olab An Introduction to Stocks
An Introduction to Stocks OLAB
Professor Frank Howland
- Stocks are the way people own (and ultimately control) corporations
- Stocks are one of the ways corporations raise money to finance investment
- Corporations finance investment in two other ways: by reinvesting their profits and by borrowing money (via bank loans and bonds)
- Stocks are owned by individuals and institutions. Stocks are an important vehicle for savings (U.S. stocks are worth around ten trillion dollars).
- Stocks are risky: successful investing depends on diversification.
- A stock’s performance is often measured by its rate of return; the performance of groups of stocks is measured by stock market indexes.
- A stock’s market value depends on investors' expectations for the future.
Two main perspectives
- Corporate financial officer
- Individual investor
Four key ideas:
- The separation between ownership and control
- Financial flows in a corporation
- Present value
Glossary of Basic concepts
- Limited liability: a legal concept which says that owners of corporations are not personally liable for the actions or losses of the corporation.
- Dividends: periodic payments by corporations to owners of stock
- Stock buyback: when a corporation purchases its own stock from current owners; in effect very similar to dividends
- Market Capitalization (Market Value): for a company, the number of shares outstanding multiplied by the market price per share
- Stock indexes: Dow Jones Industrial Average, S&P 500
- Dow Jones is (essentially) the sum of the prices of 30 major stocks, adjusted for stock splits.
- S&P 500 is a weighted sum of the values of 500 of the biggest stocks in the U.S.
- The Market Map
- Stock markets: Places where buying and selling of publicly traded securities occurs.Examples include the New York Stock Exchange, NASDAQ and stock exchanges throughout the world.
- Mutual fund: a collection (or portfolio) of stocks, bonds or other securities purchased by a group of investors and managed by a professional investment company.
- Pension fund: an institution which manages a portfolio of financial assets, the main purpose of which is to provide for the retirement of a group of workers.
- Option: a financial asset which gives you the right though not the obligation to buy (call option) or sell (put option) another financial asset at some future date for a specified price.
The owner-manager conflict
Owners hire managers to run the firm.
Managers want to maximize their income, while owners want managers to maximize the value of the firm. These goals can conflict.
Accounting firm audits and options were conceived as a way to align the interests of owners and managers. Auditors are supposed to ensure that management is telling the truth. Options were supposed to encourage managers to make the firm more valuable, because that would make the options valuable. However it has turned out that many managers made their companies' finances look better than they were in order to pump up the stock prices and thereby make the options valuable. Meanwhile accounting firms looked the other way. The latest twist on this story is that many firms granted options to executives by back-dating the options to dates when the price was especially low, making the options more valuable than they would have been otherwise.
Financial Market Flows
What Determines the Value of A Stock?
The Market's Estimate of its Present Value
Basic Idea: A stock is worth the same as a bank account which will generate the same future cash flows.
A stock pays dividends of $5 per year and is expected to continue to pay the same dividend forever, with the first dividend coming one year from now.
A bank account pays 5% interest per year. The stock must be worth $100.
This is a present value computation. See PresentValue.xls
- Companies return cash to stockholders via other methods, e.g. stock buybacks
Remedy: Treat proceeds from stock buybacks like dividends.
- Stocks are riskier than bank accounts.
- Remedy: Increase the required interest rate and use expected dividends.
- Expected dividends may be increasing or decreasing instead of constant.
- Remedy: There are more complicated present value formulas. Furthermore, Excel can handle this quite easily.
- People don't agree on expected dividends.
- Remedy: Many people are employed as analysts who carefully read company reports. Any news can cause stocks and the market as a whole to change in value.
The Market Map
The most important questions in finance:
Are markets completely rational, or can stock prices stray far away from reasonable values for long periods of time?
Can the irrationality of investors be predicted?
Are there more effective ways to deal with the owner-manager conflict?
Where to get more information
Kansas, Dave, The Wall Street Journal Complete Money and Investing Guidebook. Three Rivers Press, 2005. This contains quick descriptions of markets and financial products.
Malkiel, Burton G., A Random Walk Down Wall Street, 8th Edition. W.W. Norton & Company, 2004. Perhaps the best introduction to stocks and investing.
Morris, Kenneth M. and Virginia Morris, The Wall Street Journal Guide to Understanding Money and Investing. Lightbulb Press, 1999. Another good guide to markets and financial products.
- Access to all sorts of financial data, some of which you have to pay for, but lots of which is free.
- Many different links to company and academic websites.
- This is the Securities and Exchange Commission data base of all reports that companies file with the Commission. The best primary source for information on companies.
- Quotes, charts, historical stock data.
One of the world's largest pension funds, with useful educational material.
A low-cost leader in the mutual fund industry.
Newspapers (available in print and on the internet)
Perhaps the best financial newspaper on the web. (You have to pay for this, but you can get a two-week free trial subscription.)
Not as comprehensive as the Wall Street Journal, but still useful. And largely free (after you register).