Equity Markets

Understand the fundamentals of markets. It will expose a lot of nonsense for you.

Equity markets are markets that trade in shares. Shares are often called 'equities'. Ever wondered why?

Shareholders' rights

A share usually gives the owner rights to 1) receive future dividends, and 2) proceeds of a break-up or liquidation of the corporation, and 3) hire/fire the directors. So a share is actually a set of rights in tradeable form. In law, an equitable right is called an equity.

'Rights to future dividends' is equivalent to 'rights to future cash flows'. This is because a corporation may either distribute all its cash as dividends or may retain some of it to invest in the business, which should result in:

• larger dividends in the future, or
• a larger liquidation value

......both of which should end up in the pockets of the shareholders.

Rights have value

The point is that a share carries rights to specified future financial realisations of the corporation. Being financial rights they are susceptible to financial or other analysis to establish a value. And through stock markets these rights are tradeable.

Price is not the same as value..........

When a buyer and a seller meet they agree a price. But they do not agree a value.

They may have no concept of value at all (because they are pure market traders, and their judgement is not about value but about what the next man will pay). More likely they do each have an idea of value. But those values will be different, because:

• the buyer's value must be above the price (or he would not buy);
• and the seller's value must be below the price (or he would not sell).

The price of a share in a particular trade is a matter of fact. But value is a much more elusive concept, shifting with individuals, time and circumstance.

......but value constrains price

Although value is elusive, it falls within certain limits.

Two men standing in front of Nelson's Column to guess its height may argue whether it closer to 100 feet or 300 feet. But they would be pretty certain it it is within those limits (in fact it is 185 feet). The observation constrains the guesswork. And so it is with shares. The value constrains the price.

In that respect the market in shares is different from markets in goods (or 'things'). A Rembrandt painting has no (financial) value. But, if brought to market, it will have a price.

A purchase means a sale

And finally, the simplest but most profound feature of all markets:

• For every purchase there must be a willing seller.
• For every sale there must be a willing buyer.

Try reciting the above the next time you are peddled a formula for stock market success, bearing in mind that 90% of the trades in the London market are done by professionals who know more than you do.