prem_ppt_ch07.ppt

Chapter Seven
Stocks and Other
Assets

Copyright © Houghton Mifflin Company. All rights reserved. 7 | 2
• What determines the prices
of stock?
• How do analysts determine
if the market is over- or
undervalued?
• How do investors decide
where to invest?
• How does the stock market
help us to measure the
health of the larger
economy?
The Stock Market

• Corporations issue shares of stock to raise
funds to invest in the business
• Investors purchase shares to own a piece
of the corporation and make some claim on
its profits
• Shareholders are investors who own
shares of stock in a corporation
Issuing & Investing in Stock

• When a shareholder no
longer wants to own their
shares, they must find a
buyer to sell them to.
• A stock exchange (or
stock market) facilitates this
interaction. They may exist
physically or virtually.
Issuing & Investing in Stock (cont’d)

• Investors like to be able to see trends in stock
prices in general
• A stock index is a number that represents the
average price of a (specific) collection of stocks,
such as the Dow
• There are many well-known indexes
– Dow Jones Industrial Average
– Standard & Poor’s 500
– NASDAQ
Stock Indexes

• Indexes report only stock price, ignoring both returns and
dividends
• Indexes tend to move in tandem, but often show markedly
different total returns
• Because each index reports on many different kinds of
companies, returns sometimes vary
Please insert Table 7.1
Stock Indexes (cont’d)

• Mutual funds, companies that pool the
funds of many investors and buy large
numbers of different securities, are a way
for investors to diversify
• Index funds are a special type of mutual
fund which try to mimic a particular stock
index
Diversifying With Index Funds

• The main incentive for buying stock is
the belief in the company’s profitability
• Profits help shareholders in two ways
1) The firm may pay out part of its profit in the form of
dividends
2) The firm may retain profits to use for investment in
capital improvements, intended to lead to even
more profits in the long run
The Importance of Profits

• There are two components to an investor’s
total return on stock ownership
1) Dividend yield (the amount of dividends paid
divided by the share price)
2) Capital-gains yield (the percentage increase
in the price of the stock)
Investors’ Return on Stocks

Advantages
• Generation of cash flow
for the investor (selling
shares may be both
inconvenient & costly)
• Reassurance for
investors of company’s
cash flow position
Disadvantages
• TAXES…investor must
pay taxes on dividends
earned
• Less incentive for
companies to pay out
dividends (though tax
burden was lowered in
2003)
Are Dividends Desirable?

• Investors must also pay taxes on realized
capital gains
• Implicit capital gains are subject to more
favorable tax treatment as a result,
incentivizing investors to hold shares
longer, known as the lock-in effect
• The lock-in effect causes distortions in the
prices of stocks by reducing trading that
might otherwise occur more frequently
Capital Gains

• The same principles apply in calculating after-
tax total returns of stocks as to debt securities
• Recall, however, that only realized capital gains
are taxed
• One must account for
– taxes on income from dividends and capital gains
– loss of principal value due to inflation
Inflation & Stock Returns

Investors can boost their returns by determining a strategy
based on their tax rates and costs of trading to
determine how much and how often to buy
Planning for Taxes &
Transactions Costs

• Examining stock prices in the past is also
essential to make informed investment decisions
• The risk to well-diversified investors is primarily
that the overall market will rise or fall
• Inflation-adjusted stock prices change
dramatically over time, and returns are erratic
from year to year
• It is therefore impossible to “time the market”
Historical Returns & Stock Prices

An investor who purchased stock in 1929 would
have had a negative or zero real capital gain for
30 YEARS!
Historical Stock Prices (cont’d)

• The efficient market hypothesis is the idea
that stock prices fully reflect all available
information at any given time
• Assumes stock markets are both deep (many
buyers and sellers) and liquid (easy to buy or
sell)
• As soon as new information becomes available
about a company, the supply and/or demand for
its stock are immediately affected
Efficient Market Hypothesis

• Do stock prices follow a random walk, such that
price movements over time are inherently
unpredictable?
• Prices are somewhat predictable
– A significant relationship exists between a stock’s
return from one week to the next
– Movements in share price are relatively greater than
changes in earnings
– High returns in one period are associated with low
returns in others
Are Stock Prices Predictable?

• Anomalies, or incidents of predictable patterns
to stock prices that investors could exploit, lead
some to believe that stock markets are not
efficient
• Some prominent anomalies are
– Stocks have higher than average returns in early January
– Stock prices do not change as much as they should in response
to announcements of changes in earnings
– The day of the week has an effect on return
• Claims of anomalies depend on a model of risk
The Study of Anomalies

The Capital Asset Pricing Model
• CAPM models the return to a stock as
depending on how risky the stock is relative
to the rest of the market.
• The model is represented as
• CAPM identifies two sources of risk
– Systematic risk (attributable to the fluctuations in the
overall stock market)
– Unsystematic risk (not explained by movements in the
market)
( )
i i i
t t t t t
R r R r
 
   

• Developed as an alternative to CAPM to allow
for more sources of systematic risk
Arbitrage-Pricing Theory

• The fundamental value of the market is the
present value of expected earnings of all
companies in the stock market as a whole
• This fundamental value can be compared to
actual stock prices to determine if the market is
overvalued (when prices exceed their
fundamental value) or undervalued (when
prices are less than their fundamental value)
Market Valuation

• A convenient formula because it is based on
(known) previous earnings, the investor’s rate of
discount, and the expected growth rate of
earnings
• To see if the model explains the movement of
stock prices, we must compare its predictions to
actual market values
0
1 g
e
R g



Market Valuation (cont’d)

• Rational expectations theory states that
investors use all the information available to
them in making investing decisions
• If people have rational expectations, then stock
prices should always equal their fundamental
value
• Irrational expectations theory states that
investors do not have rational expectations, so
the stock market must go through periods of
under- and overvaluation
Rational & Irrational Expectations

The model tracks the market fairly well over time.
Given the long periods of over or
undervaluation, investors do not have rational
expectations, and it is possible to profit.
Market Valuation (cont’d)

• A useful tool to compare the returns of stocks to
their main investment alternative, debt securities
• Stocks provide a return significantly higher than
debt securities over time
Stocks vs. Debt Securities

• The equity premium is the difference
between returns on stocks and other
financial investments
• The stock market pays a premium, or
extra return, for those who hold equities
• Because the risk on equities is greater,
investors are only incentivized to hold
them if they are adequately compensated
in terms of returns
The Equity Premium

• People’s attitudes toward risk are
inconsistent with the equity premium
• While people are loathe to pay to protect
against risk in everyday situations, they
are willing to accept high opportunity costs
by choosing not to invest in the stock
market (e.g. in Treasuries)
• This inconsistency is known as the equity
premium puzzle
Size of the Equity Premium

1. Real estate
• Like stocks, capital
gains still possible
2. Precious metals
• Best only during times
of inflation
3. Small businesses
• May require a more
active role on part of
the investor
Other Assets as Investments

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