Chapter 8
Stocks, Stock Markets,
and Market Efficiency
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
Stocks and Stock Markets:
The Big Questions
• What are stocks?
• How are stocks valued?
• How risky are stocks?
8-2
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
8-3
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
8-4
Stocks:
History
• Joint stock companies
– More than one expedition at once
– Shareholders received share of profits
– Shares could be resold
8-5
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
8-6
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
8-7
Stocks:
Important Characteristics
• Residual Claim
• Limited Liability
8-8
Stocks:
Residual Claim
• Stockholders are paid after everyone
else.
• Stock is risky since it is leveraged
8-9
Stocks:
Limited Liability
• Maximum loss is the amount invested
• If firm owes money to
– Workers
– Suppliers
– Bondholders
• Stockholders are not liable for it
8-10
• 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
8-11
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)
8-12
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)
8-13
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
8-14
8-15
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
8-16
Valuing Stocks
• Why do stocks have value?
– Because they pay dividends.
– Because they will rise in value
generating capital gains
8-17
Valuing Stocks
• Capital gains
– Share repurchases
– Buyouts
8-18
Valuing Stocks:
Dividend-Discount Model
• Present Value of Dividend Flows:
Ptoday 
Dnext _ year
(1  i)

Din _ two _ years
(1  i)
2
 .....
Dn _ years _ from _ now
(1  i)
n

Pn _ years _ from _ now
(1  i)n
Dn = dividend payment in period n
i = interest rate to discount the dividend stream
8-19
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
Dn _ years _ from _ now  Dtoday (1 g)
n
8-20
Valuing Stocks:
Dividend-Discount Model
• The solution to this is
.
Ptoday 
Dtoday (1  g )
ig
8-21
• 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
8-22
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.
8-23
Return to Debt & Equity Holders for
Different Financing Assumptions
8-24
Valuing Stocks:
Risk
• The result of borrowing is to increase
the return in good times, but decrease it
in bad times.
• This is leverage.
8-25
Valuing Stocks:
Risk
• Impact of risk:
Required Stock Return (i)
= Risk-free Return (rf) + Risk Premium (rp)
• Rewrite dividend-discount model:
P0 
Dtoday (1  g )
rf  rp  g
8-26
Valuing Stocks:
Dividend-Discount Model w/ Risk
8-27
Theory of Efficient Markets
• Prices reflect all available information
• Implies stock price movements are
unpredictable
8-28
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
8-29
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
8-30
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?
8-31
• 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.
8-32
Investing in Stocks For the Long Run
8-33
Mutual funds offer
• Affordability: small initial investment
• Liquidity: can withdraw quickly
• Diversification: portfolio of stocks
• Management: professionals
• Cost: look for low management fees
8-34
Chapter 8
End of Chapter
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008