Equity Markets, Valuation, and Analysis. H. Kent Baker
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price or value per share. A firm's management should theoretically try to maximize the market value of its shares. Therefore, a good secondary market is necessary for all marketable securities, not just stocks.
THE EQUITY MARKET AND THE ECONOMY
The equity market is important to the economy for several reasons.
Source of funding. Stock markets provide a source of funding for business entities. When companies enter equity markets to issue new shares, they often cite “investment needs” as the reason for their new issues. In such cases, by selling equity (ownership) to incoming stockholders, firms obtain funding for their current and future business developments.
Facility for allocating money. The equity market provides a great facility for allocating a scarce resource – money. In a well-functioning financial market, companies with the best performance and investment potential are likely receiving greater access to funding.
Imagine that investors face two stock investment options: Company A and Company B. Company A has outperformed the general equity market for the past 10 years and has a full pipeline of innovative projects and investments. Company B has underperformed the market for the past 10 years and has limited future potential. Of the two alternatives, most equity investors would choose Company A. This situation means that in equilibrium, Company A would receive more funding for the promising investment projects in its future. In contrast, the managers at Company B are likely to find obtaining funds both more difficult and expensive. Money flows to Company A because investors consider it a better alternative for obtaining future returns than Company B. However, in the real world, the choice is not just between Company A or B. Instead, the market provides investors with a wide array of other investments, allowing the allocation of funds to the industries, sectors, and businesses that investors find to be most appealing.
A way to send signals. Equity markets send credible signals to the marketplace, which have real effects on a country's economy. If the economy is booming, most companies are likely to enjoy higher profits and cash flows. Because stock prices are forward-looking, future profits and cash flows that do better than expected generally increase a firm's stock price. The reason is that investors perceive that these firms are more likely to provide dividends and/or capital gains in the future. If the market perceives that a firm's performance may falter, resulting in lower earnings, its stock price generally falls.
As a result, market signals indicating stock performance are important to the financial market are thus also considered reliable economic indicators. Through their ongoing trades in the secondary market, investors reveal and produce information about their expectations of the future profitability of alternative investment opportunities. This information is likely to be reflected in market prices; if more investors like a stock, its price tends to increase.
Similarly, if a stock is not favored, its price typically falls. Stock prices guide business managers' investment decisions after incorporating information from investors. If a chief executive officer (CEO) sees a substantial increase in the company's stock price, this situation can indicate that investors view the firm's performance potential positively and therefore approve of its publicly known operations and investment plans. The stock market is also a predictor of the rate of corporate investment. When the stock market is on the rise as indicated by increasing stock prices, this situation indicates improved profitability and often provides firms with lower financing costs. Financing costs are the hurdle rates firms must meet or exceed to produce economic value. With lower financing costs, firms find themselves with more lucrative investment opportunities.
These investment opportunities are also an important driver in labor markets: firm managers, anticipating a favorable economic environment and ample investment opportunities, may accept more projects to maximize firm value. A byproduct of such managerial decisions is the necessity for additional employees to meet product demand. The competition for available workers also has the potential to provide increased wages for currently employed workers. The improved labor markets, as shown by lower unemployment rates and increased wages, give employees more purchasing power as consumers. Figures 3.1, 3.2, and 3.3 show the relation among industrial production, the accompanying decrease in unemployment, and the ultimate increase in consumer spending. These consumers can buy more products and services offered by firms, which in turn drive firm profits and stock prices even higher, as shown in Figure 3.4.
However, although the stock market is generally a leading indicator, signals from the stock market can also further deteriorate economic conditions. During the financial crisis of 2007–2008, after the stock market lost value due to failures in the financial markets, companies processed the signals of bleak future profitability and in turn, reduced investments. As a result of reducing the level of future investments, companies required fewer workers to meet the demand for products and services, leading to higher unemployment rates. Facing job difficulties, among other uncertainties, consumers spent less, especially on big-ticket items such as automobiles and appliances. Declining sales negatively affected firms' profitability and stock price.
FIGURE 3.1 Industrial Production Index
This figure shows the trend of the Industrial Production Index in the United States between 2009 and 2019.
Note: The Industrial Production Index (INDPRO) is an economic indicator that measures real output for all facilities located in the United States manufacturing, mining, and electric and gas utilities, excluding those in U.S. territories.
Source: Board of Governors of the Federal Reserve System (U.S.) (2019).
FIGURE 3.2 Unemployment Rate
This figure shows the unemployment trend in the United States between 2009 and 2019.
Note: The unemployment rate represents the number of unemployed as a percentage of the labor force.
Source: U.S. Bureau of Labor Statistics (2019).
Vehicle affecting government revenue. The stock market is also related to government revenue streams. As previously discussed, a booming stock market is generally associated with higher company profitability and worker income. Both of these factors are important sources of government tax revenues. Relative to the increasing corporate profitability and market returns between 2012 and 2019, Figure 3.5 shows the accompanying increase in government revenues over the same period.
FIGURE 3.3 Personal Consumption Expenditures
This figure shows the trend of aggregate personal consumption expenditures in the United States between 2009 and 2019.
Note: As per the Bureau of Economic Analysis, consumer spending or personal consumption expenditures (PCEs) are the value of the goods