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Chapter 11

Chapter 11. The Stock Market. Chapter 11. The Stock Market. 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

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Chapter 11

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  1. Chapter 11 The Stock Market

  2. Chapter 11 The Stock Market

  3. 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

  4. Chapter Preview (cont.) • Stock Market Indexes • Buying Foreign Stocks • Regulation of the Stock Market

  5. Stock • In financial markets, stock is the capital raised by a corporation or joint-stock company through the issuance and distribution of shares. • A person or organization who holds at least a partial share of stock is called a shareholder. The aggregate value of a corporation's issued shares is its market capitalization

  6. Represents ownership in a firm Earn a return in two ways Price of the stock rises over time Dividends are paid to the stockholder Stockholders have claim on all assets Right to vote for directors and on certain issues Two types Common stock Right to vote Receive dividends Preferred stock Receive a fixed dividend Do not usually vote Investing in Stocks

  7. Common Stock • common or ordinary shares - the most usual and commonly held form of stock in a corporation. • Common stock typically has voting rights in corporate decision matters, though perhaps different rights from preferred stock. • In order of priority in a liquidation of a corporation, the owners of common stock are near the last. Dividends paid to the stockholders must be paid to preferred shares before being paid to common stock shareholders

  8. Preferred Stock • sometimes called preferred shares, have priority over common stock in the distribution of dividends and assets. • Most preferred shares provide no voting rights in corporate decision matters. • However, some preferred shares have special voting rights to approve certain extraordinary events (such as the issuance of new shares, or the approval of the acquisition of the company), or to elect directors

  9. Investing in Stocks: Sample Corporate Stock Certificate Figure 11.1 Wien Consolidated Airlines Stock

  10. Investing in Stocks: How Stocks are Sold • Organized exchanges • Account for over 72% of total dollar volume • Larges U.S. Exchange is the NYSE • Others include Nikkei, LSE, Hong Kong Stock Exchange, Bursa Malaysia, etc. • Listing requirements exclude small firms • Over-the-counter markets • Best example is NASDAQ • Dealers stand ready to make a market

  11. 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 (Super Designated Order Turnaround System)

  12. Super Designated Order Turnaround System • The SuperDOT order-routing system facilitates the transmission of both market and limit orders directly to the trading post (and specialist) where the particular security is traded. • This allows for a more efficient transaction because the order can be delivered directly to the specialist rather than phoned down to a floor trader and done manually)

  13. Investing in Stocks: Organized vs. OTC • Over-the-counter markets (e.g., NASDAQ) • Multiple market makers set bid and ask prices • Multiple dealers for any given security

  14. Investing in Stocks: ECNs ECNs (electronic communication networks) 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

  15. 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

  16. 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.

  17. Computing the Price of Common Stock: The One-Period Valuation Model • Simplest model, just taking using the expected dividend and price over the next year. • Price =

  18. Computing the Price of Common Stock: The 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: Price =

  19. Computing the Price of Common Stock: The Generalized Dividend Valuation Model • Most general model, but the infinite sum may not converge. • Price = • Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model.

  20. Computing the Price of Common Stock: The Gordon Growth Model • Same as the previous model, but it assumes that dividend grow at a constant rate, g. That is, Div(t+1) = Divtx(1 + g) • Price =

  21. 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.

  22. 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. • Price =

  23. Computing the Price of Common Stock: The Price Earnings Valuation Method If the industry PE ratio for a firm is 16, what is the current stock price for a firm with earnings for $1.13 / share? Answer: Price = 16 x $1.13 = $18.08

  24. 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.

  25. How the Market Sets Security Prices • 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.

  26. 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

  27. Stock Market Indexes • Stock market indexes are frequently used to monitor the behavior of a groups of stocks. • Major indexes include the Dow Jones Industrial Average, the S&P 500, Nikkei 225, and the NASDAQ composite. • The securities that make up the (current) DJIA are included on the next slide.

  28. Stock Market Indexes: the Dow Jones Industrial Average

  29. Stock Market Indexes • The next two slides show the Dow Jones Industrial Average from 1980–2004. • 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 2004, when the Dow reached 10,000. This represented an annual growth rate around 10.6%.

  30. Stock Market Indexes, DJIA Figure 11.2a Dow Jones Industrial Average, 1980-1989 Historical stocks charts are found at http://stockcharts.com/charts/historical/

  31. Stock Market Indexes, DJIA Figure 11.2b Dow Jones Industrial Average, 1990-2004 Historical stocks charts are found at http://stockcharts.com/charts/historical/

  32. Kuala Lumpur Composite Index • The Kuala Lumpur Composite Index (KLCI) is a stock market index generally accepted as the local stock market barometer. • Introduced in 1986 to answer the need for a stock market index which would serve as an accurate performance indicator of the Malaysian stock market as well as the economy.

  33. Kuala Lumpur Composite Index • It is used to be the main index, and is now one of the three primary indices for the Malaysian stock market which the other two are FBMEMAS and FBM30 Indices • It contains 100 companies from the Main Board with approximately 500 to 650 listed companies in the Main Board which comprise of multi-sectors companies across the year 2000 to 2006 and is a capitalization-weighted index.

  34. Bursa Malaysia: Chronology • 1937 - Re-registered as the Malayan Stockbrokers' Association but public shares were not traded • 1960 - The public trading of shares commenced on the MSE • 1961 - The board system was introduced • 1964 - MSE was officially formed name Stock Exchange of Malaysia and Singapore (SEMS) • 1973 - The SEMS was separated into KLSEB and SES • 1986 - KLCI was introduced • 1993 - KLCI surpasses 1275.32 • 1994 - The Kuala Lumpur Stock Exchange Bhd (KLSEB) re-named Kuala Lumpur Stock Exchange

  35. Bursa Malaysia: Chronology • 1995 - the number of component companies was increased to 100 • 1997 - Due to the Asian Financial Crisis KLCI Slumped more than 500 points within 6 month • 1998 - KLCI slumped to the lowest ever at 261.330 in August • 1998 - KLCI worst performance volume at 15,907,400 - Average over days in Month • 2000 - KLCI tops back to 974.380 • 2004 - KLSE was Re-named Bursa Malaysia

  36. Kuala Lumpur Composite Index (1985 – 2006)

  37. Stock Returns of Kuala Lumpur Composite Index (1985 – 2006)

  38. Bursa Malaysia: Largest Stocks by Market Value • Tenaga Nasional Bhd-RM50.62 • Malayan Banking-RM47.04 • Bumiputra Commerce Holdings - RM40.08 • Maxis Communications - RM38.88 • MISC Bhd - RM37.20 • Telekom Malaysia -RM35.63 • Public Bank - RM34.88 • IOI Corp - RM34.20 • Genting - RM29.20 • Sime Darby - RM25.19

  39. Bursa Malaysia: Largest Stocks by Market Value….. • Petronas Gas Bhd /a subsidiary of Petronas - RM18.40 • DiGi Telecommunication-RM15.60 • PLUS Expressway Berhad -RM15.20 • YTL - RM14.58 • Kuala Lumpur Kepong Berhad-RM14.31 • British American Tabacco Malaysia Bhd -RM13.06 • Golden Hope Plantations Bhd -RM12.80 • MMC Corporation Berhad -RM12.03 • Hong Leong Bank Bhd -RM9.88 • Astro All Asia Networks plc -RM8.93

  40. 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.

  41. 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.

  42. 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.

  43. 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.

  44. 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

  45. 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

  46. 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

  47. Useful Website • Source for investing education: www.investopedia.com • Bursa Malaysia: www.klse.com.my • Security Commission Malaysia: www.sc.com.my

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