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VALUING STOCKS

Instead of borrowing cash to pay for its investments, a firm can sell new shares of common stock to investors. Whereas bond issues commit the firm to make a series of specified interest payments to the lenders, stock issues are more like taking on new partners. The stockholders all share in the fortunes of the firm according to the number of shares they hold. We will take a first look at stocks, the stock market, and principles of stock valuation.

We start by looking at how stocks are bought and sold. Then we look at what determines stock prices and how stock valuation formulas can be used to infer the rate of return that investors are expecting. We will see how the firm s investment opportunities are reflected in the stock price and why stock market analysts focus so much attention on the price-earnings, or P/E ratio of the company.

Why should you care how stocks are valued? After all, if you want to know the value of a firm s stock, you can look up the stock price in The Wall Street Journal. But you need to know what determines prices for at least two reasons. First, you may wish to check that any shares that you own are fairly priced and to gauge your beliefs against the rest of the market. Second, corporations need to have some understanding of how the market values firms in order to make good capital budgeting decisions. A project is attractive if it increases shareholder wealth. But you can t judge that unless you know how shares are valued.

After studying this material you should be able to

_ Understand the stock trading reports in the financial pages of the newspaper.

_ Calculate the present value of a stock given forecasts of future dividends and future stock price.

_ Use stock valuation formulas to infer the expected rate of return on a common stock.

_ Interpret price-earnings ratios.

Stocks and the Stock Market

A shareholder is a part-owner of the firm. For example, there were 1,471 million shares of PepsiCo outstanding at the beginning of 1999, so if you held 1,000 shares of Pepsi, you would have owned 1,000/1,471,000,000 = .00007 percent of the firm. You would have received .00007 percent of any dividends paid by the company and you would be entitled to .00007 percent of the votes that could be cast at the company s annual meeting. Firms issue shares of common stock to the public when they need to raise money.1

They typically engage investment banking firms such as Merrill Lynch or Goldman Sachs to help them market these shares. Sales of new stock by the firm are said to occur in the primary market. There are two types of primary market issues. In an initial public offering, or IPO, a company that has been privately owned sells stock to the public for the first time. Some IPOs have proved very popular with investors. For example, the star performer in 1999 was VA Linux Systems. Its shares were sold to investors at $30 each and by the end of the first day they had reached $239, a gain of nearly 700 percent.

Established firms that already have issued stock to the public also may decide to raise money from time to time by issuing additional shares. ales of new shares by such firms are also primary market issues and are called seasoned offerings. When a firm issues new shares to the public, the previous owners share their ownership of the company with additional shareholders. In this sense, issuing new shares is like having new partners buy into the firm.

Shares of stock can be risky investments. For example, the shares of Iridium were first issued to the public in June 1997 at $20 a share. In May 1998 Iridium s shares touched $70; a little more than a year later, the company filed for bankruptcy and the shares were no longer traded. You can understand why investors would be unhappy if forced to tie the knot with a particular company forever. So large companies usually arrange for their stocks to be listed on a stock exchange, which allows investors to trade existing stocks among themselves. Exchanges are really markets for secondhand stocks, but they prefer to describe themselves as secondary markets, which sounds more important.

The two major exchanges in the United States are the New York Stock Exchange (NYSE) and the Nasdaq market. At the NYSE trades in each stock are handled by a specialist, who acts as an auctioneer. The specialist ensures that stocks are sold to those investors who are prepared to pay the most and that they are bought from investors who are willing to accept the lowest price.

The NYSE is an example of an auction market. By contrast, Nasdaq operates a dealer market, in which each dealer uses computer links to quote prices at which he or she is willing to buy or sell shares. A broker must survey the prices quoted by different dealers to get a sense of where the best price can be had.

An important development in recent years has been the advent of electronic communication networks, or ECNs, which have captured ever-larger shares of trading volume. These are electronic auction houses that match up investors orders to buy and sell shares. Of course, there are stock exchanges in many other countries. As you can see from Figure 3.10, the major exchanges in cities such as London, Tokyo, and Frankfurt trade vast numbers of shares. But there are also literally hundreds of smaller exchanges throughout the world. For example, the Tanzanian stock exchange opens for just half an hour each week and trades shares in two companies.

PRIMARY MARKET

Market for newly-issued securities, sold by the company to raise cash.

INITIAL PUBLIC OFFERING (IPO) First offering of stock to the general public.

SECONDARY MARKET

Market in which alreadyissued securities are traded among investors.

COMMON STOCK

Ownership shares in a publicly held corporation.