auctioning its shares in an unusual IPO format. The shares originally sold for $85 / share, and closed at over $100 on the first day. In November of 2010, shares are trading on Nasdaq at over $620 / share.
Chapter Preview The stock market receives considerable attention from investors. As Google illustrates, great fortunes can be made! But also lost. This is the focus of chapter 13—a look at the equity side of investing.
Chapter Preview We examine the markets where stocks trade, and then review the underlying theories for stock valuation. We learn that stock valuations is quite difficult. Topics include: ─ Investing in Stocks ─ Computing the Price of Common Stock ─ How the Market Sets Security Prices ─ Errors in Valuation
Investing in Stocks: How Stocks are Sold Organized exchanges ─ NYSE is best known, with daily volume around 4 billion shares, with peaks at 7 billion. ─ “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
Investing in Stocks: How Stocks are Sold Over-the-counter markets ─ Best example is NASDAQ ─ Dealers stand ready to make a market ─ Today, about 3,000 different securities are listed on NASDAQ. ─ 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.
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
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
drawbacks: Don’t work as well with thinly-traded stocks Many ECNs competing for volume, which can be confusing Major exchanges are fighting ECNs, with an uncertain outcome
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 (eg., the S&P 500), so management fees are low (although commissions still apply) Exact content of basket is known, so valuation is certain
Computing the Price of Common Stock Valuing common stock is, in theory, no different from valuing debt securities: determine the future cash flows and discount them to the present at an appropriate discount rate. We will review four different methods for valuing stock, each with its advantages and drawbacks.
Computing the Price of Common Stock: The Gordon Growth Model
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.
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
valuation is not an exact science. Considering different growth rates, required rates, etc., is important in determining if a stock is a good value as an investment.
Stock Market Indexes The next two slides show the Dow Jones Industrial Average from 1980–2010. As can be seen, $1.00 invested in the DJIA back in 1980, when the DJIA was around 800, would have grown to about $12.50 in 2010, when the Dow reached 10,000. This represented an annual growth rate around 8.8%.
Buying Foreign Stocks Buying foreign stocks is useful from a diversification perspective. However, the purchase may be complicated if the shares are not traded in the U.S. American depository receipts (ADRs) allow foreign firms to trade on U.S. exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue receipts against the shares in U.S. markets.
Regulation of the Stock Market The primary mission of the SEC is “…to protect investors and maintain the integrity of the securities markets.” The SEC brings around 500 actions against individuals and firms each year toward this effort. This is accomplished through the joint efforts of four divisions.
Regulation of the Stock Market: Divisions of the SEC Division of Corporate Finance: responsible for collecting, reviewing, and making available all of the documents corporations and individuals are required to file Division of Market Regulation: establishes and maintains rules for orderly and efficient markets.
Regulation of the Stock Market: Divisions of the SEC Division of Investment Management: oversees and regulates the investment management industry Division of Enforcement: investigates violations of the rules and regulations established by the other divisions.
Chapter Summary Investing in Stocks: we developed an understanding the structure of the various trading systems, including exchanges and OTC markets Computing the Price of Common Stock: various techniques for valuing dividends and earnings were presented
Chapter Summary (cont.) How the Market Sets Security Prices: the basic idea that prices are set by the “highest bidder” was reviewed Errors in Valuation: difficulties in determining dividends, growth rates, and/or required returns can have a significant impact in the pricing models
Chapter Summary (cont.) Stock Market Indexes: a way to track changes in valuation for a broad group of stocks Buying Foreign Stocks: potential benefits for diversifications, simplified by the use of ADRs. Regulation of the Stock Market: the primary function of the Securities and Exchange Commission