How does the stock market work?
Introduction
This chapter provides important background information on how the stock market operates. If you are already familiar with share trading, you may want to continue with the next chapter, however, we suggest that you become familiar with the concepts outlined here.
The stock market is a place where people buy and sell equities. The London Stock Exchange is located in Throgmorton Street in the City of London. This was traditionally the place where people who had money they wanted to loan met with people who wanted to borrow. Now, most trading takes place on computer systems.
The Stock Exchange exists for one reason -to raise money for the government and for industry. In order to borrow money, there must be institutions and individuals who want to lend money. The Stock Exchange brings together these two groups of people and makes it possible for them to invest. In order to do this, both governments and businesses issue shares on the market.
In return for investing, the company issue shares in the business and pay dividends to share holders out of the profits. As a company grows, the value of each share increases.
Not every company which is listed on the Stock Exchange will be successful. Some will become bankrupt. The challenge to investors lies in the ability to spot newly listed companies who will be successful and increase their share price and pay high dividends. If the company is successful, the price of their shares will increase and the investor will make money. If the company does not do well, the share price will decrease and the investor stands to lose money.
What are the primary and secondary markets The stock market operates two different markets, the primary and secondary markets. The primary market is where companies, governments and other institutions offer new securities for sale to the public. When a company first joins the Stock Exchange they make a new share issue which is traded in the primary market.
Once a company issues shares, the shareholders can then trade these shares on the secondary market. The secondary market provides a forum where existing securities are bought and sold. This is where the day to day trading of quoted shares takes place.
This section explains what shares are and how they are first offered for sale.
Private individuals and institutions who participate in the Stock Exchange deal in financial assets, such as loans, bonds and equities. Large institutions such as banks provide loans, and are not part of our current discussion.
Bonds and equities, however, are the major assets bought and sold on the Stock Exchange. These are also known as securities which include ordinary shares and government bonds. Government bonds are also referred as gilt-edged securities or gilts. Gilts stands for Government Issued Long Term Stocks.
Gilts usually have a fixed interest rate and are issued by the government. Shares on the other hand, represent actual equity in a company's assets. If a company becomes bankrupt, the company's liabilities must be met first. If there is any money left over, share holders are paid.
Shares represent ownership in a company. As shareholders they are entitled to certain rights which include:
- the right to vote on proposals made by the board of directors
- the right to appoint and remove directors
- the right to receive dividends, if and when they are declared.
Often companies give perks to their shareholders such as discounts on their goods or services. There are many different types of shares which offer a variation of these rights such as preference and non-voting shares.
All companies are allowed to issue shares, although only public limited companies (plc) who qualify for the Stock Exchange can trade securities on the market. Shares in private companies (limited) are not traded in the market.
To qualify for the Stock Exchange, a company must provide a five-year trading record and offer at least 25% of its shares to the public. When a company qualifies for the Stock Exchange, they become listed by the Stock Exchange.
In order to offer shares, a company needs a sponsor who will oversee the pricing of the share and the actual sale. These sponsors are banks and stockbrokers who specialise in pricing shares and conducting sales.
One of the most important tasks the sponsors need to perform is valuing the company and establishing a share price. To do this, they must investigate the company's historic profits and forecasts for profits and dividends for the current year. The sponsors use these figures to compare this company with other companies in a similar line of business or sector.
It is important that the share price they set is one that will generate interest from investors and be sustainable in the market. If the price offered is over-valued, when trading starts the share price may fall. Sponsors generally want share prices to rise in value after they are announced.
Once the share price is established, the company can then advertise the new issues. A company can organise a share issue by using one of the following methods:
- placing
- offer for sale
- tender offer.
Issuing shares through a placing
The most common method of issuing new shares is through a placing. The company asks their sponsoring bank or stockbroker to contact key investment institutions to ask them to purchase shares. Individuals are not usually offered a chance to purchase these shares.
Issuing shares through an offer for sale
Many large companies, however, will issue new shares by making an offer for sale. The first step involves underwriting the new share issue.
A company will employ an underwriting firm which guarantees to buy new shares if no one else will. In return they receive a commission. If a share issues does not do well, the underwriters are obliged to buy the remaining shares. If the issues does go well, the underwriters still receive their commission but they do not have to purchase shares.
To help generate interest in shares, companies will advertise the share issues in newspapers and perhaps even television.
The next step is for the company to issue a prospectus setting out the structure of the company, its trading record and its future prospects. This must be printed in at least two daily newspapers. The prospectus contains an application form which interested people complete and return. Investors are then invited to apply for shares.
When the closing date arrives for the share offer, the sponsor announces whether the issue was over- or under-subscribed. If over-subscribed, more investors have applied for more shares than were offered. In some cases a ballot is held to determine who will have the opportunity of buying the shares. In other cases, shares are allocated to investors on a ratio basis.
If the issue was under-subscribed, however, there were fewer investors than there were shares, and the underwriters will have to purchase the remaining shares at the current issue price.
Issuing shares through a tender offer
Another method for issuing new shares is called a tender offer which operates more like an auction. The company will set the share price in the traditional manner, but will not announce the price to investors. Instead, the investors offer a tender price. Those who make the highest offers are given the opportunity to purchase shares at the pre-set price. After the highest bidders, the remaining shares are offered to the second highest bidder, and so forth.
Companies who already trade on the Stock Exchange can also issue entitlement shares to raise additional equity (money). These are generally referred to as rights issues. In a rights issue, shares are offered to existing shareholders in proportion to their holdings. The share price offered is usually lower than the price of the existing shares in the market to encourage shareholders to purchase them.
The existing shareholder has the right to purchase the new shares or to sell the right to do so to another investor. This enables a company to raise revenue without diminishing the shareholders investment.
In addition to rights issues, a company can create more shares without actually raising any additional money. There are several names for this type of share issue including scrip, bonus or capitalisation. This kind of issue is essentially an accounting operation in which the company transforms retained earnings into shareholders capital. It has no effect on the value of the shareholders interest nor does it raise money for the company.
Share prices rise and fall depending upon how the market views the long-term health of the company and the ability of the company to make a profit.
In the same way that a sponsor investigates a company's past performance and forecasts to determine a first issue share price, an individual investor also wants to be able to value a company. As an investor, you need a process to enable you to judge the value of a company.
To help gauge the value of companies, you can use the same methods devised by financial analysts to analyse a company's performance and share price. You can also use these methods to compare companies in the same sector. To value a company you can calculate the:
- earnings per share
- P/E ratio (price/earnings)
- yield.
The following sections explain how you arrive at these calculations. This is for your own information since Portfolio On-line provides all of this information for you. You can view this information for companies through the company detail facility. Calculating earnings per share
This is a relatively straight-forward way of analysing a company's past performance and comparing it with other similar companies. You calculate earnings per share by taking the base profits of a company divided by the number of shares in issue. Base profit is what is left after taxes have been deducted. For example:
Earnings per share = Base Profit/No of Shares
1.33=2000/1500
The earnings per share or "eps " figure is a good measure of how well the company is treating its shareholders. If the figure rises, the shareholders are getting more from the company. Conversely, if the eps figure drops, the amount of money a shareholder receives also drops.
Calculating the P/E ratio
The Price/Earnings ratio provides a rough guide to the time that is needed for an investors holdings to be paid back in full. The P/E ratio reflects the investors' expectations of a company's earnings power. To calculate the P/E ratio you divide the share price with the earnings per share. For example:
P/E Ratio = Share Price/Earnings per share
1.50=2.00/1.33
This means a company has a P/E ratio of 1.50 which can be considered attractive. The P/E ratio reflects an investors expectations of the company's future earning potential.
Calculating the yield
By calculating the yield, you can determine the percentage return on your initial investment. This figure will change every time there is a movement in the share price, but it gives you an indication of the return you might expect on your shares.
To calculate the yield you divide the Gross dividend per share by the Share price and multiply by 100. For example:
Yield = Gross Dividend per Share/Share Price
7.5%= 15/200 x 100
The yield figure differs from the P/E ratio in that it takes into account the fact that not all of a company's post-tax profits are paid out to shareholders.
The performance of the market is measured and recorded daily in the FT-SE 100 index. Whenever you listen to television or radio news or read newspaper reports about the stock market they inevitably refer to the FT index. The FT-SE 100 index is compiled by the Financial Times.
The FT-SE 100 (Financial Times/Stock Exchange 100 index) lists one hundred blue chip companies which reflect the industrial diversity of Britain and the shares involved in the market.
The FT actually publishes a number of different indices each of which use a different selection criteria. For example, the FT-SE Mid 250 index lists the average statistics for 250 companies which represent the average performance of medium size companies. Whatever the index, the FT provides the same set of statistics which includes:
- current value
- value a year ago
- percentage change in value
- highest value for the year
- lowest value for the year
- highest and lowest value since compilation.
The Financial Times also produces an index for over 800 shares on the market in the FT-SE All Share Index. There are numerous other indices such as the FT-SE-A Mid 250 and FT-SE-A 350 Higher Yield which enable you to more closely compare a company with a more narrowly defined industry average.
The FT also provides sector indices which are groups of companies who are in a similar business. The Financial Times divides the shares into sectors so that investors can compare a company's performance against others in the same type of business.
Portfolio On-line makes this information available to you daily through the Infotrade account. In this way, you have all the material you need to make important share dealing decisions. The next section explains how you locate this information.
Just as important as having the information available, Infotrade Portfolio enables you to display the information either as a table of statistics or in a graph. You can also overlay a FT index graph over a graph of your portfolio so that you can see how the performance of your investments compare with the industry's average.
