© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 8 Stocks, Stock Markets, and Market Efficiency

8-2 Stocks and Stock Markets: The Big Questions What are stocks? How are stocks valued? How risky are stocks?

8-3 Stocks and Stock Markets: Roadmap Essential characteristics of stocks Measuring the level of the stock market Valuing stocks Theory of efficient markets Investing in stocks for the long run

8-4 Stocks: History Common stock or equity represent ownership First appeared in the 16 th century to raise funds for exploration Voyages were dangerous Spread risk though joint-stock companies

8-5 Stocks: History Joint stock companies –More than one expedition at once –Shareholders received share of profits –Shares could be resold

8-6 Stocks: Essentials Key instrument used to hold wealth Central linkage between financial world & the real economy Tell us the value of a firm Allocate scarce resources

8-7 Stocks: Essentials Shares are a small fraction of firm’s value Large number of shares outstanding Priced so that small investments possible Stockholders are residual claimants Limited liability Shareholders can replace bad managers

8-8 Stocks: Important Characteristics Residual Claim Limited Liability

8-9 Stocks: Residual Claim Stockholders are paid after everyone else. Stock is risky since it is leveraged

8-10 Stocks: Limited Liability Maximum loss is the amount invested If firm owes money to –Workers –Suppliers –Bondholders Stockholders are not liable for it

8-11 When you buy a house –You get a roof over your head –You consume housing services Long-run real return to owning a house in the U.S. is 0.20% per yr A house is not an investment, it is a place to live

8-12 Measuring the Stock Market: Indices Dow Jones Industrial Average –Price-weighted: Measures the return to holding one share of each The return to holding a typical stock Standard & Poor’s Composite 500 –Value-weighted: Measures the return to owning all 500 companies (a portfolio with weights equal to the value of each)

8-13 Measuring the Stock Market: Indices Dow Jones Industrial Average Standard & Poor’s 500 Index Other Domestic Stock Market Indices –Nasdaq Composite: 5000 companies –Wilshire 5000: All publicly traded companies (really 6500)

8-14 Measuring the Stock Market: Indices Dow Jones Industrial Average Standard & Poor’s 500 Index Other Domestic Stock Market Indices World Stock Indices –Every country has an index

8-15

8-16 Measuring the Stock Market: Indices Uses of a Stock Market Index –Provides a measure of overall market performance. –Provides a benchmark against which to measure the performance of Individual stocks Various investment strategies

8-17 Valuing Stocks Why do stocks have value? –Because they pay dividends. –Because they will rise in value generating capital gains

8-18 Valuing Stocks Capital gains –Share repurchases –Buyouts

8-19 Valuing Stocks: Dividend-Discount Model Present Value of Dividend Flows: D n = dividend payment in period n i = interest rate to discount the dividend stream

8-20 Valuing Stocks: Dividend-Discount Model This expression is not very useful, unless we assume that we can know (approximately) the growth rate of future dividends If this is g, then.

8-21 Valuing Stocks: Dividend-Discount Model The solution to this is.

8-22 If a stock price goes down by 50% It needs to go up 100% to get back to its original level: Down by 50%: 100  50 (If it only goes up 50%: 50  75!) Then up 100%: 50  100

8-23 Valuing Stocks: Risk Imagine a firm that needs a $1000 computer (and that’s it). Once installed, the firm will have earnings of –$80 in bad times –$160 in good times Financing can be part equity & part debt. Debt can be obtained at a 10% interest rate.

8-24 Return to Debt & Equity Holders for Different Financing Assumptions

8-25 Valuing Stocks: Risk The result of borrowing is to increase the return in good times, but decrease it in bad times. This is leverage.

8-26 Valuing Stocks: Risk Impact of risk: Required Stock Return (i) = Risk-free Return (rf) + Risk Premium (rp) Rewrite dividend-discount model:

8-27 Valuing Stocks: Dividend-Discount Model w/ Risk

8-28 Theory of Efficient Markets Prices reflect all available information Implies stock price movements are unpredictable

8-29 Theory of Efficient Markets Evidence suggests both that –Prices are unpredictable –Professional money managers cannot beat an index like the S&P 500. Their returns 2% lower on average But we do see managers who claim to exceed the market

8-30 Theory of Efficient Markets: What’s Going On? Managers –Have inside information – that’s illegal –Taking on risk and are compensated –They are lucky –Markets aren’t efficient

8-31 How can this be the result of chance? Suppose 225 million people start with a dollar and pair off to flip a coin once. The winner takes the $2 and that’s it. Do this over and over again with only the winners. After 20 flips, there will be 215 people left with over $1 million each. Did they know anything?

8-32 There 2 stock exchanges in China –Shanghai (east coast) –Shenzhen (near Hong Kong) Each firm issues 2 types of shares –A-shares (only Chinese investors until 2001) –B-shares (only foreigners) Prices on A-shares were 4 times prices on B-shares Problem was that there was a shortage of A-shares.

8-33 Investing in Stocks For the Long Run

8-34 Mutual funds offer Affordability: small initial investment Liquidity: can withdraw quickly Diversification: portfolio of stocks Management: professionals Cost: look for low management fees

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 8 End of Chapter