The Market For Common Stock

Some companies are so small that their common stocks are not actively traded; they are owned by only a few people, usually the companies’ managers. Such firms are said to be privately owned, or closely held, corporations, and their stock is called closely held stock. In contrast, the stocks of most larger companies are owned by a large number of investors, most of whom are not active in management. Such companies are called publicly owned corporations, and their stock is called publicly held stock.

As we saw in the stocks of smaller publicly owned firms are not listed on an exchange; they trade in the over-the-counter (OTC) market, and the companies and their stocks are said to be unlisted. However, larger publicly owned companies generally apply for listing on an organized security exchange, and they and their stocks are said to be listed. Often companies are first listed on a regional exchange such as the Pacific Coast or Midwest Exchange. Then, as they grow, they move up to the American Stock Exchange (AMEX). Finally, if they grow large enough they are listed on the Big Board, the New York Stock Exchange (NYSE). About 7,000 stocks are traded in the OTC market, but in terms of market value of both outstanding shares and daily transactions,  the NYSE is most important, having about 55 percent of the business.

A recent study found that institutional investors owned about 46 percent of all publicly held common stocks, included are pension plans (26 percent), mutual funs (10 percent), foreign investors (6 percent), insurance companies (3 percent), and brokerage firms (1 percent). These institutions buy and sell relatively actively, however, so they account for about 75 percent of all transactions. Thus, institutional investors have a heavy influence on the prices of individual stocks.

Types of Stock Market Transactions

We can classify stock market transactions into three distinct types:

1. Trading in the outstanding shares of established, publicly owned companies: the secondary market. Allied Food Products, the company we analyzed in earlier chapters, has 50 million shares of stock outstanding. If the owner of 100 shares sells his or her stock, the trade is said to have occurred in the secondary market. Thus, the market for outstanding shares, or used shares, is the secondary market. The company received no new money when sales occur in this market.

2. Additional shares sold by established, publicly owned companies: the primary market. if allied decides to sell (or issue) an additional 1 million shares to raise new equity capital, this transaction is said to occur in the primary market².

3. Initial public offerings by privately held firms: the IPO market. Several years ago, the Coors Brewing Company, which was owned by the Coors family at the time, decided to sell some stock to raise capital needed for a major expansion program³. This type of transaction is called going public whenever stock in a closely held corporation is offered to the public for the first time, the company is said to be going public. The market for stock that is just being offered to the public is called the initial public offering (IPO) market. IPOs have received a lot of attention in recent years, primarily because a number of ‘hot’ issues have realized spectacular gains often in the first few minutes of trading. Consider the recent IPO of Boston Rotisserie Chicken, which has since been renamed Boston Market. The company’s underwriter, Merrill Lynch, set an offering price of $20 a share. However, because of intense demand for the issue the stock’s price rose 75 percent within the first two hours of trading. by the end of the first day, the stock price had risen by 143 percent, and the company’s end-of-the-day market value was $800 million which was particularly startling, given that the company had recently reported a $5 million loss on only $8.3 million of sales. More recently, shares of the trendy restaurant chain planet Hollywood rose nearly 50 percent in its first day of trading and when Netscape first his the market, its stock’s price hit $70 a share versus an offering price of only $28 a share. (See the Industry Practice box above, “A Wild Initial Day of Trading”).

Table 8-1 Lists the largest, the best performing, and the worst performing IPOs of 1996, and it shows how they performed from their offering dates through year-end 1996. As the table shows, not all IPOs are as well received as were Netscape and Boston Chicken. Moreover, even if you are able to identify a “hot” issue, it is often difficult to purchase shares in the initial offering. These deals are generally oversubscribed, which means that the demand for shares at the offering price exceeds the number of shares issued. In such instances, investment bankers favor large institutional investors (who are their best customers), and small investors find it hard if not impossible, to get in on the ground floor. They can buy the stock in the after-market, but evidence suggests that if you do not get in on the ground floor, the average IPO under performs the overall market over the longer run⁴.

Finally, it is important to recognize that firms can go public without raising any additional capital. For example, the Ford Motor Company was once owned exclusively by the Ford family. When Henry Ford died, he left a substantial part of his stock to the Ford Foundation. When the Foundation later sold some of this stock to the general public the Ford Motor Company went public, even though the company raised no capital in the transaction.