© The McGraw-Hill Companies, Inc., 2008McGraw-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 16th 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:
Dn = dividend payment in period n
i = interest rate to discount the dividend stream
n
nowfromyearsn
n
nowfromyearsnyearstwoinyearnexttoday i
P
i
D
i
D
i
DP
)1()1(.....
)1()1(______
2
___
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
.
ntodaynowfromyearsn gDD )1(___
8-21
Valuing Stocks:Dividend-Discount Model
• The solution to this is
.
(1 )todaytoday
D gP
i g
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:
grprf
gDP today
)1(
0
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., 2008McGraw-Hill/Irwin
Chapter 8
End of Chapter
Top Related