1. 1/27 TOPIC 12 STOCK MARKET

2. 2/27 Chapter Preview We highlight the basics of stocks market, then review the underlying theories for stock valuation. Topics include: 1. Investing in Stocks 2. Computing the Price of Common Stock 3. How the Market Sets Security Prices 4. Errors in Valuation 5. Stock Market Indexes 6. Regulation of the Stock Market

3. 3/27 Investing in Stocks 1. Represents ownership in a firm  Share of interest  Voting rights -Electing directors, capital structure, merger, issuance of new debt 2. Earn a return in two ways:  Price of the stock rises over time  Dividends are paid to the stockholder; bonus issuance

4. 4/27 Investing in Stocks 4. Riskier compared to fixed income investment: Uncertain dividend policy: Stock is riskier than bonds because stockholders have a lower priority than bondholders when the firm is in trouble, the returns to investors are less assured because dividends can be easily changed. Volatile prices: Stock price increases are not guaranteed. No maturity date: stock certificate does not list a maturity date, face value, or an interest rate, which were indicated on the bond Despite these risks, it is possible to make a great deal of money by investing in stock, whereas that is very unlikely by investing in bonds.

5. Investing in Stocks 5/27 Ownership of stock gives the stockholder certain rights regarding the firm. One is the right of a residual claimant: Stockholders have a claim on all assets and income left over after all other claimants have been satisfied. If nothing is left over, they get nothing. It is possible to get rich as a stockholder if the firm does well. Most stockholders have the right to vote for directors and on certain issues, such as amendments to the corporate charter and whether new shares should be issued.

6. 6/27 Types of Stocks Types of stocks:  Common stock A share of common stock in a firm represents an ownership interest in that firm. Right to vote Receive dividends (depending on firms’ decision - to reinvest) Various classes of common stock, denoted as type A, type B, and so on. The differences among the types usually involve either the distribution of dividends or voting rights. It is important for an investor in stocks to know exactly what rights go along with the shares of stock being contemplated.

7. 7/27 Types of Stocks Types of stocks:  Preferred stock A form of equity from a legal and tax standpoint. it differs from common stock in several important ways: Receive a fixed dividend (price stability-similar to bonds) Do not usually vote unless the firm has failed to pay the promised dividend Priority over the claims of common shareholders but after that of creditors such as bondholders.

8. Types of Stocks 8/27 Less than 25% of new equity issues are preferred stock, and only about 5% of all capital is raised using preferred stock. Because preferred dividends are not tax- deductible to the firm but bond interest payments are. Consequently, issuing preferred stock usually costs the firm more than issuing debt, even though it shares many of the characteristics of a bond.

9. Sample Corporate Stock Certificate Figure 11.1 Wien Consolidated Airlines Stock

10. 10/27 How Stocks are Sold Billions of shares of stock are sold each business day in the United States. The orderly flow of information, stock ownership, and funds through the stock markets is a critical feature of well-developed and efficient markets. This efficiency encourages investors to buy stocks and to provide equity capital to businesses with valuable growth opportunities. We traditionally discuss stocks as trading on either an organized exchange or over the counter. Recently, this distinction is blurring as electronic trading grows in both volume and influence.

11. 11/27 Stocks Trading 1. Organized exchanges: Securities being traded in a physical infrastructure/building; organized trading  72% of total dollar volume of domestic shares traded  Largest U.S. Exchange is the NYSE  Others include Nikkei, LSE, DAX, Bursa Malaysia  Listing requirements exclude small firms: Firms file applications and meet selected criteria Eg: NYSE listing requires min earnings (profit) of $10 million, market value (net worth) of $500 million and revenue (sales) of $100 million About 3000 companies listed in NYSE

12. Stocks Trading 12/27 About 8,500 companies around the world list their shares on the NYSE Euronext. The average firm on the exchange has a market value of $19.6 billion. On October 28, 1998, the NYSE volume topped 1 billion shares for the first time.1 By 2010, daily volume was usually in excess of 4 billion shares with 7 billion shares being traded on peak days. Regional exchanges, such as the Philadelphia, are even easier to list on. Some firms choose to list on more than one exchange, believing that more exposure will increase the demand for their stock and hence its price. Many firms also believe that there is a certain amount of prestige in being listed on one of the major exchanges. They may even include this fact in their advertising. Microsoft, for example, is not listed on any organized exchange, yet its stock had a total market value of over $251 billion in late 2010. Where does it sell its stock???????

13. 13/27 Stocks Trading 2. Over-the-counter markets: Trading occurs over sophisticated telecommunication networks  Example is NASDAQ- National Association of Securities Dealers Automated Quotation System  Currently has 3,300 actively traded securities  Dealers stand ready to make a market Buying for inventory when investors want to sell and selling from inventory when investors want to buy Liquidity intervention-help increase the demand for thinly traded (low volume) securities  Malaysia: MESDAQ – Malaysian Exchange of Securities Dealing and Automated Quotation

14. 14/27 Stocks Trading Not all publicly traded stocks list on one of the organized exchanges or on NASDAQ. Securities that trade very infrequently or trade primarily in one region of the country are usually handled by the regional offices of various brokerage houses. These offices often maintain small inventories of regionally popular securities. Dealers that make a market for stocks that trade in low volume are very important to the success of the over- the-counter market. Without these dealers standing ready to buy or sell shares, investors would be reluctant to buy shares of stock in regional or unknown firms, and it would be very difficult for start-up firms to raise needed capital.

15. 15/27 Organized vs OTC Organized exchanges (e.g. NYSE)  Floor traders/market specialists to facilitate trading  Auction markets with floor traders Representing brokerage firms with buy and sell order Meet at trading post on the exchange and learn about current bid and ask prices. In about 90% of trades, the specialist matches buyers with sellers. In the other 10%, the specialists may intervene by taking ownership of the stock themselves or by selling stock from inventory. It is the specialist’s duty to maintain an orderly market in the stock even if that means buying stock in a declining market  25% of trades are filled directly by specialist (large volume) Remaining (75%) trades are filled through SuperDOT (Super Designated Order Turnaround system) An electronic order routing system Transmit orders directly to specialists who trade in a stock

16. 16/27 Organized vs OTC Over-the-counter markets (e.g. NASDAQ)  Market makers facilitate trading using electronic network  Multiple market makers set bid and ask prices  Multiple dealers for any given security  Income from spread and commissions Market makers are important to the economy in that they assure there is continuous liquidity for every stock, even those with little transaction volume. Market makers are compensated by the spread between the bid price (the price they pay for stocks) and ask price (the price they sell the stocks for). They also receive commissions on trades.

17. 17/27 Organized vs OTC Although NASDAQ, the NYSE, and the other exchanges are heavily regulated, they are still public for-profit businesses. They have shareholders, directors, and officers who are interested in market share and generating profits. This means that the NYSE is vigorously competing with NASDAQ for the high-volume stocks that generate the big fees. For example, the NYSE has been trying to entice Microsoft to leave the NASDAQ and list with them for many years.

18. 18/27 Electronic Communication Networks ECNs allow major brokers and traders to trade without the need of the middleman. Advantages:  Transparency: everyone can see unfilled orders-information about ss and dd – set buying or selling strategy  Cost reduction: smaller spreads  Faster execution: fully auto, faster matching and confirmation  After-hours trading Disadvantages :  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

19. Exchange Traded Funds (ETFs) 19/27 ETFs have become the latest market innovation to capture investor interest. ETFs are formed when a basket of securities is purchased and a stock is created based on this basket that is traded on an exchange. The makeup and structure are continuing to evolve, but ETFs share the following features: 1.They are listed and traded as individual stocks on a stock exchange. Currently, all available offerings are traded on the American Stock Exchange. 2. They are indexed rather than actively managed. 3. Their value is based on the underlying net asset value of the stocks held in the index basket. The exact content of the basket is public so that intraday arbitrage keeps the ETF price close to the implied value.

20. 20/27 Computing Price of Common Stock What should be price of a particular stock based on information available Valuing common stock is, in theory, no different from valuing debt securities:  determine the future cash flows  discount them to the present at an appropriate discount rate (rate of return) Four methods for valuing stock, each with its advantages and drawbacks

21. 21/27 1. One-Period Valuation Model Suppose that you have some extra money to invest for one year. After a year you will need to sell your investment to pay tuition. After watching Wall Street Week on TV you decide that you want to buy Intel Corp. stock. You call your broker and find that Intel is currently selling for $50 per share and pays $0.16 per year in dividends. The analyst on Wall Street Week predicts that the stock will be selling for $60 in one year. Should you buy this stock?

22. 22/27 1. One-Period Valuation Model Simplest model, just using the expected dividend and price over the next year Price = where Div = dividend, P = price, k = required rate of return Example: 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. Price =

23. 1. One-Period Valuation Model Find the value of the Intel stock given the figures reported above. You will need to know the required return on equity to find the present value of the cash flows. Since a stock is more risky than a bond, you will require a higher return than that offered in the bond market. Assume that after careful consideration you decide that you would be satisfied to earn 12% on the investment. Based on your analysis, you find that the stock is worth $53.71. Since the stock is currently available for $50 per share, you would choose to buy it. Why is the stock selling for less than $53.71? It may be because other investors place a different risk on the cash flows or estimate the cash flows to be less than you do. 23/27

24. 24/27 2. Generalized Dividend Valuation Model Extend the one-period model. Most general model, but the infinite sum may not converge Price = Uncertainties about dividend payments Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model.

25. 25/27 3. Gordon Growth Model Fact is many firms strive to increase dividends at constant rate each year Same as the previous model, but it assumes that dividend grow at a constant rate, g. That is, Div (t+1) = Div t x (1 + g) P o = D o x (1 + g) k e -g The model is useful, with the following assumptions:  Dividends do, indeed, grow at a constant rate forever  Growth rate of dividends, g, is less than the required return on the equity, k e.

26. 26/27 3. Gordon Growth Model Example: Find the current market price of Coca-Cola stock assuming dividends grow at a constant rate of 10.95%, Do - $1.00 and the required return is 13%. P o = D o x (1 + g) k e -g P o = 1.00 x (1.1095).13-.1095 P o = $54.12

27. 27/27 4. Price Earnings Valuation Method Price earnings ratio (PE) is a widely watched measure of how much the market is willing to pay for $1.00 of earnings from the firms Most common measure of how expensive a stock is Current price=PE ratio x earnings expected Price = Example: 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

28. 28/27 PE ratio Is equal to a stock's market capitalization divided by its after- tax earnings over a 12-month period High P/E ratio means:  Market is willing to pay for each dollar of annual earnings  Market expects earnings to rise in the future  Market feels firms earnings very low risk and willing to pay a premium for the earnings However, comparison of P/E ratios is more meaningful for companies within same industry.  Higher than industry average PE implies investors have paid high enough for each dollar of earning  Companies with high P/E ratios are more likely to be considered "risky" investments than those with low P/E ratios, since a high P/E ratio signifies high expectations.

29. 29/27 How Market Sets Security Prices? Suppose you go to an auto auction. The cars are available for inspection before the auction begins…… -the price is set by the buyer willing to pay the highest price. -the market price will be set by the buyer who can take best advantage of the asset -Information in asset pricing. Superior information about an asset can increase its value by reducing its risk. Things that are likely to affect the price of a stock include:  What people expect its future dividends will be  When the dividends are expected to be paid  The amount of risk involved The role of information to investors

30. 30/27 How Market Sets Security Prices Prices are set in competitive markets as the price set by the buyer willing to pay the most for the share The buyer willing to pay the most for the share is usually the buyer who can make the best use of the share Superior information can play an important role Example: Bud knows great detail and confident of the future prospects of the firm. He perceives the lowest risk, so he only requires 7% return. Using the Gordon growth model, Bud ends up willing to pay the highest price

31. 31/27 How 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.

32. 32/27 Errors in Valuations Although pricing models are useful, market participants frequently encounter problems in using them. The following can have significant impact on price in the Gordon model.  Problems with estimating growth: competition prevent high growth firms from maintaining the growth. Difficult to estimate future growth rates  Problems with estimating risk-Difficult to determine the required rate of return  Problems with forecasting dividends: uncertain dividend policy

33. 33/27 Stock Market Indexes Stock market indexes are frequently used to monitor the behavior of a groups of stocks. Benchmark index Major indexes include the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite Standard and Poors 500 (S&P 500) Index:  An index based on the stock prices of the largest 500 firms traded on the New York Stock Exchange, the NASDAQ stock market, and the American Stock Exchange. Dow Jones Industrial Average Index:  An index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance.

34. 34/27 Stock Market Indexes: the Dow Jones Industrial Average

35. 35/27 Stock Market Indexes The next two slides show the Dow Jones Industrial Average from 1980– 2004. As can be seen, $1.00 invested in the DJIA back in 1980, when the DJIA was around 800, would have grown to about $12.50 in 2004, when the Dow reached 10,000. This represented an annual growth rate around 10.6%.

36. 36/27 Stock Market Indexes, DJIA Figure 11.2b Dow Jones Industrial Average, 1990-2004

37. 37/27 Regulation of the Stock Market The primary 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. 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.

38. 38/27 Regulation of Stock Market: Divisions of the SEC 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.