The plans to introduce a stock market are commendable. But for such a market to be able to satisfy its purpose of efficiently allocating capital and providing companies with liquidity, new institutions that can facilitate the process need to be developed, writes Million Kibret (firstname.lastname@example.org), managing partner at BDO Consulting Plc.
When farmers raising sheep in the countryside plan to sell their livestock at a nearby town, they know exactly where, in or around the town, they will be selling the cattle. They will also be able to check the prevailing prices set by supply and demand at the markets before setting the price.
The market enables them to study the prices of each animal on a like-for-like basis to determine the value of their livestock. If they would prefer to sell the cattle to middlemen, it would not be difficult to find and deal with them.
However, there are no markets for people owning equities of large share companies such as financial institutions in Ethiopia when they are planning to sell their shares. People might end up informally talking to friends and acquaintances for assistance in selling the shares. Estimating the going prices of these financial assets will be another difficult task, which is imposed by a lack of markets.
One of the primary purposes of individuals and institutions buying shares of companies is to benefit from expected returns in the form of dividends arising from annual profits. The other major goal is to gain on the increase in the price of shares. As companies grow continuously as a result of local and global economic acceleration, share prices are generally on an increasing trend. This trend has resulted in a buying frenzy for share of companies.
Individuals and institutions buy shares of companies using their savings and investment capital with the expectation that, in the longer term, the increase in the price of shares beats inflation and savings' deposits. However, this expected gain cannot easily materialise without organised market platforms known as stock markets.
Such markets formalise and facilitate the buying and selling of financial instruments including shares and bonds of companies. One major advantage of stock markets is in creating liquidity for holders of shares of companies listed in these exchanges.
As farmers could easily refer to local livestock markets to know the prevailing prices applicable to their cattle, stock markets are reliable indicators of the market prices for shares. Companies listed in stock exchanges can easily know their market value, known as market capitalisation, by simply multiplying the number of shares outstanding by the market price of the shares.
Regional business magazines periodically compare total values of companies in the African continent based on market capitalisation. We have our share of larg Ethiopian enterprises that can compete well with their counterparts in the region. However, they are usually left out of the lists due to a lack of stock markets to use as a reference to value their shares and to arrive at their market values.
As a result, our companies appear only when the magazines compare the enterprises using asset values, which can be misleading to the reader as the asset values can be based on historical book values.
A company churning out high-valued intellectual products using the brains of its professionals may have no significant asset book values, while the market valuation of its business could be in the billions of dollars. Currently, technology companies like Google and Amazon have beaten the traditionally resource-based companies, which dominated the race in earlier decades, on market value.
The resource-based company Exxon was the largest company in the world in 2008. In just ten years Apple, Google, Microsoft, Amazon and Facebook surpassed it in valuation. This valuation is only possible in reference to their respective stock markets.
Stock markets have become vital platforms in market-led economies in reliably informing the performance of companies and industries in particular and the economy in general and are often referred to as barometers of the economy. The existence of these platforms also facilitates the investment process in an economy by providing ease of raising capital when companies need additional resources and offer liquidity when shareholders need cash.
However, as stock markets are part of the larger financial markets, a proper understanding of these facilities calls for an understanding of financial markets, which consists of primary and secondary markets. Primary markets facilitate new issuance of financial instruments including equity and debt, in the form of shares and bonds, respectively, while secondary markets trade those financial instruments already issued by primary markets.
In our local context, share companies have been issuing shares to the public mainly to raise paid-up capital. In doing as such, the companies prepare business plans and prospectuses to be issued to the broader public as part of their marketing activities to raise funds.
The process is usually carried out by the issuing companies themselves or through consultants, sales and marketing individuals or institutions. Except for financial institutions, which are tightly controlled by the National Bank of Ethiopia (NBE), this process of raising funds from the wider public has been very lightly regulated.
The practice of light regulation in the public share offering process might have been an opportunity for a few companies, which were carefully and successfully managed from inception to growth and profitability. On the other hand, we have witnessed various startups that failed to see the light of day despite significant public capital contribution.
The main objective for the requirement of tighter control from regulatory authorities during the first public offering of shares - Initial Public Offering (IPO) - is to protect the public from misrepresentation by issuing companies in terms of reliability of the financial instruments they are offering. The offering companies will have to undergo a process of transparency regarding the company they are promoting to the regulatory bodies for rigorous validation.
After the process of validation, those companies with approval to issue their shares to the public for the raising of funds usually make their offer to institutional investors and financial brokers rather than to individual investors. This further protects unsophisticated investors - those who are not expected to be professional investors with significant net worths.
Moreover, it will ease the process of fundraising as a few institutional investors will have the capacity to buy a considerable number of newly issued shares of a company. These institutional investors start trading the shares on stock exchanges afterwards.
Relevant institutions like investment banks and stockbrokers play a critical role in the process of raising funds in primary and secondary markets. Unlike commercial banks, investment banks do not make money through savings mobilisation for consumer lending at interest.
They serve as intermediaries between companies issuing financial instruments to raise funds and the investors who acquire the shares in exchange for their funds. Investment banks assist the issuing companies in preparation of the various documents required to be filed at the regulatory bodies and serve as consultants in the valuation of the companies' shares and in contacting potential institutional investors to buy the shares.
In many cases, investment banks guarantee a fixed price for the newly issued shares by buying all of the shares in a process known as firm commitment underwriting. These institutions make money by acquiring the shares at discounts for an offer to institutional investors at slightly higher price points.
While these institutions facilitate the process of raising capital, they also provide another mechanism of protecting the public by serving as insulators between companies issuing new shares and individual retail investors.
There are a few business consulting firms and law offices in Ethiopia currently assisting investors in verifying the financial and legal standing of companies targeted by the investors. These professional firms are already providing financial and legal due diligence and business valuation services of investee companies on behalf of the investors.
The firms also assist their clients in preparation of documents required for the investment process. When these firms work for the investee, they prepare information memoranda summarising the operations and resources of the companies for presentation to potential investors. They also accompany their clients in the presentation and marketing process. This is similar to what investment bankers call a "roadshow."
As these activities are among the significant functions of investment banks, these firms can be assisted to provide full-fledged investment banking services. Our preparation for stock markets should therefore carefully consider paving the way for the development of the relevant institutions to be part of the financial markets.
Million Kibret Managing Partner At Bdo Consulting PLC.