What Is A Stock Market Finance Essay

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A stock market also known as an equity market is a public entity where shares are issued and traded either through exchanges or over-the-counter markets. It provides companies with a platform to raise capital and investors with a percentage of ownership in the company. The New York Stock Exchange is the largest stock exchange in the USA, in terms of market capitalization. In Asia, few of the prominent examples include the Tokyo Stock Exchange, the Bombay Stock Exchange etc.

The stock market allows shares of businesses to be publicly traded, or raise additional financial capital for expansion (through additional stock offerings). The liquidity that an exchange provides to the investors gives them the ability to easily buy and sell securities. Some companies actively increase liquidity by trading in their own shares.

Share prices and stock market movements are an important part of the dynamics of economic activity, and is often considered a good indicator of economic health of a nation. An economy where the stock market is on the rise is considered to be a healthy economy. In fact, the stock market is often considered the primary indicator of a country's economic strength, development and progress. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the income levels of households and their spending and consumption patterns. Therefore, central banks tend to keep a watchful eye on the smooth operation and stability of the financial system.

The intrinsic value of a company and its stock

Intrinsic or fundamental value is the perceived value of an investment's future cash flows, expected growth, and risk.

A wise investor would want to purchase shares at a rate which is lower than the intrinsic value, which may be quite different from the market price (which is determined by the forces of demand and supply) of the share. Every buyer and seller has his/her own rationale behind purchasing or selling an asset, and they may employ different methods to estimate the value of the asset before making a decision to trade in it. Therefore, an asset may trade at a price which is significantly below or above its perceived intrinsic or fundamental value.

The purpose of estimating intrinsic value is to take advantage of mispriced assets. If the market value of an asset is above its intrinsic value then the investor might choose to sell the asset. If the market value of an asset is below intrinsic value then the investor might choose to purchase the asset.

In broad terms, there are 3 commonly used methods to calculate the intrinsic value of a stock:-

Discounted Cash Flow or NPV Analysis

The most common technique is the discounted cash flow (DCF) analysis for calculating the net present value. In simple terms, the DCF technique tries to compute the value today, based on projections of all of the cash flows that the company aims to generate during a few years in the future. It works on the principle of 'time value of money (TVM)' (i.e. cash to be received in the future is of less than that received today). This is not always easy; it is a difficult task to forecast how a company's future cash flows will grow, the duration for which they will grow, and what rate should be used to discount it and arrive at its present value.

The DCF technique can be outlined in 4 steps as follows:-

Step 1: Forecast the expected cash flows of the company. Various assumptions regarding the growth rate, working capital requirements etc. will have to be used in order to arrive at a relatively accurate forecast.

Step 2: Compute the discount rate to be used for computing the NPV of the cash flows. This rate is also known as the Weighted Average Cost of Capital (WACC).

WACC = [E/(E+D)*Re] + [D/(E+D)*Rd][1-Tc]

Where,

E = Market value of the firm's equity

D = Market value of the firm's debt

Re = Cost of equity

Rd = Cost of debt

Tc = Corporate tax rate.

Step 3: Calculate the value of the company by using the WACC to discount the expected cash flows.

Step 4: Calculate the intrinsic stock value, by subtracting the company's liabilities (such as debt, preferred stock etc.) to get the Value to Common Equity and then divide this by the number of shares outstanding.

The advantage of DCF analysis is that it is based on free cash flows (FCF), which is less subject to manipulation than figures and estimates computed using the financial statements of a company. It is also forward-looking and relies more on the future performance of the company, rather than past trends.

Earnings power value (EPV)

Earnings Power Value is a valuation technique which uses the equation: EPV equals Adjusted Earnings divided by the company's Cost of Capital.

This technique works under the assumption that there is no growth. Therefore, analysts believe that this is a simpler way to analyze stocks than DCF analysis (which relies on speculative growth assumptions for the future). However, it does rely on an assumption about the cost of capital, as well as the fact that current earnings are sustainable (with several adjustments).

Asset-based methods

These methods require analysis and computed based on figures available in the financial statements of a company (such as Income Statement, Balance Sheet etc.). One of the techniques (the liquidation value technique) aims to estimate the value at which the various assets of the company (such as land, machinery etc.) can be sold off, after accounting for any liabilities that may be outstanding at that point of time.