Unit 5 - Financial Assets and Business Finance

Americans love to shop. Spend some time in the Buckhead section of Atlanta where wealth is on display in a constant parade. There are sections of Buckhead where the homes resemble palaces that would suit an emperor. These estates site on acres of perfectly manicured lawns and tended gardens that easily exceed many city parks. The main roads of Buckhead are jammed with Jaguars, Range Rovers (good protection against the charging rhinos that plague the area), Mercedes and more of the latest and most expensive luxury cars. Many of the cars are driven by people in a rush to go shopping at the plentiful malls and shops in the area. On weekends you may end up spending an hour just trying to park at the popular Lenox Mall. Of course, the rich are not bothered with parking. After spending a good twenty minutes just to enter the mall parking lot, the wealthy shopper inches his or her car up to valet parking.

For those of us who were not born rich or have a job that pays an endless supply of money, witnessing the parade through Buckhead and America's obsession with consumption becomes unsettling. And thus the moral of this unit is "if you can't join them, then save." Aside from merchants, shopping and consumption generates wealth for savers who invest their money wisely. This unit will cover common types of financial assets and give the reader a basic understanding of what drives financial markets.

How Corporations Raise Money in Capital Markets

Stocks (equity)

So you are smart. Open the newspaper, surf the Web and read about Yahoo, Amazon, Ebay and other Internet-based commerce. These companies went from an entrepreneur with a great idea to companies with multibillion-dollar valuations overnight - well actually it took a few years.

And you have the next great idea, the Web site and the ability to catch the wave of the Internet money printing press. Your site is a smash. The hit counter is spinning faster than McDonald's cheeseburger sales. What you don't have is money, and you need plenty of it to expand into an Internet empire of commerce, and you need it soon before new competitors take away your customers.

Assuming that you don't have a rich aunt Betty or access to venture capital directly provided by outside investors, you incorporate in order to take the next step to raising money.

Soon, as the CEO of your corporation, you are chumming with Wall Street's finest investment bankers. Merrill Lynch, Goldman Sachs, Bears Stern and many other investment banking firms are sending out their brightest and best talking advisors to wine and dine you, trying to convince you to underwrite your IPO (initial public offering) with their firm. You settle on Morgan Stanley, the firm that started the entire Internet frenzy on Wall Street by underwriting Netscape's IPO and many of the other hot Internet IPOs that you wish to emulate. Morgan floats a total of five million shares of your company's stock. You keep five hundred thousand shares for yourself as the primary owner and the other 4.5 million hits the street.

Morgan Stanley sets the initial price of your stock at $20 a share on the primary market, it opens on the NASDAQ for trading at $74 a share. Within weeks, the day traders have migrated to your company as the stock to trade. Daily volume soars to over six million shares. The price of your company's shares soars and the value of your personal share holdings goes from $100 million, then $500 million and soon you are worth over a billion dollars. You announce a 4-for-1 stock split. The news sets off a frenzy and a noted astrologer and market seer predicts that the price of your company's stock will "rise to the heavens."

Why do people buy stock in a company? The majority of business in America is carried out by private corporations that have public ownership. These corporations sell stock (equity) or stocks that allows for anyone who can afford it to buy shares of that company. Thus owning shares of stock in a corporation implies that you are a partial owner of that company. However, unless you have a huge block of shares, don't expect to be welcome at the next board meeting.

Some companies pay dividends on their shares. For example, a company may pay a dividend of $1 per share. Someone who owns 100 shares will receive $100 annually (paid in quarterly increments). Dividends represent a part of profits that are paid out to the company owners (its shareholders).

The price of a companies stock is determined by four primary factors:

  1. earnings growth,
  2. interest rates,
  3. the magnitude of dividends, and
  4. market forces.

When an investor buys stock in a company he or she becomes a partial owner of that company. In the most basic sense, share prices reflect the business conditions of the corporation. If the company is doing well, it is likely that the prices of its shares will rise, and they will certainly fall when the company faces a prolonged period (perhaps six months, usually less) of weak business conditions. Stock prices reflect how a business is doing and even more importantly, what the corporation is expected to do in the near future.

Earnings growth reflects the business conditions of a corporation. If quarterly and annual revenues and earnings are consistently rising (earnings = revenues - costs) then investors will want to own a part of that company. On the stock market, net purchases will increase and the price of a share will also rise. In contrast, beware the company that faces slowing earnings growth, its share price will be punished as investors flee for more promising corporations.

Stock prices are often based on the "consensus" of professional analysts that study the company in question and project earnings and earnings growth.

Unless that market is going into the tank, everyone loves a company that surpasses its quarterly earnings estimate. But the company that surprises investors and fails to meet expectations may see the price of its shares fall dramatically (perhaps 25% to 50%) within minutes of the news as institutional investors rush to sell. Earnings growth is often highly correlated to economic conditions. If macroeconomic growth is rising, so is the demand for a typical company's products and thus revenues and earnings should also increase - leading to an appreciation of the company's share price.

A common measure of an individual stock's price in comparison to the prices of other stocks is to use the Price to Earnings Ratio (P/E ratio). Price in the equation refers to the current market price of a stock. Earnings equals the earnings per share of the same stock. To calculate earnings per share, you take the dollar amount of profits that the firm has earned in the latest reported quarter and divide the earnings by the number of shares the firm has outstanding and thus are held by shareholders. For example, if the price of IBM as traded on the New York Stock Exchange equals $120 a share and the company is earning $4 a share, then IBM's P/E ratio equals 30.

Firms that have rapidly growing earnings are usually rewarded with high P/E ratios A high P/E ratio reflects expectations that future profits will increase significantly and steadily. You can do the basic math. If future earnings are expected to increase substantially then the value of earnings per share (E in the P/E equation) will also increase and the future P/E ratio will not be inflated. For example, assume that the current price of Dell Computer results in a current P/E of 50 while other comparable stocks of computer manufacturers (e.g. Compaq) trade at a P/E of 25. It would appear that the price of Dell's shares are overvalued and due for a correction to reflect the average P/E of stocks in the computer manufacturer sector. However, Dell's P/E is calculated based on trailing earnings. If Dell's future earnings are expected to grow twice as fast as those of its competitors, then the current market price reflects a fair valuation of Dell.

During the 1990s, Dell Computer was the best performer of any stock traded. Investors who purchased 100 shares of Dell stock for about $2,500 ($25 a share) in the early 1990s and held on found the value of their Dell holdings had risen to roughly $250,000 by the beginning of 1999 (Dell split a number of times during the decade). However, in early 1999 Dell's rate of earning growth began to slow (from about 100% annually to the 40% range). As a result, the price of Dell Computer shares took a tumble and as a result, the P/E of Dell fell substantially as well to reflect new earnings expectations. Long-term Dell shareholders were still doing very well regardless.

Interest Rates have an inverse effect on the stock market. Rising rates almost always lead to lower stock prices as the overall market sinks. In this case, few companies will be able to maintain their share price in the face of a unraveling stock market. There are two reasons why the stock market is hard hit by higher market interest rates. For the macroeconomy, higher interest rates will lead to slowing economic growth. Slower economic growth impacts the typical corporation with lower sales, revenues and profits. Thus higher interest rates leads to an expectation of lower earnings growth and stock prices adjust downward to reflect the new outlook.

Interest rates also affect stock prices for the reason of opportunity cost. As interest rates rise, the return on alternative investments increases. Yields on bank certificates of deposit, bonds, and other interest bearing assets rises, making the dividend yield of stocks lower in comparison. Yield sensitive savers may move some of their money out of stocks and into interest bearing assets. Sometimes expected interest rate movements are as important in determining investor behavior as do actual changes in interest rate. If there is a common belief that interest rates will rise in the future, then present stock prices will reflect the expectations and the market will fall.

Although the concept is not important for this course, higher interest rates may also lead to an appreciation of the domestic currency. The consequence is a drop in exports and greater substitution of imports for domestically made goods by consumers. The net effect is to further slow growth.

It should not come as a surprise that falling interest rates (or the expectation of a decrease in interest rates in the near future) often results in a stock market boom as the earnings growth outlook improves.

For everything else being equal, the higher the dividend, the higher a company's share price. Many companies may not pay any dividend and instead use the majority of profits for research and development and to increase their capital stock. The goal is for higher future earnings growth.

Market forces represent a critical item in determining a stock's price. If the market as a whole is falling due to a poor economic outlook or because institutional(1) investors are engaged in another one of their frequent irrational panics, even the best stocks may not be able to withstand the force of the overall market. Or, a strong bull market may lift the prices of the majority of stocks despite constant fundamentals for individual companies.

Market forces may also represent a segment of the market. Certain stock groups may become very popular and show tremendous price appreciation simply because investors are trading on momentum. In this case, economic and company fundamental are basically ignored in favor of making a rapid capital gain. The most recent example is the mania for Internet stocks that began in 1998. Individual investors known as day traders bid up the prices of Internet stocks to stratospheric levels.

(1) An institutional investor is a person who manages large sums of money. For example, the managers of popular mutual funds may control billions of dollars and manage large blocks of stock in hundreds of companies.

Bonds (debt)

You are strolling down the sidewalk, wearing your favorite pair of sunglasses on a warm afternoon. Suddenly, you bump into a sort-of friend whom you haven't seen for awhile: Luther Flash. Luther needs to borrow four hundred dollars for needed tattoo enhancements and body piercing to remain on the cutting edge of painful coolness. He knows that you can easily part with the money and promises to pay you back all four hundred dollars in about a year. Luther's reputation is stellar so you aren't worried about him skipping out of town. Plus he is dating Velvet Quick who is a good friend of yours.

How do you respond to his request?

Perhaps you disagree with Luther's choice of nose rings and adamantly refuse.

Or perhaps you simply whip out four hundred dollars from your wallet and bask in Luther's good will for the next year.

More likely, you draw upon your deepening reservoir of economic knowledge and realize that the four hundred dollars Luther pays you back in a year from now is not going to be worth as much as the four hundred dollars that you lend to him today.

Money loses value over time due to inflation or rising prices. To adjust for inflation, the price of money is measured in terms of the interest rate. There are many different interest rates present representing different lengths of time and levels of risk.

Acting fast, you collar a disoriented businessman and grab his copy of the Wall Street Journal and flip to the table of market interest rates. You see that the one-year Treasury bill is at 4.50% before flinging the newspaper at the fleeing businessman who catches it in stride.

Since Luther is good for his word, you offer to make the loan with a 4.50% interest rate, deciding that there is no need to add a risk premium. In another year, Luther will pay you back your $400 plus an additional 4.50% of that amount.

Corporations may also issue bonds to raise money. For example, in March of 1999, AT&T issued about $10 billion in new bonds. The money will be used by AT&T to finance its expansion of the cable television network to include telephone and Internet services. Bonds represent a loan from the purchaser to the issuer of the bond. Like most loans, a bond is fixed in duration and also has a fixed interest payment. If you purchased one of the newly issued AT&T 5-year bonds in March 1999, you would have loaned $1,000 to AT&T since the value of a single newly issued bond equals $1,000. In return you would receive an interest payment (coupon) on your loan. If the 5-year AT&T bond carries a coupon of 6%, then AT&T will pay $60 a year for the next five years to the bondholder. When the bond matures in the year 2004, and you are still the bond owner, you will receive the original $1,000 value of the bond plus that year's interest payment.

Like stocks, bonds are actively traded on secondary markets. Examples of secondary markets include the New York Stock and Bond Exchanges and the NASDAQ markets. Although you may have purchased a single, newly issued AT&T bond for $1,000 in 1999 there is nothing that prevents you from selling the bond in the secondary market before it matures in 2004. Perhaps you need the money or you may want to lock in a capital gain. Capital gains represent the appreciation of an asset's value from its purchase price. If you sell the AT&T bond in 2002 for $1,050, then your capital gain is $50.

The interest rate or coupon on newly issued bonds is adjusted for several factors: (for each, hold all other factors constant)

The Equilibrium Interest Rate

There is a wide spectrum of interest rates from an overnight lending rate to a thirty year Treasury bill rate, with hundreds of rates in-between. Often times, interest rates move in the same direction by a similar magnitude. For example, if the Federal Reserve Board lowers the overnight fed funds interest rate by 25 basis points (which equals 0.25% or a quarter percent) then it is likely that other interest rates will also fall and by an amount in the range of 25 basis points. Of course different markets may have varying characteristics. For example, the 30-year mortgage rate may barely budge while the prime-lending rate may fall by an even greater amount than the fed funds rate.

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If we assume that all interest rates change by an identical magnitude, then we can determine the value of an average interest rate in the capital market as shown in Figure 5-1. In the graph the demand for loanable funds is determined by the demand by domestic corporations for money in the bond market. For example, in the spring of 1996, AT&T issued billions of dollars of new bonds in the capital market, resulting in an increase in the demand for loanable funds.

As shown in the graph, the supply of loanable funds is comprised of three parts:

As noted, public savings is part of the supply of savings. Consider the U.S. economy in 1993 when President Clinton took office. U.S. interest rates were very high due in large part to the huge federal government budget deficits that were irresponsibly rung up during the 1980s and early 1990s. A deficit implies negative savings and as a result of government fiscal policy, the supply of loanable funds was significantly reduced.

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In 1993, Clinton took the politically unpopular route of raising taxes in order to reduce the federal budget deficit. The effect on interest rates is shown in Figure 5-2. A reduction in the size of the government budget deficit has the effect of increasing the supply of savings and as shown in the graph, shifting the supply of loanable funds curve to the right and the rate of interest (r) declines as a consequence. Clinton's tax increase set off an economic revival. As interest rates fell, business investment and consumer spending took off and the stock and bond markets soared. The result was increases in jobs, wages, profits and capital gains, leading in turn to higher tax collections. The deficit continued to shrink, government borrowing became a surplus by the later part of the 1990s and the supply of loanable funds continued to increase. Another important factor during this time period was substantial inflows of foreign money seeking a higher return in U.S. financial assets.

Next let us ponder the effect of changes in the inflation outlook. Consider the case of a boom economy leading to increasing inflationary pressures. If investors see higher inflation on the horizon, they may pull some of their money out of the capital markets fearing a decrease in asset prices in the near future. As investors sell of their bond holdings, they may move their money into areas better protected from inflation. Typical inflationary hedges include real estate, gold and foreign assets that are insulated from domestic inflation. As savers sell their bonds and move their money into inflationary hedges, the supply of loanable funds in the capital market decreases (money used to buy gold, real estate and foreign assets is not part of loanable funds in the capital market). A decrease in the supply of loanable funds will push up domestic interest rates.

Copyright © 2002, Jay Kaplan
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