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How does the stock market work?

Companies open their business to investors and apply to list their shares on the stock market.

Apr 23,2009
Korean securities companies light up the night on Yeouido in Seoul. [JoongAng Ilbo]
Do you want to invest in the stock market? With local stock markets showing signs of revival from months of turbulence, a growing number of Korean companies are listing their shares in Seoul’s markets. This translates into more opportunities for market investors wanting a piece of the action. This week, we take a look at how stock markets work.



What is the stock market?

A stock market is a place where people trade shares of stock in companies.

Each share represents a tiny piece of each company’s total capital. The more shares you have, the larger your stake in the company and the more weight your voice will have in how the company is run.

If the company you’re investing in does its business well and earns a profit, the value of the company will increase and the price of its stock will go up in the stock market. This means shareholders can sell their shares in the stock market at a far higher price than when purchased.



What is an IPO?

One financial term to keep in mind before you take the plunge and invest in the market is “initial public offering,” or IPO.

An IPO is when a company makes its shares available for sale to the general public for the first time in the stock market. Before a company makes an IPO, it has to go through an intensive screening process by stock market authorities and undergo scrutiny by potential investors.



Rules and regulations

Obviously, not all companies can list their shares in stock markets just because they’d like to. There are several requirements a business must meet before it can make an IPO. The business needs to be big enough to attract enough prospective investors; it needs to have been in business for a certain number of years; its annual profits should be above a certain level; and it needs to be judged to be in good financial health.

For instance, a company hoping to list its shares in Seoul’s junior Kosdaq market must be at least three years old and its total equity, or the total value of its assets after all debts are paid, must be worth at least 3 billion won ($2.2 million).

The company’s return on equity - its net profit divided by its total equity - should also be more than 10 percent, or its net profit for the previous year should be worth more than 2 billion won if its ROE hovers below 10 percent.

But the figure can vary slightly depending on the type of company. For instance, companies designated as “tech venture startups” by the government are subjected to less rigid requirements.

A company in this category doesn’t necessarily have to be three years old in order to go public and it should post a net profit of 1 billion won if its ROE hovers below 10 percent.



Time to go public

If a company believes it meets all the requirements for an IPO, then it must have its accounting records fully audited by an auditor designated by the Korea Exchange. The audit must be done at least 120 days before the date the company hopes to go public.

Once the auditor approves the company for the IPO, the next step is for the company to select an underwriter, a stock brokerage company that helps determine the appropriate share price and receives potential bids from big institutional investors.

After that, the company has to register with the Financial Services Commission, which regulates financial policy in Korea, by reporting details about their business and submitting financial statements. The company then submits its application for preliminary review to the Korea Exchange’s IPO review committee.

The committee examines the company’s financial health and ensures that its management is following certain standards for transparency.

Then it’s back to the FSC for final approval of its plan.


Getting the price right

Next comes the tough part: determining the share price. The company holds various sessions with potential investors, including stock brokerage houses and industry analysts, to promote its business and describe its future business plans.

The company’s underwriter then kicks off a process called “book building,” in which it solicits bids from institutional investors to see how much the investors are willing to pay for the company’s shares.

The underwriter then determines the price of the shares in the company’s IPO and stars taking subscriptions from individual investors wanting to buy the new shares from the company.

When the initial subscription period is over, and individual investors have purchased their shares, the company is free to list its shares in the stock market.

The company reports to financial regulators how many shares it sold during the IPO process and submits an application to the Financial Supervisory Service, the nation’s financial watchdog, for permission to sell the other shares in the market. Five days later, if the application is accepted, the company’s shares will be available for sale in the market and anyone will be able to trade the company’s stock.


Why go through so much trouble?

After reading all of this, you may wonder why so many companies are so eager to go through this excruciatingly long and complicated process.

The answer is that a company can secure a stable source of income by selling its shares in the stock market.

Before an IPO, if a company needs more money to finance its business activities, its only option is to get a loan from a bank, which can be a difficult thing to do. Loans are also difficult for companies because of the hefty interest rates they must pay.

But once a company is listed on the stock market, it does not have to rely so much on loans because it can issue more shares when it needs additional capital for its endeavors.

Another benefit is that potential clients become more familiar with a company’s corporate activities when it is listed in the stock market.


Big benefits bring big responsibilities

But there is also a downside. A company that lists its shares in the stock market has more responsibilities. The company no longer belongs to a handful of owners but to a large pool of shareholders who have the power to make decisions about how the company is managed and what kind of business it does.

It is also important for the company to maintain a certain degree of transparency. Its accounting records and financial statements must be open so that anyone interested in taking the plunge and investing can make an informed choice about where they are putting their money.



By Jung Ha-won [hawon@joongang.co.kr]


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