2. Chapter 11 The Stock Market

3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-2 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 2007, shares are trading on Nasdaq at over $650 / share. But ……

4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-3 Chapter Preview The stock market receives considerable attention from investors. As Google illustrates, great fortunes can be made! But also lost. This is the focus of chapter 11 – a look at the equity side of investing.

5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-4 Chapter Preview We examine the markets where stocks trade, and then review the underlying theories for stock valuation. We learn that stock valuations is quite difficult. Topics include: – Investing in Stocks – Computing the Price of Common Stock – How the Market Sets Security Prices – Errors in Valuation

6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-5 Chapter Preview (cont.) – Stock Market Indexes – Buying Foreign Stocks – Regulation of the Stock Market

7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-6 Investing in Stocks 1.Represents ownership in a firm 2.Earn a return in two ways – Price of the stock rises over time – Dividends are paid to the stockholder 3.Stockholders have claim on all assets 4.Right to vote for directors and on certain issues 5.Two types – Common stock Right to vote Receive dividends – Preferred stock Receive a fixed dividend Do not usually vote

8. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-7 Investing in Stocks: 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

9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-8 Investing in Stocks: 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.

10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-9 Investing in Stocks: 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

11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-10 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

12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-11 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

13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-12 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

14. 11-13 If you require a 15% return to compensate you for the risk of owning stock, you expect company XYZ to pay $.15 in dividends this year, and expect the company to sell for $30 at the end of the year, how much would you be willing to pay for the company today? Suppose if you decide the stock is more risky than you thought. How does this affect the price you are willing to pay? Computing the Price of Common Stock—QUIZ

15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-14 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.

16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-15 Computing the Price of Common Stock: The One-Period Valuation Model Basic Principle of Finance – Value of Investment = Present Value of Future Cash Flows Just taking PV using the expected dividend and price over the next year. Price =

17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-16 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: Price =

18. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-17 Computing the Price of Common Stock: The Generalized Dividend Valuation Model Recognize that P in distant future has PV near zero Price 0 = Of course, we don’t know the entire stream of dividends. One approach to this problem is the Gordon growth model.

19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-18 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) = Div t x (1 + g) Price =

20. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-19 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, k e.

21. 11-20 One difficulty in applying these stock valuation models is that we need some estimate of the long term growth of dividends, g. One simplistic approach is to use the average compound annual growth rate over a reasonably long period of time. Calculating Dividend Growth

22. 11-21 Example (Coca-Cola) 19921993199419951996 Dividend$0.660.700.800.88$1.00 Or, multiply the Gross Growth rate of annual dividends together and take the Nth root -1. See http://www2.hawaii.edu/~bonham/340/xls/GMEAN.xls http://www2.hawaii.edu/~bonham/340/xls/GMEAN.xls Example of Geometric Mean http://www.math.toronto.edu/mathnet/questionCorner/geomean.html

23. 11-22 CocaCola continued.... Assume that dividends will grow at a constant rate of g = 10.95%, D t = $1.00, and k e = 13%. --> P = $54.12 Pricing of Common Stock

24. 11-23 Another way of using the constant growth model of stock prices is to decompose the required return on equity into its component parts: Required Return on Equity

25. 11-24 The required return on equity is equal to the dividend yield plus the capital yield. Dividend yield: The amount paid to shareholders as a percentage of the firms current stock price. Capital yield: The yield a stock holder receives due to an increasing stock price, or due to internal investment of retained earnings. One way to look at this required return equation is to use it to calculate an expected return based on expected growth in dividends, earnings, or sales. Required Return on Equity

26. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-25 Quiz If the PE ratio for the Tech sector is 20, how much should you pay for a firm with earnings for $1.25 / share? Answer: Price = 20 x $1.25 = $25 Using PE ratio

27. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-26 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 =

28. 11-27 How the market PE is useful http://www.econbrowser.com/archives/2008/11/investment_advi.html

29. 11-28 How the market PE is useful http://books.google.com/irrational exuberanceBut Not a Short Run ToolShiller on PE

30. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-29 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.

31. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-30 How the Market Sets Security Prices You are considering buying Firestone with dividend growth of g=3%, a $2.0 dividend expected next year. Suppose that you are very uncertain about your dividend growth estimate, so you require a 15% rate of return, k e = 15%. Bud the race car driver is more certain about the 3% dividend growth and only requires a 7% rate of return. Find the price that each investor is willing to pay. If you and Bud are the only two investors, who gets the stock? For how much?

32. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-31 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.. See http://www2.hawaii.edu/~bonham/340/GMEAN.xlshttp://www2.hawaii.edu/~bonham/340/GMEAN.xls

33. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-32 How the Market Sets Security Prices Market price is set by buyer willing to pay highest price. And better information can increase the market value of an asset by reducing perceived risk. It is also possible that the person willing to pay the highest price is simply the one with an incorrect perception of risk!

34. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-33 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

35. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-34 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 k e – 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.

36. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-35 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, Wilshire 5000Wilshire 5000 The securities that make up the (current) DJIA are included on the next slide.

37. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-36 Stock Market Indexes: the Dow Jones Industrial Average

38. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-37 Stock Market Indexes The next two slides show the Dow Jones Industrial Average from 1980–2007. 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% = ($12.50/$1.00)^(1/25) -1

39. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-38 Stock Market Indexes, DJIA Historical stocks charts are found at http://stockcharts.com/charts/historical/ http://stockcharts.com/charts/historical/

40. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-39 Stock Market Indexes, DJIA (cont.) Historical stocks charts are found at http://stockcharts.com/charts/historical/ http://stockcharts.com/charts/historical/

41. 11-40 Stock Market Indexes Graph of Dow http://stockcharts.com/charts/historical/djia1900.html http://stockcharts.com/charts/historical/djia1900.html

42. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-41 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.

43. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-42 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.

44. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-43 Regulation of the Stock Market: Divisions of the SEC Division of Investment Management: oversees and regulates the investment management industry oversees Division of Enforcement: investigates violations of the rules and regulations established by the other divisions. violations

45. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-44 Chapter Summary Investing in Stocks: we developed an understanding the structure of the various trading systems, including exchanges and OTC markets Computing the Price of Common Stock: various techniques for valuing dividends and earnings were presented

46. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-45 Chapter Summary (cont.) How the Market Sets Security Prices: the basic idea that prices are set by the “highest bidder” was reviewed Errors in Valuation: difficulties in determining dividends, growth rates, and/or required returns can have a significant impact in the pricing models

47. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-46 Chapter Summary (cont.) Stock Market Indexes: a way to track changes in valuation for a broad group of stocks Buying Foreign Stocks: potential benefits for diversifications, simplified by the use of ADRs. Regulation of the Stock Market: the primary function of the Securities and Exchange Commission