The Capital Market (Stock Market)

Chapter 5
The Capital Market (Stock Market)

Investing in Stocks
1. Represents ownership 4. Right to vote for
in a firm directors and on
2. Earn a return in certain issues
two ways 5. Two types
 Price of the stock rises  Common stock
over time  Right to vote
 Dividends are paid to the  Receive dividends
stockholder  Preferred stock
3. Stockholders have claim  Receive a fixed
on all assets dividend

 Do not usually vote
Investing in Stocks:
Sample Corporate Stock Certificate
3
How Stocks are Sold
 Organized exchanges
 NYSE is best known, with daily volume around 2 billion shares.
 “Organized” used to imply a specific trading location. But computer
systems (ECNs) have replaced this idea.
 Others include the ASE (US), and Nikkei, LSE, DAX (international)
 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 3,300 different securities are listed on NASDAQ.
 Important market for thinly-traded securities – securities that don’t trade very
often. Without a dealer ready to make a market, the equity would be difficult to
trade.
Organized vs. OTC
 Organized exchanges (e.g., NYSE)
 Auction markets with floor specialists
 25% of trades are filled directly by specialist
 Remaining trades are filled through SuperDOT
 Over-the-counter markets (e.g., NASDAQ)

 Multiple market makers set bid and ask prices
 Multiple dealers for any given security
Investing in Stocks: 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
Investing in Stocks: ECNs
However, ECNs are not without
their drawbacks:
 Don’t work as well with thinly-traded stocks
 Many ECNs competing for volume, which can be confusing
 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 a basket of securities
 Traded on a major exchange
 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
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.
We will review four different methods for valuing stock, each
with its advantages and drawbacks.
Computing the Price of Common Stock: The One-
Period Valuation Model
 Simplestmodel, just taking using the expected dividend and
price over the next year.
 Price Div1 P1
= 
(1  ke ) (1  ke )
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:
0.16 60
Price =  53.71
(1  0.12) (1  0.12)
Computing the Price of Common Stock: The
Generalized Dividend Valuation Model
 Most general model, but the infinite sum may not converge.

 Price = Divt

t 1 (1  k e )
t
 Ratherthan worry about computational problems, we use a

simpler version, known as the Gordon growth model.
Computing the Price of Common Stock: The Gordon
Growth Model
 Same as the previous model, but it assumes that dividend grow at a
constant rate, g. That is,
Div(t+1) = Divt x (1 + g)
 Price = 
Divt D1

t 1 (1  k e )
t

(ke  g )
Computing the Price of 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
Generalized Dividend Valuation Model
 The price earnings ratio (PE) is a widely watched measure of
much the market is willing to pay for $1.00 of earnings from
the firms.
 Price = P
E
E
Computing the Price of 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 x $1.13 = $18.08

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:
 Bud, who perceives the lowest risk, is willing to pay the most and will
determine the “market” price.
Errors in Valuations
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 model.
 Problems with Estimating Growth
 Problems with Estimating Risk
 Problems with Forecasting Dividends
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 model – driving down
prices.
 Also impacts ke – higher 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.
 Major
indexes include the Dow Jones Industrial Average, the
S&P 500, and the NASDAQ composite.
 The securities that make up the (current) DJIA are included
on the next slide.
Stock Market Indexes:
the Dow Jones Industrial Average
Buying Foreign Stocks
 Buyingforeign 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.
Regulation of the Stock Market
 Theprimary mission of the SEC is “…to protect investors and
maintain the integrity of the securities markets.”
 The SEC brings around 500 actions against individuals and
firms each year toward this effort. This is accomplished
through the joint efforts of four divisions.
Regulation of the Stock Market: Divisions of
the SEC
 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
 Division of Investment Management: oversees and regulates
the investment management industry
 Divisionof Enforcement: investigates violations of the rules
and regulations established by the other divisions.

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Chapter 5

The Capital Market (Stock Market)

on all assets dividend

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

What is the price for a stock with an expected dividend and

 Ratherthan worry about computational problems, we use a

The model is useful, with the following assumptions:

If the industry PE ratio for a firm is 16, what is the current

Price = 16 x $1.13 = $18.08

buyer who can make the best use of the asset.

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