Transcript Stocks: An Introduction

• An Introduction
• Essential Characteristics of Common Stock
• Measuring the Level of the Stock Market
• Valuing Stocks
• Fundamental Value and the Dividend-Discount Model
• Investing in Stocks for the Long Run
• The Stock Market’s Role in the Economy
Stocks: An Introduction
 Stocks provide a key instrument for holding
personal wealth as well as a way to diversify,
spreading and reducing the risks that we face
 For companies, they are one of several ways to
obtain financing.
 Additionally, Stocks and stock markets are one
of the central links between the financial world
and the real economy.
 They indicate the value of the companies that
issued the stocks and, They allocate scarce
investment resources
Stocks: An Introduction
 The firms deemed most valuable in the marketplace for
stocks are the ones that will be able to obtain financing
for growth. When resources flow to their most valued
uses, the economy operates more efficiently
 Most people see stock market as a place where fortunes
are easily made or lost, and they recoil at its
unfathomable booms and busts.
 Great American Depression (1929)
 Post-September 11, 2001 scenario
 Pakistan stock market on roller-coaster-ride (March
2005)
Essential Characteristics of Common Stock
 Stocks, also known as common stock or equity, are shares
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in a firm’s ownership
From their early days, stocks had two important
characteristics : The shares are issued in small
denominations and The shares are transferable
Until recently, stockowners received a certificate from the
issuing company, but now it is a computerized process
where the shares are registered in the names of brokerage
firms that hold them on the owner’s behalf
The ownership of common stock conveys a number of
rights
A stockholder is entitled to participate in the shares of
the enterprise, but this is a residual claim i.e. meaning the
leftovers after all other creditors have been paid.
Essential Characteristics of Common Stock
 Stockholders also have limited liability
 Even if a company fails, the maximum amount that the
stockholder can lose is the initial investment
 Stockholders are entitled to vote at the firm’s annual
meeting including voting to elect (or remove) the firm’s
board of directors
 Prices of individual shares are low, allowing individuals to
make relatively small investments
 Because of limited liability, investor’s losses cannot
exceed the price they paid for the stock; and
 Shareholders can replace managers who are doing a
bad job
Measuring the Level of the Stock Market
 Stocks are one way in which we choose to hold our
wealth, so when stock values rise we get richer and
when they fall we get poorer
 These changes affect our consumption and saving
patterns, causing general economic activity to
fluctuate
 Stock market indexes are designed to give us a sense
of the extent to which stock prices are going up or
down
 Tell us both how much the value of an average stock
has changed, and how much total wealth has gone
up or down
Measuring the Level of the Stock Market
 Every major country in the world has a stock market, and
each of these markets has an index
 The Dow Jones Industrial Average
 The Standard & Poor's 500 Index
 NASDAQ Composite index
 Financial Times Stock Exchange 100 Index
 Hang Seng 100
 Nikkei 225
 The KSE100
VALUING STOCKS
 People differ in their opinions of how stocks should
be valued
 Chartists believe that they can predict changes in a
stock’s price by looking at patterns in its past price
movements
 Behaviorists estimate the value of stocks based on their
perceptions of investor psychology and behavior
 Others estimate are based on a detailed study of the
fundamentals, which can be analyzed by examining the
firm’s financial statements.
 In this view the value of a firm’s stock depends both on
its current assets and estimates of its future profitability
Fundamental Value and the Dividend-Discount Model
 As with all financial instruments, a stock represents a
promise to make monetary payments on future dates,
under certain circumstances
 With stocks the payments are in the form of dividends,
or distributions of the firm’s profits
 The price of a stock today is equal to the present value of
the payments the investor will receive from holding the
stock
 This is equal to: The selling price of the stock in one
year’s time plus The dividend payment received in the
interim
Fundamental Value and the Dividend-Discount Model
 Thus the current price is the present value of next
year’s price plus the dividend
 If Ptoday is the purchase price of stock, Pnext year is
the sales price one year later and Dnext year is the
size of the dividend payment, we can say:
Fundamental Value and the Dividend-Discount Model
Fundamental Value and the Dividend-Discount Model
Fundamental Value and the Dividend-Discount Model
Investing in Stocks for the Long Run
 Stocks appear to be risky, and yet many people
hold substantial proportions of their wealth in
the form of stock
 This is due to the difference between the short
term and the long term;
 Investing in stocks is risky only if you hold them
for a short time
 In fact, when held for the long term, stocks are
less risky than bonds.
The Stock Market’s Role in the Economy
 The stock market plays a crucial role in every modern
capitalist economy.
 The prices determined there tell us the market value of
companies, which determines the allocation of
resources.
 Firms with a high stock market value are the ones
investors’ prize, so they have an easier time garnering
the resources they need to grow.
 In contrast, firms whose stock value is low have
difficulty financing their operations
 So long as stock prices accurately reflect fundamental
values, this resource allocation mechanism works well.
The Stock Market’s Role in the Economy
 Shifts in investor psychology may distort prices;
both euphoria and depression are contagious
 When investors become unjustifiably exuberant
about the market’s future prospects, prices rise
regardless of the fundamentals, and such mass
enthusiasm creates bubbles.
 Bubbles are persistent and expanding gaps
between actual stock prices and those warranted
by the fundamentals.
 These bubbles inevitably burst, creating
crashes.
The Stock Market’s Role in the Economy
 They affect all of us because they distort the
economic decisions companies and consumers
make
 If bubbles result in real investment that is
both excessive and inefficiently distributed,
crashes do the opposite; the shift to excessive
pessimism causes a collapse in investment and
economic growth
 When bubbles grow large enough and result in
crashes the stock market can destabilize the
real economy