Chapter 13 The Stock Market

price earnings ratio (PE)

a measure of how much the market is willing to pay for $1 of earnings from a firm - can be used to estimate the value of a firm's stock - the generalized dividend valuation model - this is the best method of stock valuation. However it is sometimes difficult to apply. If a firm is not paying dividends or has a very erratic growth rate, the results may not be satisfactory. - 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.

exchange traded funds (ETFs)

a recent innovation to help keep transaction costs down while offering diversification - formed when a basket of securities is purchased and a stock is created based on this basket that is traded on an exchange - 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

stock

a share of _____ represents ownership in a firm

Gordon growth model

a simplified model to compute the value of a stock by assuming constant dividend growth - D_0: the most recent dividend paid - g: the expected constant growth rate in dividends - k_e: the required return on an investment in equity

alternative trading systems (ATSs)

trading systems that bypass traditional exchanges and allow for buyers and sellers of securities to deal directly w/ each other

advantages of PE ratio

useful for valuing privately held firms and firms that do not pay dividends

advantages of ETFs

- ETFs trade like stocks, so they allow for limit orders, short sales, stop-loss orders, and the ability to buy on margin. ETFs tend to have lower management fees than do comparable index mutual funds. - They usually have no minimum investment, whereas mutual funds often require $3,000-$5,000 minimums

problems with forecasting dividends

- 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 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 report. Does all this mean that you should not invest in the market? - No, it only means that 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.

organized exchanges

- NYSE is the best known w/ daily volume around 4 billion shares, w/ peaks at 10 billion. NYSE is the world's largest and most liquid equities exchange - 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

disadvantages of ETFs

- 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.

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. - Competition will prevent high-growth firms from being able to maintain their historical growth rate. Despite this, the stock prices of historically high-growth firms tend to reflect a continuation of the high growth rate. The result is that investors in these firms receive lower returns than they would by investing in mature, slower-growing firms.

stockholders

- ______ have claim on all assets and income left over claimants have been satisfied (aka residual claimant). If nothing is left over, they get nothing. However, it is possible to get rich as a stockholder if the firm does well. - _______ 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.

market makers

- are important in the economy in that they ensure there is continuous liquidity for every stock, even those w/ little transaction volume - are compensated by the spread b/w the bid price and ask price. They also receive commissions on trades

9/11, Enron

- both 9/11 and Enron scandal were events in 2001 - both should lower "g" (the expected constant growth rate in dividends) in the Gordon Growth model- driving down prices - also impacts k_e (the required return on an investment in equity)- higher uncertainty increases this value, again lowering prices - in both cases, prices in the market fell and subsequently rebounded as confidence in US markets returned

disadvantages of ECNs

- don't work as well w/ thinly-traded stocks (The primary disadvantage is that they work well only for stocks w/ substantial volume. Since ECNs require there to be a seller to match against each buyer and vice versa, thinly traded stocks may go long intervals w/o trading) - many ECNs competing for volume, which can be confusing - major exchanges are fight ECNs, w/ an uncertain outcome

how the market sets security prices

- generally speaking, prices are set in competitive markets as the price is set by the buyer willing to pay the most for an item (The price is not necessarily the highest price the asset could fetch, but is incrementally greater than what any other buyer is willing to pay) - the buyer willing to pay the most for an asset is usually the buyer who can make the best use of the asset - superior info about an asset can increase its value by reducing the risk - the buyer who has the best info about these cash flows will discount them at a lower interest rate than will a buyer who is very uncertain

OTC markets

- securities not listed on one of the exchanges trade in the OTC market - this market is not organized in the sense of having a building where trading takes place - best example is NASDAQ - dealers stand ready to make a market by buying for inventory when investors want to sell and selling from inventory when investors want to buy. These dealers provide small stocks w/ the liquidity that is essential to their acceptance in the market - today, about 3,000 different securities are listed on NASDAQ - important market for thinly-traded securities-securities that don't trade very often. W/o a dealer ready to make a market, the equity would be difficult to trade.

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

ETFs 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 exact content of the basket is public so that intraday arbitrage keeps the ETF price close to the implied value.

buying foreign stocks

- useful from a diversification perspective - Diversification of a portfolio reduces risk. A fully diversified portfolio not only will hold securities across a broad swatch of domestic industries, but will also hold securities from around the world. - however, the purchase may be complicated if the shares are not traded in the US - ADRs allow foreign firms to trade on US exchanges, facilitating their purchase - US banks buy foreign shares and issue receipts against the shares in US markets

high PE 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.

Gordon growth model assumptions

1. Dividends are assumed to continue growing at a constant rate forever. 2. The growth rate (g) is assumed to be less than the required return on equity, k_e.

advantages of ECNs

1. Transparency - All unfilled orders are available for review by ECN traders. This provides valuable info about supply & demand that traders can use to set their strategy. Although some exchanges make this info available, it is not always as current or complete as what the ECN provides. 2. Cost reduction - B/c the middleman and the commission are cut out of the deal, transaction costs can be lower for trades executed over an ECN. The spread is usually reduced and sometimes eliminated. 3. Faster execution - Since ECNs are fully automated, trades are matched and confirmed faster than can be done when there is human involvement. For many traders this is not of great significance, but for those trying to trade on small price fluctuations, this is critical. 4. After-hours trading - Prior to the advent of ECNs only institutional traders had access to trading securities after the exchanges had closed for the day. - Man news reports and info become available after the major exchanges have closed, and small investors were locked out of trading on this data. - Since ECNs never close, trading can continue around the clock.

two types of stock

1. common stock - right to vote - receive dividends and hope that the price of their stock will rise 2. preferred stock - receive a fixed dividend - do not usually vote

American depository receipts (ADRs)

A receipt for foreign stocks held by a trustee. The receipts trade on US stock exchanges instead of the actual stock. - one advantage of the ADR is that it allows foreign firms to trade in the US w/o the firms having to meet the disclosure rules required by the SEC

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 w/ estimating growth - problems w/ estimating risk - problems w/ forecasting dividends

disadvantages of PE ratio

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.

Yes

Do stock prices constantly change? (Yes or No) - When new info is released about a firm, expectations change, and w/ them, prices change. New info can cause changes in expectations about the level of future dividends or the risk of those dividends. - Since market participants are constantly receiving new info and constantly revising their expectations, it is reasonable that stock prices are constantly changing as well

Division of Market Regulation

Established and maintains rules for orderly and efficient markets by regulating the major securities market participants. This is the division that reviews and approves new rules and changes to existing rules.

Division of Enforcement

Investigates violations of the rules and regulations established by the other divisions. The _____ _____ _______ conducts its own investigations into various types of securities fraud and acts on tips provided by the SEC's other divisions.

Division of Investment Management

Oversees and regulates the investment management industry. This includes oversight of the mutual fund industry. Just as the Division of Market Regulation establishes rules governing the markets, the ______ ___ _______ _______ establishes rules governing investment companies.

capital, trust

Properly functioning _____ markets are a hallmark of an economically advanced economy. For an economy to flourish, firms must be able to raise funds to take advantage of growth opportunities as they become available. Firms raise funds in the capital markets, and for these to function properly investors must be able to trust the information that is released about the firms that are using them. Markets can collapse in the absence of this ______.

Division of Economic Risk and Analysis

Provides data and analysis to all of the division as needed. Among its responsibilities is to advise the divisions about the economic impact of proposed rules.

Division of Corporate Finance

Responsible for collecting, reviewing, and making available all of the documents corporations and individuals are required to file. These include annual reports, registration statements, quarterly filings, and many others. The division reviews these filings to check for compliance w/ the regulations. It does not verify the truth or accuracy of filings.

preferred stock

Stock in which a fixed dividend must be paid before common dividends are distributed. It often does not mature and does not give the holder voting rights in the company. Differs from common stock: - b/c preferred stockholders receive a fixed dividend that never changes, a share of _____ ____ is as much like a bond as it is like common stock - b/c the dividend does not change, the price of ____ ____ is relatively stable - preferred stockholders do not usually vote unless the firm has failed to pay the promised dividend - preferred stockholders hold a claim on assets that has priority over the claims of common stockholders but after that of creditors such as bondholders

Securities Act of 1933 and 1934

The main purpose of these laws was to 1. require firms to tell the public the truth about their businesses 2. require brokers, dealers, and the exchanges to treat investors fairly. - Congress established the Securities and Exchange Commission (SEC) to enforce these laws.

efficient

The orderly flow of info, 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 w/ valuable growth opportunities

True

True or False - Ways to meet the minimum listing requirements to be listed for trading on one of the organized exchanges - Generally, the firm must have substantial earnings and market value (greater than $10 million per year and $100 million market value)

valuing common stock

______ ______ _____ is, in theory, no different from valuing debt securities: - determine the cash flows - discount them to the present

National Association of Securities Dealers Automated Quotation System (NASDAQ)

a computerized network that links dealers around the country and provides price quotes on over-the-counter securities

super display book (SDBK)

a computerized system for executing trades very rapidly that removes the specialist from the process - automatically match buy orders w/ sell orders w/o intervention - only complex institutional orders continue to be executed by floor traders on the exchange - this system allows for rapid execution of the high volume of trades made daily - most orders are filled electronically via SDBK - few orders on the NYSE are filled by floor trades personally approaching the specialist on the exchange

DJIA

an index composed of 30 "blue chip" industrial firms - most market watchers agree that the _____ is not the best indicator of the market's overall day-to-day performance. Indeed it varies substantially from broader-based stock indexes in the short run. It continues to be followed so closely primarily b/c it is the oldest index and was the first to be quoted by other publications. It continues to be popular b/c it tracks the performance of the overall markets reasonably well over the long run. - 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 docs.

electronic communication networks (ECNs)

are a subset of ATSs/MTFs allow brokers and traders to trade w/o the need of the middleman - are ATSs that are fully electronic

generalized dividend model

calculates that the price of stock is determined only by the present value of the dividends - most general model, but the infinite sum may not converge - price = sum of the present value of all dividends

common stock

determining a value for a ______ ______ is very difficult and it is this difficulty that leads to so much volatility in the stock markets

stock market indexes

frequently used to monitor the behavior of a group of stocks - by reviewing the avg behavior of a group of stocks, investors are able to gain some insight as to how a broad group of stocks may have performed. Various stock market indexes are reported to give investors an indication of different groups of stocks. The most commonly quoted index is the DJIA, an index based on the performance of the stocks of 30 large companies. - major indexes include the Dow Jones Industrial average, S&P 500, and the NASDAQ composite

common stockholders

individuals who have an ownership interest in a firm, w/ rights to receive dividends and vote on major corporate issues

two

investors earn a return in _____ ways 1. Price of the stock rises over time 2. Dividends are paid to the stockholder

large

large or small? - ATSs (alternative trading systems) and MFTs (multilateral trading facilities) are typically used for _____ transactions among institutional investors - ATSs and MTFs allow buyers and sellers of securities to deal directly w/ each other

25%, 5%

less than ____ of new equity issues are preferred stock, and only about _____ of all capital is raised using preferred stock - This may be b/c 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

organized vs OTC

organized exchanges (ex. NYSE) - auction markets w/ floor specialists who specialize in particular stocks - 25% of trades are filled directly by specialist - remaining trades are filled through SuperDOT over-the-counter markets (ex. NASDAQ) - trade on electronic network where multiple market makers set bid and ask prices - multiple dealers for any given security

Securities and Exchange Commission (SEC)

primary mission is to protect investors and maintain the integrity of the securities markets - accomplishes this primarily by ensuring a constant, timely, and accurate flow of info to investors, who can then judge for themselves if a company's securities are a good investment. Thus, the ____ is primarily focused on promoting disclosure of info and reducing asymmetric info rather than determining the strength or well-being of any particular firm. - accomplished through the joint efforts of 4 divisions

one-period valuation model

simplest model, just using the expected dividend and price over the next year - 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.

dealers

that make a market for stocks that trade in low volume are very important to the success of the OTC market - w/o these ______ standing reader 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 - the more liquid an asset is, the greater its quantity demanded. By providing liquidity intervention, dealers increase demand for thinly traded securities.

bid price

the price market makers pay for the stocks

ask price

the price market makers sell the stock for