Stock Market Basics and Stock Pricing: Mishkin CH 7 - Part A Page 151-159 Plus Supplementary Lecture Notes

Lecture 14:
Stock market basics

and stock pricing
Mishkin Ch 7 part A
page 151-159
Plus supplementary lecture notes
1
Review
Term structure of interest rate

Yield curve
Expectations theory
long-term interest rate = average of short-term
interest rates.
Segmented markets theory

Liquidity premium theory
long-term
interest rate = average + liquidity premium

liquidity premium > 0 and increase with maturity
2
Interpret the yield curve using

liquidity premium theory
yield curve
expected future short-term i would?
steeply upward sloping
rise
slightly upward sloping
unchanged
flat
decline moderately
downward sloping
decline sharply
You can figure out what the market is predicting about

future short-term interest rates by looking at the slope
of the yield curve.
3
Stocks
A share of stock is a claim on the

net income and assets of the
corporation.
Rights of shareholders
Shareholders (stockholders) have

ownership interest in the company
proportional to shares owned.
Large shareholder vs. small

shareholders
Rights include:
rights to be residual claimants
2. voting rights influence management
1.
Shareholders payof
possible income:
dividends: payments made periodically,

usually every quarter, to stockholders.
Shareholders are eligible for dividends,
but no guarantee.
capital gain: can sell stocks to earn
price appreciation but may also incur
loss from price decline.
limited liability
6
Stock exchanges
New York Stock Exchange

(NYSE, "Big Board" )
NASDAQ
(National Association of Securities
Dealers Automated Quotation System)
electronic trading system
Dow Jones and S&P 500 indexes
listed companies
When a firm go public, it does not add to its

debt. Instead, it brings in additional
owners who supply it with funds.
7
Read stock quotes

Microsoft Corporation
(MSFT) NASDAQ
$26.03 $+0.05+0.19%
Open
$26.11
High:
$26.39
Low:
$25.45
52-Wk
Rng
$ 25.60 - $ 37.50
P/E Ratio
15.13
Volume
71,527,599
52-Wk Rng
Highest and lowest share

price achieved by the
stock over the past 52
weeks.
P/E Ratio
Price-Earnings Ratio =
(Current stock price)/
(Current annual earnings
per share)
Volume
Volume of shares traded

yesterday (in 100s)
8
Major events
1987 crash:
1990s boom:
total value of stocks fell by about a trillion dollars

between August 1987 and the end of October
1987.
a major boom in last half of the 1990s, the value
of stocks increased by about $2.5 trillion per year
during the boom.
bubble burst in 2000:
Starting in early 2000, the stock market began to

decline, the NASDAQ fell by over 50%, while the
Dow Jones and S&P 500 indexes fell by 30%
through January 2003.
9
If I could forecast stock

price
Fundamental analysis
Technical analysis
macro-econ and firm performance dividend

stocks intrinsic value
P/E ratio, debt-to-equity ratio, return-on-assets
ratio, price/earnings to growth ratio ...
volume of trade and price trend
moving averages, regressions, price
correlations, cycles, chart.
Behavioral finance perspective
sunspot and consumer confidence

10
Technical analysis
cycles and waves

chart
candle stick
11
Alternative views of stock pricing
1.
2.
Fundamental Finance View:

Stock prices are largely determined by the true
financial conditions of firms, as reflected in their
profits, market power, R&D prospects, etc.
Behavioral Finance View:
Stock prices are strongly affected by market
psychology:
irrational exuberance or pessimism;
beauty contest guesses about the most attractive
stocks to buy based on what other people are buying or
selling (fads, herd following, ).
12
Pricing principle of fundamental view
Basic principle of finance:

value
today = present value of future cash flows
e.g. for coupon bonds, bond price today = PV of

all future cash flows:
C
C
C
F
P
...
2
n
1 i (1 i )
(1 i ) (1 i ) n
Then, value of stock today (current price) = ?

13
One-period valuation model
current stock price = PV of all future cash flows

for a one-period stock, current price should be:
Div1
P1
P0
(1 ke ) (1 ke )
(1)
P0 = the current price of the stock

Div1 = the dividend paid at the end of year 1
ke = the required return on investment in equity
P1 = the sale price of the stock at the end of the first period
Expected end of period price, and Expected dividend
14
Generalized dividend valuation model
for a n-period stock, current price should be:
Dn
Pn
D1
D2
P0
1
2
n
(1 ke ) (1 ke )
(1 ke )
(1 ke ) n
If n is large, Pn happens far in the future, then the last

term of the equation is small. (no price bubble)
Dt
P0
t
(1
k
)
t 1
e
(2)
(3)
Price of stock is determined only by present value

of future dividends: dividend valuation15model.
Gordon growth model
Assume dividend growth is a constant,

denote as g
D0 (1 g )1 D0 (1 g ) 2
D0 (1 g )
P0
K
1
2
(1 ke )
(1 ke )
(1 ke )
(4)
Assume the growth rate g is less than the

required return on equity Ke
D0 (1 g )
D1
P0
( ke g )
( ke g )
(5)
16
Apply Gordon growth model
Gordon growth model predicts that

current stock price P0 will be lower if:
1.
Current dividend D0 is lower;
2.
Or the expected dividend growth rate g is

lower;
Or the required return on equity ke is
larger.
3.
17
Example - 9/11 attacks
Fears led to downward revision of the growth

prospects for U.S. companies and hence a
lower expected dividend growth rate g.
Increased uncertainty led to a larger required
return on investment ke.
As predicted by the Gordon Growth Model,
these two effects of the 9/11 attacks were
followed by a drop in stock market prices.
How would you predict the effects of oil price
spikes on stock market prices?
18
More about pricing formulas
The current market price P0 is an equilibrium

market price:
Right side is what investors are willing to pay for
the stock, given their current desires and
beliefs.
If right side were greater than the current market
price, investors would increase their demand for
the stock and thus bid up this market price.
If right side were less than current market price,
investors would reduce their demand for the
stock, thus causing this market price to fall.
19
How the market sets prices
The price is set by the buyer willing to pay

the highest price
The market price will be set by the

buyer who can take best advantage of the
asset
Superior information about an asset can

increase its value by reducing its risk
20

Stock Market Basics and Stock Pricing: Mishkin CH 7 - Part A Page 151-159 Plus Supplementary Lecture Notes

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Lecture 14:

Stock market basics

Term structure of interest rate

Segmented markets theory

interest rate = average + liquidity premium

Interpret the yield curve using

expected future short-term i would?

steeply upward sloping

slightly upward sloping

You can figure out what the market is predicting about

A share of stock is a claim on the

Shareholders (stockholders) have

Large shareholder vs. small

dividends: payments made periodically,

New York Stock Exchange

When a firm go public, it does not add to its

Read stock quotes

Highest and lowest share

Volume of shares traded

total value of stocks fell by about a trillion dollars

bubble burst in 2000:

Starting in early 2000, the stock market began to

If I could forecast stock

macro-econ and firm performance dividend

Behavioral finance perspective

sunspot and consumer confidence

cycles and waves

Alternative views of stock pricing

Fundamental Finance View:

Pricing principle of fundamental view

Basic principle of finance:

today = present value of future cash flows

e.g. for coupon bonds, bond price today = PV of

Then, value of stock today (current price) = ?

One-period valuation model

current stock price = PV of all future cash flows

P0 = the current price of the stock

Generalized dividend valuation model

for a n-period stock, current price should be:

If n is large, Pn happens far in the future, then the last

Price of stock is determined only by present value

Gordon growth model

Assume dividend growth is a constant,

Assume the growth rate g is less than the

Apply Gordon growth model

Gordon growth model predicts that

Current dividend D0 is lower;

Or the expected dividend growth rate g is

Example - 9/11 attacks

Fears led to downward revision of the growth

More about pricing formulas

The current market price P0 is an equilibrium

How the market sets prices

The price is set by the buyer willing to pay

The market price will be set by the

Superior information about an asset can

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