Chapter 7 – Equity Markets and Stock Valuation

The stock market is endlessly fascinating to millions of people. CNBC, the cable TV channel that bases most of its programs on the stock market, is one of the most popular channels on cable. Why? Because the stock market is just about the only way that the average person has to “beat the bank”. Average return on investments in the stock market over the last century has exceeded 10%, even though that includes the Great Depression of the 1930s, and the bear market of the past three years. ( A bear market is a market in which most prices are going down. A bull market is a market in which most prices are going up. There is no time, however, when all prices go the same way.) The mechanism of the publicly traded corporation allows everyone to buy a little piece of Microsoft, General Electric, Johnson and Johnson or other famous company and to share in the fortunes of that company for good or ill.

In addition, since the 401(k) plan was created in 1978, even people who were never interested in the stock market have necessarily become interested. Prior to the 401(k), and to a lesser extent, the IRA, most individuals still didn’t invest. Those companies that paid pensions managed the investments of the funds, and the employee got a percentage of some pay base after staying with the company for 30 years. With the 401(k), the investment decision was suddenly in the hands of the individual employee, most of whom were ill-equipped to make investment decisions. Some of the matching money in these 401(k) plans was in the form of stock in the employing company, which most employees tend to just hold, not making a real portfolio decision. Unfortunately, by not making a decision, they are by default deciding to concentrate in their own company’s stock, not a good portfolio strategy.

What all this means to you is that even if you never become a corporate financial manager worried about the price of your company’s stock as part of your job, you will probably be worrying about your company’s stock price anyway. Therefore, it pays for you to learn how the markets work and something about what determines the price of a stock. Then when you make a decision about your 401(k), you won’t be making the decisions (or not making a decision) out of ignorance.

LEARNING OBJECTIVES

When you finish your study of this chapter, you should know:

1. DESCRIBE and EXPLAIN how stock prices depend on future dividends and dividend growth.
2. CALCULATE the value of a stock based on its projected dividends and growth.
3. EXPLAIN how corporate directors are elected to office and the difference between the various kinds of stock and voting rights of shareholders.
4. INTERPRET the stock market price reporting pages in the financial press.
5. EXPLAIN how the various stock markets work, including the difference between the methods of the New York Stock
6. Exchange and the NASDAQ.

The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!

Key terminology:

Don’t forget! Homework is due by 6:30 PM on class day by e-mail to homework@nyfinancial.com! Don’t suffer a zero by being late.