Chapter 4 ▪ The Stock Market ▪ Further readings: ▪ Frederic Mishkin, Stanley Eakins, Financial Markets and Institutions, chapters 13. 1 Motivation 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. At the end of 2012, shares are trading on Nasdaq at over $707 / share. 2 Topics Addressed 1. Stock Market Indexes 2. Regulation of the Stock Market 3. Investing in Stocks 4. Computing the Price of Common Stock 5. How the Market Sets Security Prices 6. Errors in Valuation 3 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 – Price of the stock rises over time – Dividends are paid to the stockholder 5. Two types – Common stock ▪ Right to vote ▪ Receive dividends – Preferred stock ▪ Receive a fixed dividend ▪ Do not usually vote 3. Stockholders have claim on all assets 4 Stock Market Indices ▪ 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. 5 Stock Market Indexes ▪ Some indices ▪ ▪ ▪ ▪ Nasdaq The Dow Jones Industrial Average The Nasdaq composite The NYSE Composite Index The S&P 500 Index SP500 The NYSE Dow Jones 6 Bears vs. Bulls ▪ A bull market occurs when stock prices (as measured by an index like the Dow Jones Industrial or the S&P 500) move up. ▪ A bear market occurs when stocks fall. ▪ More specifically, bear markets generally occur when the market has fallen by greater than 20 percent from its highs, and a correction occurs when the market has fallen by more than 10 percent but less than 20 percent. 7 8 Investing in Stocks: How Stocks are Sold • Organized exchanges – NYSE is best known, with daily volume around 4 billion shares, with peaks at 10 billion. – “Organized” used to imply a specific trading location. But computer systems (ECNs) have replaced this idea. – Listing requirements exclude small firms. 9 Investing in Stocks: How Stocks are Sold • Over-the-counter markets – Best example is NASDAQ (National Association of Securities Dealers Automated Quotations) – Dealers stand ready to make a market – 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 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 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 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 (e.g., the S&P 500), so management fees are low (although commissions still apply) ▪ Exact content of basket is known, so valuation is certain 13 Computing the Price of Common Stock • Valuing common stock is, in theory, no different from valuing debt securities: – determine the cash flows – discount them to the present • We will review four different methods for valuing stock, each with its advantages and drawbacks. 14 Computing the Price of Common Stock: The One-Period Valuation Model • Simplest model, just taking the expected dividend and price over the next year. • P = the current price of the stock. The zero subscript refers to time period zero, or the present. 0 • Div = the dividend paid at the end of year 1. 1 • k = the required return on investments in equity. e • P = the price at the end of the first period. This is the assumed sales price of the stock. 1 15 Computing the Price of Common Stock: The One-Period Valuation Model 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 Answer: Price = (0.16 + 60) / (1 + 0.12) = $ 53.71 16 Computing the Price of Common Stock: The Generalized Dividend Valuation Model ▪ The concept remains the same. The value of stock is the present value of all future cash flows. ▪ You must find P in order to find P !!!!!! n 0 ▪ if P is far in the future, it will not affect P n 0 ▪ The generalized dividend model is rewritten without the final sales price. 17 Computing the Price of Common Stock: The Generalized Dividend Valuation Model Questions!!! ▪ Many stocks do not pay dividends, so how is it that these stocks have value? Buyers of the stock expect that the firm will pay dividends someday. Most of the time a firm institutes dividends as soon as it has completed the rapid growth phase of its life cycle. ▪ The generalized dividend valuation model requires that we compute the present value of an infinite stream of dividends, a process that could be difficult 18 Computing the Price of Common Stock: The Generalized Dividend Valuation Model (The Gordon Growth Model) ▪ The generalized dividend valuation model requires that we compute the present value of an infinite stream of dividends, a process that could be difficult. ▪ Simplified models have been developed to make the calculations easier. One such model is the Gordon growth model. ▪ The Gordon growth model that assumes constant dividend growth. 19 Computing the Price of Common Stock: The Generalized Dividend Valuation Model ▪ Where, P0= the price per share D0 = the most recent dividend paid g = the expected constant growth rate in dividends ke = the required return on an investment in equity 20 Computing the Price of Common Stock: The Generalized Dividend Valuation Model Recall Sum of a Geometric Sequence 21 Computing the Price of Common Stock: The Generalized Dividend Valuation Model 22 Computing the Price of Common Stock: The Generalized Dividend Valuation Model ▪ Where, P0= the price per share D0 = the most recent dividend paid g = the expected constant growth rate in dividends ke = the required return on an investment in equity 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. 23 Computing the Price of Common Stock: The Generalized Dividend Valuation Model Example: Find the current market price of Coca-Cola stock assuming dividends grow at a constant rate of 10.95%, D0 = $1.00, and the required return is 13%. Solution: Coca-Cola stock should sell for $54.12 if the assumptions regarding the constant growth rate and required return are correct. 24 Computing the Price of Common Stock: The Price Earnings Valuation Method The price earnings ratio (PE) is a widely watched measure of how much the market is willing to pay for $1 of earnings from a firm. A high PE has two interpretations. 1. A higher-than-average PE may mean that the market expects earnings to rise in the future. This would return the PE to a more normal level. 2. A high PE may alternatively indicate that the market feels the firm’s earnings are very low risk and is therefore willing to pay a premium for them. 25 Computing the Price of Common Stock: The Price Earnings Valuation Method Example: The average industry PE ratio for restaurants similar to Applebee’s, a pub restaurant chain, is 23. What is the current price of Applebee’s if earnings per share are projected to be $1.13? Solution: P = 23 X $1.13 = $26 0 26 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. 27 • Suppose that you are considering the purchase of stock expected to pay dividends of $2 next year (D1= $2). The firm is expected to grow at 3%. Consider the following three valuations for a stock with certain dividends but different perceived risk: Investor Discount Rate Stock Price You 15% $16.67 Sara 12% $22.22 Sami 7% $50.00 • Sami, who perceives the lowest risk, is willing to pay the most and will determine the “market” price. 28 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 model. • Problems with Estimating Growth • Problems with Estimating Risk • Problems with Forecasting Dividends 29 The End Thank you ☺ 30