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8. Stocks, Stock Markets, and Market Efficiency Common stock Stock market indexes Stock valuation Efficient Markets Theory About common stock Share of firm’s ownship A residual claimant Paid after all other creditors “last in line” Limited liability Shareholders cannot be liable beyond stock investment Measuring the Stock Market Stock market indexes Average price level in part/all of market Benchmark for performance for money managers Dow Jones Industrial Average (DJIA) Stock prices of 30 of the largest U.S. companies Return to holding a portfolio of a single share of each stock Adjusted for splits, firm changes Price-weighted average Greater wt. to higher priced stocks /mdsidx/index.cfm?event=showAvgStats The SP 500 Value of 500 of the largest firms in U.S. economy At least $5 billion in market capitalization At least 50% stock held by public Valued-weighted Weight to each stock price based on firms total market value Share price x (shares outstanding) Larger firms get more wt. /spf/pdf/index/500factsheet.pdf Nasdaq Composite Over 3000 OTC traded companies Value-weighted Smaller, newer firms $500 billion total market value DJ Wilshire 5000 “Total market index” All publicly traded stocks in U.S. with readily available price data Value-weighted Over $15 trillion in total market capitalization Stock Valuation Recall: We value an asset based on the present value of the expected future cash flows For stocks these are dividend payments, resale price D0 = dividend today g = annual dividend growth rate Pn= future resale price in year n P = price today i = discount rate value of a stock today but we do not know the future P…. assume stock is held indefinitely, just paying dividends…. Dividend-discount model interest rate = risk free rate + risk premium i = rf + rp then higher risk free rate, lower stock price higher risk premium, lower stock price higher dividends, higher stock price higher dividend growth, higher stock price example D = $2, g = 2%, rf = 3%, rp = 5%