Financial Markets and Institution: The Stock Market

Financial
Markets and
LECTURE 7
Institution
THE STOCK MARKET
Learning Objectives
To
learn about the characteristics of

common and preferred corporate stock.
To
understand the role equities play in

financing business investment.
To
compare and contrast the roles and

functions of organized stock exchanges
and the over-the-counter market.
To learn the basic stock valuation models.
To review the regulation of Malaysia stock market.
Chapter Preview
In August of 2004, Google went public,
auctioning its shares in an unusual IPO
format. The shares originally sold for $85 /
share, and closed at over $100 on the first
day. In November of 2010, shares are
trading on Nasdaq at over $620 / share.
The
stock market receives considerable

attention from investors. As Google
illustrates, great fortunes can be made!
But also lost.
Investing in Stocks
1.
Represents
ownership
in a firm
4. Right to vote for

directors and on certain
issues
2.
Earn a return in
two ways
5. Two types
Price
of the stock rises

over time
Dividends are paid to
the stockholder
3.
Stockholders have
claim on all assets
Common stock
Right to vote
Receive dividends
Preferred stock
Receive a fixed dividend
Do not usually vote
Investing in Stocks: Sample

Corporate Stock Certificate
Investing in Stocks:
How Stocks are Sold
Organized exchanges
NYSE
is best known, with daily volume around

4 billion shares, with peaks at 7 billion.
KLSE
daily volume around hundreds of

million or less.
Organized
used to imply a specific trading

location. But computer systems (ECNs) have
replaced this idea.
Listing
requirements exclude small firms
How Stocks are Sold
Over-the-counter markets
Best
example is NASDAQ
Dealers
stand ready to make a market
Today,
about 3,000 different securities are listed on

NASDAQ.
Important
market for thinly-traded securitiessecurities

that dont trade very often. Without a dealer ready to
make a market, the equity would be difficult to trade.
Trading
occurs over the sophisticated

telecommunications networks.
Organized vs. OTC
Organized exchanges (e.g., NYSE)

Auction
25%
markets with floor specialists
of trades are filled directly by specialist
Remaining
trades are filled through SuperDOT
Over-the-counter markets (e.g., NASDAQ)

Multiple
market makers (dealers) set bid and

ask prices
Multiple
Bid
dealers for any given security
ask spread is the profit margin for dealers
ECNs
ECNs
(electronic communication networks) allow brokers and
traders to trade without the need of the middleman. They provide:
Transparency:
everyone can see unfilled orders

Cost reduction: smaller spreads
Faster execution
After-hours trading
(Do
not need the specialist (middleman) who

trades (match buyers and sellers) the stocks. Bcz
ECN has high transperancy.
Investing in Stocks: ECNs

However, ECNs are not without their drawbacks:
Dont
work as well with thinlytraded stocks

Major
exchanges are fighting ECNs,

with an uncertain outcome
Investing in Stocks: ETFs

Exchange Traded Funds are a recent innovation to help
keep transaction costs down while offering diversification.
Represent
They
a basket of securities
are indexed rather than actively managed.
Traded
on a major exchange as an individual stock
Index
to a specific portfolio (eg., the S&P 500), so

management fees are low (although commissions still
apply)
Exact
content of basket is known, so valuation is certain.
Malaysia
iShare Malaysia MSCI Index Fund
1.ETF
sometimes is similar to the stock index mutual

funds. But they differs in that:
1.ETF
trades like a stock allow for limit orders,

short sale, stop-loss order, can buy on margin.
2.Lower
3.Have
management fees than index mutual funds.
no minimum investment amount.
But
ETF has brokerage fees to be paid on every time

trading.
iShare
Malaysia MSCI Index Fund measured by MSCI

Malaysia index.
Computing the Price

of Common Stock
Valuing
common stock is, in

theory, no different from valuing
debt securities: determine the
future cash flows and discount
them to the present at an
appropriate discount rate.
Computing the Price of

Common Stock: The One-Period
Valuation Model
Simplest
model, just taking using the

expected dividend and price over the next
year.
Computing the Price of Common

Stock:
The One-Period Valuation Model
What is the price for a stock with an

expected dividend and price next year of
$0.16 and $60, respectively? Use a 12%
discount rate
Answer:

Common Stock: The Gordon
Growth Model
It assumes that dividend grow at a constant

rate, g. That is,
Example 13.2 pg.350

Find
the current price of Coca-Cola

stock assuming dividends grow at a
constant rate of 10.95%, current
dividend is $1 and the required return
is 13%.
Price
If
= $54.12
divided growth has just been reestimated to be zero, what is the new
share price?

Common Stock: The
Gordon Growth Model
The model is useful, with the following
assumptions:
Dividends
do, indeed, grow at a constant rate
forever
The
growth rate of dividends, g, is less than the

required return on the equity, ke.
Computing the Price of Common

Stock:
The
Price Earnings Valuation
The price earnings ratio (PE) is a widely watched
Method
measure of much the market is willing to pay for
$1.00 of earnings from
the firms.
P/E = Price/EPS
High P/E ratio indicates:
1.
Expect the earnings to be increase in the future to make the

PE ratio back to a normal level.
2.
Investors willing to pay a premium (high price) as the firms

earnings is deemed as low risk.

Common Stock: The Price
Earnings Valuation Method
If the industry PE ratio for a firm is 16,
what is the current stock price for a
firm
with earnings for $1.13 / share?
Answer: Price 16 $1.13 $18.08
Computing the Price

of Preferred Stock
Kps = D/P
Value = D/RRR
Eg.
A Company preferred stocks are trading

at RM30 in the market and pay a RM1.5
annual dividend. Assume that the investor
have a required rate of return of 15%. What is
the expected rate of return on the stock?
What is the stocks value to you? Should your
purchase the stock?
How the Market Sets

Security Prices
Generally speaking, prices are set in competitive

markets as the price set by the buyer willing to
pay the most for an item.
The buyer willing to pay the most for an asset is

usually the buyer who can make the best use of
the asset.
Superior information can play an important role.
How the Market Sets

Security Prices
Consider the following three valuations for a stock

with certain dividends but different perceived risk:
Who perceives the lowest risk, is willing to pay the

most and will determine the market price.
Errors in Valuation
Although the pricing models are useful,
market participants frequently encounter
problems in using them. Any of these can
have a significant impact on price in the
Gordon Growth model.
Problems
with Estimating Growth
Problems
with Estimating Risk
Problems
with Forecasting Dividends
Errors in
Valuation
To illustrate this point, the next two slides

show how dramatically a stocks price can
change by simple changes in the expected
dividend growth rate (Table 13.1) and
required return (Table 13.2).
Errors in Valuation:
Dividend growth rates
Errors in Valuation:
Required returns
Case: The 20072009

Financial Crisis and the
The financial crisis, which started in August 2007,
Stock
Market
was the start of one of the worst bear markets.
The crisis lowered g in the Gordon Growth

modeldriving down prices.
Also impacts kehigher uncertainty increases this

value, again lowering prices.
The expectations were still optimistic at the start

of the crisis. But, as the reality of the severity of
the crisis was understood, prices plummeted.
Valuation has a close link with g and k.
Case: 9/11, Enron

and the Market
Both
9/11 and the Enron scandal were

events in 2001.
Both
should lower g in the Gordon

Growth modeldriving down prices.
Also
impacts kehigher uncertainty

increases this value, again lowering prices.
We
did observe in both cases that prices in

the market fell. And subsequently
rebounded as confidence in US markets
returned.
Stock Market Indexes

Stock
market indexes are frequently

used to monitor the behavior of a
groups
of stocks.
Used
a benchmark to represent the

performance of specific stock market
(stock market return).
Major
indexes include the Dow Jones

Industrial Average, the S&P 500, and
the NASDAQ composite.
Buying Foreign Stocks
Buying foreign stocks is useful from a

diversification perspective. However, the
purchase may be complicated if the shares are
not traded in the U.S.
American depository receipts (ADRs) allow
foreign firms to trade on U.S. exchanges,
facilitating their purchase. U.S. banks buy
foreign shares and issue receipts against the
shares in U.S. markets.
Trade on NASDAQ, do not need to meet the disclosure
rules.
US banks buy foreign share and place them in its vault.
Then issue receipt against these shares and trade it
Regulation of the
Malaysia Stock Market
The
primary mission of the Securities

Commission (SC) is
to
promote and maintain fair, efficient,

secure and transparent securities and
derivatives markets
to
facilitate the orderly development of

an innovative and competitive capital
market.
Ultimate
responsibility protect investors
Regulation of the Malaysia

Stock Market
Securities
Commission
Malaysia (SCM)
www.sc.com.my
Regulation of the Stock

Market: Divisions of the
SEC
(US)
Division
of Corporate Finance: responsible
for collecting, reviewing, and making
available all of the documents
corporations and individuals are required
to file
Division
of Market Regulation: establishes

and maintains rules for orderly and
efficient markets.
Regulation of the Stock

Market: Divisions of the
SEC
(US)
Division
of Investment Management:
oversees and regulates the
investment management industry
Division
of Enforcement: investigates
violations of the rules and regulations
established by the other divisions.
Tutorial 7
Mishkin
& Eakins. 2012.

Financial Markets and
Institutions, 7th ed. Pearson.
Pg. 361 Questions 3, 5
Quantitative Problems 6,7,8,9,11,12,13,16

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Financial

learn about the characteristics of

understand the role equities play in

compare and contrast the roles and

To learn the basic stock valuation models.

To review the regulation of Malaysia stock market.

stock market receives considerable

4. Right to vote for

of the stock rises

Investing in Stocks: Sample

is best known, with daily volume around

daily volume around hundreds of

used to imply a specific trading

requirements exclude small firms

stand ready to make a market

about 3,000 different securities are listed on

market for thinly-traded securitiessecurities

occurs over the sophisticated

Organized exchanges (e.g., NYSE)

markets with floor specialists

of trades are filled directly by specialist

trades are filled through SuperDOT

Over-the-counter markets (e.g., NASDAQ)

market makers (dealers) set bid and

dealers for any given security

ask spread is the profit margin for dealers

traders to trade without the need of the middleman. They provide:

everyone can see unfilled orders

not need the specialist (middleman) who

Investing in Stocks: ECNs

work as well with thinlytraded stocks

exchanges are fighting ECNs,

Investing in Stocks: ETFs

are indexed rather than actively managed.

on a major exchange as an individual stock

to a specific portfolio (eg., the S&P 500), so

content of basket is known, so valuation is certain.

iShare Malaysia MSCI Index Fund

sometimes is similar to the stock index mutual

trades like a stock allow for limit orders,

management fees than index mutual funds.

no minimum investment amount.

ETF has brokerage fees to be paid on every time

Malaysia MSCI Index Fund measured by MSCI

Computing the Price

common stock is, in

Computing the Price of

model, just taking using the

Computing the Price of Common

What is the price for a stock with an

Computing the Price of

It assumes that dividend grow at a constant

Example 13.2 pg.350

the current price of Coca-Cola

Computing the Price of

do, indeed, grow at a constant rate

growth rate of dividends, g, is less than the

Computing the Price of Common