Told and untold myths of stock market
Wednesday, 19 May 2010
Anup Chowdhury
A "stock" is a share in the ownership of a company. It represents a claim on a company's assets and earnings. As one acquires more stocks, his or her ownership stake in the company becomes greater. In finance, a share is a unit of account for various financial instruments including stocks, mutual funds, limited partnerships, and real estate investment trust. In other way, a share or stock is a document issued by a company. This entitles its holder to be one of the owners of the company. Sometimes different words like shares, equity, stocks etc., are used. All these words mean the same thing.
So, what does ownership of a company give one? Holding a company's stock means that one is one of the many owners (shareholders) of a company and, as such, he or she has a claim to everything the company owns. This means that technically one owns a tiny little piece of all the furniture, every trademark, and every contract of the company. As an owner, one is also entitled to his or her share of the company's earnings as well. The company may distribute some or all portion of this earnings in the form of 'dividend', provided they do not have better use of this funds. However, the companies are not legally obligated to distribute dividends. Take the example of McDonald's Corporation. The company started in the 1950s, paid its first dividend in 1975. Though it was a billion-dollar company, Microsoft, which was established in 1975, paid its first dividend in 2003. If we analyse the history of dividend payment pattern of different companies, then we will see that firms with high growth rates are likely to pay no or lower dividends.
Hence, the Dhaka Stock Exchange (DSE) is categorising their listed companies on the basis of percentage of dividend declared each year, e.g., with 10% dividend a company can be listed in 'A' category. And failure to follow this instruction is penalised by downgrading to 'B' or 'Z' category. This regulation is hardly found in other stock exchanges of the world. Legal experts in company law may see this directive of the DSE to be ultravires of the real epitome of company formation or its operation. That is why, companies may be prohibited to talk about future dividend even in their prospectus. In addition to this, while becoming public, companies should have a dividend policy. This document is not found in the case of any firm operating in our country. However, Securities Exchange Commission (SEC) and DSE have not indicated anything about their stance on this issue.
Now, a question might come into one's mind about why the founders of a company would like to share the profits with thousands of people when they could keep profits to themselves. The reason is that at some point every company needs to "raise money". To do this, companies can either borrow the same from somebody or raise the amount by selling ownership of the company. The later is known as issuance of stock. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way.
Investors, on their part, enter the secondary market (stock market) with the hope that they can make money on a stock through the appreciation of its price. Sometimes they can earn 100% or more capital gain if the company is successful. However, by becoming an owner, investors also assume the risk of the company not being successful and, thus, may incur capital loss. At this point, it is noteworthy that investors' risk is locked by 'limited liability'. This means, as owners of a stock, investors are "not personally liable" if the company is not able to pay its debt.
Companies are sharing their profit with millions of shareholders only to raise equity funds from the capital market. But what would be the situation when sponsors themselves are in the capacity of financing maximum part of their fund requirements? This will then mean general investors will be fighting for only a small portion of shares available in the market and pull the demand curve. This is very true in our capital market. In most of the companies sponsors are holding more than 50% of the shares and in some instances, the percentage soars up to ninety. As our market regulators are talking about market correction, price stabilisation, lack of supply, increase of market depth, fundamental analysis before investment and so on, then why are the SEC and DSE allowing this big holding? Is it because of poor demand for initial public offerings (IPOs)? We believe the demand for IPOs is not low. The subscription result of last ten IPOs does not allow us to draw any contrary conclusion. In most cases, all such issues were oversubscribed five to ten times. This high demand shows investors' confidence in those IPOs and ultimately, when such shares are traded in the secondary market, their prices rise to unexpected height. Thus, genuine investors are not getting time for their fundamental analysis. Moreover, when excess demand makes the share overpriced, market regulators then intervene in the name of market correction. Who is the loser in this correction process? Obviously, the small investors, who bought those shares observing the market trends before intervention.
There is a confusion about the definition and implication of face value of shares in our market. The face value of a common stock is the nominal value assigned by a corporate charter, and has no specific financial relevance after the issue date. It is also known as par value of share and a company decides what will be the par value of its share. However, it depends on two different factors: authorised capital and number of shares they want to issue. Authorised capital is the maximum capital a company can raise in its lifetime and is mentioned in its legal documents (Article of Incorporation and Memorandum of Association). A company also decides how many investors they want to share their ownership, i.e., the number of shareholders. When authorised capital is divided by the number of shares, a company gets face value or par value of its share.
In our capital market we have experienced certain comments on face value, e.g., no firm can issue share for more than Tk. 10 or Tk. 100. There is, thus, a strong trend to ensure a uniform face value for all companies to minimise the ambiguity between market price and par value. This has largely misguided the investors because fundamentally face value has no connection to the market price and not even is a determinant. For example, if there are two companies with net asset value of Tk. 500, the share of one can have a face value of Tk. 10 and that of the other, Tk. 100. In that case, what would be the expected market price of shares of each company or at what price an investor should buy the share from that the market, assuming the risk and all other market-related parameters are exactly the same for both companies? Both the shares should definitely be traded in the market at around Tk. 500 (±). Now the question is, how is the face value creating ambiguity in this case? Or how is this 'non-uniformity' of the face value misdirecting the investors? The regulatory body might have different explanations. Furthermore, the company law provides no scope for such 'uniformity' or 'ambiguity'. The law says company is the only authority to determine their par value.
One more issue related to face value and market value may be discussed here. Fundamentally, they have no connection. For any shareholder, the price of a stock (market value) is equal to what he or she has paid for it in the secondary market, other than IPOs. Even, if the firm issues shares at a premium, the price will be more than par value at the time of subscription for IPOs. Nonetheless, at a later date when companies announce earnings, they declare the same on face value because of accounting convenience. So as an investor, one needs to calculate the value of his or her return, as compared to market value, not on par value. Let this issue be illustrated with an example. Let us say one has bought one share at Tk. 200 (investor's investment is Tk. 200) from the market, whereas its face value is Tk. 10 and then the concerned company announces 50% dividend. In that case, the investor will receive Tk. 5.0 (Tk. 10 x 50% x 1 share) on his or her investment. Therefore, his or her actual return (dividend only) on one share is 2.5% (Tk. 5.0/Tk. 200). Based on this calculation, the distinction between par value and market value is clearly visible. An investor might become very happy over the announcement of 50% dividend on par value; however, the eventual impact on his or her wealth is only 2.5%. It is a tricky game!
The writer is a Senior Lecturer at BRAC Business School and can be reached at
e-mail: anup@bracu.ac.bd
A "stock" is a share in the ownership of a company. It represents a claim on a company's assets and earnings. As one acquires more stocks, his or her ownership stake in the company becomes greater. In finance, a share is a unit of account for various financial instruments including stocks, mutual funds, limited partnerships, and real estate investment trust. In other way, a share or stock is a document issued by a company. This entitles its holder to be one of the owners of the company. Sometimes different words like shares, equity, stocks etc., are used. All these words mean the same thing.
So, what does ownership of a company give one? Holding a company's stock means that one is one of the many owners (shareholders) of a company and, as such, he or she has a claim to everything the company owns. This means that technically one owns a tiny little piece of all the furniture, every trademark, and every contract of the company. As an owner, one is also entitled to his or her share of the company's earnings as well. The company may distribute some or all portion of this earnings in the form of 'dividend', provided they do not have better use of this funds. However, the companies are not legally obligated to distribute dividends. Take the example of McDonald's Corporation. The company started in the 1950s, paid its first dividend in 1975. Though it was a billion-dollar company, Microsoft, which was established in 1975, paid its first dividend in 2003. If we analyse the history of dividend payment pattern of different companies, then we will see that firms with high growth rates are likely to pay no or lower dividends.
Hence, the Dhaka Stock Exchange (DSE) is categorising their listed companies on the basis of percentage of dividend declared each year, e.g., with 10% dividend a company can be listed in 'A' category. And failure to follow this instruction is penalised by downgrading to 'B' or 'Z' category. This regulation is hardly found in other stock exchanges of the world. Legal experts in company law may see this directive of the DSE to be ultravires of the real epitome of company formation or its operation. That is why, companies may be prohibited to talk about future dividend even in their prospectus. In addition to this, while becoming public, companies should have a dividend policy. This document is not found in the case of any firm operating in our country. However, Securities Exchange Commission (SEC) and DSE have not indicated anything about their stance on this issue.
Now, a question might come into one's mind about why the founders of a company would like to share the profits with thousands of people when they could keep profits to themselves. The reason is that at some point every company needs to "raise money". To do this, companies can either borrow the same from somebody or raise the amount by selling ownership of the company. The later is known as issuance of stock. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way.
Investors, on their part, enter the secondary market (stock market) with the hope that they can make money on a stock through the appreciation of its price. Sometimes they can earn 100% or more capital gain if the company is successful. However, by becoming an owner, investors also assume the risk of the company not being successful and, thus, may incur capital loss. At this point, it is noteworthy that investors' risk is locked by 'limited liability'. This means, as owners of a stock, investors are "not personally liable" if the company is not able to pay its debt.
Companies are sharing their profit with millions of shareholders only to raise equity funds from the capital market. But what would be the situation when sponsors themselves are in the capacity of financing maximum part of their fund requirements? This will then mean general investors will be fighting for only a small portion of shares available in the market and pull the demand curve. This is very true in our capital market. In most of the companies sponsors are holding more than 50% of the shares and in some instances, the percentage soars up to ninety. As our market regulators are talking about market correction, price stabilisation, lack of supply, increase of market depth, fundamental analysis before investment and so on, then why are the SEC and DSE allowing this big holding? Is it because of poor demand for initial public offerings (IPOs)? We believe the demand for IPOs is not low. The subscription result of last ten IPOs does not allow us to draw any contrary conclusion. In most cases, all such issues were oversubscribed five to ten times. This high demand shows investors' confidence in those IPOs and ultimately, when such shares are traded in the secondary market, their prices rise to unexpected height. Thus, genuine investors are not getting time for their fundamental analysis. Moreover, when excess demand makes the share overpriced, market regulators then intervene in the name of market correction. Who is the loser in this correction process? Obviously, the small investors, who bought those shares observing the market trends before intervention.
There is a confusion about the definition and implication of face value of shares in our market. The face value of a common stock is the nominal value assigned by a corporate charter, and has no specific financial relevance after the issue date. It is also known as par value of share and a company decides what will be the par value of its share. However, it depends on two different factors: authorised capital and number of shares they want to issue. Authorised capital is the maximum capital a company can raise in its lifetime and is mentioned in its legal documents (Article of Incorporation and Memorandum of Association). A company also decides how many investors they want to share their ownership, i.e., the number of shareholders. When authorised capital is divided by the number of shares, a company gets face value or par value of its share.
In our capital market we have experienced certain comments on face value, e.g., no firm can issue share for more than Tk. 10 or Tk. 100. There is, thus, a strong trend to ensure a uniform face value for all companies to minimise the ambiguity between market price and par value. This has largely misguided the investors because fundamentally face value has no connection to the market price and not even is a determinant. For example, if there are two companies with net asset value of Tk. 500, the share of one can have a face value of Tk. 10 and that of the other, Tk. 100. In that case, what would be the expected market price of shares of each company or at what price an investor should buy the share from that the market, assuming the risk and all other market-related parameters are exactly the same for both companies? Both the shares should definitely be traded in the market at around Tk. 500 (±). Now the question is, how is the face value creating ambiguity in this case? Or how is this 'non-uniformity' of the face value misdirecting the investors? The regulatory body might have different explanations. Furthermore, the company law provides no scope for such 'uniformity' or 'ambiguity'. The law says company is the only authority to determine their par value.
One more issue related to face value and market value may be discussed here. Fundamentally, they have no connection. For any shareholder, the price of a stock (market value) is equal to what he or she has paid for it in the secondary market, other than IPOs. Even, if the firm issues shares at a premium, the price will be more than par value at the time of subscription for IPOs. Nonetheless, at a later date when companies announce earnings, they declare the same on face value because of accounting convenience. So as an investor, one needs to calculate the value of his or her return, as compared to market value, not on par value. Let this issue be illustrated with an example. Let us say one has bought one share at Tk. 200 (investor's investment is Tk. 200) from the market, whereas its face value is Tk. 10 and then the concerned company announces 50% dividend. In that case, the investor will receive Tk. 5.0 (Tk. 10 x 50% x 1 share) on his or her investment. Therefore, his or her actual return (dividend only) on one share is 2.5% (Tk. 5.0/Tk. 200). Based on this calculation, the distinction between par value and market value is clearly visible. An investor might become very happy over the announcement of 50% dividend on par value; however, the eventual impact on his or her wealth is only 2.5%. It is a tricky game!
The writer is a Senior Lecturer at BRAC Business School and can be reached at
e-mail: anup@bracu.ac.bd