When it is predicted that on average the stock return would be abnormally high, there will be
an increased demand for the stock. This will push the current stock price up, thereby lowering Rf.
When the current price had risen sufficiently so that Rf equalled R* and the efficient market
condition was satisfied, the buying of the stock would stop. Similarly, for an optimal forecast
return below the equilibrium level will lead to selling off of the security resulting in a higher
current price which would raise the optimal forecast to the equilibrium level.

An extremely important factor in this reasoning is that not everyone in a financial market must
be well informed about a security that its price to be driven to the point at which the efficient
market condition would hold. Financial markets are structured so that many participants can
play. As long as a few keep their eyes open for unexploited profit opportunities (often referred to
as "smart money"), they will eliminate the profit opportunities that appear, because in so doing,
they make a profit. The efficient market hypothesis makes sense, because it does not require
everyone in a market to be cognizant of what is happening to every security.

Measuring the Level of the Stock Market

Changes in stock value cause general economic activity to fluctuate by affecting consumption
and savings patterns. Stock market index is a barometer of market behaviour and acts as a
precursor of economic cycles. Therefore, it is imperative to understand the dynamics of stock
market. From the macroeconomic perspective, we need to measure the level of fluctuations in all
stock values measured as stock-market indices. Stock indices can tell us both how much the
value of an average stock has changed and how much total wealth has gone up or down. There
are three alternative methods for calculating stock indexes. They are discussed below.

1. Full market capitalization method – in this method, the number of shares outstanding
multiplied by the current market price per share of a company, known as market
capitalisation, determines the company’s weight in the index. The index can be computed
by adding up the market capitalization of all companies listed and dividing it by the
number of securities in the index. Obviously, companies with large market capitalisation
get larger weights in this method.
2. Free-float market capitalization method –free float is the percentage of shares that are
freely available for purchase in the markets. Therefore, it excludes shares of a company
held by government, controlling share holders and their families, company’s
management, shares locked under the employee stock ownership plans etc, known as
closely held shares. Thus, companies with large full market capitalisation but less free-
 float will have less weight under this method. Under free-float weighting scheme a float
factor is assigned to each stock to account for the proportion of outstanding shares that
are held by the general public, as opposed to "closely held" shares owned by the
government, royalty, or company insiders. For example, if for some stock 15% of shares
are closely held, and the other 85% are publicly held, the float factor will be 0.85, by
which the company's market capitalization will be multiplied. In other words, the number
of shares used for calculation is the number of shares "floating", rather than outstanding.
Free float market capitalisation is considered to be a better method, since it includes only
those shares which are available in the market and influence the stock prices. Also, it
reduces the influence of large, closely held stocks on the index movement and prices.
Further, it helps in better investment decision making for the fund managers.
3. Price weighted index – in this method, the index is calculated by adding the prices of
each of the stocks in the index and then dividing them by the total number of stocks.
Stocks with a higher price will be given more weight and, therefore, will have a greater
influence over the performance of the index.

Important indices
Some important indices are discussed below. First two important indices from the US are
described followed by Indian indices.

The Dow Jones Industrial Average – the first and still the best known stock market index is the
Dow Jones Industrial Average (DJIA) created by Charles Dow, Edward Jones and Charles
Bergstresser in 1882, the DJIA began as an average of the prices of 11 stocks. Later on it
expanded to include 30 of the largest companies in the US. Since the structure of the US
economy has changed markedly, so the DJIA. From an initial composition primarily dominated
by railroad stocks, today it includes the stocks of information technology firms, like Microsoft
and Intel, to retailing firms such as Wal-Mart and Home Depot. General Electric is the only one
of the original 11 stocks that remains in the index. It is computed by adding up the per-share
prices of all 30 stocks and divided by Dow divisor which is constantly modified. Dow divisor is
adjusted for any changes in the stock price created by events such as stock-splits, spinoffs or
other structural changes to ensure that such events do not affect the index. It is a price-weighted
average, which gives greater weight to shares with higher prices. Because, changes in the prices
of higher-priced stocks leave a greater impact on the overall index and hence, dominate the
movements in the index.

Aside: a stock-split implies that a corporation divides its each existing shares into multiple
shares. The most common ratios are 2-for-1 or 3-for-1 where each share is equivalent to two or
three shares, respectively. Although, the total outstanding number of shares increases with splits,
total value of shares remains the same. This is done in for two reasons primarily. One, when the
stock prices are very high it becomes too pricey for investors to hold a good number of stocks. A
split helps the investors. Second, splits make shares more liquid and increases trading. Most
often it has a positive impact on share prices, though temporary. Stock dividends are distribution
of stocks among the shareholders in lieu of dividends in the form of fractions per existing share.
Spinoffs are sale or distribution of new shares of an existing company or division of a parent
company for creation of an independent company. This is a type of divestiture.

The Standard and Poor’s (S&P’s) 500 Index – this index is based on the value of the 500 largest
firms in the US economy. It is a market capitalization weighted index. Most money managers
treat S&P500 as the proxy for the US stock market. It tries to cover all major areas of the US
economy. To be included in the S&P500, a company must be profitable, at least 50 percent of its
stocks should be public (not closely held) and must have a large daily trading volume, no less
than a third of its total shares.

The Nasdaq Composite Index – this is another market capitalization based index of the prices of
all the stocks listed in the Nasdaq stock market. Nasdaq is the World’s second largest stock
exchange, preceded by New York Stock Exchange and it is also World’s first electronic
exchange.

The Nasdaq 100 Index – Nasdaq 100 comprises of the largest computer, software and telecom
stocks by market capitalisation on Nasdaq. For a company to be included in Nasdaq 100, it must
have a minimum average trading volume of 1,00,000 shares per day and must have been trading
on a major exchange for at least two years.

Indian Indices – there are two major indices in India: BSE Sensex (Sensitive Index) and NSE
Nifty. Bomay Stock Exchange (BSE) is the apex stock exchange in India. It is the biggest in size
in terms of fresh capital raised, secondary market turnover and capitalisation and the total listed
companies and their paid up capital. It is the 10th largest stock exchange in the world. Established
in 1875, BSE is Asia’s first stock exchange and so the oldest stock market in India. A large
number of Indian stock indices are based on scrips from BSE. Other than Sensex, BSE also
publishes some of the major indices like i) BSE 100, ii) BSE 200, iii) BSE 500, iv) BSE
Smallcap, and v) BSE Midcap. S&P BSE SENSEX, first compiled in 1986, is now calculated on
a 'free-float Market Capitalization-Weighted' methodology of 30 component stocks representing
large, well-established and financially sound companies across key sectors. Once the Free-float
factor of a company is determined, it is rounded-off to the higher multiple of 0.05 and each
company is categorized into one of the bands such as, companies with free float percentage
between 0 – 5% is assigned a float factor of .05. Similarly, companies with free float percentages
between 5-10% are given a float factor of 0.1 and so on. The banding structure reduces the
potential of frequent changes in Free-float factors of index companies. A Free-float factor of say
0.6 means that only 60% of the market capitalization of the company will be considered for
index calculation.The base year of S&P BSE SENSEX was taken as 1978-79. BSE 100
comprises of 100 stocks listed at five major stock exchanges in India -
Mumbai, Calcutta, Delhi, Ahmedabad and Madras. It was initially constructed in January 1989
as BSE National Index and was renamed on October 14, 1996. BSE launched two new index
series on 27 May 1994: The 'BSE-200' and the 'DOLLEX-200'. BSE-500 Index and 5 sectoral
indices were launched in 1999. BSE Smallcap and Midcap were introduced to track the
performance of firms with relatively smaller market capitalization. The CNX Nifty, launched on
July 8, 1996, is a well diversified 50 stock index accounting for 22 sectors of the economy.