Financial Markets and Institutions (2-downloads)

http://finance.yahoo.com/calculator

/index

. Under Retirement find the calculator “How

should I allocate my assets?” After answering the ques-

tionnaire, discuss whether you agree with the recom-

mended asset destination.

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302

The Stock Market

Preview

In the last chapter we identified the capital markets as where long-term securi-

ties trade. We then examined the bond market and discussed how bond prices

are established. In this chapter we continue our investigation of the capital

markets by taking a close look at the stock market. The market for stocks is

undoubtedly the financial market that receives the most attention and scrutiny.

Great fortunes are made and lost as investors attempt to anticipate the mar-

ket’s ups and downs. We have witnessed an unprecedented period of volatility

over the last decade. Stock indexes hit record highs in the late 1990s, largely

led by technology companies, and then fell precipitously in 2000. By 2007 they

had returned to record highs before falling back to 1997 levels in 2009. In this

chapter we look at how this important market works.

We begin by discussing the markets where stocks trade. We will then

examine the fundamental theories that underlie the valuation of stocks. These

theories are critical to an understanding of the forces that cause the value of

stocks to rise and fall minute by minute and day by day. We will learn that

determining a value for a common stock is very difficult and that it is this diffi-

culty that leads to so much volatility in the stock markets.

13

C H A P T E R

Investing in Stocks

A share of stock in a firm represents ownership. A stockholder owns a percentage

interest in a firm, consistent with the percentage of outstanding stock held.

Investors can earn a return from stock in one of two ways. Either the price of the

stock rises over time, or the firm pays the stockholder dividends. Frequently,

investors earn a return from both sources. Stock is riskier than bonds because stock-

holders have a lower priority than bondholders when the firm is in trouble, the returns

to investors are less assured because dividends can be easily changed, and stock price

increases are not guaranteed. Despite these risks, it is possible to make a great deal

of money by investing in stock, whereas that is very unlikely by investing in bonds.

Another distinction between stock and bonds is that stock does not mature.

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Ownership of stock gives the stockholder certain rights regarding the firm. One

is the right of a residual claimant: Stockholders have a claim on all assets and

income left over after all other claimants have been satisfied. If nothing is left over,

they get nothing. As noted, however, it is possible to get rich as a stockholder if the

firm does well.

Most stockholders have the right to vote for directors and on certain issues, such

as amendments to the corporate charter and whether new shares should be issued.

Notice that the stock certificate shown in Figure 13.1 does not list a maturity

date, face value, or an interest rate, which were indicated on the bond shown in

Chapter 12.

Common Stock vs. Preferred Stock

There are two types of stock, common and preferred. A share of common stock in

a firm represents an ownership interest in that firm. Common stockholders vote,

receive dividends, and hope that the price of their stock will rise. There are various

classes of common stock, usually denoted as type A, type B, and so on. Unfortunately,

the type does not have any meaning that is standard across all companies. The dif-

ferences among the types usually involve either the distribution of dividends or vot-

ing rights. It is important for an investor in stocks to know exactly what rights go along

with the shares of stock being contemplated.