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

8-2 Essential Characteristics of Common Stock Common stock or equity are shares in a firm’s ownership Stockholder is merely a residual claimant Limited liability

8-3 Measuring the Level of the Stock Market The Dow Jones Industrial Average The Standard & Poor's 500 Index Nasdaq Composite index Wilshire

8-4

8-5 Valuing Stocks Fundamental Value and the Dividend- Discount Model

8-6 Valuing Stocks

8-7 Valuing Stocks assume that the firm pays dividends forever, then

8-8 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.

8-9 Valuing Stocks Risk and the Value of Stocks Return to Holding Stock for One Year =.

8-10 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)

8-11 Valuing Stocks

8-12 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)

8-13 Valuing Stocks The Theory of Efficient Markets The basis for the 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.

8-14 Investing in Stocks For the Long Run

8-15 Investing in Stocks For the Long Run

8-16 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.

8-17 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

8-18 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.

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