Financial Markets and Institutions

Lecture 5: The Stock Market and Stock Valuation

Dr. Mary Dawood

Lecturer in Economics

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 Outline

Investing in Stocks

Organisation of Stock Markets

Stock Valuation

Trading Mechanics

Stock Market Indices

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 Investing in Stocks1

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 Characteristics of Common Stocks

Stocks (or equity) are shares in a firm’s ownership, i.e. common

stockholders are the real owners of the firm

A stockholder has the right to:

▶ share in the profits of the firm (dividends)

▶ share in the assets of the firm in case of liquidation

▶ vote at the firms annual meeting

Stockholders earn returns in two ways:

▶ Rise in the price of the stock

▶ Dividends paid out of firm profits

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 Characteristics of Common Stocks

Although stockholders are entitled to participate in the profits of

the firm, they are merely residual claimants

▶ common stockholders are paid last, after all creditors and

preferred stockholders have been paid

However, stockholders have limited liability in the firm

▶ even if a firm goes bankrupt, the maximum amount shareholders

can lose is their initial investment

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 Characteristics of Preferred Stocks

Preferred stockholders are owners like common stockholders, but

they possess some aspects of bondholders

They have the right to:

▶ preferred dividend, which is determined as a fixed percentage of
the par value and must be paid first before common dividends

▶ liquidation priority over common stockholders but subordinate

to bondholders

▶ preferred stock normally has no voting rights

failure to meet the fixed obligations to preferred stockholders does

not drive the firm to bankruptcy, unlike bondholders

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 Why Stocks are Risky

Stockholders share part of the profits, but only after everyone else
is paid ⇒ stocks are risky because shareholders are residual
claimants

In contrast, bondholders receive fixed nominal payments and are

paid before stockholders in the event of bankruptcy

Borrowing (debt) creates leverage, and leverage creates risk for

shareholders (refer to the paradox of leverage handout)

Shareholders also bear trading risk, i.e. the risk of incurring capital
losses when selling their stocks

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 Why Stocks are Risky

Example: A company requires a £1,000 capital investment that

can be financed by either stock or 10% interest-bearing bonds

Percent Percent Payments on Payment to Equity Expected Standard

Equity Debt 10% Bonds Shareholders Return Return Deviation

100% 0 £0 £80-160 8-16% 12% 4%

50% 50% £50 £30-110 6-22% 14% 8%

20% 80% £80 £0-80 0-40% 20% 20%

More debt creates greater risk for shareholders

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 Organisation of Stock Markets2

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 The Primary Market

When a firm goes public it issues new stocks in the primary market
in exchange for funds

Going public has two effects on the firm:

1. changes the firm’s ownership structure by increasing the
number of owners

2. changes the firm’s capital structure by increasing the equity

investment in the firm, which allows the firm to pay off some of
its debt and/or expand its operations

There two major types of public offerings:

1. initial public offering by firms that never previously issued stocks

2. secondary stock offering by firms that issued stocks in the past

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 Initial Public Offer (IPO)

IPO happens when a privately owned company issues stocks to the

general public for the first time

The process of going public usually involves a securities firm or

investment bank serving as the lead underwriter:
1. Developing Prospectus: contains details about the firm, its
financial statements, and the risks involved

2. Pricing: determine the offer price at which the shares will be

sold at the time of IPO

3. Allocation of IPO shares: most of the shares are underwritten

to institutional investors

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 Initial Public Offer (IPO)

In allocating the IPO shares, the underwriter can either agree to:
▶ firm commitment: buy all the stocks at a set price

▶ best efforts: sell the stocks on behalf of the firm without buying
them first

Flipping shares is the process of purchasing the stock at its offer

price and selling it shortly afterwards

The fee (gross spread) earned from underwriting the stocks is the
difference between the price paid to the firm and the price at which
the underwriter reoffers the stocks to the public

IPOs tend to occur during bullish stock markets, i.e. when stock
prices are rising

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 Initial Public Offer (IPO)

Another variation for underwriting securities is the Auction Process:

▶ the issuer announces the terms of the stock issue

▶ interested underwriters submit bids for the price they are willing
to pay and the amount of stocks they are willing to buy

▶ the stocks are allocated from highest to lowest bidders until the
entire issue is allocated

It is also possible for firms to sell some proportion of stocks

directly to existing stockholders via pre-emptive rights offering,
while the underwriter buys the rest of the unsubscribed shares

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 Initial Public Offer (IPO) - Google Case

in August 2004 Google’s IPO attracted massive media attention

because of the firm’s name recognition

initial expectation were that the stock would sell for $118 - $135
per share

Google used a Dutch auction process, which allowed individual

investors to participate directly in the IPO and obtain shares at the
initial offer price

the auction resulted in a price of $85 per share, which only

increased to $100.34 by the end of the first day!

Ferrari IPO: https://www.theguardian.com/business/2015/oct/

21/ferrari-ipo-zooms-on-to-wall-street

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 The Secondary Market

The secondary market is the financial market in which previously

issued securities are bought and sold among investors, while the
issuer no longer receives proceeds

However, they provide several important functions:

1. provides liquidity to investors

2. media for determining asset prices

3. indicator of economic activity

4. provides framework for active trading based on company

performance ⇒ efficient allocation of resources

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 The Secondary Market

Typical investors may not be skilled or informed enough about

every facet of trading in the market ⇒ use intermediaries

Major players in the secondary market:

▶ Brokers execute trade orders on behalf of others in exchange for
a commission/fee
■ bring together buyers and sellers and negotiate prices

■ provide advising and recordkeeping services

▶ Dealers are authorized to execute trades for themselves, i.e. can

hold inventory of securities
■ profit from bid-ask spread

■ price stabilization in case of unmatched buy and sell orders

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 Market Microstructure

Structure of secondary markets

▶ Organized exchanges: regulated auction markets in specific
central locations (e.g. NYSE, LSE, Euronext)

▶ Over-the-counter: collection of dealers who trade with one other

electronically (e.g. NASDAQ)

Types of markets
▶ Order-Driven Market: all participants are natural buyers and
natural sellers with no dealer acting as an intermediary

▶ Quote-Driven Market: is where the price is determined by the

dealer based on prevailing market conditions

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 Stock Valuation3

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 Pricing of Common Stock

People differ on how stocks should be valued:

▶ Fundamentalists estimate stock value based on its current assets
and on estimates of future profitability

▶ Chartists believe they can predict changes in prices by looking at

patterns or past movements

▶ Behaviouralists estimate stock value based on their perceptions

of investor psychology and behaviour

We can use the concept of discounting the future to compute the

fundamental value of stocks

However, chartists and behaviouralists question the usefulness of

fundamentals in understanding the movement of stock prices

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 Constant Dividend Discount Model

With a finite holding period, fundamental value (price) of a stock

can be estimated as the present value of all future cash flows:
D1 D2 Dn Pn
P0 = + ... +
(1 + re )1 (1 + re )2 (1 + re )n (1 + re )n

where:
▶ Dt is expected dividend at period t
▶ re is required rate of return on the stock = equity cost of capital
▶ Pn is expected price at the end of the holding period

Current stock price is the sum of the present value of:

1. expected dividends over the holding period n
2. expected stock selling price at period n

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 Constant Dividend Discount Model

With an indefinite holding period, the stock price would reflect the
present value of expected dividend stream over the infinite life of
the corporation
∞
X Dt
P0 =
(1 + re )t
t=1

If current stock price is less than P0 , investors rush in to buy it,

driving up the stock’s price (and vice versa)
▶ Arbitrage guarantees that the stock price remains at P0

However, this model ignores risk and uncertainty associated with

forecasting future dividends and stock price

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 Constant Dividend Discount Model

Expected rate of return on the stock is composed of:

▶ dividend yield
▶ capital gains rate

For a stock that is held for one year

D1 P1
P0 = +
(1 + re ) (1 + re )

Solving for re gives:

D1 + P1 D1 P1 − P0
re = −1= +
P0 P0 P
|{z} | {z0 }
Dividend Yield Capital Gain Rate

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 Constant Dividend Growth Model

We can forecast future dividends by assessing the stream of future

dividends to one of several stylised dividend growth pattern

The simplest forecast assumes that dividends grow at a constant

rate, g , forever

Hence, dividend at any period t can be estimated as:

Dt = D0 (1 + g )t

The stock price equation can be rewritten as:

D0 (1 + g ) D0 (1 + g )2 D0 (1 + g )n Pn
P0 = + 2
+ . . . + n
+
(1 + re ) (1 + re ) (1 + re ) (1 + re )n

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 Constant Dividend Growth Model

With an indefinite holding period, this equation becomes a

geometric series:
(1 + g )2
 
D0 (1 + g ) (1 + g )
P0 = 1+ + + ...
(1 + re ) (1 + re ) (1 + re )2
Using the rules of the sum of geometric series, this equation
collapses to:
D0 (1 + g )/(1 + re ) D0 (1 + g )
P0 = =
1 − (1 + g )/(1 + re ) (1 + re ) − (1 + g )

D0 (1 + g ) D1
P0 = =
(re − g ) re − g

where g < re

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 Constant Dividend Growth Model

The model tells us that stock prices will be high when:

▶ current dividends level is high

▶ dividend growth is rapid (g is large)

▶ cost of equity (re ) is low

As D ↑ P ↑; however, if the firm ↑ D it will have less retained

earnings for reinvestment, which in turn reduces future earnings
and hence the dividend growth rate ⇒ as g ↓ P ↓

There is a trade-off between maintaining high dividend payout

ratio and a high dividend growth rate ⇒ Dividend Payout Policy

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 Gordon Growth Model

While constant dividend growth model is simple and elegant, it

does not reflect the lifecycle of a corporation

A more realistic model should reflect the distinct stages of growth

that a corporation goes through:

▶ young firms often retain most of their earnings to exploit

profitable investment opportunities

▶ as they mature, their earnings start to exceed their investment

needs and they begin to pay out dividends

Combining the dividend discount model with the constant dividend

growth model, we can arrive at a better estimate of the stock price

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 Gordon Growth Model

We assume a simple case where dividends do not grow for the first
N years, after which they are expected to grow at constant rate, g ,
starting year N + 1

At period N, the stock price of the firm will be:

DN+1
PN =
re − g
The current stock price equation becomes:
N
X Dt DN+1 1
P0 = + ×
(1 + re )t re − g (1 + re )N
t=1

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 Trading Mechanics4

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 Trading Orders

Orders are buy or sell instructions that traders give to brokers or

dealers to arrange and execute their trades

Orders always specify:

▶ the security to be traded
▶ the quantity to be traded
▶ the side of the order (buy or sell)

Orders may specify:

▶ price specifications
▶ how long the order is valid
▶ when the order can be executed
▶ whether they can be partially filled or not

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 Important Terminology

Bid: buy order specifying a price, called the bid price

Offer: sell order specifying a price, called the offer/ask price

Best Bid: highest bid available at a certain time

Best Offer: lowest offer available at a certain time

▶ difference between best offer and best bid is bid-ask spread

Short selling: selling securities not owned at time of sale to be

purchased later to execute the sale

Buying on margin: borrowing to buy securities using them as

collateral ⇒ magnifies returns on investment

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 Microsoft Stock Example

Bids and offers at 11:06 am on February 28, 2022

▶ Bids are in green and the best bid is $296.81
▶ Asks are in blue and the best ask is $296.88
▶ Bid-ask spread = $0.07, which is profit to broker/dealer
▶ the most recent execution price is $296.85

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 Short Selling Example

Suppose an investor believes that GM stock is overpriced at $18

per share and wants to benefit if his assessment is correct

The investor instructs a broker to sell 100 shares of GM

The proceeds from the sale of $1800 will remain with the broker
since the investor is “short 100 shares of GM”

Now, suppose that one week later the price of GM stock declines
to $15 per share

The investor instructs the broker to buy 100 shares of GM, costing
$1500, to “cover his short position”

The broker subtracts his commission from the realized profits of

$300 and transfers the funds back to the investor

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 Buying on Margin Example

Suppose two investors want to buy a stock at price £50:

▶ investor A funds half of the purchase with his own money (initial
investment = £25) and half buying on margin at 10% interest

▶ investor B uses his own money only (initial investment = £50)

A year later, there might be two different scenarios:

1. price rises to £100

2. price falls to £25

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 Buying on Margin Example

return on investment is calculated as:

P − INV − LOAN + D
ROE =
INV
P = price, INV = initial inv., LOAN = principal + interest, D = dividends

if the prise rises to £100:

▶ investor A gains: R = 100−25−27.5
25 = 190%
100−50
▶ investor B gains: R = 50 = 100%

if the prise falls to £25:

▶ investor A loses: R = 25−25−27.5
25 = −110%
25−50
▶ investor B loses: R = 50 = −50%

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 Types of Orders

Proprietary orders: submitted by traders for their own account (i.e.

by dealers)

Agency orders: submitted by a broker to the market on behalf of

other traders

Market orders: to buy or sell at the price currently available in the

market

Limit orders: specify a price threshold for the trade

▶ buy limit orders specify a maximum price below which to buy
▶ sell limit orders specify a minimum price above which to sell

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 Market Order Example

Suppose that the quotes are £20 bid and £24 ask, and that the
best estimate of the true value of the security is £22

A market buy order:

▶ would be executed at £24

▶ cost of immediacy is £2 (= 24-22)

A market sell order:

▶ would be executed at £20

▶ cost of immediacy is £2 (= 22-20)

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 Limit Order Example

If an investor submits a limit buy order for 100 shares with limit
price of £20, the broker will not execute the order as long as the
price is above £20

If an investor submits a limit sell order for 100 shares with limit
price of £24, the broker will not execute the order as long as the
price is below £24

If the limit order is executable, the broker will fill the order,
otherwise the order will be a standing order to trade

Standing limit orders are placed in a file called limit order book

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 Stock Market Indices5

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 Stock Market Indices

Stock market indices are frequently used to monitor the behaviour

of a groups of stocks

They are used to analyse how much the value of an average stock
has changed

They provide benchmarks for the performance of a portfolio

▶ They can tell whether a portfolio has done better or worse than
‘the market’ as a whole

About a third of all the countries in the world have a stock market
and each has at least one index

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 Dow Jones Industrial Average Index

DJIA is the first known stock market index, which is based on the
stock prices of 30 of the largest companies in the U.S.

It measures the value of purchasing a single share of each of the

stocks in the index
▶ The percentage change in the DJIA over time is the percentage
change in the sum of the 30 prices

The DJIA is a price-weighted average index, which gives greater

weight to shares with higher prices

The behaviour of higher priced stocks dominates the movement of

a price-weighted index

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 Standard and Poor’s 500 Index

The S&P 500 is constructed from the 500 largest firms in the U.S.

It tracks the total value of owning the entirety of those firms

It is a value-weighted index, where larger firms carry more weight

Ex: If a firm is priced at $100 and has 10 million shares

outstanding, its total market value, or market capitalization, is
worth $1 billion

The behaviour of stocks with higher market capitalization

dominates the movement of a value-weighted index

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 DJIA and S&P500 Comparison

A price-weighted index gives more importance to stocks that have

high prices

A value-weighted index gives more importance to companies with a

high market value

The two types of index simply answer different questions:

▶ changes in a price-weighted index tell us the changes in the
price of a typical stock

▶ changes in the value-weighted index accurately mirror changes

in the economy’s overall wealth

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 Stock Market’s Role in the Economy

The prices determined in the stock market tell us the market value
of companies

If stock prices accurately reflect fundamental values, the resource

allocation mechanism is efficient

However, stock prices sometimes deviate significantly from the

fundamentals

Both euphoria and depression are contagious

▶ when investors become unjustifiably exuberant, prices rise
regardless of the fundamentals

▶ this creates bubbles: persistent and expanding gaps between

actual stock prices and those warranted by the fundamentals

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 Stock Market’s Role in the Economy

Bubbles distort economic decisions that firms and consumers make

▶ firms sell shares for prices that are too high
▶ firms then invest too much and take higher risks
▶ people think they are wealthier and spend too much

Crashes do the opposite!

The shift from over-optimism to excessive pessimism causes a

collapse in investment and economic growth

Large stock market swings alter economic prospects even if

grounded in fundamentals

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