Chapter 8 Stocks Stock Markets and Market Efficiency

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Chapter 8 Stocks, Stock Markets, and Market Efficiency Mc. Graw-Hill/Irwin Copyright © 2006 by

Chapter 8 Stocks, Stock Markets, and Market Efficiency Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Essential Characteristics of Common Stock • Common stock or equity are shares in a

Essential Characteristics of Common Stock • Common stock or equity are shares in a firm’s ownership • Stockholder is merely a residual claimant • Limited liability 2

Measuring the Level of the Stock Market • • The Dow Jones Industrial Average

Measuring the Level of the Stock Market • • The Dow Jones Industrial Average The Standard & Poor's 500 Index Nasdaq Composite index Wilshire 5000 • www. bloomberg. com 3

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Valuing Stocks • Fundamental Value and the Dividend. Discount Model 5

Valuing Stocks • Fundamental Value and the Dividend. Discount Model 5

Valuing Stocks 6

Valuing Stocks 6

Valuing Stocks • assume that the firm pays dividends forever, then 7

Valuing Stocks • assume that the firm pays dividends forever, then 7

Valuing Stocks • Why Stocks Are Risky • Stocks are risky because the shareholders

Valuing Stocks • Why Stocks Are Risky • Stocks are risky because the shareholders are residual claimants. Since they are paid last, they never know for sure how much their return will be. 8

Valuing Stocks • Risk and the Value of Stocks Return to Holding Stock for

Valuing Stocks • Risk and the Value of Stocks Return to Holding Stock for One Year =. 9

Valuing Stocks • Since the ultimate future sale price is unknown the stock is

Valuing Stocks • Since the ultimate future sale price is unknown the stock is risky • the investor will require compensation in the form of a risk premium • Required Stock Return (i) = Risk-free Return (rf) + Risk Premium (rp) 10

Valuing Stocks 11

Valuing Stocks 11

Valuing Stocks • Implications of the Dividend-Discount Model with Risk: Stock Prices are High

Valuing Stocks • Implications of the Dividend-Discount Model with Risk: Stock Prices are High When • Current dividends are high (Dtoday is high) • Dividends are expected to grow quickly (g is high) • The risk-free rate is low (rf is low) • The risk premium on equity is low (rp is low) 12

Valuing Stocks • Theory of Efficient Markets • The basis for theory of efficient

Valuing Stocks • Theory of Efficient Markets • The basis for theory of efficient markets is the notion that the prices of all financial instruments, including stocks, reflect all available information • When markets are efficient, the prices at which stocks currently trade reflect all available information, so that future price movements are unpredictable. 13

Investing in Stocks For the Long Run 14

Investing in Stocks For the Long Run 14

Investing in Stocks For the Long Run 15

Investing in Stocks For the Long Run 15

Investing in Stocks For the Long Run • Professor Jeremy Siegel of the University

Investing in Stocks For the Long Run • Professor Jeremy Siegel of the University of Pennsylvania’s Wharton School wrote a book titled Stocks for the Long Run • investing in stocks is risky only if you hold them for a short time. But if you buy them and hold them for long enough, they really are not very risky. 16

The Stock Market’s Role in the Economy • The stock market plays a crucial

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 17

The Stock Market’s Role in the Economy • bubbles • persistent and expanding gaps

The Stock Market’s Role in the Economy • bubbles • persistent and expanding gaps between actual stock prices and those warranted by the fundamentals. • These bubbles inevitably burst, creating crashes. 18

Chapter 8 End of Chapter Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill

Chapter 8 End of Chapter Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved.