PRINCIPLES OF FINANCE

Chapter 13 (ME)

The Stock Market

1
Key concepts

─ Stock Market Indexes

─ Buying Stocks
─ Investing in Stocks
─ Computing the Price of Common Stock
─ How the Market Sets Security Prices
─ Errors in Valuation
Investing in Stocks
1. Represents ownership in a firm
2. Earn a return in two ways
─ Priceof the stock rises
over time
─ Dividends are paid to the stockholder
3. Stockholders have claim on all assets
4. Right to vote for directors and on certain
issues
Investing in Stocks
5. Two types
─ Common stock
• Right to vote
• Receive dividends
• Callable / Putable
─ Preferred stock
• Receive a fixed dividend
• Do not usually vote
• Callable / Putable
• Convertible
Investing in Stocks: How Stocks are Sold
 Organized exchanges
─ Baku Stock Exchange, Istanbul Stock Exchange,
NYSE is best known.
─ “Organized” used to imply a specific trading location. But
computer systems (ECNs) have replaced this idea.
─ All organized exchange markets have their own listing
requirements.
Order Types
• Orders can be either buy or sell by its direction.
• All submitted orders are valid until the end of the
trading day.

Limit
• Order Quantity and price must be
indicated at the submission
• Executed at indicated price or at better

order
price best order price on opposite side
or indicated(lowest price for sell
orders, highest price for buy orders).

Market
• Only order quantity is indicated.
• Executed at best market price at the
time of submission

order
• If there is not limit order in order book
no market order is accepted
Continuous Trading

• Most prevalent order-driven trading method.

• Continuous trading method involves the immediate
execution of matching orders upon their reception.
• Continuous trading algorithm works/matches orders
based on best execution price principle.
• If an order can not be executed at the order price or
a better price, then such orders are kept in order
book.
• All submitted and non-executed orders are valid only
until the end of trading session.
Auction Trading

• Auction trading is conducted for government bonds

and corporate bond placements. This particular type
of auction is called Competitive Auction
• Issuers decide on auction requirements (number of
orders, issue amount etc.) and auction results (cut-off
price, executed quantity and etc.)
• Stock Exchange announces auction to market
participants and organize trading.

8
 Order matching
Two main principles of matching:

1. Order book is organized based on the two layered priority- “price-

time priority”
2. Order matching is done based on the algorithm of “best price
execution”
• Orders with better
Price prices than other
orders have priority
priority of execution over
others

• Orders with the

Time same price are
priority executed by
time priority
Best Price
Order matching is done by trading system based on the algorithm
of “best price execution”.
When a new order is submitted, trading system checks the current
order book for opposite side order with the “best price”;

What is “best price” at any time?

Lowest
price order
among sell
orders

Highest
price among
buy orders
Best Price Execution

A new buy limit order is A new sell limit order is

matched with a sell order matched with a buy order
(or orders) if the sell order (or orders) if the buy order
price is equal to or lower price is equal to or higher
than buy order price. than sell order price.
Example / Buy Side
A new buy limit order is submitted with the price of 9.81 AZN
For that time, there were Sell side orders:

Buy side Sell Side

9.85 AZN
9.20 AZN
9.15 AZN
Example / Buy Side
A new buy limit order is submitted with the price of 9.81 AZN
For that time, there were Sell side orders:

Buy side Sell Side

9.81 AZN 9.85 AZN
9.20 AZN
9.15 AZN

The best price opposite order is 9.15 AZN.

The new limit order will be executed at 9.15 AZN
Example / Sell Side
A new sell limit order is submitted with the price of 10.15 AZN
For that time, there were Buy side orders:

Buy side Sell Side

10.01 AZN
9.85 AZN
9.70 AZN
8.5 AZN
Example / Sell Side
A new sell limit order is submitted with the price of 10.15 AZN
For that time, there were Buy side orders:

Buy side Sell Side

10.01 AZN 10.15 AZN
9.85 AZN
9.70 AZN
8.5 AZN

No execution.
It will be waiting in the order book.
Example / Sell Side
A new sell limit order is submitted with the price of 10.15 AZN
For that time, there were Buy side orders:

Buy side Sell Side

10.20 AZN
10.15 AZN
9.70 AZN
8.5 AZN
Example / Sell Side
A new sell limit order is submitted with the price of 10.15 AZN
For that time, there were Buy side orders:

Buy side Sell Side

10.20 AZN 10.15 AZN
10.15 AZN
9.70 AZN
8.5 AZN

Best price opposite order is 10.20 AZN

The new limit order will be executed at 10.20 AZN
Investing in Stocks: How Stocks are Sold
 Over-the-counter markets
─ Best example is NASDAQ
─ Dealers stand ready to make a market
─ Today, about 3,000 different securities are listed on NASDAQ.
─ Important market for thinly-traded securities—securities that
don’t trade very often. Without a dealer ready to make a
market, the equity would be difficult to trade.
Investing in Stocks: Organized vs. OTC
 Organized exchanges (e.g., NYSE)
─ Auction markets with floor specialists
 Over-the-counter markets (e.g., NASDAQ)
─ Multiple market makers set bid and ask prices
─ Multiple dealers for any given security
Investing in Stocks: ETFs
Exchange Traded Funds are a recent innovation to help
keep transaction costs down while offering diversification.
 Represent a basket of securities
 Traded on a major exchange
 Index to a specific portfolio (e.g., the S&P 500), so
management fees are low (although commissions still apply)
 Exact content of basket is known, so valuation is certain
Computing the Price of Common Stock
 Valuingcommon stock is, in theory, no different
from valuing debt securities:
─ determine the cash flows
─ discount them to the present
Computing the Price of Common Stock:
The Dividend Valuation Model
 Mostgeneral model, but the infinite sum may not
converge.

 Ratherthan worry about computational problems,

we use a simpler version, known as the Gordon
growth model.
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,
Computing the Price of Common Stock:
The Dividend Valuation 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.
Computing the Price of Common Stock: Ratios

 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.


Computing the Price of Common Stock:
Ratios

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  $1.13 = $18.08
Errors in Valuation
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 dividend
discount model.
• Problems with Estimating Growth
• Problems with Estimating Risk
• Problems with Forecasting Dividends
Case: The 2007–2009 Financial Crisis and
the Stock Market
 The financial crisis, which started in August 2007, was the
start of one of the worst bear markets.
 The crisis lowered “g” in the Dividend Growth Model -
driving down prices.
 Also impacts ke - higher uncertainty increases this value,
again lowering prices.
 The expectations were still optimistic at the start of the
crisis. But, as the reality of the severity of the crisis was
understood, prices dropped down.
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, and the NASDAQ composite.
Stock Market Indexes
 $1.00invested in the DJIA back in 1980 (DJIA was
around 800) would have grown to about $16.40 in
2012 (Dow closed year at 13,104). This
represented an annual growth rate around 8.8%.