WK3b Flashcards
What is a stock
also known as common stock or equity, are shares in a firm’s ownership.
What are stockholders entitled to do (2)
- A stockholder is entitled to participate in the profits of the enterprise.
- Stockholders are entitled to vote at the firm’s annual meeting.
How do stockholders earn a return (2)
- price of the stock rises over time
- dividends are paid to the stock holder
What is residual claimant
Stockholders are paid last after all creditors have been paid
What does it mean that stockholders have limited liability
Even if a company fails completely, the maximum amount shareholders can lose is their initial investment.
What does a firm do when it goes public
Issues stock on the primary market in exchange for cash
What effects does going public have (2)
- It changes the firms ownership structure by increasing the number of owners
- it changed the firms capital structure by increasing the equity investment in the firm, this allows them to pay off there debts and increase their operations
When does an ipo happen
When a privately owned company issues shares of stock to be allocated to the general public
Why might stockholders not recieve dividends
The company may chose to reinvest the profit into the company hence increasing the value of the company and stockholders will receive capital gains
What is the process of going public (4)
will involve a security firm serving as the lead underwriter
- developing a prospectus
- pricing
- allocation of IPO shares
- transaction costs
What is developing a prospectus
Contains details discussions about the consonant and the financial statements and a discussion about of the risks involved
What does pricing mean
The offer price that the shares will be offered at the time of the IPO
Allocation of IPO
Most of the shares are sold to institutional investors
What happens before a company goes public
Company are valued by asset liability
The pricing process of a company
Look at demand and supply of the stock
Selling the shares for a lower price is called “leaving money on the table”
Timings of ipo
IPO tend to occur when frequently during bullish stock markets and when the market is doing well
What are initial returns of IPOs
Flipping shares is the process of purchasing the stock at its offer price and sell it shortly afterwards.
Gooogle IPO
- massive media attention (18 August 2004 )
- used a Dutch auction process instead of institutional investors
- price per share was $85
- end of the day the price increased by 18% to $100.34
What is an organised exchange
Auction markets that use floor traders who specialise in particular stocks
Structure of the secondary market (2)
- order driven market
- quote driven market
Order driven market
All participants are natural buyers and seller and there are no intermediary
Quote driven market
The price is decided by the dealer based on the current market conditions
Bid
Buy order specifying a price ( price )
Offer
We’ll order specifying s price (price is called an ask )
Best bid
standing buy order that bids the highest price bid
Best offer
standing sell order that has the lowest price offer.
What do dealers do
have an obligation to continuously quote bids and offers, and the associated sizes (number of shares), when they are registered market markers for the stock.
What is the bid ask spread
The difference between the best bid and the best offer
What is an order
They are instructions to trade that traders give to brokers and exchanges that arrange their trades
What do orders always specify
- the security to be traded
- the quantity to be traded
- the side of the order (buy or sell)
What might order specify
- price specs
- how long the order can be executed
- how long the order is valid
- whether they can be partially filled or not
What are proprietary orders (3)
Orders submitted by traders for their own account are proprietary orders.
- Broker-dealers can executed both trades on behalf of others and trade
for themselves
- Dealers execute trades for themselves
What are agency order
Since most traders are unable to directly acess the markets they are ordered through agency orders
- orders from traders who cannot directly access financial markets, so they have to send their requests to buy/sell through an intermediary who can trade on their behalf, i.e. a broker.
What is a market order
to buy or sell at the best price currently available in the market.
What is a limit order
Buy a limit order at a maximum price
Sell a limit order specifies a minimum price
Standing limit orders are placed in a limit order book
Short sale
Borrow from someone who owns it and you get some cash from the sale of the security but you will still be indebted to the lender for the share
You expect the price of the share to decrease in value
Then he can buy back the security at the lower price than what was sold and gain profit from the margins
Stock market index
frequently used to monitor the behaviour of a groups of stocks using a portfolio with certain characteristics
- wealth changes
- value of stock changes
The Dow Jones Industrial Average Index
- most well known
- 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.
- The DJIA is a price-weighted average index, which gives greater weight to shares with higher prices.
- The behaviour of higher priced stocks dominates the movement of a price-weighted index.
The Standard and Poor’s 500 Inde
- 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 owning the entirety of those firms.
- It uses a value-weighted index, where larger firms carry more weight.
- If a firm is priced at $100 and has 10 million shares outstanding, its total
market value or market capitalization, is worth $1 billion.
DIJA and S&P 500
- 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
- Changes in a price-weighted index tell us the changes in the price of a typical stock.
- Changes in the value-weighted index accurately mirror changes in the economy’s overall health.
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 like S&P 500
- Investors view global stock markets as a means to diversify risk away from domestic markets.
- there is an increase of correlation between global markets - if one stock market is doing well they all will
Why are stocks risky compared to bond (3)
- stockholders are residual claimants
- whereas bond holders receive nominal payments ans are paid beck stockholders in the event of bankruptcy
- borrowing creates leverage and that creates risk
The more debt the more leverage
What is a stock market bubble
When stock prices stop reflecting the fundamental value and the prices rise leading to the resource allocation mechanism being off
- the gap between the fundamentals and the actual stock prices
- bubbles lead to crashes
Why are bubbles bad
- they distort economic decisions that companies and consumers make.
- Companies sell shares for prices that are too high.
- Companies then invest too much.
- house prices and too high morgatges
-People think they are wealthier than they are and spend too much - The shift from over-optimism to excessive pessimism causes a collapse in investment and economic growth.
How do chartists
Believe they can predict changes in prices by looking at patterns or
past movements.
How do Behaviouralists value stocks
Estimate the value of stocks based on their perceptions of investor psychology and behaviour
How do Fundamentalists value stocks
Estimate stock based on both its current assets and on estimates of
future profitability.
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What is the fundamental value
The fundamental value of a stock is based on the timing and uncertainty of the returns it brings.
Chartists and behaviouralists question the usefulness of fundamentals in understanding the level and movement of stock prices.
What does a stock represent
promise to make monetary payments ( in the form of dividends) on future dates, under certain circumstances.
What is the eqation for the present share price
P0= D1+P1/ 1+re
P0 = the price if the share today at time t=0
P1 the expected price pershare at price t= 1
D1 = the expected dividend per share for the year assumed to be paid at the end of thr year at t=1
Re = the required rate of return on the stock
Why would the stock price increase
If the current stock price were less than this amount, then investors would rush in and buy it
Why would stock prices fall
Is the stock price of the receipts this amount then people would start selling it
What the difference between holding a bond and share for 10 years
You will receive 10 different dividends at the end of the year whereas a bond you will get a fixed amount every year
What is the expected holding period
Dividend yield + capital gain rate
D1/P0 + P1- P0/P0
Expected total return
The expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk.
Multi year horizon
P0 = D1/ (1+re) + D2+P2/(1+re)2
Dividend discount model
Predicts the price of the companies stock based on the sum of present value of its expected dividends
D1/(1+re) + D2/(1+re)2 … Dn + Pn/(1+re)^n
Growth model
Estimates the stocks price assuming the dividends grow at a constant rate
P0= D1/r-g
When would you buy a stock
If the intrinsic value Is the greater than the market price then you want to buy the stock
What does the dividend growth model tell us (3)
When stock prices are high dividends are high
When g is large and the growth rate is rapid
When the interest rate is low
What assumptions do we need for the dividends growth model (2)
Dividends grow at a constant rate
That g is smaller than the required return on the share re
Rearranged constant dividend growth model
Re = D1/P0 +g
G equals the capital gain rate
With constant expected dividend growth, the expected growth rate of the
share price matches the growth rate of dividends.
Downside if the dividend growth model
We cannot use it to calculate a stock that doesn’t have a constant growth rate
e.g a small firm my have high growth rate at first which they retain to invest and eventually there growth slows and earnings exceed investment needs and they can pay dividends
What is the equation for constant long term growth
PN= DN+1/ are- g
A firm is expected to have constant dividend growth after N+1 years
Limitations of dividend discount model
Ignored risk when deriving
Small changes in the dividend stock rate can have large changes in the stock price
A lot of uncertainty when predicting future dividends and prices
