Stock Markets Overview

Stock Markets: Learning Objectives

• Describe the purpose of stock markets.
• Explain methods of valuing stocks and determining the required rate of return.

What are Stocks?

• Stocks are securities that represent a share of ownership in a company.
• Stocks are also called equities.

Who are the Market Participants?

• Individuals: Investments by individuals in large corporations often exceed 50% of the total equity. Individual investments are usually small, resulting in ownership being spread among many shareholders.
• Institutions: Financial institutions like commercial banks, stock-owned savings institutions, savings banks, finance companies, stock mutual funds, securities firms, insurance companies, and pension funds participate in stock markets. Their participation takes various forms, including issuing stock, managing trust funds containing stocks, investing in stocks for portfolios, and using proceeds to invest in stocks. Pension funds often invest a significant portion of their contributions in the stock market.

Role & Function of Stock Markets

• Stock markets facilitate the flow of funds from households, mutual funds, and other institutional investors to corporations to support expansion, operations, and investments.

Why People Buy Stocks?

• Capital appreciation: Increased stock prices.
• Dividend payments: Distributions of company earnings to stockholders.
• Voting rights: Ability to vote and influence company decisions.

Why Companies Issue Stocks?

• Funding: Raise capital for various purposes including paying off debt, launching new products, expanding into new markets, and enlarging facilities.

What Kinds of Stocks are There?

• Common stock: Standard stock
• Preferred stock: A separate class of stock

What Categories of Stocks are There?

• Growth stocks: Earnings grow faster than market average.
• Income stocks: Pay consistent dividends.
• Value stocks: Low price-to-earnings ratio (PE ratio).
• Blue-chip stocks: Shares in large, established companies with a proven history of growth.

Stock Valuation

• The present value of a stock is the sum of the present values of all future dividend payments.

Required Rate of Return on Stocks

• Present Value of a stock: A formula calculating the present value of a stock based on future dividend payments.
• Required rate of return estimation methods:
  • Capital asset pricing model (CAPM): Assumes the only relevant risk of a firm is the systematic risk of exposure to general stock market movements. Unsystematic risk is irrelevant.
    • The formula is Rᵢ = Rf + Bi(Rm - Rf) where: Rᵢ = return of an asset; Rf = prevailing risk-free rate; Rm = market return; Bi = beta of the asset.
  • Arbitrage pricing model (APM): A model suggests that a stock's price can be influenced by a set of factors, in addition to the market, such as economic growth and inflation. The formula is E(R) = Bo + ∑ BiFi. Where: E(R) = expected return of the asset; Bo = a constant; Bi = Sensitivity of the asset return to a particular force; Fi...Fm = values of factors 1 to m

Factors That Affect Stock Prices

• International economic conditions
• U.S. fiscal policy
• U.S. monetary policy
• U.S. economic conditions
• Industry conditions
• Firm-specific conditions
• Stock market conditions
• Market risk premium
• Firm's systematic risk (Beta)
• Risk-free Interest Rate
• Firm risk premium
• Expected Cash Flows

Stock's Risk Measurement

• Volatility: Indicates uncertainty about future returns; measured using standard deviation.
• Beta: Estimated by obtaining past returns of the firm and the market; using regression analyses.
• Value-at-risk (VaR): Measures potential loss in value of an asset or portfolio.

Measuring Stock Performance

• Sharpe index: Measures excess return above the risk-free rate per unit of risk. A higher index implies better performance.
  • The formula is (R - Rf) / σ.
• Treynor index: Measures excess return above the risk-free rate per unit of beta. A higher index implies better performance.
  • The formula is (R - Rf) / β.

Can Investors Earn Abnormal Returns?

Stock Market Efficiency

• Weak-form efficiency: Security prices reflect all past trade-related information, such as historical prices and trading volume.
• Semistrong-form efficiency: Security prices reflect all publicly available information, such as announcements by firms, economic news, and political events.
• Strong-form efficiency: Security prices reflect all information, including private or insider information.

Key Takeaways

• When valuing a stock using the free cash flow model, an accurate estimate of the required rate of return is essential.
• Stock prices are influenced by factors affecting future cash flows and the investors' required return.
• Stock risk is measured by volatility, beta, and value-at-risk.
• Stock market efficiency implies stock prices reflect available information.