Chapter 13 The stock market
The market for stocks is undoubtedly the one that receives the most attention and scrutiny. Great fortunes
are made and lost as investors attempt to anticipate the market’s ups and downs.
Investing in Stocks
A share of stock in a firm represents ownership. A stockholder owns a percentage interest in a firm,
consistent with the percentage of outstanding stock held.
Investors can earn a return from stock in one of two ways:
- Either the price of the stock rises over time or,
- the firm pays the stockholder dividends.
Stock is riskier than bonds because stockholders have a lower priority than bondholders when the firm is in
trouble, dividends are less assured, and stock price increases are not guaranteed. 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. Another distinction between stock and bonds is that stock does not mature.
Ownership of stock gives the stockholder certain rights regarding the firm:
- the right of a residual claimant: Stockholders have a claim on all assets and income left over after all
other claimants have been satisfied.
- 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.
Common Stock vs. Preferred Stock
There are two types of stock, common and preferred.
Common stock
- A share of common stock in a firm represents an ownership interest in that firm.
- Common stockholders vote, receive dividends, and hope that the price of their stock will rise.
- no guaranteed variable dividend
- volatile price
Preferred stock
- Preferred stock is a form of equity from a legal and tax standpoint.
- preferred stockholders do not usually vote unless the firm has failed to pay the promised dividend.
- preferred stockholders receive a fixed dividend that never changes
- because the dividend does not change, the price of preferred stock is relatively stable.
- preferred stockholders hold a claim on assets that has priority over the claims of common
shareholders.
Less than 25% of new equity issues are preferred stock, and only about 5% of all capital is raised using
preferred stock. This may be because preferred dividends are not tax-deductible to the firm like bond
interest payments. Consequently, preferred stock usually has a higher cost than debt, even though it shares
many of the characteristics of a bond.
How Stocks Are Sold
We traditionally discuss stocks as trading either on an organized exchange or over the counter.
Organized Securities Exchanges
Historically, the New York Stock Exchange (NYSE) has been the best known of the organized exchanges. The
traditional definition of an organized exchange is that there is a specified location where buyers and sellers
meet on a regular basis to trade securities using an open-outcry auction model. There are also major
organized stock exchanges around the world. The most active exchange in the world is the Nikkei in Tokyo.
To have a stock listed for trading on one of the organized exchanges, a firm must file an application and
meet certain criteria set by the exchange designed to enhance trading. Generally, the firm must have
substantial earnings and market value (greater than $10 million per year and $100 million market value).
Over-the-Counter Markets
Securities not listed on one of the exchanges trade in the over-the-counter (OTC) market. This market is not
organized in the sense of having a building where trading takes place. Instead, trading occurs over
sophisticated telecommunications networks. One such network is called the National Association of
Securities Dealers Automated Quotation System (NASDAQ). Dealers “make a market” in these stocks by
buying for inventory when investors want to sell and selling from inventory when investors want to buy.
These dealers provide small stocks with the liquidity that is essential to their acceptance in the market.
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.
Organized vs. Over-the-Counter Trading
There is a significant difference between how organized and OTC exchanges operate.
Organized exchanges are characterized as auction markets that use floor traders who specialize in
particular stocks. These specialists oversee and facilitate trading in a group of stocks. Floor traders,
representing various brokerage firms with buy and sell orders, meet at the trading post on the exchange
and learn about current bid and ask prices. These quotes are called out loud. In about 90% of trades, the
specialist matches buyers with sellers.
Whereas organized exchanges have specialists who facilitate trading, over-the counter markets have
market makers. Rather than trade stocks in an auction format, they trade on an electronic network where
bid and ask prices are set by the market makers. There are usually multiple market makers for any particular
stock. They each enter their bid and ask quotes.
Market makers are important to the economy in that they ensure 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.
ECNs (Electronic Communication Networks)
An ECN is an electronic network that brings together major brokerages and traders so that they can trade
among themselves and bypass the middleman. ECNs have a number of advantages that have led to their
rapid growth.
- Transparency: All unfilled orders are available for review by ECN traders.
- Cost reduction: Because the middleman and the commission are cut out of the deal, transaction
costs can be lower for trades executed over an ECN.
- Faster execution: Since ECNs are fully automated, trades are matched and confirmed faster than
can be done when there is human involvement.
- After-hours trading: Since ECNs never close, trading can continue around the clock.
Along with the advantages of ECNs there are disadvantages. The primary one is that they work well only for
stocks with substantial volume.
Exchange Traded Funds
In their simplest form, 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:
- They are listed and traded as individual stocks on a stock exchange.
- They are indexed rather than actively managed.
- Their value is based on the underlying net asset value of the stocks held in the index basket.
The primary disadvantage of ETFs is that since they trade like stocks, investors have to pay a broker
commission each time they buy or sale shares. This provides a cost disadvantage compared to mutual funds
for those who want to frequently invest small amounts.
Computing the Price of Common Stock
One basic principle of finance is that the value of any investment is found by computing the value today of
all cash flows the investment will generate over its life.
1. The One-Period Valuation Model
This assumes that you buy the stock, hold it for one period to get a dividend, then sell the stock. To value
the stock today, you need to find the present discounted value of the expected cash flows (future
payments) using the formula
𝐷1 𝑃1
𝑃0 = +
(1 + 𝑘𝑒 ) (1 + 𝑘𝑒 )
The cash flows consist of one dividend payment plus a final sales price, which, when discounted back to the
present leads to this equation.
𝑃0 = the current price of the stock. The zero subscript refers to time period zero, or the present.
𝐷1 = the dividend paid at the end of year 1.
𝑘𝑒 = the required return on investments in equity.
𝑃1 = the price at the end of the first year. This is the assumed sales price of the stock.
2. The Generalized Dividend Valuation Model
The one-period dividend valuation model can be extended to any number of periods.
The current value of a share of stock can be found as simply the present value of the future dividend
stream. The generalized dividend model is rewritten in Equation 3 without the final sales price.
The generalized dividend model says that the price of stock is determined only by the present value of the
dividends and that nothing else matters.
3. The Gordon Growth Model
Same as the previous model, but it assumes that dividend grows at a constant rate, g.
This model is useful for finding the value of stock, given a few assumptions:
- Dividends are assumed to continue growing at a constant rate forever.
As long as they are expected to grow at a constant rate for an extended period of time (even if not
forever), the model should yield reasonable results.
- The growth rate is assumed to be less than the required return on equity, 𝒌𝒆 .
In theory, if the growth rate were faster than the rate demanded by holders of the firm’s equity, in
the long run the firm would grow impossibly large.
4. 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. The PE ratio can be used to estimate the value of a firm’s stock.
Firms in the same industry are expected to have similar PE ratios in the long run. The value of a firm’s stock
can be found by multiplying the average industry PE times the expected earnings per share. 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.
The PE ratio approach is especially useful for valuing privately held firms and firms that do not pay
dividends. The weakness of the PE approach to valuation is that by using an industry average PE ratio, firm-
specific factors that might contribute to a long-term PE ratio above or below the average are ignored in the
analysis. A skilled analyst will adjust the PE ratio up or down to reflect unique characteristics of a firm when
estimating its stock price.
How the Market Sets Security Price
- the price is set by the buyer willing to pay the highest price. The price is not necessarily the highest
price the asset could fetch, but it is incrementally greater than what any other buyer is willing to
pay.
- the market price will be set by the buyer who can take best advantage of the asset.
- Superior information about an asset can increase its value by reducing its risk. When you consider
buying a stock, there are many unknowns about the future cash flows. The buyer who has the best
information about these cash flows will discount them at a lower interest rate than will a buyer who
is very uncertain.
When new information is released about a firm, expectations change, and with them, prices change.
New information can cause changes in expectations about the level of future dividends or the risk of
those dividends. Since market participants are constantly receiving new information and constantly
revising their expectations, it is reasonable that stock prices are constantly changing as well.
Errors in Valuation
Although the pricing models are useful, there are many opportunities for errors in applying the models:
- Problems with Estimating Growth
The constant growth model requires the analyst to estimate the constant rate of growth the firm
will experience. You may estimate future growth by computing the historical growth rate in
dividends, sales, or net profits. This approach fails to consider any changes in the firm or economy
that may affect the growth rate.
- Problems with Estimating Risk
The dividend valuation model requires the analyst to estimate the required return for the firm’s
equity. Clearly, stock price is highly dependent on the required return, despite our uncertainty
regarding how it is found.
- Problems with Forecasting Dividends
Even if we are able to accurately estimate a firm’s growth rate and its required return, we are still
faced with the problem of determining how much of the firm’s earnings will be paid as dividends.
Clearly, many factors can influence the dividend payout ratio. These will include the firm’s future
growth opportunities and management’s concern over future cash flows.
Putting all of these concerns together, we see that stock analysts are seldom very certain that their stock
price projections are accurate. This is why stock prices fluctuate so widely on news reports.
Short-term fluctuations in stock prices are expected and natural.
Over the long term, the stock price will adjust to reflect the true earnings of the firm. If high-quality firms
are chosen for your portfolio, they should provide fair returns over time.
Stock Market Indexes
A stock market index is used to monitor the behavior of a group of stocks. By reviewing the average
behavior of a group of stocks, investors are able to gain some insight as to how a broad group of stocks may
have performed. The most commonly quoted index is the Dow Jones Industrial Average (DJIA), an index
based on the performance of the stocks of 30 large companies. Other indexes, such as Standard & Poor’s
500 Index, the NASDAQ composite, and the NYSE composite, may be more useful for following the
performance of different groups of stocks.
