Stock Markets. Dr. Patrick Toche. Zvi Bodie, Alex Kane, Alan J. Marcus. Essentials of Investment. McGraw- Hill Irwin.

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1 Stock Markets Dr. Patrick Toche References : Zvi Bodie, Alex Kane, Alan J. Marcus. Essentials of Investment. McGraw- Hill Irwin. Frederic Mishkin, The Economics of Money, Banking, and Financial Markets. Pearson Addison-Wesley. Chapter 2 of the Bodie-Kane-Marcus textbook will be followed closely. Other references may be given from time to time. In this chapter you will learn... assets & financial instruments: Common Stocks Preferred Stocks Stock Market Indices monetary policy, interest rates, regulation

2 Common Stocks Common stocks, also known as equity securities or equities or shares, represent ownership shares in a corporation. Each share of common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation s annual meeting and to a share in the financial benefits of ownership (dividends). The corporation is controlled by a board of directors elected by the shareholders. The board, which meets only a few times each year, selects managers who actually run the corporation on a day-to-day basis. Managers have the authority to make most business decisions without the board s specific approval. The board s mandate is to oversee the management to ensure that it acts in the best interests of shareholders. A corporation sometimes issues two classes of common stock, one bearing the right to vote, the other not. Stocks Traded on the NYSE Source: The Wall Street Journal, 9 Jan Active Learning: Compare with the latest data on

3 Common Stocks Consider the highlighted listing for General Electric. The table provides the ticker symbol (GE), the closing price of the stock ($37.56), and its change ($.19) from the previous trading day. Almost 27 million shares of GE traded on this day. The table also provides the highest and lowest price at which GE has traded in the last 52 weeks. Dividends may be expressed as a percentage of the current market price the dividend yield. The 1.12 value in the DIV column means that the last quarterly dividend payment was $.28 per share, which is consistent with annual dividend payments of $ = $1.12. This corresponds to a dividend yield (i.e., annual dividend per dollar paid for the stock) of 1.12/37.56 = = 3.0%. Dividends AAPL GE MSFT XOM 0.7 Dividends (dollars, Not Seasonally Adjusted) Dividend payments of 4 popular blue-chip stocks, Apple, Exxon Mobil, General Electric, and Microsoft. In 1996, Apple stopped paying dividends, as the company was close to bankruptcy. In 2012, following the success of the Ipod, Iphone and Ipad, Apple started paying a quarterly dividend of $2.65 per share. In 2003, Microsoft paid a special one-time dividend of $3 a share this outlier has been omitted for clarity. Note: Dollar figures unadjusted for the stock price.

4 Common Stocks Dividend policy is decided by the board. Expanding companies reinvest most of their profit and distribute few (if any) dividends. The dividend yield is only part of the return on a stock investment. The other part includes capital gains or losses. Shares in low dividend firms presumably offer greater prospects for capital gains, otherwise investors would not be willing to hold these stocks in their portfolios. The P/E ratio, or price-to-earnings ratio, is the ratio of the current stock price to last year s earnings. The P/E ratio tells us how much stock purchasers must pay per dollar of earnings the firm generates for each share. For GE, the ratio of price to earnings is 23. The P/E ratio also varies widely across firms. Where the dividend yield and P/E ratio are not reported, the firms have zero dividends, or zero or negative earnings. In the last column, we see that GE s stock price has increased by 0.9% since the beginning of the year. Common Stocks The two most important characteristics of common stock as an investment are: residual claim and limited liability. Residual claim means that stockholders are the last in line of all those who have a claim on the assets and income of the corporation. In a liquidation of the firm s assets the shareholders have a claim to what is left after all other claimants such as the tax authorities, employees, suppliers, bondholders, and other creditors have been paid. For a firm not in liquidation, shareholders have claim to the part of operating income left over after interest and taxes have been paid. Management can either pay this residual as cash dividends to shareholders or reinvest it in the business to increase the value of the shares.

5 Common Stocks The two most important characteristics of common stock as an investment are: residual claim and limited liability. Limited liability means that the most shareholders can lose in the event of failure of the corporation is their original investment. Unlike owners of unincorporated businesses, whose creditors can lay claim to the personal assets of the owner (house, car, furniture), corporate shareholders may at worst have worthless stock. They are not personally liable for the firm s obligations. Preferred Stock Preferred stock has features similar to both equity and debt. Preferred stock is an equity investment. The firm retains discretion to make the dividend payments to the preferred stockholders: It has no contractual obligation to pay those dividends. Like bonds, preferred stock promises to pay to its holder a fixed stream of income each year: similar to an infinite-maturity bond (a perpetuity). Like bonds again, preferred stock does not give the holder voting power over the firm s management. Preferred dividends are usually cumulative: unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock. The firm does have a contractual obligation to make timely interest payments on the debt: Failure to make these payments sets off corporate bankruptcy proceedings.

6 Preferred Stock Preferred stock also differs from bonds in terms of its tax treatment for the firm. Because preferred stock payments are treated as dividends rather than as interest on debt, they are not taxdeductible. In the U.S. corporations may exclude from their taxable income up to 70% of dividends received from domestic corporations. Even though preferred stock ranks after bonds in terms of the priority of its claim to the assets of the firm in the event of corporate bankruptcy, they often sells at lower yields than corporate bonds. This reflects the value of the dividend exclusion in taxable income. Corporations issue preferred stock in variations similar to those of corporate bonds. Preferred stock can be callable by the issuing firm, in which case it is said to be redeemable. It can be convertible into common stock at some specified conversion ratio. Adjustable-rate preferred stock ties the dividend rate to current market interest rates. Bankruptcy The bankruptcy system is generally favourable to debtors. Stockholders are often wiped out in the process. Most countries have several bankruptcy regimes. In the U.S. Chapter 11 bankruptcy is an intermediate stage designed to protect the firm from its creditors while seeking to rehabilitate it, while Chapter 7 bankruptcy triggers the firm s liquidation. During liquidation, the firm s management is sidelined, and auditors, courts, judges arbitrate various claims. Chapter 11 aims to reorganize the firm. However, settling the firm s debts may make it impossible to revive the business. In France, the primary duties of the bankruptcy court are to keep the firm in business and preserve employment. Only once these duties have been performed does the court have a responsibility to creditors.

7 Bankruptcy How are liabilities prioritized during bankruptcy proceedings? 1. Latest Creditors: Loans made after the company filed for Chapter 11 bankruptcy, also known as Debtor-In-Possession financing. 2. Secured creditors. Example: Bank lending backed by real estate mortgages. Loans may be settled by transferring the collateral. 3. General creditors: Suppliers of goods and services, other lenders, bondholders. Unsecured bonds are called debentures. A lower class of debentures is subordinated debentures. 4. Preferred Stocks. 5. Common Stocks. Stock Splits A stock split is the process of creating new shares which are given free of charge to existing shareholders. A company has 10,000 shares outstanding currently trading at a price of $100,000, for a market capitalization of $1bn. The company s board of directors decides to split the stock 10-for-1. Right after the split, the number of shares outstanding rises to 100,000, while the share price falls to $10,000, leaving market capitalization unchanged at $1bn. The greater number of shares can raise liquidity and narrow the bid-ask spread. In the UK a stock split may be referred to as a scrip issue, bonus issue, or capitalization issue.

8 Stock Splits: BRK-A & BRK-B Berkshire Hathaway Class A shares (BRK-A) have never experienced a stock split, because chairman Warren Buffett believes the high share price attracts investors focused on longterm profits rather than on short-term price movements. In 2015 BRK-A traded at over $200,000 per share! In 1996, Buffett created Class B shares (BRK-B), offering investors the ability to invest in Berkshire Hathaway for one-30th the price of a Class A share. In 2010, a 50-to-one stock split changed the ratio to one-1,500th. While Class B shares carry lower voting rights, they offer more flexibility. If a Class A stockholder needs a little cash, selling a single share may exceed the amount needed. A Class B stockholder can liquidate a smaller amount. Another benefit of BRK-B is that the lower price allows the stock to be passed on to heirs without triggering the gift tax. Stock Splits: BRK-A & BRK-B BRK A (Price of 1 Stock) BRK B (Price of 50 Stocks) 250,000 Stock Price (dollars, Not Seasonally Adjusted) 200, , ,000 BRK B listed in ,000 BRK B 50/1 split Berkshire Hathaway: BRK-A versus BRK-B. In 2010, BRK-B experienced a 50-to-1 stock split, while BRK-A did not.

9 Depository Receipts American Depository Receipts (ADRs) are certificates traded in U.S. markets that represent ownership in shares of a foreign company. Each ADR may correspond to ownership of a fraction of a foreign share, one share, or several shares. ADRs were created to make it easier for foreign firms to satisfy U.S. security registration requirements. ADRs are the most common way for U.S. investors to invest in and trade foreign shares. Stock Market Indices DJIA S&P SP 500 and DJIA (Initial values set to 100) The DJIA and SP500. These are the most popular stock market indices for stocks listed in the United States exchanges. Active Learning: Reproduce the graph with data from

10 Dow Jones Averages The Dow Jones Industrial Average (DJIA) of 30 large, bluechip corporations has been computed since Originally, the DJIA was calculated as the simple average of the stocks included in the index. So, if there were 30 stocks in the index, one would add up the value of the 30 stocks and divide by 30. The percentage change in the DJIA would then be the percentage change in the average price of the 30 shares. This procedure means that the percentage change in the DJIA measures the return (excluding any dividends paid) on a portfolio that invests one share in each of the 30 stocks in the index. The value of such a portfolio is the sum of the 30 prices. Because the percentage change in the average of the 30 prices is the same as the percentage change in the sum of the 30 prices, the index and the portfolio have the same percentage change each day. Today the Dow is a price-weighted average: The amount invested in each company in the portfolio is proportional to its share price. Standard & Poor s Indices The Standard & Poor s Composite 500 stock index represents an improvement over the Dow Jones averages: it has a broader base of 500 firms, and it is a market value-weighted index. The S&P 500 is based on the total market value of the 500 firms in the index. The percentage increase in the total market value from one day to the next gives the increase in the index. The rate of return of the index equals the rate of return that would be earned (excluding dividends) by an investor holding a portfolio of all 500 firms in the index in proportion to their market value. One way to buy market indexes is to purchase shares in mutual funds that hold shares in proportion to their representation in the S&P 500. These index funds yield a return equal to that of the particular index. Another approach is to purchase an exchange-traded fund or ETF, which is a portfolio of shares.

11 The SoftApple Index Imagine an index of the stock prices of Microsoft (MSFT) and Apple (AAPL) the SoftApple Index. Let the stock prices be: P MSFT = $55 and P AAPL = $120 Is Apple worth more than twice Microsoft? No, because they have different amounts of stock outstanding: Q MSFT = 7.998bn and Q AAPL = 5.575bn Stock Market Capitalization (SMC) is thus: SMC MSFT = $ bn = $439bn SMC AAPL = $ bn = $669bn The SoftApple Index A simple index treats relative stock market capitalization as weights applied to the share price: I SoftApple = w MSFT P MSFT + w AAPL P AAPL $55 + 1,108 1,108 $ $ $ Fix the weights for a few periods and update the prices. Every once in a while, update the weights to reflect structural changes in the relative market capitalization. A more informative index would account for dividends too.

12 U.S. Stocks After the Crisis DJIA Nasdaq Composite S&P 500 Wilshire U.S. Stock Market, Various Indices (Initial values set to 100) The DJIA, SP500, Nasdaq Composite, and Wishire 5000 Indices. Stock Markets in the Eurozone Selected Stock Markets in Europe Athens SE (Greece) CAC 40 (France) DAX (Germany) IBEX (Spain) Selected Stock Market Indices. By end 2015, only the DAX (Germany) had recovered from the Crisis, while the Athens SE shows a near 90% decline.

13 Stock Markets in Europe After the Crisis Selected Stock Markets in Europe Athens SE (Greece) CAC 40 (France) DAX (Germany) FTSE (United Kingdom) IBEX (Spain) Selected Stock Market Indices. While not in the Eurozone, the London SE has not done better than the Paris SE. At the end of 2014, the Frankfurt SE experienced a large jump. No sign of a recovery in Athens. Corporate Bonds Versus Stock 7 U.S. Stocks Index and U.S. Corporate Bonds Index S&P 500 Stocks and Merrill Lynch U.S. AAA Corporate Bonds (Initial values are arbitrarily set to 1 on ) Stocks Bonds S&P 500 Index and U.S. AAA Corporate Bond Index. The Standard & Poor s 500 is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The U.S. AAA Corporate Bond Total Return Index is published by Merrill Lynch.

14 Summary 1. Common stock is an ownership share in a corporation. Each share entitles its owner to one vote on matters of corporate governance and to a prorated share of the dividends paid to shareholders. Stock, or equity, owners are the residual claimants on the income earned by the firm. 2. Preferred stock usually pays a fixed stream of dividends for the life of the firm: It is a perpetuity. A firm s failure to pay the dividend due on preferred stock does not set off corporate bankruptcy: unpaid dividends cumulate. New varieties of preferred stock include convertible and adjustable-rate issues. 3. Many stock market indexes measure the performance of the overall market. The Dow Jones averages are price-weighted indexes. Well-known indexes are the S&P 500, the NYSE, the Nasdaq index, the Wilshire 5000, Nikkei, FTSE, DAX. Problems and Applications 1. Pick a stock exchange and examine the first 50 stocks listed in the newspaper. For how many of these stocks is the 52-week high price at least 50% greater than the 52-week low price? What do you conclude about the volatility of prices on individual stocks? 2. In what ways is preferred stock like long-term debt? In what ways is it like equity? 3. If you buy 100 shares of IBM stock, what is the most money you can make on that investment over the next year?