© 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