CHAPTERS 4

Stock Markets
SECTION 4 – GROUP 3

1. Tigist Kebede Bayabil GSE/8186/14

2. Tihut Berhanu Jijo GSE/5297/14
3. Tilahun Woldeamanuel Atrago GSE/0488/14
4. Wubeshet Kifle Ayigemit GSE/7663/14
5. Yeamlaksira Markos Yetemegn GSE/1328/14
6. Yibeltal Assefa Haileselassie GSE/7805/14
7. Yonas Tufa Kukuba GSE/6060/14
PRESENTATION GUIDE

Topic outline
• What are stocks?
• What is common stock?
• What is preferred stock?
• Characteristics of common and preferred stocks
• Primary vs secondary markets
 Where did the term “Common
WHAT ARE STOCKS? Stocks” come from? The investors
are “Shareholders in Common.”

• Stocks represent ownership in a corporation

• Stocks are Equity Financing – “Equities”
• Enable investors to participate in the profits and growth generated by the
business enterprise
• But stockholders are limited liability owners
• Can only lose their investment (unlike a sole proprietor)
• These days stock certificates have been dematerialized. (No physical
document)
• Stockholders receive …
• Dividends
• Optional payments of earnings
• Capital Gains – a.k.a. Capital Appreciation
• Value of corporation rises as business grows
COMMON AND PREFERRED
STOCKS
• Common Stock
• Represents a fractional ownership claim in a public or private corporation

• Preferred Stock
• is a hybrid security that has characteristics of both a bond and a common
stock.
• Preferred stock is similar to common stock in that it represents an ownership
interest in the issuing firm, but like a bond it pays a fixed periodic (dividend)
payment.
 CHARACTERISTICS OF COMMON
STOCK

Discretionary dividend
• While common stockholders can potentially receive unlimited dividend payments
if the firm is highly profitable, they have no special or guaranteed dividend rights.
• They have no special or guaranteed dividend rights. Rather the size and
payment is determined by BOD. They are also taxed twice.
Residual claim
• In the event of liquidation, common stockholders have the lowest priority in terms
of any cash distribution.
• In the event of liquidation, common stockholders have the lowest priority in
terms of any cash distribution. E.g bankruptcy of Washington Mutual Bank
- 5 cents per share
 CHARACTERISTICS OF COMMON
STOCK – CON’D

 Limited liability

• No matter what financial difficulties the issuing corporation encounters,

neither it nor its creditors can seek repayment from the firm’s common
stockholders. Common stockholders’ losses are limited to the original
amount of their investment.

 Voting rights
• While common stockholders do not exercise control over the firm’s daily
activities, they do exercise control indirectly through the election of the
board of directors.
 CHARACTERISTICS OF
PREFERRED STOCK

Receives better treatment during liquidations

Limited liability

Have first right to dividends and must be paid before

common stockholders

No voting rights

PRIMARY VS. SECONDARY
MARKET
• Primary Market
• The market in which new issues of securities are sold to the public
• Initial Public Offering (IPO)
• The first public sale of a company’s stock
• a.k.a. “Going public”, “Taking the company public”

• Secondary Market
• The market in which securities are traded after they have been issued to the public
• The vast majority of transactions take place in the secondary market
 PRIMARY STOCK MARKETS
TRANSACTIONS

Stocks Stocks

Issuing Investment
Investors
corporation bank

Funds Funds
 STOCK ISSUE ANNOUNCEMENT

Originating houses

Syndicate
 PRIMARY MARKET

• Why “Go Public?”

• Why do corporations issue common stock?
• To raise money to start or expand a business
• To help pay for ongoing business expenses
• As a way to gain prestige and respect within the investment and
industrial communities
• As a reward for those who started the business/ lets early investors
cash out part or all of their investments
• And also simply because once a business becomes sufficiently large, it
becomes very difficult for the owners to “divvy up the spoils” without
going public

Examples of some of the largest private companies.

 PRIMARY MARKET (continued)

• Why “Go Public?” (continued)

• The corporation does not have to repay the money
• It is under no obligation to repurchase the shares of the stock
• The shareholder may or may not be able to find someone who will purchase
the shares from them
TYPES OF PRIMARY MARKETS

• Initial Public Offering (IPO)

• the ‘traditional’ way that companies issue shares on the primary market
• involves a private company becoming publicly traded

• Equity placement
• a less conventional way for companies to issue shares on the primary market,
• lets the company sell its stock to a small group of private investors

• Preemptive rights
• a rights issue gives people that already own company stock the opportunity to buy new
shares on the primary market at a discounted price compared to the current market value
of the stock.
SECONDARY MARKETS

• Markets in which securities are sold after they have

been issued
• a.k.a. Aftermarket or second-hand market

• Secondary markets provide…

• Liquidity
• Easy method for transferring ownership of securities

• Mechanism for pricing and valuation of securities

TYPES OF SECONDARY MARKETS

• Organized Securities Exchanges

• Centralized institutions in which transactions are made in outstanding
securities
• “Double Auction” Market (Face-to-Face)

• Over-the-counter (OTC) Market

• Widely scattered telecommunications network through which
transactions are made in outstanding securities and smaller IPOs
• Quote-based system (On-line)

This is an outdated comparison. Due to technology advancements,

mergers, and acquisitions, the traditional differences between the two
have been erased. And the changes are just getting started!
ORGANIZED SECURITIES
EXCHANGES
• All trading conducted on an exchange floor (called trading post)
• Each stock is assigned a special market maker (a specialist ).
• The Floor Brokers
• House Brokers
• Execute orders on behalf of their firm’s customers or occasionally on behalf of their
firm’s own account
• Independent Brokers
• Provide as-needed execution services to house brokers, member or non-member
broker-dealers
• Independent of a particular firm
• Examples of organized securities exchange includes:-
• NYSE,
• AMEX
THE NEW YORK STOCK EXCHANGE
THE NEW YORK STOCK
EXCHANGE
• Companies listed on the NYSE must meet stringent requirements

• Companies can be de-listed (example: Kodak)

• If they fail to continue to meet the NYSE requirements

THE NEW YORK STOCK
EXCHANGE (continued)

• Big Changes at the NYSE

• In 2005, purchased Archipelago electronic exchange and the
Pacific regional exchange
• Became a publicly traded corporation in March of 2006
• Merged with the Euronext electronic exchange
• Phasing out face-to-face, double auction trading
• In favor of exclusively trading electronically
• In 2011, Germany’s stock market tried to purchase the NYSE but
was blocked by European regulators
• The NYSE is now being acquired for $8 billion by a 12-year old
derivative trading firm from Atlanta.
THE OVER-THE-COUNTER
MARKET
• Widely scattered telecommunications network through
which transactions of securities are made – a.k.a. OTC
• There is no single location as with an exchange
• Transactions are completed via an electronic market
• Quote-based system
• As opposed to the double auction of the exchanges

• Is primarily a dealer market, in which dealers

are the market makers who stand ready to buy or
sell particular securities
THE ROLE OF DEALERS IN THE
OTC
• Dealers are traders who “make markets” by offering to buy or sell certain
securities at stated prices – a.k.a. “market makers”
• The dealers offer to buy and/or sell quotes from their own inventory of stocks
• Whereas brokers simply serve as a go-between buyers & sellers. They
keep no inventory
• Ask price – “retail price”
• The price a dealer offers to sell a security
• Bid price – “wholesale price”
• The price a dealer offers to purchase a security
• The spread
• The difference between the bid and the ask prices
THE ROLE OF DEALERS IN THE
OTC (continued)

• Unlike brokers who charge a commission, dealers

make money from the spread of the bid and ask prices

• The dealer’s markups or markdowns are not reported

to the customers
• Whereas the broker’s commissions are reported
PRESENTATION GUIDE

Topic outline
• What is equity valuation?
• Valuation methods
• What is IPO underpricing?
• WHY are IPOs underpriced?
• What are stock indices?
• Recognize the major stock market indexes,
• What is market efficiency? and
• Explain the three forms of market efficiency
EQUITY VALUATION

• Valuation is the process of determining the present

value an assets.
• Equity valuation therefore refers to the process of
determining the fair market value of equity securities.
• Required inputs
• The stream of expected future returns, or cash flows
• The required rate of return on the investment
EQUITY VALUATION METHODS
1. Intrinsic value – is the present value of firm’s expected
future net cash flows discounted at the required rate of
return
2. Relative valuation – looks at the price relative to some
factor like earnings or book value and compares it to other
similar firms.
 EQUITY VALUATION

Equity
valuation

Relative
Intrinsic value
valuation

Discounted
Dividend
cash flow Price Earning Price to book
discount model Price to sales
valuation (PE) ratio ratio
(DDM)
(DCF)
 DIVIDEND DISCOUNT MODEL (DDM)

• is one of the most basic techniques of absolute stock

valuation.
• is based on the assumption that the company’s dividends
represent the company’s cash flow to its shareholders.
• the model states that the intrinsic value of the company’s
stock price equals the present value of the company’s
future dividends.
• is applicable only if a company distributes dividends
regularly and the distribution is predictable.
DIVIDEND DISCOUNT MODEL

1.The One-Period Valuation Model

Po = D1 + P1
1 + Ke

2. The Generalized Dividend Valuation Model

3. The Gordon Growth Model

Po = D0 x (1+ g)
(Ke - g)
EXAMPLE – SUPER NORMAL
GROWTH DIVIDEND MODEL

• ABC Co. estimates that its dividend growth will be 30% per
year for the next 3 years. It will then settle to a sustainable,
constant, and continuing rate of 10%. Let’s say that the
current year’s dividend is $2 and the required rate of return
(or discount rate) is 15.8%. What is the current value of
ABC Co.?
 SOLUTION

Step 1 • First, we will need to calculate the dividends for each year
until the second, stable growth rate phase is reached.
Step 2 • Next, we apply the DDM to determine the terminal value,
or the value of the stock at the end of the three-year high-
growth phase and the beginning of the second, lower
growth-phase.
Step 3 • Find the PV of non-constant dividends and horizontal value
SOLUTION
 DISCOUNTED CASH FLOW
VALUATION (DCF)

• the intrinsic value of a stock is calculated by

discounting the company’s free cash flows to its
present value.
• it does not require any assumptions regarding the
distribution of dividends.
• Thus, it is suitable for companies with unknown or
unpredictable dividend distributions.
IPO UNDERPRICING

• Underpricing is the practice of listing an initial public

offering (IPO) at a price below its real value in the stock
market.
• =[(Pm-Po)/Po]*100
• Pm price of stock at end of trading day
• Po offering price
 WHY UNDERPRICING?

Winner’s curse (information asymmetry),

Bandwagon effect,
Investment bankers monopsony power,
Legal issues,
Signaling, and
Ownership dispersion
 STOCK MARKET INDICES

• A stock market index is the composite

value of a group of secondary market–
traded stocks.
• The media refer to stock market indices
daily, reporting on movements in the
FTSE, Dow Jones, S & P and others.
 STOCK MARKET INDICES
continued

• Stock indices do the following:

 Provide a snapshot of how share prices are performing
in a particular stock market, or across several markets.
 Measure price movements in markets across a number
of different types of stocks.
 Calculate the aggregate price movement of its targeted
stocks on a daily basis,
 Provide a single figure for ease of comparison.
 BENEFITS OF SHARE INDICES

 Allows investors to gauge the overall performance of the

market
 A stock index will smooth out anomalies and provide a
consistent picture of the mood across the market.
 Provide a benchmark for investors - assess whether their
portfolios of shares are doing better (outperforming) or
worse (underperforming) than the market in general.
Stock Market Indices - World

World Indices

Japan France UK USA Germany

Hong Kong
Xetra DAX
China

S&P 500 30 Stocks

A wider view of Hang Seng
225 Stocks 40 Stocks 100 Stocks Nasdaq Composite
Dow Jones Industrial the US stock Focuses on shares
58 Stocks
Average market
500 stocks traded on the Nasdaq
(DJIA or ‘The Dow’) Includes many
A narrow view of the Value-weighted technology companies
US stock market 3000+ stocks
30 stocks
Price-weighted
READING STOCK QUOTES
• Current price during trading hours
• The bid and the ask
• Open, High, Low, Close (a.k.a. Last)
• 52-Week High and Low
• Dividend Yield
https://finance.yahoo.com/quote/BABA?
• P/E Ratio p=BABA&.tsrc=fin-srch.

• Volume
• Net Change
• Year-to-Date Change
READING STOCK QUOTES
(continued)

• On-line Examples
• Yahoo!
• Bloomberg’s
• Google finance
MARKET EFFICIENCY

• The speed with which financial security prices adjust to

unexpected news pertaining to interest rates or a stock
specific characteristic.
• An efficient market is characterized by a perfect, complete,
costless, and instant transmission of information.
• Three measures (weak form, semi-strong form, and
strong form market efficiency) are commonly used to
measure the degree of stock market efficiency.
 MARKET EFFICIENCY

Strong Form All information,

public and private
Semi-Strong

Weak Form

All public information All historical prices and

returns
WEAK FORM MARKET
EFFICIENCY

• assumes that the prices of securities reflect all

available public market information but may not
reflect new information that is not yet publicly
available.
• successive price changes are generally random and
that the correlation between stock prices from one day
to the next is virtually zero.
• Thus, historical price and volume trends are of no help
in predicting future price movements (and technical
analysis has no value as a trading strategy).
SEMI-STRONG FORM

• Prices fully reflect all publicly available information (even

those reported in the financial statements of the companies)
and expectations about the future.
• This suggests that prices adjust very rapidly to new
information, and that old information cannot be used to earn
superior returns.
• The assertion behind semi-strong market efficiency is still
that one should not be able to profit using something that
“everybody else knows” (the information is public).
Nevertheless, this assumption is far stronger than that of
weak-form efficiency.
• The semi-strong form, if correct, repudiates fundamental
analysis
STRONG FORM

• The strong form says that prices fully reflect all

information, whether publicly available or not.
• Even the knowledge of material, non-public information
cannot be used to earn superior results.
• The rationale for strong-form market efficiency is that the
market anticipates, in an unbiased manner, future
developments and therefore the stock price may have
incorporated the information and evaluated in a much more
objective and informative way than the insiders
• Most studies have found that the markets are not efficient in
this sense.
Thank You.