Chapter Eight

1. Chapter Eight

2. Introduction • By giving individuals a way to transfer risk, stocks supply a type of insurance enhancing our ability to take risk. • Companies use stocks as a way to obtain financing. • Stocks are a central link between the financial works and the real economy. • Stocks tell us the real value of a company. • Stocks allocate scarce resources.

3. Introduction • During a week in 1929, the New York Stock Exchange lost more than 25 percent of its value. • This marked the beginning of the Great Depression. • In October 1927, prices fell nearly 30 percent in one week. • In the 1990’s stock prices increased nearly fivefold, and we forgot about the black Octobers.

4. Introduction • From January 2000 to the feel after the Sept. 11, 2001 terrorist attacks, the Dow Jones Industrial Average fell more than 30 percent. • During the same period, the Nasdaq composite index fell 70 percent and has remained low ever since. • This was dubbed the “Internet bubble”. • The recent financial crisis lead to the stock market roughly halving in value by early 20009 from its 2007 value.

5. Introduction • The subsequent rebound from the trough has been the sharpest since the Great Depression. • However, despite all of this, stock prices tend to rise steadily and slowly, collapsing only on rare occasions when normal market mechanisms are out of alignment.

6. Introduction • The goals of this chapter are: • To try to make sense of the stock market. • To show what fluctuations in stock value mean for individuals and for the economy as a whole. • To look at a critical connection between the financial system and the real economy. • Explain why we sometimes have bubbles and crashes.

7. The Essential Characteristics of Common Stock • Stocks, also known as common stock or equity, are shares in a firm’s ownership. • Stocks first appeared in the 16th century as a way to finance voyages of explorers. • The idea was to spread the risk through joint-stock companies, organizations that issued stock and used the proceeds to finance several expeditions at once. • In exchange for investing, stockholders received a share of the company’s profits.

8. The Essential Characteristics of Common Stock • Shares were issued in small denominations, allowing investors to buy as little or as much as they wanted. • Shares were transferable - an owner could sell them to someone else. • Although one used to receive a stock certificate, most stockholders no longer do. • Information is all computerized which is safer and makes it easier to transfer.

9. The Essential Characteristics of Common Stock • The ownership of common stock conveys rights: • A stockholder is entitled to participate in the profits of the enterprise. • Stockholders are entitled to vote at the firm’s annual meeting.

10. The Essential Characteristics of Common Stock • Although a stockholder is entitled to participate in the profits of the firm, they are merely a residual claimant. • Stockholders are paid last, only after all other creditors have been paid. • However, stockholders have limited liability in the firm. • Even if a company fails completely, the maximum amount a shareholder can lose is their initial investment.

11. The Essential Characteristics of Common Stock • The thriving market of stocks is possible because: • An individual share is only a small faction of the company’s value. • A large number of shares are outstanding. • Prices of individual stocks are low. • Stockholders are residual claimants. • Stockholders have limited liability. • Shareholders can replace managers who are doing a bad job.

12. When you buy a house • You consume housing services. • You should expect to get back the original purchase price. • The average long-run real change in housing prices in the U.S. is 0.20%. • Unlike other financial investments, you don’t get a place to live - that is your return on your investment.

13. Measuring the Level of the Stock Market • We need to understand the dynamics of the stock market. • What are the connections between stock values and economic conditions? • We also need to be able to measure the level of fluctuation in all stock values. • This concept is the value of the stock market. • We will refer to its measures as stock-market indexes.

14. Measuring the Level of the Stock Market • Stock indexes: • Tell us how much the value of an average stock has changed, and • Tell us how much total wealth has gone up or down. • Provide benchmarks for performance of money managers. • You can tell whether a money manager has done better or worse than “the market” as a whole.

15. The Dow Jones Industrial Average • The DJIA • Is the first and best known stock market index. • Is based on the stock prices of 30 of the largest companies in the U.S. • 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.

16. The Dow Jones Industrial Average • The DJIA is a price-weighted average,which gives greater weight to shares with higher prices. • The behavior of higher priced stocks dominates the movement of a price-weighted index.

17. The Standard and Poor’s 500 Index • The S&P 500 is constructed from the prices of many more stocks than the DJIA. • It is based on the value of 500 largest firms in the U.S. economy. • It tracks the total value of owing the entirety of those firms. • It uses a value-weighted index where larger firms carry more weight.

18. The Standard and Poor’s 500 Index • If a firm is priced at $100 and has 10 million shares outstanding, its total market value or market capitalization, is worth $1 billion. • 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. • Price per se is irrelevant.

19. The Standard and Poor’s 500 Index • The two types of index simply answer different questions. • Changes in a price-weighted index tells us the change in the price of a typical stock. • Changes in the value-weighted index accurately mirror changes in the economy's overall wealth.

20. The financial pages report on the major stock-market indexes. • Some indexes cover a particular sector or industry, or a set of certain sized firms. • When you encounter a new index, make sure you understand both how it is constructed and what it is designed to measure.

21. Other U.S. Stock Market Indexes • The Nasdaq Composite Index and the Wilshire 5000 are the next largest indexes in the U.S. • Nasdaq is a value-weighted index of over 5000 companies traded on the over-the-counter (OTC) market. • Nasdaq is mainly composed of smaller, newer firms and has recently been dominated by technology and Internet companies. • The Wilshire 5000 is the most broadly based index in use; it covers all publicly traded stocks in the U.S. • Wilshire is value-weighted and is the best measure of overall market wealth.

22. World Stock Indexes • About a third of all the countries in the world have a stock market and each has an index. • Most are value-weighted indexes. • Table 8.2 gives behavior of these in early 2010. • The percentage change in these indexes is the most important as their stated number does not mean much without comparison. • Investors view global stock markets as a means to diversify risk away from domestic markets. • However, there is now increased correlation of global markets.

24. Valuing Stocks • People differ on how stocks should be valued. • Some believe they can predict changes by looking at patterns or past movements - chartists. • Some estimate the value of stocks based on their perceptions of investor psychology and behavior - behavioralists. • Others estimate stock based on both its current assets and on estimates of future profitability - the fundamentals.

25. Valuing Stocks • The fundamental value of a stock is based on the timing and uncertainty of the returns it brings. • We can use the information we have already studied to compute the fundamental value of stocks. • Chartists and behavioralists question the usefulness of fundamentals in understanding the level and movement of stock prices.

26. Fundamental Value and the Dividend-Discount Model • A stock represents a promise to make monetary payments on future dates, under certain circumstances. • The payments are usually in the form of dividends: • Distributions made to the owners of a company when the company makes a profit. • If a company is sold, the stockholders receive a final distribution that represents their share of the purchase price.

27. Valuing Stocks:Dividend-Discount Model • The current price is the present value of next years price plus the dividend: • Expanding over an investment horizon of n years:

28. Valuing Stocks:Dividend-Discount Model • The price today is the present value of the sum of the dividends plus the present value of the price at the time the stock is sold n years from now. • What if a company does not pay dividends? • We estimate when the company will start paying dividends and use the present-value framework. • We must know something more about annual dividend payments.

29. Valuing Stocks:Dividend-Discount Model • Assume that dividends grow at a constant rate of g per year so: • As long as growth remains constant, we can do this for n year from now: .

30. Valuing Stocks:Dividend-Discount Model • We can rewrite the price equation as: • But we don’t know the price in n years, so we assume firm pays dividends forever turning the stock into something like a consol. • We can then covert the above into: .

31. Valuing Stocks:Dividend-Discount Model • This relationship is the dividend-discount model. • The model tells us that stock prices should be high when • dividends are high (Dtoday), • dividend growth is rapid (g is large), or • the interest rate (i) is low. • Although this model is simple, we have ignored risk in deriving it.

32. Why Stocks are Risky • When you buy stocks, it is as if you put up your wealth to buy the firm and borrow the rest. • Stockholders get part of the profits, but only after everyone else is paid, including bondholders. • The borrowing creates leverage, and leverage creates risk. • The more debt, the more leverage and the greater the owners’ risk.

33. Why Stocks are Risky • Imagine a firm that only needs a $1000 computer. • Once installed, the firm will have equal probability of earnings: • $80 in bad times. • $160 in good times. • Financing can be part equity (stock) & part debt (bonds). • Debt can be obtained at a 10% interest rate.

34. Return to Debt & Equity Holders for Different Financing Assumptions

35. Why Stocks are Risky • Stocks are risky because shareholders are residual claimants. • They never know for sure how much their return will be. • In contrast, bond holders receive fixed nominal payments and are paid before stockholders in the event of bankruptcy.

36. Sometimes investment reports imply that you can evaluate a fund’s performance simply by adding the percentage loss and gain over a period to get a total percent change. • This is not the case. • If a firm has a loss of 75%, an increase of 300% is required to return to initial level. • In general, the percentage required to return to original value = , where d is initial decline.

37. Risk and the Value of Stocks • Stockholders require compensation for risk. • The higher the risk, the higher the compensation. • An investor will buy a stock with the idea of obtaining a certain return, which includes compensation for the stock’s risk. • We know the return to holding stock for one year

38. Risk and the Value of Stocks • We can think of the required return as the sum of the risk-free return and the risk premium (equity risk premium). • We can write this as: Required Stock Return (i) = Risk-free Return (rf) + Risk Premium (rp) • Rewrite dividend-discount model:

39. Risk and the Value of Stocks • We can summarize as follows from this equation:

40. The Theory of Efficient Markets • The basis for the theory of efficient markets is the notion that the prices of all financial instruments reflect all available information. • Markets adjust immediately and continuously to changes in fundamental values. • This implies that stock price movements are unpredictable. • Any prediction that causes people to buy or sell the stock, thereby changes the price through simple supply and demand.

41. The Theory of Efficient Markets • This means active portfolio management will not yield a higher return than of the broad stock-market index, year after year. • Evidence suggests both that: • Prices are unpredictable, and • Professional money managers cannot beat an index like the S&P 500 regularly. Their returns are 2% lower on average.

42. The Theory of Efficient Markets • But we do see managers who claim to exceed the market. How? • They have inside information, which is illegal. • They are taking on risk and are compensated as such. • They are lucky. • Markets aren’t efficient. • This means that high or low investment returns could simply be a result of chance.

43. The Theory of Efficient Markets • Suppose 225 million people start with a dollar and pair off to flip a coin once. The winner takes the $2 and moves on to next round. • Do this over and over again. • After 20 flips, there will be 215 people left with over $1 million each. • Did the winners know anything special? • As is true in the stock market, the number of people who “win” is about the same number as we would expect to be lucky.

44. There 2 stock exchanges in China. • Shanghai (east coast) • Shenzhen (near Hong Kong) • Each firm issues 2 types of shares. • A-shares (only Chinese investors until 2001) • B-shares (only foreigners) • Prices on A-shares were 4 times prices on B-shares. • But they are the same stock - why so different? • Problem was that there was a shortage of A-shares created by the government. • Shortage drove up price and when released, prices fell more than 50 percent from their peak.

45. Investing in Stocks For the Long Run • Stocks appear to be risky, but people hold a substantial proportion of their portfolio in stock. • Either stocks are not that risky or people are not that risk averse. • What is the case?

46. Investing in Stocks For the Long Run • Figure 8.2 plots the one-year real return of the S&P 500 for 140 years. • The average real return was 8% per year. • In the past 50 years: • The minimum return was -34% (in 2008). • The maximum return was +31% (in 1996). • Professor Jeremy Siegel suggested that investing in stocks is risky only if you hold them for a short time.

47. Investing in Stocks For the Long Run • If you hold stocks long enough, they are not that risky. • If we look at holding stocks for 25 years instead of one year. • The minimum average annual real return was 2.5%. • The maximum average annual real return was 11.3%. • Between 1871 and 1992 there were no 30-year periods where bonds outperformed stocks. • When held long enough, stocks are less risky than bonds.

48. Investing in Stocks For the Long Run

49. Prepackaged mutual funds are a great way to buy stocks. • Mutual funds offer • Affordability: small initial investment • Liquidity: can withdraw quickly • Diversification: portfolio of stocks • Management: professionals • Cost: look for low management fees

50. Markets may use available information efficiently and still face large setbacks if the information is incomplete or incorrect. • An important source of the financial crisis of 2007-2009 was the failure to understand and manage risks in the U.S. housing market. • The efficient market hypothesis does not rule out large swings in market prices when new information becomes widely available.