Capital Markets: Stock Markets Overview

Capital Markets

Stock Markets

• Stock market prices reflect the value of firms’ stocks, crucial for financial management aiming to maximize stock prices.
• Two main types of market procedures exist:
  • Physical Location Stock Exchanges: Registered entities with physical trading floors, conducting auction markets for listed securities. Governed by elected boards.
  • Over-The-Counter (OTC): An electronic network of brokers and dealers trading unlisted securities; includes dealer markets where transactions are conducted outside physical exchanges.

Equity Valuation

• The goal of equity valuation is to estimate a firm's or security's value, primarily driven by the underlying business fundamentals.
• Key methods of valuing companies:
  • Comparables Approach: Compares a company’s equity value with that of similar firms in the industry.
  • Discounted Cash Flow (DCF): Values equity based on projected future cash flows discounted to present value; relies on solid forecasting data.
  • Precedent Transactions: Uses historical M&A transaction prices of similar companies for valuation.
  • Asset-Based Valuation: Values equity based on the fair market value of net assets, ideal for firms with significant tangible assets.
  • Book-Value Approach: Values equity using acquisition costs, relevant for stable companies with minimal growth.

Capital Structure

• Capital comprises investor-supplied funds: debt, preferred stock, common stock, and retained earnings.
• Excludes accounts payable and accruals since they originate from operational activities, not direct investments.
• Defined as the percentage mix of each capital type, totaling 100%.
• An optimal capital structure increases intrinsic stock value and reduces the weighted average cost of capital (WACC).

Behavioral Finance

• Behavioral finance studies psychological influences on financial markets, covering five main concepts:
  • Mental Accounting: Individuals allocate funds for specific purposes psychologically, affecting spending and investment decisions.
  • Herd Behavior: Investors often follow the majority's financial actions, leading to market trends such as rallies or sell-offs.
  • Emotional Gap: Extreme emotions (like fear or excitement) can hinder rational decision-making, impacting investment choices.
  • Anchoring: Refers to setting spending levels based on references, such as budgets, influencing financial behavior.

This quiz covers the fundamentals of capital markets, focusing specifically on stock markets. It examines how stock prices are established and the significance of stock markets to financial management. Understanding these concepts is essential for anyone involved in managing a business.