Maryam 69 3641 1 C11

Chapter 11
The Stock Market

Investing in Stocks
1. Represents ownership 4. Right to vote for directors

in a firm and on certain issues
5. Two types
2. Earn a return in
– Common stock
two ways • Right to vote
– Price of the stock rises • Receive dividends
over time – Preferred stock
– Dividends are paid to • Receive a fixed dividend,
the stockholder prices are stable
• Do not usually vote
3. Stockholders have • Priority over common
claim on all assets stockholders
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-2

How Stocks Are Sold
• Literally billions of shares of stock are sold each

business day in the United States.
• The orderly flow of information, 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
with valuable growth opportunities.

Investing in Stocks:
How Stocks are Sold
• Organized exchanges
– Began trading in 1792 when 24 brokers began trading
a few stocks on Wall Street.
– NYSE is best known, with daily volume around 2 billion
shares.
– “Organized” used to imply a specific trading location.
But computer systems (ECNs) have replaced this idea.
– Others major exchanges include the ASE (US), and
Nikkei in Tokyo, LSE in England, DAX in Germany
(international)
– Listing requirements exclude small firms

• 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.
• At least 2200 shareholders with a monthly
trading volume of 100,000 shares.
• Earnings of at least $10 million for the last
three years.
• $100 million market value.

• About 2800 companies are listed on NYSE. More
than 70% of companies have joined the
exchange since 1986.
• Second largest exchange in US is American
Stock Exchange and 700 firms trade on it.
• It has less restrictive listing requirements.
• Regional exchanges such as Philadelphia and
Pacific Stock Exchange are even easier to list on.
• Many firms list on more than one exchange with a
belief that it will increase the demand and price of
the stock.

How Stocks are Sold
• Over-the-counter markets
– Trading occurs over a sophisticated telecommunications network
– Best example is NASDAQ
– Introduced in 1971 and provides current bid and ask prices on
about 3200 actively traded securities
– Dealers stand ready to make a market
– These dealers provide small stocks with the liquidity that is
essential to their acceptance in the 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.

• Not all publicly traded stocks list on one of the
organized exchanges or on NASDAQ. Securities
that trade very infrequently or trade primarily in one
region of the country are usually handled by the
regional offices of various brokerage houses.
These offices often maintain small inventories of
regionally popular securities. 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. 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
– Market makers are important to the economy in that they assure 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.

Investing in Stocks: ECNs
ECNs (electronic communication networks)

allow brokers and traders to trade without the
need of the middleman. They provide:
– Transparency:All unfilled orders are available for
review by ECN traders. This provides valuable
information about supply and demand that traders
can use to set their strategy. Although some
exchanges make this information available, it is not
always as current or complete as what the ECN
provides.

• Cost reduction: Because the middleman and the
commission is cut out of the deal, transaction
costs can be lower for trades executed over an
ECN. The spread is usually reduced and
sometimes eliminated.
• 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.

• 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. Many news reports and
information 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.

Investing in Stocks: ECNs
However, ECNs are not without

their 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.
• Introduced in 1990 and by 2007 over 400 separate ETFs were being
traded.
• ETF is formed when a basket of securities is purchased and a stock
is created based on this basket that is traded on an exchange.
• They are listed and traded as individual stocks on a stock exchange.
Currently, all available offerings are traded on the American 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.

Computing the Price
of Common Stock—QUIZ
If you require a 15% return to compensate you for

the risk of owning stock, you expect company
XYZ to pay $.15 in dividends this year, and
expect the company to sell for $30 at the end of
the year, how much would you be willing to pay
for the company today?
Suppose if you decide the stock is more risky
than you thought. How does this affect the price
you are willing to pay?
11-15
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
One-Period Valuation Model
• Basic Principle of Finance

– Value of Investment = Present Value of Future
Cash Flows
• Just taking PV using the expected dividend

and price over the next year.
Div1 P1

Price = (1  ke ) (1  ke )

One Period Valuation Model

One-Period Valuation Model
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:
0.16 60
Price =   53.71
(1  0.12) (1  0.12)

Computing the Price of Common Stock:
The Generalized Dividend Valuation
Model
Recognize that P in distant future has PV near zero
• Price0 = 
Divt

t 1 (1  k ) t
• It requires to compute the PV of an infinite stream
e
of dividend payments which is difficult. One

approach to this problem is the Gordon growth
model.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-20

Gordon Growth Model

Divt D1

t 1 (1  k e )
t

(k e  g )
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.

Pricing of Common Stock
• Assume that dividends will grow at a constant
rate of g = 10.95%, Dt = $1.00, and ke = 13%.
--> P = $54.12
11-24
Required Return on Equity
• Another way of using the constant growth model
of stock prices is to decompose the required
return on equity into its component parts:
11-26
Required Return on Equity
The required return on equity is equal to the dividend yield

plus the capital yield.
• Dividend yield: The amount paid to shareholders as a
percentage of the firms current stock price.
• Capital yield: The yield a stock holder receives due to
an increasing stock price, or due to internal investment
of retained earnings.
• One way to look at this required return equation is to use
it to calculate an expected return based on expected
growth in dividends, earnings, or sales.
11-28
Computing the Price of Common Stock:
The Generalized Dividend Valuation
Model
• The price earnings ratio (PE) is a widely
watched measure of much the market is
willing to pay for $1.00 of earnings from
the firms.
P
• Price =  E
E

• P/E = Current Price/ EPS
• P = P/E x EPS

Quiz
If the PE ratio for the Tech sector is 20,

how much should you pay for a firm with
earnings for $1.25 / share?
Answer:
Price = 20 x $1.25 = $25
Using PE ratio

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.
• You are considering buying Firestone with dividend

growth of g=3%, a $2.0 dividend expected next year.
Suppose that you are very uncertain about your dividend
growth estimate, so you require a 15% rate of return, ke =
15%.
• Bud the race car driver is more certain about the 3%
dividend growth and only requires a 7% rate of return.
• Find the price that each investor is willing to pay.
• If you and Bud are the only two investors, who gets the
stock? For how much?

• Consider the following three valuations for a

stock with certain dividends but different
perceived risk:
• Bud, who perceives the lowest risk, is willing

to pay the most and will determine the
“market” price.
. See http://www2.hawaii.edu/~bonham/340/GMEAN.xls

Market price is set by buyer willing to pay highest

price. And better information can increase the
market value of an asset by reducing perceived
risk.
It is also possible that the person willing to pay

the highest price is simply the one with an
incorrect perception of risk!

Errors in Valuations
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
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. Table 13.2 shows how the
price of a share of stock offering a $2
dividend and a 5% growth rate changes with
different estimates of the required return.
Clearly, stock price is highly dependent on
the required return, despite our uncertainty
regarding how it is found.
Problems with Forecasting
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.

Stock Market Indexes
• Stock market indexes are frequently used to

monitor the behavior of a groups
of stocks. How a major group of stocks may
have performed?
• Major indexes include the Dow Jones Industrial
Average, the S&P 500, and the NASDAQ
composite, Wilshire 5000
• The securities that make up the (current) DJIA
are included on the next slide.
Stock Market Indexes:
the Dow Jones Industrial Average

Buying Foreign Stocks
• Stockholders can diversify their risk across different countries.
• The problem with buying foreign stocks is that most foreign companies
are not listed on any one of the US stock exchanges so the purchase of
shares is difficult.
• Intermediaries solve this problem by selling American depository receipts.
• US bank buys the shares of a foreign company and places them in vault.
The bank then issues these receipts against shares and these receipts
can be traded domestically, usually on the NASDAQ.
• Trade in ADRs is usually conducted in US dollars and bank converts
stock dividends in to US dollars.
• One advantage of ADRs is that it allows foreign firms to trade in the US
without the firms having to meet the disclosure rules required by the SEC.

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.

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Chapter 11

The Stock Market

1. Represents ownership 4. Right to vote for directors

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-2

• Literally billions of shares of stock are sold each

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-3

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-4

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-5

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-6

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-7

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-8

• Organized exchanges (e.g., NYSE)

• Over-the-counter markets (e.g., NASDAQ)

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-9

ECNs (electronic communication networks)

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-10

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-11

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-12

However, ECNs are not without

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-13

• Exchange Traded Funds are a recent innovation to help keep

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-14

If you require a 15% return to compensate you for

Valuing common stock is, in theory, no

We will review four different methods for

• Basic Principle of Finance

• Just taking PV using the expected dividend

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-17

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-18

What is the price for a stock with an

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-19

Recognize that P in distant future has PV near zero

of dividend payments which is difficult. One

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-20

The model is useful, with the

• Dividends do, indeed, grow at a constant

• The growth rate of dividends, g, is less than

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-23

The required return on equity is equal to the dividend yield

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-29

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-30

If the PE ratio for the Tech sector is 20,

Price = 20 x $1.25 = $25

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-31

• Generally speaking, prices are set in

• You are considering buying Firestone with dividend

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-33

• Consider the following three valuations for a

• Bud, who perceives the lowest risk, is willing

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-34

Market price is set by buyer willing to pay highest

It is also possible that the person willing to pay

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-35

Although the pricing models are useful,

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-37

• The dividend valuation model requires the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-39

• Stock market indexes are frequently used to

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-41

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-42

• The primary mission of the SEC is “…to

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-43

• Division of Corporate Finance: responsible