Introduction
There exists an important relationship between economic growth and financial intermediation. The banking sector and capital market together can play a vital role in enhancing economic growth. It has been observed that well-developed financial systems give the required impetus to economies to reach their potential since they allow financial institutions to identify profitable opportunities and exploit them through intermediaries by funneling investment funds from investors to those opportunities. (Michael Tiel, July 2001).
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There can be three types of financial intermediaries: investment bankers, dealers and brokers. When companies or even governments for that matter want to sell securities to generate capital they need financial intermediaries. The investors can also re-sell the securities to other investors. Financial intermediaries also facilitate this process. The financial intermediaries thus ensure that the financial system works smoothly and makes it possible for surplus and deficit economic units to interact and exchange funds for mutual benefit. (Gallagher and Andrew, 2003)
Many informal financial institutions make use of methods to serve wide-ranging segments of society that lack access to banks (or just simply facilitate access to banks).
The utility of financial intermediation is evident when an organization wants to go public; i.e. offer stocks on the capital markets through IPO (Initial Public Offering). It is usually the investment bankers that handle all the details associated with the issuance and pricing of the stock and marketing it to the public. (Gallagher and Andrew, 2003)
The intermediaries bring together the two parties by borrowing funds from lenders and lending them to borrowers so that both parties find the transaction more favorable than if they traded directly with each other. Financial intermediaries such as banks, investment companies, and mutual funds e.t.c collect resources from various small investors and then lend or invest them.
Let us look at how the financial intermediaries benefit from the situation. According to (Mishkin and Eakins, 2006) financial intermediaries can significantly reduce transaction costs associated with the time and money spent in performing financial transactions. The exchange of goods or services or assets is a good example. The intermediaries due to their large size and expertise are able to take advantage of economies of scale. The low transaction costs allow these institutions to offer liquidity services as it is simpler to sell financial instruments to raise cash. Another important factor is that financial intermediaries are able to greatly reduce the potential risks by sharing the risks among various investors and thus achieving high levels of diversification due to the varied portfolios. This not only makes investments less risky but also means profits for the intermediary itself as they gain profits on the difference between the returns and the payments they make.
Another one of financial intermediaries’ roles in the financial system is the flow of information (from one party to the other and vice versa). Information is essential to understanding the need for regulation as it has a bearing on the sense of balance that any market needs to remain in a stable situation. Due to the financial involvement in the intermediation process, the intermediaries are better able to screen out bad risks and monitor the utilization of the loans provided.
(This characteristic is debatable however what with the spade of financial scandals involving major intermediation companies. Scandals such as those of Arthur Andersen, Enron, WorldCom, and General Motors are cases in point.)
So it is evident that financial intermediaries play an important role in improving the performance of the economy and are therefore vital elements of the financial system. The financial markets and institutions together represent a mixture of specific elements combined for the purpose of controlling and coping with the enormous amount of assets available and the income generated by them. At the same time, however, it is imperative to consider the new trends that are jeopardizing their position and the factors that are needed to return the confidence to the market and avoid instability of the financial system.
Common Stocks
Common stocks are a form of security that represents ownership in a corporation. The owners of common stock have the authority to elect a board of directors and vote on corporate policy. These are comparatively high-risk investment options for investors since common shareholders are last on the list of priority ladders for ownership structure. In the case of bankruptcy, common stockholders have rights to a company’s assets only after all the other liabilities, bondholders, preferred stockholders have been compensated. The common stocks are also known as “ordinary shares” in some countries such as the U.K
As mentioned earlier in the case of liquidation the common stockholders will not receive their money until the creditors and preferred stockholders have received their particular share, so this makes common stocks more vulnerable but the benefit lies in common shares usually outperforming the other mentioned securities when it comes to returning. (This reiterates our understanding of the basic investment principle of high risk, high return and vice versa)
Comparison of common stocks with preferred stocks
Let us now look at the two major types of stock and their differences;
Common Stock
The owners of common shares reap two major benefits by investing in stocks of the company name; capital appreciation and dividends. Capital appreciation is simply the increase in the value of the stock (usually with the passage of time) over the amount initially paid for it. The market price (in the case of a public limited company) is usually determined at the stock exchanges and the stockholder makes a profit when the stock is sold at its market value which is higher than what it was acquired for.
Dividends (taxable) are paid by a company to its shareholders from its retained earnings or profits made. Usually, dividends payments are made at the time of fiscal periods (although it is not necessary). Dividend payments can be both in the form of cash and/or company stock but payments obviously depend on whether the company is making profits and its growth. Possession of common stock also gives its holder voting rights on company issues and in selecting the board of governors. These issues are usually dealt with at annual general meetings or special meetings where all the shareholders are invited.
Preferred Stock
The other type of stock is the preferred stock. They are less risky than common stocks but then the potential returns are also lower than common stock. The payments from preferred stock are usually stable as it accrues and guarantees a regular dividend. These stocks in a way are not directly linked to the market as in the case of common stock but relate more to interest rate levels (there is an inverse relationship between interest rates and preferred stock rates). Since dividend is guaranteed, dividend payments will be made whether or not the organization earns a profit.
Also the preferred stockholders get priority when it comes to the payment of dividends or in the event of bankruptcy. Preferred stockholders get paid earlier than common shareholders in profits and also elicit priority in distribution of the company’s assets, (bondholders precede both common and preferred stockholders when it comes to liquidation).
Even though preferred stock represents ownership in a company as common stock but owners of preferred stock do not get voting rights in the business.
Several common measures are available for calculating the value of common stock. While most shareholders look mainly for the price per share, it’s not the only indicator of a stock’s worth. Other factors include earnings per share, the price-earnings ratio, net asset value per share, and yield.
Let us now consider the valuation of common stocks.
There are several different methods available to value common stocks and only a few will be discussed keeping in mind the requirements of the paper and our own financial understanding and knowledge.
Earnings per Share
This is the most commonly used indicator of a stock’s value (evident from its widespread use at all stock websites television channels e.t.c. The traditional way to compute EPS is to take the income of a company (available to common stockholders) or its net earnings after taxes and any dividends to preferred shareholders divided by the number of outstanding common shares of stock.
Return on Equity
Return on equity (ROE) is another important measure of the value of a stock since it has a direct impact on the company’s growth, profits, and dividends. It reflects the overall profitability of the corporation, and shows how successful the organization is in managing its assets, operations, and capital. Higher ROE means better financial position of the company.
Price-Earnings Ratio
The price-earnings ratio or the P/E ratio for a common stock is found by dividing the share price of the stock by the current earnings per share. The P/E ratio is also a widely used method of measuring a stock’s value.
When evaluating a stock, it’s always best to consider the historical P/E ratio data.
Yields
There are two ways of measuring the yields of a common stock “nominal” or “current.” They measure the rates of return for a stock. Before investment in stocks it’s important to calculate the yields, so as to make an informed decision.
Nominal yield is calculated by taking the annual interest or dividend payment and dividing it by the stock’s par value. Current yield is found by dividing the annual investment income by the security’s current price. Usually current yield is more useful measure than nominal yield. (Scott, 2005)
Differences between Debt and Equity financing
Apart from owner’s capital there are usually two other means of raising capital namely debt and equity financing. Both of them are discussed below.
Debt financing
As the name suggests it is a form of bank loan. If the organization is well established and has a solid operating history and assets to cover up then a bank may extend a loan. This can prove to be a very cost-effective method especially when interest rates are low.
The other advantage is that there is no loss of ownership in debt financing. Debt financing is also stable in the way as payments to the bank for the debt are fairly evenly spread out (better cost forecasts).
The downside of debt financing is that the company has to have a respectable standing and adequate cash flows in order to secure large loans and mark assets as collateral. These assets are liable to confiscation in case of default on re-payments of debt. Extreme case is that of liquidation whereby the business expresses its inability to pay the debt and may be taken over by the financial institution or its assets sold off to compensate for the debt.
Equity financing
The other option available is that of equity financing, i.e issuing stocks of the company.
Inequity financing other parties buy out a stake in the business for a price deemed fit by both parties. Equity financing can be done through a stock exchange (in the case of public companies), where anyone can invest their money in the company if they want for the market price. The shares can also be given to a small circle of people such as family or friends (in the case of private companies). Equity financing can be an easy option for start-ups that find it difficult to obtain bank loans. Also, no regular payments have to be made on the shares. If the company performs well the share prices reflecting investor confidence and due to the dynamics of supply and demand will automatically escalate. Dividend payments will depend on the discretion of the top management or board of governors.
At the same time it must be kept in mind that equity financing leads to a decrease in the original owner’s stake in the business. Also management will have to take heed and satisfy the demands of the investors.
References
Gallagher, Timothy J, and Andrew, Joseph D., 2003, “Financial Management Principles and Practice”, by Pearson Education Inc, Upper Saddle River, New Jersey.
World Bank, 1997, “Informal Financial Markets and Financial Intermediation in Four African Countries” [Electronic Version]. Web.
Michael Tiel, Finance and Economic Growth: A Review of Theory and the available Evidence, ECFIN Economic Papers, 2001.
Stock Valuation (McGraw-Hill Library of Investment and Finance), Scott Hoover McGraw-Hill; 1st edition , 2005.