CHAPTERS 4

Stock Market
PRESENTATION GUIDE

Topic outline
• What are stocks?
• What is common stock?

• What is preferred stock?

• Characteristics of common and preferred stocks
• Primary vs secondary markets
 Where did the term “Common
WHAT ARE STOCKS? Stocks” come from? The investors
are “Shareholders in Common.”

• Stocks represent ownership in a corporation

• Stocks are Equity Financing – “Equities”
• Enable investors to participate in the profits and growth generated by the business
enterprise
• But stockholders are limited liability owners
• Can only lose their investment (unlike a sole proprietor)
• These days stock certificates have been dematerialized. (No physical document)
• Stockholders receive …
• Dividends
• Optional payments of earnings
• Capital Gains – a.k.a. Capital Appreciation
• Value of corporation rises as business grows
COMMON AND PREFERRED
STOCKS
• Common Stock
• is the fundamental ownership claim in a public or private corporation

• Preferred Stock
• is a hybrid security that has characteristics of both a bond and a common
stock.
 CHARACTERISTICS OF COMMON
STOCK

Discretionary dividend
• While common stockholders can potentially receive unlimited dividend
payments if the firm is highly profitable, they have no special or guaranteed
dividend rights.

Residual claim
• In the event of liquidation, common stockholders have the lowest priority in
terms of any cash distribution.
 CHARACTERISTICS OF COMMON
STOCK – CON’D

Limited liability
• No matter what financial difficulties the issuing corporation encounters, neither
it nor its creditors can seek repayment from the firm’s common stockholders.

Voting rights
• While common stockholders do not exercise control over the firm’s daily activities,
they do exercise control over the firm’s activities indirectly through the election of the
board of directors
 CHARACTERISTICS OF
PREFERRED STOCK

Receives better treatment during liquidations

Limited liability

Have first right to dividends and must be paid before

common stockholders

No voting rights

PRIMARY VS. SECONDARY
MARKET
• Primary Market
• The market in which new issues of securities are sold to the public
• Initial Public Offering (IPO)
• The first public sale of a company’s stock
• a.k.a. “Going public”, “Taking the company public”

• Secondary Market
• The market in which securities are traded after they have been issued to the public
• The vast majority of transactions take place in the secondary market
 PRIMARY STOCK MARKETS
TRANSACTIONS

Stocks Stocks

Issuing Investment
Investors
corporation bank

Funds Funds
 STOCK ISSUE ANNOUNCEMENT

Originating houses

Syndicate
 PRIMARY MARKET

• Why “Go Public?”

• Why do corporations issue common stock?
• To raise money to start or expand a business
• To help pay for ongoing business expenses
• As a way to gain prestige and respect within the investment and industrial
communities
• As a reward for those who started the business
• And also simply because once a business becomes sufficiently large, it
becomes very difficult for the owners to “divvy up the spoils” without going
public
Examples of some of the largest private companies.
 PRIMARY MARKET (continued)

• Why “Go Public?” (continued)

• The corporation does not have to repay the money
• It is under no obligation to repurchase the shares of the stock
• The shareholder may or may not be able to find someone who will purchase
the shares from them
TYPES OF PRIMARY MARKETS

• Initial Public Offering (IPO)

• the ‘traditional’ way that companies issue shares on the primary market
• involves a private company becoming publicly traded

• Equity placement
• a less conventional way for companies to issue shares on the primary market,
• lets the company sell its stock to a small group of private investors

• Preemptive rights
• a rights issue gives people that already own company stock the opportunity to buy new
shares on the primary market at a discounted price compared to the current market value of
the stock.
SECONDARY MARKETS

• Markets in which securities are sold after they have been issued
• a.k.a. Aftermarket

• Secondary markets provide…

• Liquidity
• Easy method for transferring ownership of securities

• Mechanism for pricing and valuation of securities

TYPES OF SECONDARY MARKETS

• Organized Securities Exchanges

• Centralized institutions in which transactions are made in outstanding securities

• “Double Auction” Market (Face-to-Face)

• Over-the-counter (OTC) Market

• Widely scattered telecommunications network through which transactions are made in
outstanding securities and smaller IPOs

• Quote-based system (On-line)

This is an outdated comparison. Due to technology advancements,

mergers, and acquisitions, the traditional differences between the two
have been erased. And the changes are just gettin’ started!
ORGANIZED SECURITIES
EXCHANGES
• All trading conducted on an exchange floor (called trading post)
• Each stock is assigned a special market maker (a specialist ).
• The Floor Brokers
• House Brokers
• Execute orders on behalf of their firm’s customers or occasionally on behalf of their
firm’s own account
• Independent Brokers
• Provide as-needed execution services to house brokers, member or non-member
broker-dealers
• Independent of a particular firm
• Examples of organized securities exchange includes:-
• NYSE,
• AMEX
THE NEW YORK STOCK EXCHANGE
THE NEW YORK STOCK
EXCHANGE
• Companies listed on the NYSE must meet stringent requirements

• Companies can be de-listed (example: Kodak)

• If they fail to continue to meet the NYSE requirements

THE NEW YORK STOCK
EXCHANGE (continued)

• Big Changes at the NYSE

• In 2005, purchased Archipelago electronic exchange and the Pacific
regional exchange
• Became a publicly traded corporation in March of 2006
• Merged with the Euronext electronic exchange
• Phasing out face-to-face, double auction trading
• In favor of exclusively trading electronically
• In 2011, Germany’s stock market tried to purchase the NYSE but was
blocked by European regulators
• The NYSE is now being acquired for $8 billion by a 12-year old
derivative trading firm from Atlanta.
THE NEW YORK STOCK
EXCHANGE (continued)
• The Specialists
• Stock exchange members who specialize in making
transactions in one or more stocks
• The job of the specialist is to manage the auction process.
The specialist buys or sells the stock from their own
inventory to provide a continuous, fair, and orderly market
• The role of the specialists is being squeezed out by
technology and the tremendous volume of trading. They are
becoming less and less involved in the typical market trading
day

From time to time, the specialists are either praised or maligned.

Suffice to say that the specialists are trying to make a profit just like
everyone else. While their goal may seem altruistic, they make sure
that when the market receives benefits from their efforts, so do they.
THE OVER-THE-COUNTER
MARKET
• Widely scattered telecommunications network through which transactions of
securities are made – a.k.a. OTC
• There is no single location as with an exchange
• Quote-based system
• As opposed to the double auction of the exchanges
• Three tiers
• NASDAQ – National Association of Securities Dealers Automated Quotation system –
over 3,000 securities
• OTC Bulletin Board – 5,000 securities
• Pink sheets, etc. – 20,000+ thinly traded securities
THE ROLE OF DEALERS IN THE
OTC
• Dealers are traders who “make markets” by offering to buy or sell certain
securities at stated prices – a.k.a. “market makers”
• The dealers offer buy and sell quotes from their own inventory of stocks
• Whereas brokers simply serve as a go-between between buyers & sellers. They keep no
inventory

• Ask price – “retail price”

• The price a dealer offers to sell a security

• Bid price – “wholesale price”

• The price a dealer offers to purchase a security

• The spread
• The difference between the bid and the ask prices
THE ROLE OF DEALERS IN THE
OTC (continued)

• Unlike brokers who charge a commission, dealers make money from the
spread of the bid and ask prices
• Just as the Casas de Cambio in San Ysidro make money on the difference between the
prices in which they buy and sell pesos and dollars

• The dealer’s markups or markdowns are not reported to the customers

• Whereas the broker’s commissions are reported

How do you think the Internet brokers make money on

only $5 or $7 per trade? (More later)
THE NASD AND THE NASDAQ
• National Association of Securities Dealers Automated Quotation system –
NASDAQ
• National Association of Securities Dealers (NASD)
• Non-governmental organization that used to be responsible for self-regulation of

registered representatives (stockbrokers) – (Now done by FINRA)

• The NASD is now simply called the NASDAQ
• Created the first electronic communications network for trading securities in 1971
• Provides up-to-date bid and ask prices on approximately 3,200 stocks

The NASDAQ used to be the arena for small companies to get started.
Once they became large enough, they would move to the NYSE.
However, since the 1980’s, many prestigious companies decided to stay
on the NASDAQ rather than move to the NYSE.
THE NASD AND THE NASDAQ
(continued)

• The NASDAQ is now a three-tier system

• NASDAQ Global Select Market
• 1,530 “crème de la crème”
• Companies that would easily qualify for the NYSE
• NASDAQ Global Market
• nee NASDAQ National Market
• 680 larger companies
• NASDAQ Capital Market
• nee NASDAQ SmallCap Market
• 530 smaller companies

The NASDAQ began positioning itself as the “Securities Market of the

Future” as it became apparent that the traditional face-to-face,
double auction model was not adequate to keep up with the massive
increase of trading.
EQUITY VALUATION

• Valuation is the process of determining the

present value an assets.
• Equity valuation therefore refers to the process of
determining the fair market value of equity
securities.
EQUITY VALUATION METHODS
1. Intrinsic value – is the present value of firm’s expected
future net cash flows discounted at the required rate of
return
2. Relative valuation – looks at the price relative to some
factor like earnings or book value and compares it to other
similar firms.
EQUITY VALUATION

Equity
valuation

Relative
Intrinsic value
valuation

Discounted
Dividend
cash flow
discount model PE ratio
valuation
(DDM)
(DCF)
 DIVIDEND DISCOUNT MODEL

• is one of the most basic techniques of absolute stock

valuation. 
• is based on the assumption that the company’s dividends
represent the company’s cash flow to its shareholders.
• the model states that the intrinsic value of the company’s
stock price equals the present value of the company’s
future dividends.
• is applicable only if a company distributes dividends
regularly and the distribution is predictable.
DIVIDEND DISCOUNT MODEL

•Models
1.The One-Period Valuation Model
2.The Generalized Dividend Valuation Model
3.The Gordon Growth Model
 THE ONE-PERIOD VALUATION
MODEL

•Suppose that you have some extra money to invest for one year.
After a year you will need to sell your investment to pay tuition.
After watching Wall Street Week on TV you decide that you want
to buy Intel Corp. stock. You call your broker and find that Intel
is currently selling for $50 per share and pays $0.16 per year in
dividends. The analyst on Wall Street Week predicts that the stock
will be selling for $60 in one year. Should you buy this stock?

AAU, SOC November, 2022 31

 THE ONE-PERIOD
VALUATION MODEL
Find the value of the Intel stock
given the figures reported above.
You will need to know the required
return on equity to find the present
value of the cash flows. Since a
stock is more risky than a bond, you
will require a higher return than that
offered in the bond market. Assume
that after careful consideration you
decide that you would be satisfied
to earn 12% on the investment.
AAU, SOC
Based on your analysis, you
find that the stock is worth
$53.71. Since the stock is
currently available for $50 per
share, you would choose to
buy it. Why is the stock
selling for less than $53.71? It
may be because other
investors place a different risk
on the cash flows or estimate
the cash flows to be less than
you do.
November, 2022 32
 THE GENERALIZED DIVIDEND
VALUATION MODEL

•The one-period dividend valuation model

can be extended to any number of periods.
The concept remains the same. The value
of stock is the present value of all future
cash flows. The only cash flows that an
investor will receive are dividends and a
final sales price when the stock is
ultimately sold. The generalized formula
for stock can be written as in Equation 2.

AAU, SOC November, 2022 33

 THE GORDON GROWTH MODEL

• Many firms strive to

increase their dividends at
a constant rate each year
THE GORDON GROWTH MODEL

• Assumptions
1. Dividends are assumed to continue
growing at a constant rate forever
2. The growth rate is assumed to be less
than the required return on equity
 DISCOUNTED CASH FLOW
VALUATION (DCF)

• the intrinsic value of a stock is calculated by

discounting the company’s free cash flows to its
present value.
•  it does not require any assumptions regarding the
distribution of dividends. 
• Thus, it is suitable for companies with unknown or
unpredictable dividend distributions.
PRESENTATION GUIDE

Topic outline
• What is IPO underpricing?
• WHY are IPOs underpriced?
• Recognize the major stock market indexes,
• Know who the major stock market participants are,
and
• Explain the three forms of market efficiency
IPO UNDERPRICING

• Underpricing is the practice of listing an initial public

offering (IPO) at a price below its real value in the stock
market.
• =[(Pm-Po)/Po]*100
• Pm price of stock at end of trading day
• Po offering price
 WHY UNDERPRICING?

Winner’s curse (information asymmetry),

Bandwagon,
Investment bankers monopsony power,
Legal issues,
Signaling, and
Ownership dispersion
 STOCK MARKET INDICES

• The media refer to stock market indices daily, reporting on

movements in the FTSE, Dow Jones, S & P and others.

• You have come across indices before which are used to

measure different things:

• e.g. Retail Price Index (RPI) and Consumer Price Index

(CPI) both measure inflation
 STOCK MARKET INDICES
continued

• Stock indices do the following:

 Provide a snapshot of how share prices are performing
in a particular stock market, or across several markets.
 Measure price movements in markets across a number
of different types of stocks.
 Calculate the aggregate price movement of its targeted
stocks on a daily basis,
 Provide a single figure for ease of comparison.
 BENEFITS OF SHARE INDICES

 Allows investors to gauge the overall performance of the

market (not easy to do by looking at individual share
prices)
 A stock index will smooth out anomalies and provide a
consistent picture of the mood across the market.
 Provide a benchmark for investors - assess whether their
portfolios of shares are doing better (outperforming) or
worse (underperforming) than the market in general.
Stock Market Indices - World

World Indices

Japan France UK USA Germany

Hong Kong
Xetra DAX
China

S&P 500 30 Stocks

A wider view of Hang Seng
225 Stocks 40 Stocks 100 Stocks Nasdaq Composite
Dow Jones Industrial the US stock Focuses on shares
58 Stocks
Average market
500 stocks traded on the Nasdaq
(DJIA or ‘The Dow’) Includes many
A narrow view of the Value-weighted technology companies
US stock market 3000+ stocks
30 stocks
Price-weighted
READING STOCK QUOTES
• Current price during trading hours
• The bid and the ask
• Open, High, Low, Close (a.k.a. Last)
• 52-Week High and Low
• Dividend Yield
https://finance.yahoo.com/quote/BABA?
• P/E Ratio p=BABA&.tsrc=fin-srch.

• Volume
• Net Change
• Year-to-Date Change
READING STOCK QUOTES
(continued)

Wall
Street
Journal
Example

“Omigod! You mean you actually wait until the next day to find out
how much your stock is worth?! How Twentieth Century!”
READING STOCK QUOTES
(continued)

• On-line Examples
• Yahoo!
• Bloomberg’s
• CBS Marketwatch
• Any others you want to check out?
THE DOW JONES INDUSTRIAL
AVERAGE
• Stock market average made up of 30 high-quality stocks selected for total
market value and broad public ownership and believed to reflect overall
market activity
• Share price calculation
• Most famous of the stock market measures
• a.k.a. the Dow, the Dow Average, the DJIA
• Changes from time to time as companies and industries evolve
• As such, it now has more non-industrial stocks than industrial stocks

Dow Jones is the company that publishes the Wall Street Journal.
It was recently purchased by Rupert Murdoch of Fox News fame.
THE DOW JONES INDUSTRIAL
AVERAGE (continued)

The Thirty Stocks in the Dow Jones Industrial Average

Alcoa Dupont Merck
American Express ExxonMobil Microsoft
AT&T General Electric Pfizer
Bank of America Hewlett Packard Proctor & Gamble
Boeing Home Depot 3M
Caterpillar IBM Travelers
Chevron Intel United Healthcare
Cisco Johnson & Johnson United Technologies
Coca Cola J. P. Morgan Chase Verizon
Disney McDonald’s Walmart
THE DOW JONES INDUSTRIAL
AVERAGE (continued)

Years Dow Jones Average Rise

1906 ─ 1924 100  100 -
1924 ─ 1929 100  300 3x
1929 ─ 1954 300  300 -
1954 ─ 1966 300  1000 3x
1966 ─ 1982 1000  1000 -
1982 ─ 2000 1000  11000 11x
2000 ─ 2011 11000  11000 -
So, how do you make money in stocks during times when the
markets and capital gains are flat? The answer depends upon
whether you are an investor or a speculator/trader.
OTHER DOW JONES AVERAGES
• Dow Jones Transportation Average
• 20 railroad, airline, freight, etc.

• Dow Jones Utilities Average

• 15 public utilities

• Dow Jones 65 Stocks Composite Average

• Industrial, Transportation & Utilities stocks

• Dow Jones U.S. Total Stock Market Index

• nee Dow Jones Wilshire 5000 Total Market Index
• nee Wilshire 5000

• Dow Jones U.S. Completion Total Stock Market Index

• nee Dow Jones Wilshire 4500, nee Wilshire 4500
• It is the Wilshire 5000 minus the 500 stocks in the S&P 500

• Dow Jones Internet Index

STANDARD & POOR’S 500 COMPOSITE
INDEX – A.K.A. THE S&P 500, THE S&P
• 500 stocks chosen for market size, liquidity, and industry group
representation
• Market-value weighted index
• Traditionally, the largest 500 companies based in the United States (can now
contain foreign stocks)
• Very popular index although has lost some of its original focus
• Used by many index mutual funds

Because the S&P 500 is market-weighted, it was affected by the bubble

of the late 1990’s in a bizarre manner. The market values of a small
percentage of technology companies were inflated to extremes. This
skewed the index even more toward those companies. Consequently, in
1998, 10% of the gain in the S&P 500 was due to one stock.
OTHER STANDARD & POOR’S
INDICES
• Standard & Poor’s Industrial 400

• Standard & Poor’s Midcap 400

• Medium-sized companies

• Standard & Poor’s Smallcap 600

• Small companies

• Standard & Poor’s 1500 Index

• Includes 500 Index, Midcap 400 and Smallcap 600

• Other Standard & Poor’s Indices

• Transportation, Utilities, Financials
• Many other global, international & sector indices
NYSE, AMEX AND NASDAQ
INDICES
• NYSE Composite Index
• Measure of the current price behavior of approximately 2,000 stocks listed on the NYSE
• AMEX Composite Index
• Now called the NYSE MKT Composite Index

• NASDAQ Composite Index (a.k.a. tech index)

• Ditto for the NASDAQ
• NASDAQ 100 Index
• Top 100 non-financial firms listed on the NASDAQ

The NASDAQ Composite went from 800 in 1995 to 5000 in 2000 and
then dropped to 1200 in 2002 before starting to recover in 2003.
The NASDAQ indices are technology laden.
 OTHER POPULAR STOCK
MARKET INDICES
• Total Stock Market Indices
• Dow Jones U.S. Total Stock Market Index
• nee Dow Jones Wilshire 5000 Index
• nee Wilshire 5000
• Now competing with S&P Total Market Index and
• MSCI US Broad Market Index
• Extended / Completion Stock Market Indices
• Dow Jones U.S. Completion Total Stock Market Index
• nee Dow Jones Wilshire 4500
• nee Wilshire 4500
• Now competing with the S&P Completion Index
 OTHER POPULAR STOCK
MARKET INDICES(continued)
• Russell 2000
• Meant to measure small company performance in the United States
• Russell 1000 is the top 1,000 largest companies
• Russell 3000 is the top 3,000 companies
• Russell 2000 is the top 3,000 without the top 1,000
• MSCI Indices
• Morgan Stanley Capital International
• MSCI World Index (Global developed world)
• The MSCI All Country World Index is replacing the World Index
• Includes developing world countries
• MSCI EAFE Index (International developed world)
• The MSCI All Country World ex-USA Index is replacing the EAFE
Index – (again, includes developing countries)

Stock Worksheet #1 contains the indices you should know by name

MARKET EFFICIENCY

• The speed with which financial security prices adjust to

unexpected news pertaining to interest rates or a stock
specific characteristic.