Topic 2: Equity Finance

Dr Benjamin Lynch
 Topic Overview:
Equity
• Types of Equity

• Valuing Shares

• Selling Shares
 What is Equity?
• Equity is financing (capital) which is provided by the owners of a
company

• Internal equity is financing provided by the initial entrepreneur or

generated from the firm’s operations i.e. profit that is retained (4a)

• External equity is financing provided by other investors through the sale

of shares in the company (1)
• Shares are discrete units of equity
• Shares are also called stock

• Equity represents ownership of a company

• Buying shares means buying a part of a company
• Ownership % = No. of shares owned / Total no. of shares
Types of Shares

Types of Shares

2. Preference
1. Ordinary Shares
Shares
Ordinary (Common) Shares
• An ordinary share is the most common form of equity

• Ordinary shareholders have a degree of control over a firm

via voting rights
• Right to vote on certain decisions
• Board of directors, auditors, takeovers
• 1 vote per share owned

• Return is received in the form of a dividend or a capital gain

Meaning Depends on Frequency
Capital Gains/loss Increase/decrease in the value of an share The markets perception of the Realised upon liquidation
current and future performance
(expected) of the firm
Dividend Part of the after tax profits distributed to It depends on the decisions of the On a periodical basis, depending
shareholders senior management on firm policies
Ordinary (Common) Shares
• Ordinary shares are a risky investment:

1. Capital gains:
• Share price can be volatile
• Firms do not have to repay the share price or nominal value

2. Dividend
• Dividends are optional. Up to board of directors.
• Dividends can only be paid after lenders and preference
shareholders have been paid

3. Bankruptcy
• Ordinary shareholders are last on the liquidation ladder

Shareholders have a residual claim on the firm’s cash flows and assets.
The Liquidation Ladder
Liquidation: when a company does not have enough funds to pay its debts, the its
assets are sold to cover the debts, and the remaining cash is distributed to
owners/shareholders.
Lower Risk

Bondholders and Banks (secured)

Bondholders and Banks (unsecured) Bond and bank financing is

referred to as debt financing,
debt financing is the other
main source of finance for
Preference shareholders companies, we will cover this
later in the course

Ordinary shareholders

High Risk
Rights of Ordinary (Common) Shareholders
• Right to attend the AGM
• Right to vote on certain decisions
• Board of directors, auditors, takeovers

• Right to receive annual accounts and reports

• Right to receive a portion of any dividends paid

• Right to receive a share of the proceeds from the
liquidation of the firm
• After all the companies creditors and preference shareholders have
been paid

• Right to purchase new shares issued

• Pre-emptive right
 Firm’s Perspective
Advantages Disadvantages
• The capital amount does not • High cost
have to be repaid • It can be quite expensive to issue shares
• As they are risky, investors expect a high return
• The payment of dividends is
• Loss of control
optional, and so the firm can • Through voting rights, shareholders can exert
hold onto cash if needed control. Thus, entrepreneurs lose control when
• Shareholders cannot force a firm they sell shares.
into liquidation • Dividends are not tax deductible
• More equity makes a firm less
likely to go bankrupt

A Company’s Balance Sheet

 Investor Perspective

Advantages Disadvantages

• Higher potential return • No fixed return

• cash flows to shareholders are uncertain
• When a company prospers, the
benefits beyond its debt obligations • Risky – take first losses
accrue to shareholders • Conversely, if the company stumbles, the
shareholders suffer, assuming lenders can
still be replayed
• Voting rights (Control)
• Usually very liquid
Preference Shares
• The dividend is fixed in advance
• Dividend per share = Dividend % x nominal value of share
• Preference shares are higher up the liquidation ladder
• There are no voting rights
• Except when the dividend can’t be paid
• They are less risky than ordinary shares
• Preference dividends must be paid before ordinary dividends
• Share price is less volatile as the return is less subject to firm performance

Advantages (Firm) Disadvantages (Firm)

• Fixed dividend but not guaranteed, so there is Dividend paid is more expensive than interest paid on debt
flexibility in relation to paying dividends “Fixed” but not tax deductible
• Do not dilute entrepreneur’s control as there • Interest on debt has to be paid but has the
are no voting rights (usually) advantage of being tax deductible.
• Preference dividends are almost always paid but are
• An alternative to ordinary shares when not tax deductible.
financial gearing (debt) is high • Thus, they are like debt but don’t have one of the
benefits
 Valuing Shares: Discounted Cash
Flow Method

It values a share as the present value of its expected future cashflows,

applying a discount rate that reflects the riskiness of the cashflows.
 Two fundamental economic principles of valuation

1. Investors Purchase Securities for their Future Cash Flows

• Investors acquire and value stocks (and other financial securities) for the
future cash flows they generate.
• The future cash flows from stock come as dividends as well as the proceeds
from the subsequent sale of the stock.
• The future cash flow from debt securities (bonds) come as interest payments
and the return of their principle.

2. Investors Require higher Expected Payoffs for Riskier Investments

• Investors must be rewarded for investing in riskier types of securities or riskier
firms.
• They will only invest in a riskier stock or bond if they anticipate that it will
provide them with a higher return than less risky assets.
 Valuing Shares
• The Discounted Cash Flow Method is a method for valuing investments, where the value
of an investment is the present value of all the cash flows the investment provides
Ct
PV 
1  r t
• The cash flows provided by a share are the dividends the shareholder receives and the
share price at the investment horizon (H)

• The market value of a share is the present value of the future cash flows it will generate

• Equity value = PV (expected future dividends)

= PV(= + +…

• We call ‘’ the required rate of return on equity (the return shareholders demand) or the cost of
equity capital (the return that a firm needs to pay shareholders)
• The more risky the firm the higher the required rate of return
 Equity value using Dividend discount model
• At the beginning of 2018, two companies invested €80 million to create a joint venture, Short-life Pharma.
It used the money to construct a plant and would produce a drug for sale in developing markets. Operating
profits before depreciation were €50 million for 2018, €40m for 2019 and €30m for 2020. All operating
profits were paid out as dividends, it was in a tax free zone and the company would terminate at the end of
2020 with no remaining value. The partners expected to earn a 10% return given the risk of the investment.
What is the value of the company’s equity?

Equity Value = +
However, most firms don’t
Equity Value = +
only exist for 3 years!

Year Dividend PV factor How do you value

2018 50 0.9091 45.45 something that lasts
2019 40 0.8264 33.06
forever?
2020 30 0.7513 22.54
Equity Value 101.05
 Example: Valuing Shares
Current forecasts are for XYZ Company to pay dividends of $3.00, $3.24, and $3.50 over the
next three years, respectively. At the end of three years you anticipate selling your stock at
a market price of $94.48. What is the price of the stock given a 12% required return (the
rate used to discount back to PV)?

PV = + +…

PV = +

PV = +

PV = +
 Valuing Shares: Dividend Discount Model (DDM)

The two basic versions of the DDM assume that:

1. Dividends stay constant forever and thus the 2. Dividends grow at a constant rate per annum and
share can be valued as a perpetuity: thus can be valued as a growing perpetuity:

Value of stock with constant Value of stock with constant growth:

dividends :
DDM: Constant Dividends
• The constant dividend discount model is unsuitable for valuing ordinary shares as
dividends on ordinary shares do not stay constant
• They grow or decline depending on board of directors and company performance

• However, dividends on preference shares can be considered constant, and thus can be
valued using this model
C
PV perpetuity 
r

• DPS, the cash flow, is the constant dividend paid on each share,
• , the discount rate, is the return required by preference shareholders. It is the discount
rate for valuing preference shares.
 Example: DDM Constant Dividend
(Preference Share)
• What is the value of a stock that pays a €1.20 dividend indefinitely? Assume
shareholders require a 9% return.

DPS = €1.20, r = 9% or 0.09

DDM: Constantly Growing Dividends
• A more realistic assumption about dividends on ordinary shares is that they
grow at a constant rate
• Firms tend to try to maintain a constant growth in earnings and dividends, thus it is a
reasonable model

• Therefore, an ordinary share can be valued using as a growing perpetuity

C1 𝐷𝑃𝑆 1
PVgrowing perpetuity  𝑃0=
rg 𝑟𝑒− 𝑔

• Where:
• DPS1, next year’s cash flow, is the dividend paid to each share next year,
• , the discount rate, is the return required by ordinary shareholders,
• g, growth rate, is the is the constant growth in dividends
 Example: DDM Constantly Growing
Dividend (Ordinary Share)
• What is the value of a stock that expects to pay a $3.00 dividend next year,
and then increase the dividend at a rate of 8% per year, indefinitely?
Assume shareholders require a 12% return.
𝐷𝑃𝑆 1
𝑃0=
𝑟𝑒− 𝑔
DPS1= $3.00, = 0.12, g = 0.08

= €75
 Dividend Discount Model
• Which is the more expensive share:

• One that pays a €4.60 dividend indefinitely when shareholders require a 10% return.

or

• One that expects to pay a €2.75 dividend next year, and then increase the dividend at a
rate of 6% per year, indefinitely when shareholders require a 13% return.
 Dividend Discount Model
• One that pays a €4.60 dividend • One that expects to pay a €2.75 dividend
next year, and then increase the dividend
indefinitely when shareholders require at a rate of 6% per year, indefinitely when
a 10% return. shareholders require a 13% return.

𝐷𝑃𝑆 1
𝑃0=
𝑟𝑒− 𝑔
€46

= €39.29
 DDM: The Growth Rate

• Firms can achieve growth in earnings by reinvesting a portion of their

earnings and earning a return on the investment

• The % retained is referred to as the retention ratio

• The rate of return earned is referred to as the return on equity

• This is not the same as the return required by shareholders

• Growth rate in earnings = retention ratio x return on equity

 Where G comes from?

Growth rate in earnings = retention ratio x return on equity

• How rapidly they grow depends on both:
• The proportion of earnings reinvested into the business (plowback ratio/retention ratio)
• The profit generated by those investments (Return on Equity: ROE)

• If firms maintain a constant payout ratio (1 – the retention ratio), dividends

also grow at this rate

Growth rate in dividends = retention ratio x return on equity

 The Growth Rate
• Earnings, Dividends and Retained Earnings grow at the same rate (g)
g = Retention ratio × Return on retained earnings

Or

g = b X ROE

• b= fraction of retained earnings (retention ratio)

• ROE: Return on Equity
 Example 1: DDM Constant Growth
• A firm retains 60% of its earnings each year and invests them at a rate of 15%.
If the dividend per share is expected to be €5 next year and shareholders
expect a return of 12%, What is the price of the share?

𝐷𝑃𝑆 1 g= b X ROE
𝑃0=
𝑟𝑒− 𝑔

g  0.6  0.15  0.09

€5.00
P0   €166.67
0.12  0.09
Example 2: DDM Constant
Growth
Pump plc has a retention ratio of 75% and a return on equity of 18%. The
company expects to pay a dividend of €0.15 next year and its shareholders
demand a return of 16%, how much would you pay for a share in this
company?
• g = b x ROE
• g = 0.75 x 18% = 13.5%

𝐷𝑃𝑆 1
𝑃0=
𝑟𝑒− 𝑔

= €6.00
 Example 3: DDM Constant Growth
Jo is considering purchasing shares in Firm Plc which has just paid a dividend per share of €2.40 from earnings
per share of €6. Firm reinvests the same proportion of earnings each year and it’s ROE is 20% Jo thinks the
required return on Firm’s shares is 14%. What price should she pay for the shares?

Earnings Payout ratio = = = 0.4

Retention Ratio = 1- 0.4 = 0.6

0.4

0.6
ROE = 20%

g = 0.6 x 0.20 = 0.12

Dividends Retained Earnings

= = .50
DPS1 = DPS0 x (1+ g)
DPS1 = x(1+ g)
DPS1 = x(1+ 0.12) =
 Example 4: DDM Constant Growth
You have been offered the opportunity to buy shares in Fuse Plc which has just
paid a dividend per share of €1.10 from earnings per share of €6.75. The firm
reinvests the same proportion of earnings each year with an ROE of 24% If
shareholders require a return of 23%, how much will you pay for each share?

DPS1 = €1.10 x (1+g) 𝐷𝑃𝑆 1

𝑃0=
g = b x ROE
𝑟𝑒− 𝑔
b = 1 – payout ratio
Payout ratio = DPS/EPS = 1.10/6.75 = 0.163
b = 1 – 0.163 = 0.837
€45.24
g = 0.837 x 24% = 20.08%

DPS1= 1.1 x 1.2008 = €1.32

 The Dividend Discount Model
• Value of no growth stock =

• Value of stock with constant growth =

• Value of stock with non constant growth =

PV of dividend from year 1 to horizon PV of stock

price at horizon
 The Equity Markets

Also referred to as the Stock Markets

E.g. The Irish Stock Exchange (ISE), the London

Stock Exchange (LSE), the New York Stock
Exchange (NYSE)
• All have equity and debt markets
Types of Private
Investors
• Angel Investors
• Investors who finance
companies in their earliest
stages of growth. Typically
wealthy individual investors.
• Corporate Venturers
• Corporations that offer venture
assistance to finance young,
promising companies.
• Private Equity Investing
• Investors who offer funds to
finance firms that do not trade
on public stock exchanges such
as the NYSE or NASDAQ.
• Venture capital is a subset of the • Private Equity – yourself, friends, VC investors
larger class of private equity
investing. • Going Public – issuing shares to be traded on a stock exchange
Primary market

where the company gets equity finance

 Secondary Market

 The secondary market is the market

where securities that have been
issued previously are traded.

 Secondary trading of common stock

occurs at several trading locations in the
United States: centralized exchanges and where the company’s shares are traded
the over-the-counter (OTC) market.
The Primary Market
• When a company lists on the Stock
Exchange it will sell its shares to the
public for the first time
• A primary offering: raise additional cash for
the company
• A secondary offering: founders and early
investors cash in some of their shares

• The first time a firm sells its shares to the public is commonly known as an Initial Public Offering (IPO)
• E.g. Snapchat's parent company, Snap, went public in March 2017.
• Its shares were priced at $17 each,
• It issued over 1.4 billion shares
• This gave the company a market valuation of almost $24 billion ($17 x 1.4 billion)

• Shares sold in an IPO are sold on the primary market

Preparing for an IPO is an expensive and lengthy process

 The IPO Process: The birth of a public company
Step 1: Select financial midwife (carefully)

These are called Underwriter and are usually The underwriter receives payment in the form of a spread - this is,
investment banking firms (or a syndicate). they are allowed by the company to sell the shares at a slightly higher
Have a triple role: price than they paid for them.
1. Providing the company with procedural and - Investment bank assumes the risk of not being able to resell to public
financial advice - Underwritten (firm commitment) vs. “Best Effort”
2. Buying the Stock
3. Reselling the stock to the market
Step 2: Register the issue with local regulator (SEC)

• Preparation of detailed and sometimes

cumbersome registration statement, which
contains:
• Information about the proposed financing
• The firm’s history
• Existing business Accurate &
• Plans for the future Complete

A Prospectus is then distributed

to the public

Step 3: Issue Prospectus

A document informing investors on the company's strategy, its
directors and management and includes past audited financial
statements.
 Step 3: Set Price
A member of the investment bank, the bookmaker, helps the company to decide
on an issue price.
• The issue price should be low enough to be attractive to potential investors
• But it should be high enough to allow the required finance to be raised
without the issue of more shares than necessary.

To gauge how much the stock is worth they might:

• Undertake discounted cashflow analysis
• Look at financial ratios (PE ratio etc) of the shares of the firm’s competitors
• Investor “roadshow” -> Build a book

• When the shares are issued in private to

institutional investors only it is referred to as ‘a
Step 4: Offering day placing’.
• When the shares are also sold to members of
the public it is referred to as ‘a public offer’.
 Advantages and Disadvantages of Going Public

• Access to large scale funding from diverse investors

• Increased growth potential due to greater access to funds
• Provides an exit route to venture capitalists
• Investors who took the initial risk can cash out by selling their shares
• Increased public exposure and prestige
• Acts as a marketing tool – receives a lot of publicity
• Makes borrowing money easier – lenders know the firm has met a certain
standard
• Makes mergers and acquisitions easier
• Can buy other companies with shares rather than cash
• Alternative method of paying employees
• Stock based compensation schemes where employees receive shares instead of
cash
 Disadvantages Of Going
Public
• Issuing shares is an expensive process
• Fees for accountants, solicitors and investment banks
• Administration fees and management time
• Opportunity costs of selling shares at a discounted price. Known
as “underpricing”, this is where shares are sold below their true
value

• Subject to shareholders expectations

• Directors must satisfy shareholders – more pressure to manage
the company well
• Subject to greater scrutiny and must disclose more information
• Entrepreneur may be ousted from the board of directors as
shareholders have voting rights
Seasoned Equity Offerings
(SEOs)
Seasoned Equity Offerings (SEOs)
• Once a firm has listed its shares on a stock exchange, it is easier and cheaper to
issue additional shares

• A number of methods can be used to issue new shares (we will focus mainly on
the first)
• Rights Issue
• Shares are sold to existing shareholders in proportion to the number of shares they own
• General Cash Offer
• Scrip Issue (bonus or capitalisation issue)
• Company reserves are converted into shares
• The aim is to reduce share price and improve liquidity of shares.
• Share Split
• The number of shares in existence is increased by reducing the nominal value and issuing more
shares
• The aim is to reduce share price and improve liquidity of shares
Note: Liquidity refers to the ease with which something can be bought or sold
 Rights Issues
• Remember shareholders have rights
• To vote, to receive any dividend paid, to receive a copy of the company’s annual
reports and financial statements

• Another right shareholders are granted is the pre-emptive right

• The pre-emptive right: firms must offer any new shares issued to existing shareholders
before offering them to new investors.

• Thus, the issue of shares to existing investors is referred to as a rights issue.

 Rights Issues
• Shares are issued on a pro rata basis e.g. 1 share for every four shares owned
• This ensures % ownership and control is preserved
Wayne owns 100 shares in Sunshine Plc. The company has 1 million shares in issue and
has announced it will issue 100,000 new shares, how many shares is Wayne entitled to
purchase?
• Sunshine plc has 1,000,000 shares in issue
• It will issue 100,000 new shares
• Therefore it is a 1:10 rights issue- 1,000,000 ÷100,000 = 10
• Wayne can buy 1 share for every 10 he owns
• He owns 100 shares

• So he can buy 100 ÷ 10 = 10 new shares

• His new shareholding is 100 + 10 = 110 shares
• He used to own 100/1,000,000 or 0.01% of the company
• He now owns 110/1,100,000 or 0.01% of the company.
• His voting (control) rights also change in the same way
• So the percentage of ownership and control is preserved!
 Rights
Issues
In normal circumstances shares trade with the pre-emptive right
• When a share can be bought with this right, it is trading cum-rights

• Shares in a rights issue are usually sold at a discount (15% to

20%)
• Makes the issue more attractive
• This is referred to as the rights issue price

• As a result, when a rights issue takes place, the share price will
decrease
• The opportunity to use the pre-emptive right has passed so the
shares are less valuable
• The price the share falls to what is called the ex-rights price
• But overall value of the company will go up by the amount raised
from the sale of the new shares (theoretically)
 Schedule of Rights Issue Example

2nd January 4th January 9th January 10th January 16th January 17th January

4. Shares trade ex-rights 5. Rights Issue takes

2. Company place
announces • An investor buying a
share from today • Shareholders on the
rights issue 3. Company finalises its list can purchase
cannot participate in
1. Shares trade as normal list of shareholders at the the upcoming rights the new shares at 6. Shares begin to
• The price of the share is close of business issue the rights issue trade cum-rights again
the cum-rights price • Because the shares no price • An investor buying
• This is the share price • Shareholders on this longer offer the same a share today will
quoted under normal list can participate in value of the pre- receive the pre-
circumstances the upcoming rights emptive right, share emptive right to
issue price falls to the ex- participate in the
rights price next rights issue

We can calculate the price the share will fall to, we call this the theoretical ex-rights price…
 Theoretical Ex-rights Price
• The theoretical ex-rights price is a weighted average of the cum rights price (Pcum) and
the rights issue price (Pri):
N old N new
Pex  Pcum   Pri 
N total N total
• Where:
• Pcum: Cum-rights price (share price in normal circumstances)
• Pex: Ex-rights price (share price just before a rights issue)
• Pri: Rights issue price (discounted price at which shares can be purchased in the rights issue)

• Nold: The number of shares in issue before the rights issue

• Nnew: The number of new shares being issued
• Ntotal: The total number of shares after the issue (Nold + Nnew)
Example: Theoretical Ex-rights Price
Nolig plc has in issue 2 million ordinary shares, currently trading at €2.10 per share.
The company decides to raise new equity funds by offering its existing shareholders the right to
subscribe for one new share at €1.85 each for every four shares already held (1:4).
What is the theoretical ex-rights price?
Pcum= €2.10 N old N new
Pri = €1.85 Pex  Pcum   Pri 
Nold = 2 million
N total N total
Nnew= 2 million/4 = 0.5 million
Ntotal= 2.5 million xx

xx =

Notice the company offers its existing shareholders the right to subscribe for 1 new share for every 4 shares already held (a
1:4 rights issue). This ratio is the same as the ratio of Nold:Nnew (2 million:0.5 million)
 Exercise: Theoretical Ex-rights Price

• John has just received a letter from Lights plc in

which he holds shares. The letter details
information in relation to a rights issue that the
company is offering. John can have 1 share for
every 3 he currently holds. He can purchase these
share at a price 10% below the current market
price of €3.00.
Example: Theoretical Ex-rights Price
• John has just received a letter from Lights plc in which he holds shares. The letter details
information in relation to a rights issue that the company is offering. John can have 1 share for
every 3 he currently holds. He can purchase these share at a price 10% below the current market
price of €3.00.
• What is the theoretical ex-rights price?
N old N new
Pex  Pcum   Pri 
N total N total
• Pcum= €3
• Pri = €3 x (1-0.1) = €2.70
= €3 x ¾ + €2.70 x ¼
• Nold = 3
= (€3 x 0.75) + (€2.70 x 0.25)
• Nnew= 1
= €2.25 + €0.675
• Ntotal= 4
= €2.93
The Value Of The Rights
• Shareholders may not wish to take up the rights

• However, they can sell the rights on to other investors

• The value of the rights is the difference between the theoretical ex-
rights price and the rights issue price

• This is usually measured on a per share basis

Example: The Value Of The
Rights
• For Nolig Plc, the value of the rights would be €2.05 - €1.85 = €0.20
• (theoretical ex-rights price -rights issue price)

• Investors would have the right to buy a share for €1.85 when it will be worth
€2.05 in the market

• Expressed on a per share basis (from the perspective of the seller) it is €0.20 / 4 =
€0.05
• The €0.20 relates to 4 shares
Rights Issues
Sexton plc has 40 million shares in issue and needs €20m for a new plant but does not
want to take on any more debt so it is going to raise equity finance for the plant through a
rights issue.
Shares in Sexton plc are trading at €2.50. The firm will issue 10 million shares. The shares
will be sold at a 20% discount on the current share price.
Pat owned 12 shares in Sexton prior to the rights announcement and is considering her
options. As her financial adviser, you must guide her as to

• The rights issue price

• The ex-rights price
• How her wealth will be effected if she subscribes for the issue
• How her wealth will be effected if she sells her rights
• How the situation will differ if Sexton issued 20 million new shares instead.
Solution:
The Rights Issue Price The Ex-rights Price
• Shares in Sexton plc are trading at N old N new
€2.50.
Pex  Pcum   Pri 
N total N total
• The shares will be sold at a 20%
discount on the current share price.
Pex = €2.50 x (40m/50m) + €2 x 10m/50m
= €2 + €0.40 = €2.40
• Pri = €2.50 – (€2.50 x 0.2)
= €2.50 - €0.50 Or it is a 1:4 issue (40 million old shares: 10 million new
shares)
= €2.00 So Pex = (€2.50 x 4/5) + (€2 x 1/5) = €2 + €0.40 = €2.40
The Wealth Effect for Pat if she Subscribes
• Decline in Price
• Pcum – Pex = €2.50=€2.40 = €0.10 loss per share
• Purchase share in 1:4 rights issue at €2
• €2.40 - €2 = €0.40 gain per 4 shares or €0.10 gain per share

• Value of rights= = = €0.10 per share

IF she Subscribes Sells her

Patrights
owned 12 shares Does Nothing
Decline in Price of existing -€1.20 Decline in Price of -€1.20 Decline in Price of existing -€1.20
shares (-€0.10 x 12) existing shares (-€0.10 x shares (-€0.10 x 12)
Increase in price of newly €1.20 12) €1.20
issued shares (€0.40x 3) Sale of rights (€0.10 x
12)
Change in Wealth 0 Shares and Cash 0 -€1.20
Wealth composition 15 Shares 12 Shares & 12
€1.20 Cash Shares
The secondary
market
 The Secondary Market
• Once the company’s shares have been sold on the primary market they
begin to “trade” on the secondary market
• The stock market where investors buy and sell between themselves

• The New York Stock Exchange (NYSE), The London Stock Exchange (LSE) are
two of the most famous secondary stock markets

• Companies don’t actually receive money from the secondary markets

• So why is “share price” so important and why are these markets relevant to
companies???
The Role of the
Secondary Market
• The secondary market provides a number of important functions to
companies
• They provide liquidity
• Liquidity refers to the ease with which assets can be turned into
cash

• They provide price signals

• The secondary market provides a good mechanism for a fair
valuation of a company
• It aids the efficient allocation of capital

• They provide discipline (market for corporate control)

• They dictate the required return investors demand (r)

Why do share prices change?
• The price of a share is simply the last price at which the share was bought /
sold by an investor

• It is determined by how much an investor is willing to pay for the share

• The amount an investor is willing to pay for a share is determined by his or

her opinion of the firm’s current and future performance
• i.e. whether or not the firm will make profits in the short-term and
the long-term, whether or not it can provide a return to shareholders
now and in the future

• This opinion itself is affected by factors that may affect the firms current
and future performance and profit.
• As these factors change, investors opinions change and share prices
change
Factors Affecting Stock Prices
• Firm specific events affect the share prices of individual firms, and tend to have a minor effect on the
prices of stock indices
• Law suit
• Strike
• Earnings shock
• Company fundamentals

• Market-wide events affect the share prices of many firms, and tend to have a major effect on the
prices of stock indices
• Inflation
• Government policy
• Central bank policy
• Energy costs
• Currency fluctuations
• Natural disasters
• Market sentiment
• Economic data
• Employment data
 Examples of
Stock Exchanges
• There are 29 companies listed on the Main
Market of the Irish Stock Exchange (Euronext
Dublin) with a combined market capitalisation of
approx. €178 billion.
• Market capitalisation = Share price x No. shares in
issue
• Listed companies include AIB plc, Diageo plc, Ryanair
Holdings plc.
• The Exchange also has a market for smaller
companies- The Euronext Growth Market

• There are over 1,400 companies from 40 sectors

on the Main Market of the London Stock
Exchange with a combined market capitalisation
of £3.7 trillion.
• Over the last 10 years, £366 billion has been raised
through new and further issues by Main Market
companies
• Listed companies include Tesco plc, JD Sports plc,
Sky plc.
• The Exchange also has a market for smaller
companies- The Alternative Investment Market
2020 data
Euronext Dublin's 25 highest market capitalization
for Irish domestic shares by the end of July 2022 (in millions of
Euros)
 Stock Market S&P 500
• An index represents theIndex
collective value of a group of stocks

• Each index is comprised of stocks with a common feature

• The stock market on which they are listed e.g. NASDAQ Composite
• Geographic location of the firm e.g. S&P 500 for US firms, FTSE 100 for UK firms, DAX for
German firms, Hang Seng for Hong Kong
NASDAQ Composite
• The industry in which they are located e.g. NASDAQ 100-Technology sector
• Often taken as indicator of overall economic performance

• It indicates the performance of the market as a whole i.e. are share prices in
general increasing, decreasing or staying the same

• How firms are chosen depends on the index and the firms that manage them e.g.
chosen by a committee, determined by total market value of capitalisation
Hang Seng FTSE 100
DAX
 Calculating The Index
• The index value / level / price is determined by the stock prices of
the constitute firms (Constituents)
• However, different indices are calculated in different ways

1. Sum of stock prices

• The share prices of all firms are added together
• The share prices of larger firms are not given greater weighting or importance i.e.
€1 change in the price of any share has the same effect on the price of the index.

2. Market-value weighted
• The share price of each firm is multiplied by the value of the particular
firm and divided by the total value of all firms, and then added together
• The share prices of larger firms are given greater weighting or importance i.e. €1
change in the price of a large firm has a greater effect on the index price than a €1
change in the price of a small firm

3. Fundamentally weighted
• Weighting is based on firm characteristic e.g. Sales, total assets, rather
than on total market value
 Example: Calculating The
Index
• The following information relates to 5 firms whose shares are trading on the London
Stock Exchange:
Firm 1 Firm 2 Firm 3 Firm 4 Firm 5
Share Price £5 £0.80 £20 £10 £50
Market Value £500m £900m £1,000m £4,000m £750m
Sales £200m £350m £600m £1,200m £180m

• Calculate a stock index comprised of these 5 stock prices using the following methods
• Sum of stock prices
• Market-value weighted
• Fundamentally weighted
 Firm 1 Firm 2 Firm 3 Firm 4 Firm 5

Share Price £5 £0.80 £20 £10 £50

Market Value £500m £900m £1,000m £4,000m £750m

Sales £200m £350m £600m £1,200m £180m

• Sum of stock prices

Index Value  £5  £0.80  £20  £10  £50  85.8

• Market value weighted

• Total market value = £7,150m
£500m  £5 £900m  £0.8 £1,000m  £20 £4,000m  £10 £750m  £50
Index Value     
£7,150m £7,150m £7,150m £7,150m £7,150m
 14.1

• Fundamentally weighted
• Total sales = £2,530m £200m  £5 £350m  £0.8 £600m  £20 £1,200m  £10 £180m  £50
Index Value     
£2,530m £2,530m £2,530m £2,530m £2,530m
 13.5
 Example: Calculating The Index
• The following information relates to 6 firms whose shares are trading on the Irish
Stock Exchange, together they make up the Nation Six Index:

Ireland plc England France Italy plc Wales Scotland

plc plc plc plc
Share Price €9.70 €2.75 €6.60 €4 €7.50 €0.20
Market Value €100m €30m €70m €55m €90m €10m
Total Assets €18m €8m €12m €10m €16m €6m

• Calculate a stock index comprised of these 6 stock prices using the following
methods
• Market-value weighted
• Fundamentally weighted
 Ireland plc England France Italy plc Wales Scotland
plc plc plc plc
Share Price €9.70 €2.75 €6.60 €4 €7.50 €0.20
Market Value €100m €30m €70m €55m €90m €10m
Total Assets €18m €8m €12m €10m €16m €6m

• Market value weighted

• Total market value = €355m
€9.70 x 100 + €2.75 x 30 + €6.60 x 70 + €4 x 55 + €7.50 x 90 + €0.20 x 10
€355m €355m €355m €355m €355m €355m

= 2.732 + 0.232 + 1.301 + 0.62 + 1.901 + 0.006

= 6.792

• Fundamentally weighted
• Total total assets = €70m
€9.70 x 18 + €2.75 x 8 + €6.60 x 12 + €4 x 10 + €7.50 x 16 + €0.20 x 6
€70m €70m €70m €70m €70m €70m

= 2.494 + 0.314 + 1.131 + 0.571 + 1.714 + 0.017

= 6.241
 Weight (%)

75

65

55

45

S & P 500
Constituent
Weight
35

weights 25

15

Apple Microsoft Amazon Tesla Alphabet Alphabet Berkshire United Johnson & Exxon Mobil Other
Class A Class C Hathaway Health Johnson Corporation
Inc. Class B Group In-
corporated
Weight (%) 7.125518 5.568143 3.37362 2.513518 1.887087 1.700193 1.536087 1.496418 1.334876 1.186003 72.278537

Axis Title
Any
Questions?