Sharp declines on the stock exchange are usually discussed through investors’ losses. Those losses matter. If, however, we confine the discussion to the change in value on investors’ accounts, we miss the exchange’s function of providing resources to companies. When the view spreads that prices are not being formed in a reliable way, it also becomes harder for companies that wish to expand production capacity, develop a new product or open to foreign markets to raise equity. The relationship between what happens on the exchange and the real economy begins here.
Confidence in the secondary market is the foundation of financing in the primary market. An investor wants to know that the share bought today can be sold, within the investor’s own investment horizon, when needed and on “acceptable terms”. “Acceptable terms” here does not mean that the investor must necessarily exit at a profit on the purchase price. It means that a sale is possible, that the transaction price is not distorted in an extraordinary way by a single order, and that market rules operate in a predictable manner. When this expectation weakens, an investor may be willing to take part in a new public offering or a capital increase only at a lower price.
Where resources enter the company
In the primary market the company issues new shares; the amount paid by investors, after issue expenses, provides resources to the company. The portion of a public offering that consists of the sale of new shares, and a rights issue, are examples. In the portion of a public offering in which existing shareholders sell their own shares, the sale proceeds go not to the company but to the shareholders who sell. This detail prevents the assumption that every public offering provides resources to the company’s cash to the same extent.
In the secondary market, shares already issued change hands among investors. An investor’s purchase of a share on the exchange from another investor does not, as a rule, provide a direct cash inflow to the company. The two markets are nevertheless connected. When a company issues new shares, the investor assesses the liquidity, the price formation and the information environment of the market on which those shares will subsequently trade. The exchange both makes it possible for shares to change hands and provides a reference for the pricing of new issues.
The economic life of a factory is measured in years. The investor who finances that factory may wish to sell the share earlier. An effective secondary market makes it easier to finance a long-lived investment with short- or medium-term savings. For this, the continuous display of a bid and an offer price on the screen is not sufficient by itself. If the bid–ask spread is wide, or if a large order changes the price to a serious extent, the investor’s effective cost of exit rises. In assessing liquidity one must look not only at trading volume, but also at the price impact of a transaction of a given size.
How a loss of market confidence affects the cost of equity
The value of a share is related to the cash flows the investor expects will belong to the company in the future, and to the risk undertaken in reaching those flows. The company’s sales, costs, debts and investment projects are inside this calculation. Alongside them, the reliability of information, the fairness of transactions and the probability that the share can be sold when required also affect the price the investor is willing to pay.
Even if expected cash flows do not change, the investor may offer a lower price for the same share if market-related risks are regarded as higher. Other things equal, a lower price today means that the expected return demanded by the investor has risen. The company’s cost of raising new equity rises by this route as well. Not every price decline should, however, be attributed automatically to a loss of confidence. The company’s cash-flow expectation may have deteriorated, operating risk may have increased, or the general level of interest rates may have risen. In the analysis these causes must be separated from distrust in the way the market functions.
A numerical example makes the distinction concrete. Suppose a company has 20 million shares outstanding and needs 100 million TL of equity to finance its investment. If the new shares can be sold at 10 TL, the company issues 10 million shares. After the issue there are 30 million shares in total; the ownership share of those who take the new shares is 33.3 per cent. If the 100 million TL the company needs can be raised only at a price of 5 TL per share, 20 million new shares are required. This time, half of the 40 million shares in total belongs to the new investors.
In the example we hold constant the increase in value that the investment will provide in the future, and the other conditions. In a real issue the value of the new investment, the value of the existing shares and the pricing conditions are calculated separately. A lower issue price may cause existing shareholders’ ownership stake to be diluted further for the same resources. The company may also choose not to accept these conditions and to postpone the investment. A problem in the secondary market thus affects a capacity expansion or a production decision directly.
How a liquidity spiral spreads
If the number of shares in free float is limited and ownership is concentrated in particular investors and funds, purchases of a small amount can raise the price rapidly. The last price formed on the screen does not mean that all the shares held can be sold at that same price. When the quantity offered for sale increases, the price falls if there are not enough buyers. The basic technical distinction here is that the visible market value and the amount for which a large position can be turned into cash are not the same.
The first large sales may give rise to a need to post additional collateral on leveraged positions, or to redemption requests in funds. Further sales made to meet these requests pull the price down again. As the liquidity of the share weakens, more shares must be sold in order to obtain the same amount of cash. The fall in price and the need to sell can turn into a spiral that feeds on itself. In such periods one should examine separately how much of the price movement arises from a change in the company’s expected cash flows and how much from temporary selling pressure.
The spiral can affect other companies as well. Investors become more cautious towards shares with a similar ownership structure and towards the funds that hold those shares. If doubt about information and about price formation becomes widespread, even a company with a strong balance sheet may meet a low valuation when seeking new resources. The degree of this spillover is not the same for every company; companies that make sound disclosures, and that have sufficient trading depth and a broad investor base, can differentiate more readily. What matters is that the market possess the information and trading infrastructure capable of making this distinction.
Does a fall in the share price empty the company’s cash?
When the share price falls in the secondary market, money does not leave the company’s cash automatically. Existing factories, inventories and the cash flow arising from operations do not change merely because the price on the screen has fallen. The direct cash effect should not be confused with the effect on future financing.
If a low valuation becomes permanent, however, more shares may have to be issued in a rights issue in order to raise the same amount. A business preparing a public offering may postpone its plan. The bargaining power of a company that wishes to use its shares as consideration in the acquisition of another company may weaken. The conditions for offering share-based incentives to employees may also change. The market price does not empty today’s cash; it affects the value of future options.
When equity becomes harder to raise, greater borrowing may come onto the agenda. Debt is a valuable financing instrument when used at a suitable cost and maturity. Financing with short-term, high-cost debt an investment that will generate cash over a long period does, however, create payment pressure on operating cash flow. The company may reduce the scale of the investment or postpone its start. If a large number of companies take a similar decision, the effect is reflected over time in production capacity, employment and the growth of productivity.
Not every sharp price decline is a market breakdown
When a company’s expected cash flow deteriorates, when interest rates rise, or when the economic outlook changes, a fall in prices may be an ordinary result of valuation. The market then performs its task by reflecting new information in the price. The functioning of the capital market does not mean that the investor is guaranteed an exit without loss.
Does the price change rest on reliable information and on sound transactions? Misleading disclosures, conflicts of interest, concentrated positions, or forced sales that are very large relative to market depth can distort price formation. The task of the regulatory and supervisory authorities is not to defend a particular price. What is required is to ensure that information is disclosed in good time, that transactions are conducted in accordance with the rules, and that allegations of market abuse are examined.
An investor may assume a company’s commercial risk. If, however, the investor is continually in doubt as to whether the same material information is available as to other investors, or whether the trading rules are applied equally to everyone, a different uncertainty is faced. A loss of confidence capable of driving long-term capital away is fed, in particular, by this second uncertainty.
Funds and companies that are not listed are affected as well
The portfolio of a fund that offers its investors frequent exit may, in a period of stress, be concentrated in shares that cannot readily be sold. The mismatch between the conditions for redeeming fund units and the capacity of the portfolio assets to be turned into cash becomes apparent when exit requests increase. Rapid sales undertaken in order to raise cash can also reduce the portfolio value of the investors who remain. Portfolio concentration, the method of pricing, possible exit requests and selling capacity under stress should therefore be assessed together.
An SME whose shares are not traded on the exchange is part of the same ecosystem. A venture-capital or private-equity investor considers by what route, and at what value, the ownership stake bought today can be disposed of in the future. If the prices of listed companies cease to be a sound benchmark, the future exit value becomes more uncertain. That uncertainty may lead the SME to accept a lower valuation when raising capital, or to postpone its project.
Bank credit, private equity, venture capital and the public issue of shares are different routes of financing. The maturity, the risk and the investor profile of each differ. They are not, even so, wholly disconnected from one another. A problem in the equity market can increase demand for the other channels; those channels cannot be expected, on their own, to meet the whole of the need for investment.
The time dimension in the chain of financing
The consequences of a loss of confidence in the market do not appear on company balance sheets on the same day. The existing cash balance remains in place; the terms of credit already obtained may not change of themselves either. The effect often appears when the financing of a new investment is under discussion, when debt falling due is being renewed, or when additional capital is requested from the shareholders. This delay should not lead us to underestimate the economic consequences of a deterioration on the exchange.
In an investment decision, the company’s management does not calculate only the expected return of the project. It also takes into account when the resources will be found, and at what cost. Even if the economic return of the investment is positive, a delay in providing funds may postpone an order for machinery and shift the date on which production begins. The cost of the delay grows with lost sales opportunities and with rising project expenses. The orderly working of the capital market therefore offers companies a service broader than an inflow of money at every moment: the possibility of foreseeing the conditions of future financing.
When confidence in the market strengthens, the investor can choose more soundly among companies. The probability rises that resources will be directed not only towards shares that attract attention easily, but towards productive projects. The economic value of financial intermediation is not confined to savings changing hands. It is the determination of the project to which those savings will be transferred, against which risk, and at which cost.
It should also be seen that the relationship is not one-directional. Successful investments and consistent company disclosures feed investor confidence over time. When confidence makes a lower cost of financing possible, more investment can become economic. In the contrary case, expensive capital and postponed projects weaken the expectation of future growth, and the weakened expectation in turn presses on valuation. Beyond daily price movements, therefore, the matter is to understand the reciprocal relationship between companies’ capacity to invest and the market’s power to direct savings.
In assessing what is happening on the stock exchange in Türkiye, we should ask which investor has lost how much today, and, in the same measure, which company will be able to find capital tomorrow and at what cost. Confidence in the secondary market is the foundation of financing in the primary market. Protecting that confidence is in the interest of the investor and of the companies that seek resources for production and growth.
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