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Chapter 3: Learn the Language of Stocks. By: Mariangelí Lugo Zayas. TIP. A strong stock market vocabulary will help you learn and grow into a strong stock investor…. Introduction.

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TIP

A strong stock market vocabulary will help you learn and grow into a strong stock investor…

Guide to the Stock Market - Chapter 3

introduction
Introduction
  • Equity Security: A stock in a publicly traded company. Is evidence that you have a claim to whatever residual value would be left in a company if it were liquidated and all of its debts and any associated fees were paid.
  • Security:An evidence of debt (bonds) or property (stock).
  • Equity:Monetary value of a property or business by any amounts owed on it in mortgages, claims, and so on.

Guide to the Stock Market - Chapter 3

introduction cont
Introduction(Cont)
  • Stocks: the are two kinds:
    • Common Stocks: An ownership claim against a corporation.
    • Preferred Stocks:Also an ownership claim against a corporation, with a preferred treatment in certain events (discussed later on).
  • Convertible Securities: A security that can be converted into another type of security, such as when converting preferred stock into common stock or vice versa.

Guide to the Stock Market - Chapter 3

common stock characteristics
Common Stock, Characteristics
  • Equity security with no special dividend rights
  • Lowest priority claim if the company goes broke, called residual claim right, or what is the same, receives the leftovers: residual value of a firm.
  • The most common type of stock.
  • Owners of this stock are called common stockholders.
  • Makes you a part owner of a corporation.

Guide to the Stock Market - Chapter 3

common stock characteristics1
Common Stock, Characteristics
  • Limited liability:Stockholder’s losses are limited to the original amount invested and personal assets cannot be taken away to satisfy any obligation of the corporation.

Corporate Managers decide if any profits are paid.

Guide to the Stock Market - Chapter 3

common stocks dividends
Common Stocks, Dividends
  • Dividends are corporate payments from profits to the stockholders.
  • Are not guaranteed: they are a prerogative of the managers of the company.
  • Paid out of the firm’s after-tax cash flows.
  • It’s taxable for most investors.
  • Corporations are double taxed, first on profits and second on investor’s income tax (when receiving dividends, that is).

Guide to the Stock Market - Chapter 3

common stocks dividends1
Common Stocks, Dividends
  • Growth Stocks: a way to avoid double taxation, it uses accumulated earnings from company and reinvest instead of paying dividends. Allows the company to:
    • Accumulate capital
    • Grow faster
  • Benefit comes from an expectative of growth in earnings and eventually rise the stock price, though it can be tricky, since both increases might not go hand in hand.

Guide to the Stock Market - Chapter 3

common stocks tax treatment
Common Stocks, Tax Treatment
  • Since 1997, the Tax Reduction Act (“TRA”), tax rates on capital gains are lower than dividends.
  • Capital gains is the amount by which an asset’s selling price exceeds its initial purchase price.
  • Because taxes on capital gains are paid when a sale is effected, a way to reduce tax bills may be the dilation of the sale of stocks so that a capital gain is not realized.

Guide to the Stock Market - Chapter 3

slide10
Trap

Do not ever buy shares of stock because you are attracted to the company’s product or some report about the quality of the company.

Focus on buying stock in companies that, mysteriously, nobody seems to be paying attention to.

Guide to the Stock Market - Chapter 3

common stocks voting rights
Common Stocks, Voting Rights
  • A company’s control over day-to-day activities rest in the hands of not the owner’s (stockholder’s) but in the Board of Directors, inside corporate executives concerned about shareholder’s financial welfare, elected by the shareholder’s themselves.
  • Board of directors are elected in annual meetings of the shareholder’s, though most shareholder’s cannot attend those, and instead vote by absentee ballot or endorsing a representative.

Guide to the Stock Market - Chapter 3

common stocks election process
Common Stocks, Election Process
  • There are two ways of voting: Cumulative and straight voting.
  • Cumulative: directors are elected at the same time and shareholders are given a number of votes equal to the number of directors being elected times the number of shares owned.
    • The effect of this way of voting is to give minority shareholders a voice in the company’s decision.

Guide to the Stock Market - Chapter 3

common stocks election process1
Common Stocks, Election Process
  • Straight Voting: directors are elected one by one. The maximum number of votes for each director equals the number of shares owned.
    • This technique is the less favorable to minority shareholders since any shareholders owns a large number of shares, say 50% of a number around it, can elect the entire board.

Guide to the Stock Market - Chapter 3

common stocks election process2
Common Stocks, Election Process
  • Dual-Class Firms: companies that among the stocks offered, there are some that let them raise equity capital but have limited voting rights.
    • The control of these companies rests on the hands of the original investors who would not let corporate executives do what they want, or what they should do.

Guide to the Stock Market - Chapter 3

common stocks corporate governance
Common Stocks, Corporate Governance
  • The task of the manager of a corporation is, in general, to create and work with different growth strategies like reinvesting profits or payout profits by making dividend payments to shareholders.
  • Managerial inefficiencies (also called shirking):
    • Misfeasance: agency costs associated with laziness among top corporate executives.
    • Malfeasance: agency costs associated with use of perks, lavish executive goddies that cost the corporation lots of money.

Guide to the Stock Market - Chapter 3

common stocks corporate governance1
Common Stocks, Corporate Governance
  • The mayor goal of Corporate Governance is to “align as nearly as possible the interests of individuals, corporations, and society”. Is supposed to encourage the efficient use of resources and to require accountability for the stewardship of said resources.
  • The importance of knowing the truth about corporate governance can take you, not to dislike the system altogether, but to use it in your advantage.

Guide to the Stock Market - Chapter 3

common stocks corporate governance2
Common Stocks, Corporate Governance
  • Chief Executive Office: Top manager of the company, hired by the board of directors.
  • Chairman: (of the board) presides the meetings and recommends members of the board to the shareholders.
  • Shareholder Pool Dilution:When a group of shareholders change from a familiar (or related people) group to a more diverse group, allowing external people to become owners of the company.

Guide to the Stock Market - Chapter 3

common stocks corporate governance3
Common Stocks, Corporate Governance
  • It is common to a company that as the company develops and grows, family grasp becomes more loose and external interests might come first, making them control less and less number of shares.
  • Shareholders eventually cease to be relevant to make decisions, because some of this power (ownership) they have to let go in order to allow the firm to grow (for investments to arrive).

Guide to the Stock Market - Chapter 3

common stocks corporate governance4
Common Stocks, Corporate Governance
  • Voluntary Shareholder Absenteeism: situation created when shareholders power is so small they cannot make good, informed decisions, making them loose interest and eventually throw the proxy in the wastebasket.
  • The practice nowadays is to spot CEO’s in the Chairman’s chair, making it even more difficult to make impartial rules and take advantage of the company, since it opens up the door to cronyism, the practice of allowing close friends be on the board, without any real merits.

Guide to the Stock Market - Chapter 3

common stocks takeovers
Common Stocks, Takeovers
  • Takeovers: when a company (bidder) acquires another company (target), making a bid.
  • Friendly Takeovers: is a welcomed takeover approved by the corporate executives from the target company.
  • Hostile Takeovers: is an unwelcome takeover that, even though management may resist or disapprove of the offer, the acquisition of the target company is carried out anyway.

Guide to the Stock Market - Chapter 3

common stocks hostile takeover
Common Stocks, Hostile Takeover
  • This takeover might be unwelcomed simply because top managers are afraid their positions might be jeopardized.
  • Poison Pill: a technique used by deadwoods (corrupt or incompetent corporate executives) to stop a bidder from acquiring the target company. Is a clause in the by laws triggered when an investor acquires 15% share of the company: all new purchases, except the 15% investor, are priced at an arbitrary low amount.

Guide to the Stock Market - Chapter 3

common stocks hostile takeover1
Common Stocks, Hostile Takeover
  • Moran v. Household International (1985): a Delaware Supreme Court decision where the court upheld the board’s right to refuse to remove a poison pill, saying inside corporate executive employees had more power essentially than shareholders.
  • Through history, hostile takeovers have transformed lots of poorly managed companies into well business machines. After 1985, no hostile takeovers have gone through.

Guide to the Stock Market - Chapter 3

common stocks a new hope
Common Stocks, A New Hope
  • In recent years, after the upsetting situation in investment pools, where inside corporate executives continue to enjoy of enormous amounts of control and “goodies” at owner’s expense, absentee shareholders have regained a voice on the board again.
    • Starting with the Disney case, where CEO Michael Eisner was forced to step down after having dug almost 1 billion from the company, among other cases.

Guide to the Stock Market - Chapter 3

common stock flaws in voting process
Common Stock, Flaws in Voting Process
  • When shareholders receive the ballot, the only options for the propositions are “yes” or “abstain”. This way, CEO may propose a candidate of his interest.
  • An proposal was presented to the Congress of the US, when Arthur Levitt fought to force corporate executives to report certain benefits received as part of their functions as a cost in accounting books. But he was no successful and the idea rejected.

Guide to the Stock Market - Chapter 3

the disney case
The Disney Case
  • Michael Eisner filled Disney’s corporate governance with his personal cronies, and made poorly judged decisions, as well took advantage of his position by making many millions in profits despite the industry overall being performing so poorly over the first years of the millennium.
  • Some improvements were introduced in 2002.
  • In the end, voting never made any serious effect in the board.

Guide to the Stock Market - Chapter 3

survival rule
Survival Rule

Learn to Think

Fiercely Independently

Guide to the Stock Market - Chapter 3

preferred stock
Preferred Stock
  • Preferred treatment when receiving dividends or a cash payout, if the company goes broke.
  • If the company decides to spread dividends, they get paid before common stock stockholders.
  • Owners of this stock are called preferred stockholders.
  • Because is a fixed obligation of the company, it cannot decide not pay or change any amount previously arranged to do it.

Guide to the Stock Market - Chapter 3

preferred stock dividends
Preferred Stock Dividends
  • Not to be confused with bonds, which are a debt that the company has with an investor, where they have to pay (according to the terms) interest payments and then one final sum (principal) when the bond comes due.
  • Most preferred stocks are cumulative and nonparticipating.

Guide to the Stock Market - Chapter 3

preferred stocks
Preferred Stocks
  • Non-Participating:Preferred dividends remains constant regardless any increase in the firm’s earnings. Also, the firm can decide not to pay dividends on this stock without going into default (going bad on a loan).
  • Cumulative:Means that the company cannot pay dividends to common stock until it has paid the preferred stockholders the dividends in arrears.

Guide to the Stock Market - Chapter 3

preferred stocks1
Preferred Stocks
  • Adjustable-rate Preferred Stock: popular in early 1980s, are preferred stock rate adjusted periodically according to the change in market interest rate.
  • Preferred stock, in general, do not vote for the board of directors. But this rule may have some exceptions including, when the corporation is in arrears on its dividend payments.

Guide to the Stock Market - Chapter 3

convertible securities
Convertible Securities
  • Convertible Preferred Stock: Preferred stocks that can be converted to common stock at a predetermined ratio. Once you choose to convert to common stock, you may no get any preferred dividend payment.
  • Convertible Bond:Bonds that can be exchanged for shares of common stock. It is an obligation that the corporation must pay until it converts.

Guide to the Stock Market - Chapter 3

convertible bonds
Convertible Bonds
  • Claims on this security ranks lower against corporate profits than other debts, but ranks higher than stockholders.
  • Increases value with rising stock prices and provide a fixed income and security of the bonds, making it a popular security among investors.
  • When converted in stock, the company does not have to repay the initial loan made when the bond was bought.

Guide to the Stock Market - Chapter 3

equity markets
Equity Markets
  • When a company issues for the first time (goes public), this first offering is called Initial Public Offering, or IPO.
  • After going public, a company must decide if financing is cheaper by getting a bank loan, selling bonds, or issuing more stock.
  • Primary Market: stock purchases through primary offerings; new issuance of securities. Companies use this money to expand, develop grow.

Guide to the Stock Market - Chapter 3

equity markets1
Equity Markets
  • Secondary Market:Purchasing of securities after an IPO is offered.
  • Securities are identified by a ticker symbol, a system used in Wall Street to identify each and every one company that issues stock and mutual funds. Three letters used on NYSE and four letters used in NASDAQ. Five letters are used for NASDAQ stocks that are not single issues of common stock. Symbols of five letters ending in X are mutual funds.

Guide to the Stock Market - Chapter 3

equity markets2
Equity Markets
  • Seasoned Offering:When a public company trades securities to raise money for operations. Company chooses to, either issue bonds or stocks.
  • Investment Banker: Direct distributor (to investors) of new issues of equity securities by three methods:
    • Underwritten Offering
    • Private Placement
    • Shelf Registration

Guide to the Stock Market - Chapter 3

equity markets3
Equity Markets
  • Underwritten Offering: the most common of the three, here the investment banker purchases securities from the firm at a guaranteed amount (net proceeds), then resells securities for a greater amount (gross proceeds).
  • Private Placement: investment banker acts only as an agent for the firm and receives a commission for placing equity securities with investors.

Guide to the Stock Market - Chapter 3

equity markets4
Equity Markets
  • Shelf Registration: permits a corporation to register a quantity of securities with the SEC and sell them over time, instead of all at once.
  • Rights offering: right of the stockholders to purchase additional shares at a below market price in proportion to its current ownership in the firm, but they may not want to exercise this right and let another investor have to opportunity.

Guide to the Stock Market - Chapter 3

equity markets5
Equity Markets
  • Underwriter Spread:Difference between the net and gross proceeds (in other words, the profit). Several factors affects its size:
    • Inversely related to the size of offering: the larger the offering, the smaller the spread tends to be.
    • The more uncertain the market price of share securities, the larger the spread tends to be. Investment banker bears all the price risk on unseasoned offerings.
    • Shelf registrations tend to have lower spreads: stock is already trading so there is less price risk to the underwriter.

Guide to the Stock Market - Chapter 3

secondary markets
Secondary Markets
  • Most secondary market transactions are made through the New York Stock Exchange (NYSE) or Over-the-Counter Market (OTC).
  • Principal function of these markets is to provide liquidity (the speed which an asset can be converted into cash) at fair prices.
    • Asset: item of economic value owned by an individual or a corporation, that can be converted into cash.

Guide to the Stock Market - Chapter 3

secondary markets1
Secondary Markets
  • Liquidity exists if investors can trade large amounts of securities without affecting prices.
  • Liquidity characteristics desirable to investors:
    • Depth: When there are people waiting on the sidelines to enter the market if the prices go up or down.
    • Breadth:When orders in large volume give its market depth. The broader the market for a stock, the greater the potential for stabilization of temporary price changes arisen from order imbalances.
    • Resiliency:When new orders pour in promptly in response to price changes resulting from temporary order imbalances, and investors quickly buy of sell when stock prices moves up or down.

Guide to the Stock Market - Chapter 3

direct search secondary markets
Direct Search Secondary Markets
  • Offers the least complete price information, where buyers and sellers must find each other directly.
  • Is an infrequently “visited” market. There is no broker or dealer making any profits.
  • Highly relies on word of mouth information to attract trading partners to buy or sell.

Guide to the Stock Market - Chapter 3

brokered secondary markets
Brokered Secondary Markets
  • Where trading transactions happen through the work of brokers.
  • For a fee, brokers help find trading partners and negotiate acceptable transaction prices for their clients.
  • Brokers are more likely seen in markets where there are economies of scale: when there are lots of investors in the market.

Guide to the Stock Market - Chapter 3

brokered secondary markets1
Brokered Secondary Markets
  • Because the broker gives special information away when trading securities (and of course, is doing a job), they will only accept when commission is greater than the cost of direct search.
  • Brokers are likely to know what a fair price of a transaction is. They take advantage of the extensive contact information, providing them with a pool price information too costly for individual investors to know on their own.

Guide to the Stock Market - Chapter 3

dealer secondary markets
Dealer Secondary Markets
  • Dealers: buy and sell their own inventory at their own quoted price, eliminating time consuming searches among other trading partners.
  • Contrary to brokered markets, a dealer can guarantee that an investor’s orders will be executed promptly.
  • They earn commissions when they sell at an asking price greater than the bid they paid. It compensates them for the liquidity provided.

Guide to the Stock Market - Chapter 3

dealer secondary markets1
Dealer Secondary Markets
  • Bid-ask spread: is the commission dealers get. It also pays the risk the dealer incurs by holding stock in their inventory and have it ready for any client. Is formed by two prices.
    • Bid price: The highest price someone is willing to pay to by your shares of stock.
    • Ask Price: The lowest price you can pay for a stock.

Guide to the Stock Market - Chapter 3

dealer secondary markets2
Dealer Secondary Markets
  • Disadvantages:
    • There’s no guarantee that the quotation of a dealer could be improved by contacting another dealer, so investors on dealer markets will have to bear anyway some cost for searching for the best price.
    • Dealer’s bid-ask spread might be more expensive than if the investor himself would’ve known another investor’s interest (and good price). But investors are willing to sell at a lower cost or buy at a higher price for a quick transaction.

Guide to the Stock Market - Chapter 3

auction secondary markets
Auction Secondary Markets
  • Provides purchase or sale of a security to market participants simultaneously.
  • Virtually eliminate the expense of looking for trading partners and bargaining a favorable price.

Guide to the Stock Market - Chapter 3

bid ask spreads
Bid-Ask Spreads
  • Spread prices are not the same to all equity securities because of differences in trading costs.
  • Factors that may affect the spread includes: price of the stock, size of the transaction, frequency of the transaction, and presence in the market of investors trading on inside information. But overall, the spread for a stock should be proportional to its stock price.

Guide to the Stock Market - Chapter 3

bid ask spreads size of transaction
Bid-Ask Spreads, Size of Transaction
  • Extremely small or extremely large transactions tend to have higher spreads in percentage terms.
    • Extremely Small: Because of the hassle in filling small orders in less than a round lot of 100 shares.
    • Extremely Large:Because it requires a lot of small buyers the broker has to find.

Guide to the Stock Market - Chapter 3

bid ask spreads frequency of transaction
Bid-Ask Spreads, Frequency of Transaction
  • The most frequently a stock is traded, the less costly for the dealer, because is easier to find buyers and sellers, decreasing inventory costs.
  • Short-term insiders, on the other hand, will cause dealers to get a higher spread, because is information that only dealer have access to (as opposed to an individual investor).
  • Traders and investors without short-term inside information are known as uninformed.

Guide to the Stock Market - Chapter 3

bid ask spreads1
Bid-Ask Spreads
  • It is important to remember that inside training is an illegal move, monitored by the SEC, and it is because of this that very little academic research around the subject exists.

Guide to the Stock Market - Chapter 3

over the counter
Over-the-Counter
  • There are a number of reasons why a stock is not listed, including lack of investor interest, small issue size, or insufficient order flow.
  • OTC is essentially a dealer market, and often concentrate their trading in a particular industry group or geographical area.
  • In average, there are about 30,000 types of equity securities traded in this market, although only half of it are actively traded.

Guide to the Stock Market - Chapter 3

over the counter1
Over-the-Counter
  • When an order of buying or selling is placed, broker or dealer contact other dealers with a particular stock for sale. The broker then acts as an agent for the investor. He will get the best price for the buying or selling transaction, and in the end, will charge the same price of the transaction plus a commission price.
  • Two problems are created when an order is placed. To figure out which dealers are market makers in the stock interested and to look for the best price available.

Guide to the Stock Market - Chapter 3

over the counter2
Over-the-Counter
  • National Quotation Bureau: a list with bid and ask prices submitted by dealers that provide brokers an easy way of finding a dealer perfect for the type of stock your looking for.
  • NASDAQ: automatic computer based quotation system that helps brokers find the right price for clients. It offers bid and ask prices for the most actively OTC stocks. Its most important contribution is the faster disclosure of dealer quotations to brokers.

Guide to the Stock Market - Chapter 3

nasdaq three levels
NASDAQ, Three Levels
  • Level 3 NASDAQ Terminals: available only dealers, it allow them to enter bid and ask quotations for specific stocks directly into the system. This information appears immediately.
  • Level 2 NASDAQ Terminals: display all dealers price bid and ask quotations for a given stock, but these cannot be changed on the terminal.
  • Level 1 NASDAQ Terminals: provides only the best bid and ask prices for a stock.

Guide to the Stock Market - Chapter 3

stock exchanges
Stock Exchanges
  • A place where a company can raise money by offering ownership to hundreds of small investors (sell shares of stock). Its also a place where people can sell their stock to someone else whenever they wish.
    • Organized markets include the NYSE (the largest and most organized auction market in the US), American Stock Exchange (AMEX) in New York, the Pacific Stock Exchange in San Francisco and LA, Chicago Stock Exchange, Philadelphia Stock Exchange, Boston Stock Exchange and Cincinnati Stock Exchange.

Guide to the Stock Market - Chapter 3

slide57
NYSE
  • All transactions completed in a stock listed on the NYSE occur at a unique place on the floor called the post.
  • Three major sources of active bid and ask prices:
    • Floor brokers executing customer stock orders.
    • Limit orders for stock left with the specialist for the execution.
    • Specialists in the stock buying and selling for his or her own account.

Guide to the Stock Market - Chapter 3

nyse process of buying and selling
NYSE, Process of Buying and Selling
  • An order is received from brokerage houses to brokers on the floor of NYSE, who brings the orders to the appropriate posts for execution.
    • Market Orders: an order to buy or sell at the best possible price available at the time.
    • Limit Orders: an order to buy or sell at a designated price (limit price) or better if possible. This is when investors want to buy or sell above or below the bid-ask spread. If an order cannot be executed soon, it may enter on the order book maintained by the specialist, where it will be posted until a buyer or seller appears, making it an advantage for brokers who would otherwise have to wait physically for an order to take place.

Guide to the Stock Market - Chapter 3

nyse process of buying and selling1
NYSE, Process of Buying and Selling
  • Specialists are dealers and order clerks at the same time, and members of the exchange. Their job is to maintain bid and ask quotations at all times. They also maintain the book of limit orders left by floor brokers.
  • Heavily traded stocks do not need the presence of specialists, since a heavy trading volume ensures there is always an active bid and ask available from either brokers or limit order books.

Guide to the Stock Market - Chapter 3

global stock markets
Global Stock Markets
  • The Securities Act Amendment of 1975 mandated that the SEC move toward creating a national market system. Although many steps have been made to move toward a national integration of market systems, there’s a lot of road yet to cover.
  • After this proposition, there exists also pressure to do the same with international stock markets.

Guide to the Stock Market - Chapter 3

global stock markets1
Global Stock Markets
  • The London Stock Exchange created a system similar to NASDAQ that permitted US and Japanese investment firms enter trades in the British system. This has also opened the doors for European investors, increasing their interest for trading in US companies.
  • Global competitiveness increased further when SEC permitted NYSE after-hours trading, broadening the market of US securities (and making it easier to raise money overseas).

Guide to the Stock Market - Chapter 3

american depository receipts
American Depository Receipts
  • Many foreign companies might get discouraged with the unfamiliar market practices, confusing tax legislation, incomplete shareholder communications, and other reasons.
  • American Depository Receipts, or ADRs, have helped foreign companies overcome some of these difficulties. These are dollar denominated claims issued by US banks representing ownership of shares in a foreign company’s stock trading in US stock markets.

Guide to the Stock Market - Chapter 3

american depository receipts1
American Depository Receipts
  • Sponsored ADRs: an ADR where the issuing company absorbs the legal and financial costs of creating and trading said security.
  • Unsponsored ADRs: the issuing firm is not involved in the issuance of the security, and may even oppose it. Usually is a US company demanding shares from a foreign company.
  • Dividends must be paid in American dollars.

Guide to the Stock Market - Chapter 3

american depository receipts2
American Depository Receipts
  • Each ADR represents either a fracture of a multiple of a share in the foreign company.
  • Arbitrage: a technique used to gain some profit from a price discrepancy, like the purchase of stock in one market and form immediate sale in other (if you are sure to make some profit from the transaction). It keeps price in line, making one stock be sold at the same price in any exchange market.

Guide to the Stock Market - Chapter 3

regulation of equity markets
Regulation of Equity Markets
  • Securities Act of 1933: requires full disclosure of relevant information relating to the issuance of new stock in primary market. Other requirements:
    • Full registration of IPO
    • Recent financial history of the company
  • SEC’s acceptance of the requirement do not mean that the security is a good investment. You must make your own evaluations of the value of a stock.

Guide to the Stock Market - Chapter 3

regulation of equity markets1
Regulation of Equity Markets
  • Securities Exchange Act of 1934: created to administer the provisions of the 1933 act. It also required from companies that with outstanding stocks on secondary exchanges to periodically disclose relevant financial information.
  • Also allowed the SEC to register and regulate securities exchanges, OTC trading, brokers and dealers. Finally, it made the SEC responsible for broad oversight of US secondary markets.

Guide to the Stock Market - Chapter 3

equity valuation basics introductory terms
Equity Valuation Basics, Introductory Terms
  • Market Capitalization: the total value of all outstanding shares of a company (market cap). This is done by multiplying the number of shares outstanding times the share price.

Guide to the Stock Market - Chapter 3

equity valuation basics introductory terms1
Equity Valuation Basics, Introductory Terms
  • Book Value: The value of the company as shown in the firm’s balance sheet: what the company owns less what it owes, following the guidelines from the Financial Accounting Standards Board (FASB).
  • Fundamental Analysis:Analysis using a company’s financial statements like balance sheet, income statement and cash flow statement, in order to know the financial health of a company.

Guide to the Stock Market - Chapter 3

equity valuation basics introductory terms2
Equity Valuation Basics, Introductory Terms
  • One big problem concerning Fundamental Analysis is that even though an analysis of financial health of a company can be good, this does not promise that the company will issue dividends, is not an obligation.
  • Technical Analysis:Attempts to predict the future of stock price movements based on two types of information: historical price and volume behavior and investor sentiment (attitudes).

Guide to the Stock Market - Chapter 3

stock market indexes
Stock Market Indexes
  • They provide a useful tool for summarizing relevant information generated by the continuous buying and selling of stocks. One must be cautious since each index will give you different information using different resources when extracting that information. You must become, then, familiar and know what each index means.

Guide to the Stock Market - Chapter 3

stock market indexes construction
Stock Market Indexes, Construction
  • Select a base index value and starting date.
  • Make a selection of which stocks should be included in the index. There are three methods to decide the index composition:
    • Index may represent a stock exchange,
    • The organization producing the index can subjectively select the stocks to be included, or
    • The stocks to be included may be selected based on some objective measure (such as market value).
  • Stocks must be combined in certain proportions to construct the index: each stock must be assigned some relative weight.

Guide to the Stock Market - Chapter 3

price weighted index
Price Weighted Index
  • First computed by summing the prices on individual stocks composing the index. The sum, then, is divided by a divisor to yield the chosen base index value. The divisor remains constant as stock prices change unless: there is a stock split, stock dividend or a change in index composition.
  • In the case of one of the events above mentioned, the divisor is adjusted so that the index value is not affected by the event.

Guide to the Stock Market - Chapter 3

price weighted index example
Price Weighted Index, Example
  • Stock A - $20
  • Stock B - $10
  • Stock C - $50
    • Total - $80
  • In the base index value is to be 100, then:
  • 0.8 because 100=
  • On the next trading day, lets say prices change:
    • Stock A - $25
    • Stock B - $10
    • Stock C - $40
      • New Total - $75
    • = 93.75
    • or 6.25% lower

Guide to the Stock Market - Chapter 3

price weighted index example1
Price Weighted Index, Example
  • Now, lets say that Stock C undergoes a two-for-one split after the market closes on the 2nd day; price per share declines $20
  • Price is now $55, though index remains the same because market value did not change.
  • New divisor should be adjusted so the index stays at 93.75:
  • It would remain constant until adjusted again for another event.

Guide to the Stock Market - Chapter 3

market value weighted index
Market Value Weighted Index
  • Computed by calculating total market value of the firms of the index and the total market value of those firms on the previous trading day.
  • Percentage change in the total market value from one day to the other represents change in the index.
  • Do not require adjustments for stock splits or stock dividends since they do not affect market capitalization.

Guide to the Stock Market - Chapter 3

market value weighted index1
Market Value Weighted Index
  • Require adjustments when the composition of the index changes.
  • This index is better because it accounts for price and firm size at the same time.
  • Example: (using the prices in example above)
    • Stock A – 100 million shares ($20)
    • Stock B – 200 million shares ($10)
    • Stock C – 10 million shares ($50)
      • Total market value: $4.5 billion

Guide to the Stock Market - Chapter 3

market value weighted index example
Market Value Weighted Index, Example
  • Market value on the 2nd day would be $4.9 billion, after an increase of 8.8%.
  • When Stock C goes through the two-for-one split, its price per share declines to $20, no impact on this index occurs because the number of shares outstanding will double to 20 million and market value will remain $400 million.
  • Total market value continues to be $.9 billion on 2nd day, and the increase will still be 8.8%.

Guide to the Stock Market - Chapter 3

price and market value weighted indexes
Price and Market Value Weighted Indexes
  • Both led to different results.
  • They reflect the returns to buy-and-hold investment strategies:
    • Market Value: tracks capital gains on the underlying index.
    • Price: tracks the returns on a portfolio composed of equal shares of each company.

Guide to the Stock Market - Chapter 3

dow jones average
Dow Jones Average
  • The most widely cited index, first published on 1896, with only common stocks of 20 companies, all of them industrial.
  • Is a price weighted index.
  • Today, it includes indexes for a total of 100 companies; from transportation to utilities to industrial.
  • Base index value of 20.

Guide to the Stock Market - Chapter 3

new york stock exchange index
New York Stock Exchange Index
  • Published on 1966, includes preferred and common stocks.
  • It’s a market value weighted index.
  • Its stocks are divided into four sub-indexes that tracks stock performance of industrial utility, finance, and transportation companies.
  • Base index value is 50.

Guide to the Stock Market - Chapter 3

standard and poor s 500 index largecap s p
Standard and Poor’s 500 Index – LargeCap(S&P)
  • Also a market value weighted index, consisting of 500 largest US stocks companies.
  • Is computed on a continuous basis during the trading day.
  • Is divided into two sub-indexes that follow performances of industrial and utility companies.
  • Base index value is 10.

Guide to the Stock Market - Chapter 3

s p 400 index midcap
S&P 400 Index - MidCap
  • Market vale weighted index, that consists of 400 stocks with market value less than those of the stocks in the S&P 500.
  • Follows the performance of medium sized companies.

Guide to the Stock Market - Chapter 3

s p 600 index smallcap
S&P 600 Index - SmallCap
  • Market vale weighted index, that tracks 600 companies with less market value than those followed in S&P 400 MidCap Index.
  • Follows the performance of small sized companies.
  • In the end, S&P 1500 includes companies of all S&P Indexes.

Guide to the Stock Market - Chapter 3

nasdaq indexes
NASDAQ Indexes
  • Published since 1971 and has three categories of companies: industrial, banks and insurance.
  • Includes all stocks traded in the National Market System (NMS) and those that are not.
  • NMS introduced two indexes in 1984:
    • NMS Composite Index
    • NMS Industrial Index
  • Both of the above are weighted by market capitalization and have an index base of 100.

Guide to the Stock Market - Chapter 3

other stock indexes
Other Stock Indexes
  • American Stock Exchange Index: market value weighted index. Includes all common stocks listed on AMEX.
  • Russell 3000 Stock Index: includes the largest companies ranked by market capitalization.
  • Russell 1000 Stock Index: includes the 1,000 largest market capitalization companies.
  • Russell 2000 Stock Index: includes the bottom 2,000 companies of the Russell 3000.

Guide to the Stock Market - Chapter 3

reliability of stock market to foretell economic crashes
Reliability of Stock Market to Foretell Economic Crashes
  • Prior experience and mayor crashes makes people skeptic to trade in the stock market.
  • Some economists, though, believe the stock market can predict economic downturns, making a relationship between decline of stock prices and lower corporate profits that lead to lower spending consumption and national income.
  • A study by the Reserve Board of Kansas City proved them wrong, analyzing recessions between 1900 and 1987 where the stock market did little to predict recessions on those periods.

Guide to the Stock Market - Chapter 3