International Secondary Markets for Equity

So far, we have concentrated on U.S. markets. However, since large corporations now

raise capital from all over the world, financial managers need to have a basic under-

standing of the markets outside the United States.

Exhibit 3.3 lists the top 20 equity markets by capitalization. The list of countries

holds few surprises: Large economies generally have large equity markets. The United

States, Japan, and the United Kingdom have been and continue to be the three largest

stock markets in the world. One surprise is that the German stock market is quite small

relative to the size of its economy (see Chapter 1). Economies about one-tenth the size

of Germany’s, such as those in Switzerland and the Netherlands, have stock markets

that are about 50 to 60 percent of Germany’s market capitalization.

3.5Equity Market Informational Efficiency and Capital Allocation

Part II of this book examines, in detail, various methods that can be used to value

equities. All these methods assume that security prices satisfy what financial econ-

omists call the efficient markets hypothesis. Fama (1970) summarizes the idea of

efficient markets as a “market in which prices ‘fully reflect’available information.”

¹⁰See

Christie and Schultz (1994).

Grinblatt176Titman: Financial	I. Financial Markets and	3. Equity Financing	© The McGraw176Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

76	Part IFinancial Markets and Financial Instruments

EXHIBIT3.3

Equity Market Capitalization (Billion US$) of the 20 LargestStock Markets, September2000

U.S.	10,547
Japan	2,394
U.K.	1,903
France	1,014
Germany	760
Canada	543
Switzerland	524
Netherlands	488
Italy	387
Sweden	272
Australia	244
Hong Kong	195
Mexico	109
Korea	107
Taiwan	103
South Africa	93
Singapore	90
Brazil	88
Greece	62
Malaysia	58

Source:Merrill Lynch Global Economic Trends, January 2001.

In other words, financial market prices are quite close to their fundamental values

and hence do not offer investors high expected returns without exposing them to

high risks.

Economists are concerned about the efficiency of stock prices because stock

prices affect how capital is allocated throughout the economy. To understand this,

consider Netscape’s initial public offering (IPO) in August 1995, which launched the

Internet boom in the last half of the 90s. The underwriters who issued the shares

originally anticipated an offering at around $14 a share, but, because of strong

demand at that price, the offering price was raised to $28. The price of the shares

skyrocketed from their $28.00 per share issue price to more than $70.00 in the ini-

tial trading before closing at $58.25 per share. Within months of the original offer-

ing the price had again doubled. At these prices, the shares retained by the com-

pany’s cofounders_Marc Andreesen, a 24-year-old programming whiz; Jim Clark,

a former Stanford University professor; and the company’s CEO, James Barks-

dale_were worth hundreds of millions of dollars. Clark, with more than nine mil-

lion shares, was an instant billionaire at Netscape’s high in the months following

the offering.

The market’s enthusiastic acceptance of the Netscape IPO had a major effect on

the Internet industry. After Netscape’s IPO, it was widely acknowledged that public

markets were providing equity financing at very favorable terms for Internet firms. As

a result, a substantial amount of capital flowed into newly formed Internet firms, and

a major new industry was born.

Grinblatt177Titman: Financial	I. Financial Markets and	3. Equity Financing	© The McGraw177Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 3

Equity Financing

77

The important point to remember from this example is that stock market prices pro-

vide valuable signals that indirectly allocate capital to various sectors of the economy.

Some economists and policymakers have argued that the U.S. economy in the 1990s

was more vibrant than, for example, the German economy, because the former econ-

omy’s more active stock market. The argument was that new industries are less likely

to obtain funding in an economy, like Germany’s, with a less active stock market, where

new issues are very rare. Perhaps, in response to this view, a new stock market, the

Neuer Markt,was created in Germany in 1997 to attract innovative growth stocks.

There were 11 IPOs listed on this market in 1997, 40 new firms listed in 1998, 132 in

1999, and 133 in the year 2000.

The German decision to start this new market is based on the idea that stock mar-

kets are efficient aggregators of information and hence efficiently allocate capital within

an economy. However, if the stock market is not informationally efficient, then the mar-

ket will provide too much capital to some industries and not enough to others. For exam-

ple, many critics expressed the belief that Internet stocks were grossly overpriced at the

turn of the millennium and that the U.S. economy was providing too much capital to this

industry and too little capital to the energy industry. If this was in fact the case, the sit-

uation subsequently reversed. The price of Internet stocks dropped precipitously in the

last half of 2000, and the flow of capital to the Internet industry subsequently slowed.

Result 3.1

The stock market plays an important role in allocating capital. Sectors of the economy thatexperience favorable stock returns can more easily raise new capital for investment. Giventhis, the stock market is likely to more efficiently allocate capital if market prices accuratelyreflect the investment opportunities within an industry.

3.6	The Market forPrivate Equity

Along with the boom in the public equity markets during the 1990s, the role for pri-

vate equityincreased in importance. By private equity we mean equity that is not reg-

istered with the SEC and cannot be traded in the public equity markets. Individuals and

families hold the largest portion of private equity with personal investments in rela-

tively small private businesses. In addition, there are large institutions that provide pri-

vate equity to companies.

These institutions can be classified as those specializing in venture capital, or

providing equity capital for emerging new companies, and those specializing in

restructuring, or providing equity capital for more mature firms that are making fun-

damental changes in the way that they are doing business. In both cases, the institu-

tions can be viewed as specialists in transforming businesses and providing the firms

they invest in with managerial support and oversight as well as capital. The Private

Equity Analyst (January 2001) reported that in 2000, private equity institutions invested

about $150 billion, which was more than a 50% increase over the 1999 total. The

money was just about evenly divided between venture funds and restructuring funds.