chapter seven stocks and other assets. copyright © houghton mifflin company. all rights reserved.7...

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 it t t t tR 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 ge

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

chapter seven stocks and other assets. copyright © houghton mifflin company. all rights reserved.7...

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