• An Introduction• Essential Characteristics of Common Stock• Measuring the Level of the Stock Market• Valuing Stocks• Fundamental Value and the Dividend-Discount Model• Investing in Stocks for the Long Run• The Stock Market’s Role in the Economy

Stocks: An IntroductionStocks provide a key instrument for

holding personal wealth as well as a way to diversify, spreading and reducing the risks that we face

For companies, they are one of several ways to obtain financing.

Additionally, Stocks and stock markets are one of the central links between the financial world and the real economy.

They indicate the value of the companies that issued the stocks and, They allocate scarce investment resources

Stocks: An IntroductionThe firms deemed most valuable in the

marketplace for stocks are the ones that will be able to obtain financing for growth. When resources flow to their most valued uses, the economy operates more efficiently

Most people see stock market as a place where fortunes are easily made or lost, and they recoil at its unfathomable booms and busts.

Great American Depression (1929) Post-September 11, 2001 scenarioPakistan stock market on roller-coaster-ride

(March 2005)

Essential Characteristics of Common StockStocks, also known as common stock or equity, are

shares in a firm’s ownershipFrom their early days, stocks had two important

characteristics : The shares are issued in small denominations and The shares are transferable

Until recently, stockowners received a certificate from the issuing company, but now it is a computerized process where the shares are registered in the names of brokerage firms that hold them on the owner’s behalf

The ownership of common stock conveys a number of rights

A stockholder is entitled to participate in the shares of the enterprise, but this is a residual claim i.e. meaning the leftovers after all other creditors have been paid.

Essential Characteristics of Common StockStockholders also have limited liabilityEven if a company fails, the maximum amount that

the stockholder can lose is the initial investmentStockholders are entitled to vote at the firm’s

annual meeting including voting to elect (or remove) the firm’s board of directors

Prices of individual shares are low, allowing individuals to make relatively small investments

Because of limited liability, investor’s losses cannot exceed the price they paid for the stock; and

Shareholders can replace managers who are doing a bad job

Measuring the Level of the Stock MarketStocks are one way in which we choose to

hold our wealth, so when stock values rise we get richer and when they fall we get poorer

These changes affect our consumption and saving patterns, causing general economic activity to fluctuate

Stock market indexes are designed to give us a sense of the extent to which stock prices are going up or down

Tell us both how much the value of an average stock has changed, and how much total wealth has gone up or down

Measuring the Level of the Stock Market

Every major country in the world has a stock market, and each of these markets has an index

The Dow Jones Industrial Average The Standard & Poor's 500 Index NASDAQ Composite index Financial Times Stock Exchange 100 Index Hang Seng 100 Nikkei 225 The KSE100

VALUING STOCKSPeople differ in their opinions of how stocks

should be valuedChartists believe that they can predict changes

in a stock’s price by looking at patterns in its past price movements

Behaviorists estimate the value of stocks based on their perceptions of investor psychology and behavior

Others estimate are based on a detailed study of the fundamentals, which can be analyzed by examining the firm’s financial statements.

In this view the value of a firm’s stock depends both on its current assets and estimates of its future profitability

Fundamental Value and the Dividend-Discount Model

As with all financial instruments, a stock represents a promise to make monetary payments on future dates, under certain circumstances

With stocks the payments are in the form of dividends, or distributions of the firm’s profits

The price of a stock today is equal to the present value of the payments the investor will receive from holding the stock

This is equal to: The selling price of the stock in one year’s time plus The dividend payment received in the interim

Fundamental Value and the Dividend-Discount Model

Thus the current price is the present value of next year’s price plus the dividend

If Ptoday is the purchase price of stock, Pnext year is the sales price one year later and Dnext year is the size of the dividend payment, we can say:

Fundamental Value and the Dividend-Discount Model

Fundamental Value and the Dividend-Discount Model

Fundamental Value and the Dividend-Discount Model

Investing in Stocks for the Long Run

Stocks appear to be risky, and yet many people hold substantial proportions of their wealth in the form of stock

This is due to the difference between the short term and the long term;

Investing in stocks is risky only if you hold them for a short time

In fact, when held for the long term, stocks are less risky than bonds.

The Stock Market’s Role in the Economy

The stock market plays a crucial role in every modern capitalist economy.

The prices determined there tell us the market value of companies, which determines the allocation of resources.

Firms with a high stock market value are the ones investors’ prize, so they have an easier time garnering the resources they need to grow.

In contrast, firms whose stock value is low have difficulty financing their operations

So long as stock prices accurately reflect fundamental values, this resource allocation mechanism works well.

The Stock Market’s Role in the Economy

Shifts in investor psychology may distort prices; both euphoria and depression are contagious

When investors become unjustifiably exuberant about the market’s future prospects, prices rise regardless of the fundamentals, and such mass enthusiasm creates bubbles.

Bubbles are persistent and expanding gaps between actual stock prices and those warranted by the fundamentals.

These bubbles inevitably burst, creating crashes.

The Stock Market’s Role in the EconomyThey affect all of us because they distort

the economic decisions companies and consumers make

If bubbles result in real investment that is both excessive and inefficiently distributed, crashes do the opposite; the shift to excessive pessimism causes a collapse in investment and economic growth

When bubbles grow large enough and result in crashes the stock market can destabilize the real economy