Seminars of Market Finance Nathalie AMINIAN 2011-2012

Financial System

Function of the financial system

Why study financial system?
Because well-functioning financial system is a key factor in producing high economic growth; and poorly performing financial system is a reason that countries in the world face difficulties and low economic development.
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Function of the financial system

Function of the financial system:
Make the connection between people who have an excess of available funds and people who have a shortage. In others words, the role of financial

system is to finance the economic activity by channeling funds people who do not have a productive use for them to those who do.
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Function of the Financial System

Financial markets perform the economic function of channeling funds from households, firms, and government that have saved surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income. Funds flow from lender-saver to borrower-spenders via 2 routes: In direct finance, borrowers borrow funds directly from lenders in financial markets by selling them securities/financial instruments. When borrowers and lenders face difficulties to meet each other, financial intermediaries stand between them and help transfer funds from one to the other. This second route to finance economic activity is called indirect finance.
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Overview of the Financial System

Indirect Finance

Financial Intermediaries

Lender-savers: 1.Households 2.Firms 3.Government 4.Foreigners

Borrower-spenders:

Funds

Financial Markets

Funds

1.Firms 2.Government 3.Households 4.Foreigners

Direct Finance
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Structure of Financial Markets

Stock exchange : exchange of capital in the long run
Equity market: issuing and trading of equities. The first method for a firm of rising funds is by issuing equities such as common stocks. It represents a share of ownership in a corporation. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities. If you own one share of common stock in a company that has issued 1 million shares, you are entitled to 1 one-millionth of the firms net income and 1 one-millionth of the firms assets. Equities often make periodic payments called dividends to their holders and are considered long-run securities because they have no maturity date. The stock market, in which shares of stock are traded, is the most widely followed financial market, that is why it is often called the market .
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 The Market !

Structure of Financial Markets

Stock exchange : exchange of capital in the long run

Debt market: issuing and trading of bonds.

The second method for a firm or a State of raising funds is to issue a debt instrument, called bonds, which is a contractual agreement by the borrower to pay the holder of the bond fixed amounts (interest payments) until a specified date (the maturity date), when the principal is repaid. A debt instrument is short-term if its maturity is less than a year and long-term if its maturity is 10 years or longer. Debt markets are important to economic activity because : they enable corporations and governments to borrow to finance their activities; are where interest rates are determined.
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Structure of Financial Markets

Primary Market:
Is a financial market in which new issues of financial instruments, such as bond or stock, are sold to initial buyers. The primary markets are not well known to the public because the selling of financial instruments to initial buyers takes place behind closed doors and the market is organized by an investment bank.

Secondary market:
Is a financial market in which securities that have been previously issued can be resold.
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Structure of Financial Markets

Money market: exchange of capital in the short run
Loans and deposits in domestic money Transaction of short-term debt instruments: certificates of deposits, commercial papers and Treasury bills.

Inter-bank market:
Loans and deposits between banks and/or between banks and Central Bank.
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Structure of Financial Markets

Internationalization of financial markets: the growing internationalization of financial markets has become an important trend. The growth of foreign financial markets has been the result of increases in the pool of savings in most countries and the deregulation of financial markets. Lets have a look into the global financial market through 3 financial instruments: foreign bonds, eurobonds and eurocurrencies.
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Structure of Financial Markets

Foreign bonds are sold in a foreign country and are denominated in that countrys currency. For example if a Japanese automaker Toyota sells a bond in Germany denominated in euro, it is classified as foreign bond. Foreign bonds have been an important instrument in the international financial market for centuries. A large percentage of US railroads built in the nineteenth century were financed by sales of foreign bonds in Britain.
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Structure of Financial Markets

Euro-bond is a bond denominated in a currency other than that of the country in which it is sold. For example if a Japanese automaker Toyota sells a bond in Germany denominated in Japanese yen, it is classified as eurobond. Over 80% of the new issues in the international bond market are eurobonds.
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Structure of Financial Markets

Eurocurrencies are foreign currencies deposited in banks outside home country. The most important eurocurrencies are eurodollars, which are USD deposited in foreign banks outside the US or in foreign branches of US banks.
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Structure of Financial Markets

Derivatives Market:
Trading of hedging instruments such as:
Futures contract: a standardized contract to buy/sell an asset at a specified price, on a specified date in the future . Options contract: a contract giving the option/right to its purchaser to buy/sell the underlying financial instrument at a specified price within a specific period of time. The purchaser of the option has to pay a premium to the seller. Swap: a contract whereby 2 parties agree to a periodic exchange of cash flows.
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To hedge: to protect oneself against risks.

Structure of Financial Markets

March montaire: change de capitaux court terme Monnaie banques & BC Certificats de dpts banques Billets de trsorerie firmes Bons du Trsor Etat March des valeurs mobilires: change de capitaux long terme March des fonds propres/actions March de dettes/obligations March des drivs (contrats terme, options)

Money market: Money Certificates of Deposits Commercial Papers Treasury Bills

Stock exchange: Equity Market Bond Market (corporate bonds, Tbonds) Derivatives (futures, options)
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FX Market
For funds to be transferred from one country to another, they have to be converted from the currency in the country of origin into the currency of the country they are going to. The trading of currencies and bank deposits denominated in foreign currencies takes place in the FX market. Transactions conducted in the FX market determine the rates at which currencies are exchanged (FX rates).
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Foreign Exchange Market

FX Brokers

Inter-bank Market

Customers buy FX with euros

Retail Market

FX Market

Retail Market

Customers sell FX for euros

Stockbrokers
FX Futures/ options Market
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Financial intermediaries
Why do financial intermediaries exists? The process of financial intermediation is the primary route for moving funds from lenders to borrowers. Although the media focus much of their attention on stock market, financial intermediaries are a more important source for corporations than capital markets are.
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Financial intermediaries
Why are financial intermediaries so important in financial markets? They help reducing:
transaction costs, information costs, the exposure to risk.

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Financial intermediaries
Transaction costs:
Time and money spent in carrying out financial transctions. How FI reduce transaction costs? They can reduce these costs because they have developed expertise in lowering them.thanks to their large size allowing them to take advantage of economies of scales. Example: a bank can find a good lawyer to produce a loan cantractthis contract can be used over and over again. 21

Financial intermediaries
Asymmetric information: Lack of information creates problems in financial markets on 2 fronts:
before the transaction is entered into adverse selection; and after moral hazard.

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Financial intermediaries
Adverse selection occures when the potential borrowers who are most likely to produce an adverse outcome (bad risk) are the ones who most actively seek out a loan and are thus most likely to be selected. Moral hazard is the risk (hazard) that the borrower might engage in activities that are risky from the lenders point of view. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan.
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Financial intermediaries
Risk sharing: FI create and sell assets with risk characteristics that people are comfortable with. FI then use the funds they acquire by selling these assets to purchase other assets that may have more risk. This process is referred to as asset transformation i.e. risky assets are turned into safer assets. Risk: the degree of uncertainty associated with the return on an asset. Risk appetite!
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Financial intermediaries
FI promote risk sharing by helping individuals to diversify and lower the amount of risk to which they are exposed. Diversification means investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets. You shouldnt put all your eggs in one shouldn basket !
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Types of financial intermediaries

1. Depository institutions:
Checkable deposits: deposits on which checks can be written Saving deposits: deposits that are payable on demand

Commercial banks raise funds

by issuing deposits then use these funds to make loans. Mutual saving banks obtain funds through saving deposits and checkable deposits.

Credit

unions

are

small

cooperative lending institutions organized around a particular group: union members, employees of a firm

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Banks
Investment bank: a bank whose longfunction is the provision of long-term equity and loan finance for industrial and other companies, particularly new securities. They are also involved in mergers and acquisitions advice and financial engineering.
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Banks
4 functions form the core of investment banking activities: 1. Underwriting and selling shares and bonds to investors. 2. Making makets in these securities for the investors who want to buy or sell them. 3. Selling advice to large companies and governments. 4.Investment 4. Investment management and financial engineering (packaging of different instruments).
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Banks
What is Underwriting?
longproviding of long-term equity and debt finance for corporations and governments through the issuance and trading of new securities to the public in the primary markets.
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Banks
Retail banking: A subset of commercial banking, it refers to the provision of banking services to individual customers. This includes: deposit taking, lending car for home, car, credit card services, insurance and investment management services for individual clients.
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Banks
Glass Steagall Act : Refers to the Banking Act of 1933 that prohibited commercial banks from engaging in investment banking activities in the US. Is has been largely repealed in 1999 (Clinton Administration). It can be considered as the origin of the subprimes crisis of 2007.
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Types of financial intermediaries

2. Contractual savings institutions are FI that require funds on a contractual basis.
Life insurance companies insure people against financial hazards following a death. Casualty insurance companies insure people against loss from fire, accident.they raise funds through premiums for their policies. Pensions funds and government retirement funds provide retirement income. Funds are raised by contributions from employers and employees.
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Types of financial intermediaries

3. Investment intermediaries:
Finance companies raised funds by selling commercial papers and by issuing stocks and bonds. They lend these funds to consumers. Mutual funds acquire funds by selling shares to many individuals and use these funds to buy stocks and bonds. Money market mutual funds sell shares to raise funds that are used to buy money market instruments that are both safe and very liquid. Investment banks raise funds in capital markets. They help/advise corporations to issue securities and organize the 33 primary market.

Financial intermediaries
Type of intermediary
Depository Institutions Commercial banks Mutual saving banks Credit unions Contractual savings institutions Life insurance companies Pension funds Premiums from policies Employer & employees contributions Corporate bonds & mortgages Corporate bonds & stocks Deposits Deposits Deposits Business and consumer loans, mortgages, T. Bonds Mortgages Consumer loans

Sources of funds

Uses of funds

Investment intermediaries Finance companies Mutual funds Money market mutual funds Com. Papers, stocks & bonds Shares Shares Consumer and Business loans Stocks & bonds Money market instruments
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Regulation of the financial system

What is the aim?
1. Increase information available to investors: The supervisor requires corporations issuing securities to disclose certain information about their sales, assets.in order to make inverstors better informed and protected from abuses in financial markets. 2. Ensuring the soundness of financial intermediaries to avoid financial panic.
Financial panic: doubts about the health of the FI.
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Principal Regulatory Agencies

France: Autorit des marchs financiers (AMF) Commission bancaire BCE USA: Securities and Exchange Commission (SEC) Office of the Comptroller of the Currency (federally chartered commercial banks) State banking & insurance commissions (state-chartered depository instituions) FED (all depository institutionjs)
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Stock Market
A stock market or equity market is a public entity for the trading of company stock (shares) and derivatives at an agreed price. Stock exchanges are entities of a corporation or mutual organization specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together.

Stock market
The largest stock market in the United States, by market capitalization, is the New York Stock Exchange (NYSE). In Canada, the largest stock market is the Toronto Stock Exchange. Major European examples of stock exchanges include the Amsterdam Stock Exchange, London Stock Exchange, Paris Bourse, and the Deutsche Brse (Frankfurt Stock Exchange). In Africa, examples include Johannesburg Stock Exchange and Nigerian Stock Exchange. Asian examples include the Singapore Exchange, the Tokyo Stock Exchange, the Hong Kong Stock Exchange, the Shanghai Stock Exchange, and the Bombay Stock Exchange. In Latin America, there are such exchanges as the BM&F Bovespa or Mexican Stock Exchange. 38

Rank

Country

Stock exchange

location

Market capitalization (Billion USD) 14,242

Trade value (Billion USD)

US-EU

NYSE-EURONEXT NASDAQ OMX (US & North Europe) Tokyo Stock Exchange LSE SSE HKSE TSE BM&F Bovespa

New York City

20,161

US-EU

New York City

4,687

13,552

3 4 5 6 7 8

Japan UK China Hong Kong Canada Brazil

Tokyo London Shanghai Hong Kong Toronto So Paulo

3,325 3,266 2,357 2,258 1,912 1,229

3,972 2,837 3,658 1,447 1,542 931

Australia

AST

Sydney

1,198

1,197

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Germany

Deutsche Brse

Frankfurt

1,185

1,758
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Stock market
Participants in the stock market range from small individual stock investors to large hedge fund traders, who can be based anywhere. Their orders usually end up with a professional at a stock exchange, who executes the order of buying or selling.
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Stock market
Some exchanges are physical locations where transactions are carried out on a trading floor, by a method known as open outcry. This type of auction is used in stock exchanges and commodity exchanges where traders may enter "verbal" bids and offers simultaneously. The other type of stock exchange is a virtual kind, composed of a network of computers where trades are made electronically via traders.
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Stock market
Trades are based on an auction market model where a potential buyer bids a specific price for a stock and a potential seller asks a specific price for the stock. When the bid and ask prices match, a sale takes place, on a first-come-firstserved basis if there are multiple bidders or askers at a given price.
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Stock market
The New York Stock Exchange is a physical exchange, also referred to as a listed exchange. Only stocks listed with the exchange may be traded. Orders enter by way of exchange members and flow down to a floor broker, who goes to the floor trading post specialist. The specialist's job is to match buy and sell orders using open outcry.
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Stock market
If a spread exists, no trade immediately takes place. In this case the specialist should use his own resources (money or stock) to close the difference after his judged time. Once a trade has been made the details are reported on the "tape" and sent back to the brokerage firm, which then notifies the investor who placed the order.
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Stock market
The NASDAQ is a virtual listed exchange, where all of the trading is done over a computer network. The process is similar to the New York Stock Exchange but buyers and sellers are electronically matched. One or more NASDAQ market makers will always provide a bid and ask price at which they will always purchase or sell 'their' stock.
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Stock market
The Paris Bourse, now part of Euronext, is an order-driven, electronic stock exchange. It was automated in the late 1980s. Prior to the 1980s, it consisted of an open outcry exchange; stockbrokers met on the trading floor. In 1986, the CATS trading system was introduced, and the order matching process was fully automated.
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Price-driven & 0rder-driven Systems

The NASDAQ is a priceprice-driven system There is no centralized book of limit orders. When posting a quote, quote, the market maker does not know what trades generates. it will generates. The market maker, places a buy limit order bid) (bid) and a sell limit ask). order (ask).
Paris, Frankfurt or Tokyo orderare electronic order-driven systems. systems. The computer stores all orders, orders, which become public knoledge. knoledge. All limit orders that have not been executed are stored in a central order books. The highest limit bid and the lowest limit offer act as bid and ask prices in the pricepricedriven system.
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Order-driven system: example

LVMH is listed on the Paris Bourse. You can access the central limit order book directly on the internet and find the following information You wish to buy 1,000 shares and enter a order. market order. At what price will you shares? buy the shares?
Sell orders Buy orders

quantity

limit

limit

quantity

1,000 3,000 1,000 1,000 500

58 54 52 51 50

49 48 47 46 44

2,000 500 1,000 2,000 10,000

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Stock market
Investors may 'temporarily' move financial prices away from their long term aggregate price 'trends'. Positive or up trends are referred to as bull markets. Negative or down trends are referred to as bear markets. Over-reactions may occur: so that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. Economists continue to debate whether financial markets are 'generally' efficient.
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Stock market
According to the efficient-market hypothesis, only changes in fundamental factors, such as the outlook for margins, profits or dividends, ought to affect share prices beyond the short term. This academic viewpoint also predicts that little or no trading should take place since prices are already at or near equilibrium. However, the efficient-market hypothesis is sorely tested by such events as the stock market crashes.
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Stock market
Other researches have shown that psychological factors may result in exaggerated stock price movements. They have demonstrated that people are predisposed to 'seeing' patterns, and often will perceive a pattern in what is just noise. This means that a succession of good news items about a company may lead investors to overreact positively (unjustifiably driving the price up). A period of good returns also boosts the investor's self-confidence, reducing his risk threshold.
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Stock market
Another idea is the group thinking. As social animals, it is not easy to stick to an opinion that differs markedly from that of a majority of the group. An example is the reluctance to enter a restaurant that is empty; people generally prefer to have their opinion validated by those of others in the group.
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Stock market
Other researches draw an analogy with gambling: in normal times the market behaves like a game of roulette. In times of market stress, the game becomes more like poker (herding behavior takes over). The players must give heavy weight to the psychology of other investors and how they are likely to react psychologically. Herd: troupeau Herding

behaviour:
comportement gr grgaire.

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Stock market indexes

A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds. The index may be weighted to reflect the market capitalization of its components, or may be a simple index which represents the net change in the prices of the underlying instruments. Benchmark: rep talon ou repre. Benchmarking is the process of comparing one's business processes and performances to industry bests and/or best practices from other industries.
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Stock market indexes

Stock market indices may be evaluated in many ways. A 'world' or 'global' stock market index includes (typically large) companies without regard to where they have their activities or are traded. 3 examples are MSCI World, FTSE and S&P Global 1250. MSCI: Morgan Stanley Capital International has published global indices since 1970. FTSE: joint venture of FT and LSE has published global indices since 1987.
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Stock market indexes

A 'national' index represents the performance of the stock market of a given nation, and by proxy, reflects investor sentiment on the state of its economy. The most regularly quoted market indices are national indices composed of the stocks of large companies listed on a nation's largest stock exchanges: the US Dow Jones 30, the Japanese Nikkei 225, the Russian RTSI, the Indian SENSEX and the British FTSE 100.
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Stock market indexes

More specialized indices exist tracking the performance of specific sectors of the market. Some examples: the Wilshire US REIT which tracks more than 80 US real estate investment trusts and the Morgan Stanley Biotech Index which consists of 36 US firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria
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Stock Indexes
An index may be classified according to the method used to determine its price. In a price-weighted index such as the Dow Jones Industrial Average, Amex Major Market Index, and the NYSE ARCA Tech 100 Index, the price of each component stock is the only consideration when determining the value of the index. Thus, a price movement of even a single security will heavily influence the value of the index, ignoring the relative size of the company as a whole.
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Stock Indexes
In contrast, a market-value weighted or capitalization-weighted index takes into consideration the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index. In a market-share weighted index, price is weighted relative to the number of shares, rather than their total value.

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Stock Indexes
The CAC 40 is a benchmark French stock market index. The index represents a capitalizationweighted measure of the 40 most significant values among the 100 highest market caps on the Paris Bourse. It is one of the main national indices of the pan-European stock exchange group Euronext alongside Brussels' BEL20, Lisbon's PSI-20 and Amsterdam's AEX.
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Stock Indexes
The CAC 40 index composition is reviewed quarterly by an independent Index Steering Committee (Conseil Scientifique). If any changes are made, they are effected a minimum of two weeks after the review meeting. At each review date, the companies listed on Euronext Paris are ranked according to free float market capitalization and share turnover over the prior 12 months.
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Stock Indexes
From the top 100 companies in this ranking, 40 are chosen to enter the CAC 40 such that it is "a relevant benchmark for portfolio management" and "a suitable underlying asset for derivative products". If a company has more than one class of shares traded on the exchange, only the most actively traded of these will be accepted into the index (generally this will be the ordinary share).[
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Stock Indexes
The CAC 40 is a market value-weighted index. The number of shares issued of a company is reviewed quarterly, on the third Friday of March, June, September and December. The index value of the CAC 40 index is calculated using the following formula:

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Stock Indexes
With t the day of calculation;
N the number of constituent shares in the index (usually 40); Qi,t the number of shares of company i on day t; Fi,t the free float factor of share i; fi,t the capping factor of share i; Ci,t the price of share i on day t; Qi,0 the number of shares of company i on the index base date; Ci,0 the price of equity i on the index base date; Kt the "adjustment coefficient for base capitalization" on day t (reflecting the switch from the French franc to the Euro in 1999).
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Stock Indexes
Although the CAC 40 is almost exclusively composed of French-domiciled companies, about 45% of its listed shares are owned by foreign investors, more than any other main European index. German, Japanese, American and British investors are among the most significant holders of CAC 40 shares. This large percentage is due to the fact that CAC 40 companies are more international, or multinational, than any other European market. CAC 40 companies conduct over two thirds of their business and employ over two thirds of their workforce outside France.

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Company Accor Air Liquide Alcatel-Lucent Alstom ArcelorMittal AXA BNP Paribas Bouygues Capgemini Carrefour

Sector hotels

Ticker symbol AC

Index weighting (%) at 20 December 2011 0.49 4.64 0.47 0.83 2.05 3.21 5.01 0.80 0.65 1.75
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commodity chemicals AI telecommunications ALU equipment industrial machinery ALO steel full line insurance banks heavy construction computer services food retailers and wholesalers MT CS BNP EN CAP CA

Company Crdit Agricole EADS EDF Essilor France Tlcom GDF Suez Groupe Danone L'Oral Lafarge Legrand

Sector banks aerospace electricity medical supplies

Ticker symbol ACA EAD EDF EI

Index weighting (%) at 20 December 2011 0.74 1.70 0.90 1.91 3.96 4.41 4.73 3.41 0.86 0.94
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fixed line FTE telecommunications gas distribution food products personal products building materials and fixtures electrical components and equipment GSZ BN OR LG LR

Company LVMH Michelin Pernod Ricard

Sector clothing and accessories tires

Ticker symbol MC ML

Index weighting (%) at 20 December 2011 4.84 1.40 2.28 0.33 1.47 0.83 0.88 0.90 1.99 11.14
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distillers and vintners RI UG PP PUB RNO SAF SGO SAN

PSA Peugeot Citron automobiles PPR Publicis Renault Safran Saint-Gobain Sanofi broadline retailers media agencies automobiles aerospace building materials and fixtures pharmaceuticals

Company Schneider Electric Socit Gnrale STMicroelectronics Technip Total Unibail-Rodamco Vallourec Veolia Environnement Vinci Vivendi

Sector electrical components and equipment banks semiconductors oil equipment and services

Ticker symbol SU GLE STM TEC

Index weighting (%) at 20 December 2011 3.36 1.98 0.48 1.22 14.13 2.14 0.79 0.53 2.60 3.27
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integrated oil and gas FP real estate investment trusts UL

industrial machinery VK water heavy construction broadcasting and entertainment VIE DG VIV

Dow Jones
The Dow Jones Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow. It was founded on May 26, 1896, and is now owned by Dow Jones Indexes, which is majority owned by the CME Group. It is an index that shows how 30 large, publicly owned companies based in the US have traded during a standard trading session in the stock market.
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Dow Jones
To calculate the DJIA, the sum of the prices of all 30 stocks is divided by a divisor, the Dow Divisor. The initial divisor was composed of the original number of component companies; which made the DJIA at first, a simple arithmetic average. The present divisor, after many adjustments, is less than one: meaning the index is larger than the sum of the prices of the components. Events like stock splits or changes in the list of the companies composing the index alter the sum of the component prices. In these cases, in order to avoid discontinuity in the index, the Dow Divisor is updated so that the quotations right before and after the event coincide.
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Stocks
A stock represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. Issuing stocks and selling it to the public is a way for a corporation to raise funds to finance its activities. The stock of a business is divided into multiple shares.
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Types of Stock
As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders.

Types of Stock
Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. They are called "convertible preference shares" in the UK.
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Types of Stock
A stock derivative is any financial instrument which has a value that is dependent on the price of the underlying stock. Futures and options are the main types of derivatives on stocks. The underlying security may be a stock index or an individual firm's stock, e.g. single-stock futures.
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What is Value?
In general, the value of an asset is the price that a willing and able buyer pays to a willing and able seller. Note that if either the buyer or seller is not both willing and able, then an offer does not establish the value of the asset.
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What is Value?
There are several types of value:
Book Value - The assets historical cost less its accumulated depreciation Market Value - The price of an asset as determined in a competitive marketplace Intrinsic Value - The present value of the expected future cash flows discounted at the decision makers required rate of return
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What is Value?
There are two primary determinants of the intrinsic value of an asset to an individual:
The size and timing of the expected future cash flows The individuals required rate of return (this is determined by a number of other factors such as risk/return preferences, returns on competing investments, expected inflation, etc.)

Note that the intrinsic value of an asset can be, and often is, different for each individual Thats what makes markets work! That
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Stock valuation
The first step in valuing common stocks is to determine the cash flows. For a stock, there are two:
Dividend payments The future selling price

Finding the present values of these cash flows and adding them together will give us the value.
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Stock valuation
Assume that you are considering the purchase of a stock which will pay dividends of $2 next year, and $2.16 the following year. After receiving the second dividend, you plan on selling the stock for $33.33. What is the intrinsic value of this stock if your required return is 15%?
VCS 2.00 2.16 + 33.33 = + = $28.57 1 2 (1 + .15 ) (1 + .15 )
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Stock valuation

In valuing the common stock, we have made two assumptions:

We know the dividends that will be paid in the future

We know how much you will be able to sell the stock for in the future

Both of these assumptions are unrealistic, especially knowledge of the future selling price. Furthermore, suppose that you intend on holding on to the stock for 20 years, the calculations would be very tedious!
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Stock valuation
We cannot value common stock without making some simplifying assumptions. If we make the following assumptions, we can derive a simple model for common stock valuation: Assume:
Your holding period is infinite (i.e., you will never sell the stock) The dividends will grow at a constant rate forever.

Note that the second assumption allows us to predict every future dividend, as long as we know the most recent dividend.
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Stock valuation
With these assumptions, we can derive a model which is known as the Dividend Discount Model, or the Gordon Growth Model. This model gives us the present value of an infinite stream of dividends that are growing at a constant rate:
VCS D 0 (1 + g ) D1 = = k CS g k CS g
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Stock valuation
Recall our previous example in which the dividends were growing at 8% per year, and your required return was 15%. The value of the stock must be:
VC S 1.8 5 (1 + .0 8 ) 2 .0 0 = = = 2 8 .5 7 .1 5 .0 8 0 .1 5 . 0 8

Note that this is exactly the same value that we got earlier.
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Stock valuation
There is no reason that we cant use the GGM at any point in time. For example, we might want to calculate the price that a stock should sell for in two years. To do this, we can simply generalize the GGM:

DN (1 + g) DN +1 VN = = k CS g k CS g
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Stock valuation
In the earlier example, how did we know that the stock would be selling for $33.33 in two years? Note that the period 3 dividend must be 8% larger than the period 2 dividend, so:

2.16(1+ .08) 2.33 V3 = = = 33.33 .15.08 0.15 .08

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Stock valuation
Preferred stock represents an ownership claim on the firm that is superior to common stock in the event of liquidation. Typically, preferred stock pays a fixed dividend periodically and the preferred stockholders are usually not entitled to vote as are the common shareholders.

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Stock valuation
Preferred stock is very much like common stock, except that the dividends are constant (i.e., the growth rate is 0%) Therefore, we can use the GGM with a 0% growth rate to find the value:
D 0 (1 + 0 ) D = = k CS 0 k CS
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V PS

Stock valuation
Suppose that you are interested in purchasing shares of a preferred stock which pays a $5 dividend every year. If your required return is 7%, what is the intrinsic value of this stock?

V PS

5 = = $ 71 . 43 0 . 07
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Price Earnings Valuation Model

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INCOME STATEMENT Universal Office Furnishings

2011 Net sales Cost of goods sold Gross operating profit Expenses Amortization Other income Earnings before interest & taxes Interest expense Earnings before taxes Income taxes Net profit after taxes Dividends per share EPS Number of common shares 1,938.0 1,128.5 809.5 497.7 77.1 0.5 235.2 13.4 221.8 82.1 139.7 0.15 2.26 61.8
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STATEMENT OF CASH FLOW Universal Office Furnishings

Cash from Operations Net earnings Amortization Other noncash charges Increase in current assets Increase in current liabilities Net chash flow from operations Cash from investing activities Acquisition of property, plant, equipment Net cash flow from investing activities Cash from financing activities Proceeds from LT borrowing Reduction in LT debt Net purchase of capital stock Payment of dividends on common stock Net cash flow from financing activities 749.8 728.7 47.2 9.3 35.4
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2011 139.7 77.1 5.2 41.7 21.8 202.1 150.9 150.9

Price Earnings Valuation Model

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Price Earnings Valuation Model

This means that the stock is currently selling at a multiple of 18 times its earnings. P/E ratios are widely quoted in the financial press and are an essential part of many stock valuation models. Anyhow, one would like to find stocks with rising P/E ratios, because higher P/E multiples usually translate into higher future stock prices and better returns to stockholders.
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Price Earnings Valuation Model

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Price Earnings Valuation Model

A PEG ratio close to 1 is reasonable and suggests that the companys P/E in not out of the line with the earnings growth of the firm. The idea is to look for stocks that have PEG ratios that are equal or less than 1. A high PEG means that P/E has outpaced its growth in earnings and the stock is fully valued . Some investors wont even look at stocks if their PEGs are too high!
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Stock valuation
Another way to assess the P/E ration is to compare it to the average industry or sector P/E.

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