Chapter 2

Equities

Companies issue equities to provide them with a permanent stock of capital to fund their business activities. The investors in that company are known as shareholders, as each investor holds a share in the ownership of the business. The investor expects to be rewarded in two ways. If the company does well then the market value of each share will increase over time, providing the investor with capital growth. In addition, the investor expects that the company will also provide a source of income in the form of regular dividends. Dividends are a way of distributing the profits of the company to its shareholders.

There are no guarantees that the investor will in fact benefit from either capital growth or from dividend income. For example, a young company with an exciting new product which it is bringing to market for the first time may not have any income to distribute yet, but because other investors take a very positive view of its long-term prospects, there may be considerable scope for capital growth. At the other end of the spectrum, an old established company that produces low technology products that do not require lots of investment may have a high income, but very limited prospects for capital growth.

A third possibility is that a company continues to make either very low profits or actual losses and investors take a negative view of its long-term prospects. In such a case income distribution in the form of dividends is likely to be very low or non-existent, and the prospects for capital growth are negative. In other words the investors are more likely to lose capital than to increase it.

2.1 LISTED AND UNLISTED EQUITIES

In this book we are concerned with equities that are regularly bought and sold by professional investment firms. Usually, such equities are listed on one or more stock exchanges. However, not all equities are listed on a stock exchange. Private companies are often owned by their founding families and do not have stock exchange listing. Companies that do have their shares listed are known as public companies; and most medium-sized public companies list their shares on a single stock exchange in the country in which they are incorporated.

2.2 MULTI-LISTED SECURITIES

Many large multinational companies, however, list their shares on a number of exchanges in different countries. For example, Sony Corporation shares are listed on the Tokyo Stock Exchange (where Sony shares are priced in Japanese yen), the London Stock Exchange (where prices are quoted both in yen and sterling); the New York Stock Exchange (prices quoted in US dollars); and on the Deutsche Borse (prices quoted in euros).

2.3 THE ISSUANCE OF LISTED EQUITIES – THE PRIMARY MARKET

When a company that was previously privately owned lists its shares on a stock exchange, it will almost invariably look to issue additional new shares in order to raise extra capital at the same time. The money paid by investors for the newly issued shares goes directly to the company. The sale of shares by the company for the first time is known as the primary market for that company’s shares. It is also known as an initial public offering (IPO), or just public offering, of those shares.

The IPO introduces the company to a wide pool of stock market investors to provide it with capital for future growth. The existing shareholders will see their shareholdings diluted as a proportion of the company’s shares. However, they hope that the capital investment will make their shareholdings more valuable in absolute terms.

In addition, once a company is listed, it will be able to issue further shares to the new and existing shareholders via rights issues. Rights issues enable existing shareholders to buy further stock at a discounted price, and also provide the issuer with further capital for expansion. This regular ability to raise large amounts of capital from the general market, rather than having to seek and negotiate with individual investors, is a key incentive for many companies seeking to list their shares.

IPOs generally involve one or more investment banks as “underwriters”. The company offering its shares, called the “issuer”, enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell them these new shares.

2.4 THE SECONDARY MARKET IN EQUITIES

Equity capital is permanent; the issuer does not as a rule return it to the investor2 and therefore there has to be a means by which the investor can realise its capital gain, or sell its holding to prevent further losses. For this reason, stock exchanges provide a marketplace for investors to buy and sell shares in the companies in which they are interested. This marketplace is known as the secondary market, to distinguish it from the initial distribution of shares by the company, which is known as the primary market. The role of investment exchanges is discussed more fully in Chapter 7.

When shares are bought and sold on the secondary market, each purchase and sale is known as a trade. When one investor (the seller) sells all or part of a holding to another investor (the buyer), then:

The process of organising the exchange of stock and cash is known as trade settlement. Settlement can occur on the same day that the trade was done, but more usually occurs a few days after the date of the trade. In most securities markets, settlement normally takes place three business days after the trade date.

2.4.1 Trade prices in the secondary market

The price at which equities are bought and sold in the secondary market depends upon supply and demand, and prices of an individual company’s shares fluctuate according to market participants’ views as to the prospects of:

• Individual companies
• Industry sectors in which these companies operate
• The economies of the countries in which they operate
• The perceived probability of another company paying a premium to acquire this company.

2.4.2 Secondary market terminology

When equities are traded on the secondary market there are a number of terms used to describe the features of that trade. Table 2.1 examines some of these terms before proceeding – others will be introduced later in the book.

Table 2.1 Equity trade terminology

On most exchanges, equity prices are quoted as units of currency, e.g. US$10.00 per share. The notable exception to this rule is the London Stock Exchange, where equity prices are more often quoted in pennies than in whole pound units.

2.4.3 Forms of securities

Securities (both equities and debt instruments in this context) may be issued in one of the following forms:

• Registered securities are where the name and address of the owner are recorded on a register maintained by a firm is known in some countries as a registrar and in others as a transfer agent. The register contains the holder’s name, address, quantity of shares or bonds owned, and the dates on which they were acquired. Registered shares may, in turn, exist in one or other of the following forms:

  – Certificated form – the evidence of ownership is represented by a share certificate which is printed and sent to the holder shortly after purchase. If the holder wishes to sell some or all of its holding, then it has to deliver the certificates as part of the settlement process.

  – Dematerialised form – no certificates are issued, the share register itself is the evidence of ownership.

• Bearer securities are issued where there is no register or registrar. When the security is first issued on the primary market, the issuer prints certificates representing the entire amount of shares or bonds issued, and these are posted to the investors who have purchased the shares in the primary market. If an investor wishes to sell all or part of its holding then it has to deliver the bearer certificates as part of the settlement process.

Prior to 1990, most securities were issued in either registered certificated form, or in bearer form. However, as securities trading became more global, the need to move large amounts of physical paper around the world whenever bonds or equities were traded in the secondary market became a major obstacle to efficient settlement. Financial regulators encouraged issuers to issue securities in dematerialised form, and investment exchanges set up the necessary market infrastructure to handle the trading and settlement of dematerialised securities.

1 A stock split is a form of corporate action where the total number of shares in issue is increased, and the additional shares are given to existing shareholders in proportion to their existing shareholding free of cost.

2 There are exceptions to this rule; some companies that have surplus capital do engage in share buyback programmes.