Stock Markets GD20503 PDF

STOCK MARKETS GD20503 Learning objectives  To describe the purpose of stock markets  Explain methods of valuing stocks and determining the required rate of return 2 What are stocks?  Stocks are a type of security that gives stockholders a...

STOCK MARKETS GD20503 Learning objectives  To describe the purpose of stock markets  Explain methods of valuing stocks and determining the required rate of return 2 What are stocks?  Stocks are a type of security that gives stockholders a share of ownership in a company. Stocks also are called “equities.” Who are the market participants? i. Individual  The investment by individual in a large corporation commonly exceeds 50% of the total equity.  However, each individual’s investment is typically small, causing the ownership to be scattered among numerous individual shareholders. ii. Institutional (see Exhibit 10.2) 4 EXHIBIT 10.2 INSTITUTIONAL USE OF STOCK MARKETS 5  Role & Function of Stock Markets HOW STOCK MARKETS FACILITATE THE FLOW OF FUNDS 6 Why people buy stocks?  Capital appreciation, which occurs when a stock rises in price  Dividend payments, which come when the company distributes some of its earnings to stockholders  Ability to vote shares and influence the company Why do companies issue stocks? Companies issue stock to get money for various things, which may include:  Paying off debt  Launching new products  Expanding into new markets or regions  Enlarging facilities or building new ones What kinds of stocks are there?  Common stock  Preferred What categories of stocks are there?  Growth stocks have earnings growing at a faster rate than the market average.  Income stocks pay dividends consistently.  Value stocks have a low price-to-earnings (PE) ratio.  Blue-chip stocks are shares in large, well-known companies with a solid history of growth. 11 Stock Valuation Real World Example 1 REQUIRED RATE OF RETURN ON STOCKS  Present Value of a stock: where D0….Dn are dividend payments for each year. 13 REQUIRED RATE OF RETURN ON STOCKS  When investors attempt to value a firm based discounted cash flows, they must determine the required rate of return by investors who invest in that stock.  Required rate of return estimation methods: i. Capital asset pricing model ii. Arbitrage pricing model 14 REQUIRED RATE OF RETURN ON STOCKS 1. Capital asset pricing model:  This model is based on the premise that the only important risk of a firm is systematic risk or the risk that results from exposure to general stock market movements.  This model is not concerned with unsystematic risk, which is specific to an individual firm. Rj = Rf + Bj(Rm – Rf) where Rj is the return of an asset, Rf is the prevailing risk-free rate, Rm is the market return and Bj represents the beta and is measured as COV(Rj, Rm)/VAR(Rm). 15 REQUIRED RATE OF RETURN ON STOCKS 2. Arbitrage pricing model:  This model suggests that a stock’s price can be influenced by a set of factors (such as economic growth and inflation) in addition to the market.  Where E(R) = expected return of asset, B0 = a constant, Fi…Fm = values of factors 1 to m and Bi = sensitivity of the asset return to particular force. 16 FACTORS THAT AFFECT STOCK PRICES 18 Stock’s Risk Measurement RISK MEASUREMENT  A stock’s risk reflects the uncertainty about future returns, such that the actual return may be less than expected.  The risk of a stock can be measured by using: i. Its price volatility ii. Its beta iii. The value-at-risk 19 RISK MEASUREMENT 1. Volatility of a stock:  A stock’s volatility serves as a measure of risk because it may indicate the degree of uncertainty surrounding the stock’s future returns.  Method of measuring volatility: Standard Deviation 20 RISK MEASUREMENT 2. Beta of a stock:  The beta of a stock can be estimated by obtaining returns of the firm and the stock market over the last 12 quarters and applying regression analysis to derive the slope coefficient  Rjt = B0 + B1Rmt + µt  Where Rjt = return of stock j during period t, B0 = a constant, B1 = the beta, Rmt = market return during period t and µt = error term.  21 RISK MEASUREMENT 3. Value-at-risk (VaR):  VaR measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. 22 RISK MEASUREMENT: VaR FIGURE 1 Example:  Figure 1 shows that our worst daily loss will not exceed 4% with 95% confidence level.  If we invest $100, we are 95% confident that our worst daily loss will not exceed $4 ($100 x -4%). 23 24 Measuring Stock Performance METHODS OF MEASURING STOCK PERFORMANCE 1. Sharpe index:  This index measures the excess return above the risk- free rate per unit of risk.  The higher the index, the better the performance. 25 METHODS OF MEASURING STOCK PERFORMANCE 2. Treynor Index:  If beta is thought to be the most appropriate type of risk, a stock’s performance can be measured by the Treynor index.  The higher the index, the better the performance. 26 Can investors earn abnormal returns? STOCK MARKET EFFICIENCY  If stock markets are efficient, the prices of stocks at any point in time should fully reflect all available information.  Efficient markets can be classified into three forms: i. Weak-form efficiency ii. Semistrong-form efficiency iii. Strong-form efficiency 28 STOCK MARKET EFFICIENCY 1. Weak-form efficiency:  This suggests that security price reflect all trade-related information such as historical security price movements and trading volume.  If the market is weak-form efficient, investors will not be able to earn abnormal returns on a trading strategy that is based solely on past price movements. 29 STOCK MARKET EFFICIENCY 2. Semistrong-form efficiency:  This suggests that security prices fully reflect all public information such as announcements by firms, economic news or events, and political news or events.  Market-related information is a subset of public information.  Thus, if a market is semistrong-form efficient, the market must be weak-form efficient as well. 30 STOCK MARKET EFFICIENCY 3. Strong-form efficiency:  This suggests that security prices fully reflect all information, including private or insider information.  Inside information gives insiders (such as some employees or board members) an unfair advantage over other investors.  However, insiders are discouraged from using this information because it is IILEGAL.  If a market is strong-form efficient, the market must be semistrong-form efficient as well. 31 Key Takeaways  When applying the free cash flow model to value a stock, a required rate of return must be estimated.  Stock prices are affected by those factors that affect future cash flows or the required rate of return by investors.  The risk of a stock is measured by its volatility, its beta, or its value-at-risk estimate.  Stock market efficiency implies that stock prices reflect all available information.