I. The Economic
Functions of the Stock Market
A. The stock market allows nearly anyone to participate in the risks and opportunities of corporate America. Real returns for the past two centuries have averaged 7 percent per year.
B. How the Stock Market Works for Savers and Investors
1. Savers invest in the stock market as a strategy to build wealth.
2. Investors can buy a diverse portfolio of shares and hold them over long periods of time, substantially reducing risk.
3. Small investors can purchase stock in an equity mutual fund, a corporation that buys and holds shares of stock in many firms.
4. Equity mutual funds have reduced the risk of stock ownership and attracted large amounts of funds into the market, helping to push stock prices upward.
C. How the Stock Market Works for Corporations
1. To raise money, a corporation can a) use retained earnings, b) borrow money, or c) sell stock. Buyers can, if they wish, later resell shares on the stock market.
2. Each share of the stock is a fractional share in the firmís future net revenues.
3. People buy the stock of a corporation to get future dividends paid from corporate earnings and gains derived from increases in share prices.
4. The decisions of a firmís executives influence the firmís stock price. When investors (and their advisors and fund managers) believe that the decisions of corporate managers will increase the firmís future income, they will buy more of the stock, driving its price up. When investors believe that bad decisions are being made, the reverse happens and the stockís price falls.
5. Corporate board members are usually stockholders, and top managers are often given stock options. The value of the stock options will rise sharply as the firmís stock price increases. This helps bring the interest of corporate decision makers into harmony with other stockholders.
D. How the Stock Market Works for the Economy
1. The stock market benefits stockholders, helps discipline corporate decision makers to be more efficient, and to undertake productive projects.
2. The price of a corporationís shares constantly sends signals to the listed corporationís board of directors and managers. Changing stock prices reward good decisions and penalize bad ones.
3. To increase the firm's value, the firm must undertake productive projects.
II. Stock Prices
A. Underlying the price of a firmís stock is the present value of the firmís expected future net earnings, or profit.
B. The value of a share depends on (1) the expected size of future net earnings, (2) when these earnings will be achieved, and (3) the interest rate by which the investor discounts the future income.
C. The PE (price/earnings) ratio of a firm is a general measure of the price of the stock compared to the actual asset value of the company. A PE below the sector average represents an 'undervalued' stock; a PE ration above the sector represents an 'overvalued' stock.
D. The PEG (PE/Growth) ratio is a general measure of the price of the stock versus it's future expected earnings. The closer to 1 the PEG ratio is, the more the stock price represents actual predicted future value.
III. Stock Analysis
A. Stockholder who purchase stock for long term gain from dividends and capital gains are investors; stockholder who purchase stock for short term gain from capital gains are speculators.
B. Speculators are primarily concerned with the value and volatility of the stock itself; investors are more concerned with the health and growth of the company the stock represents.
C. Speculators use Technical analysis of the quantitative aspects of the stock's price over time to go long or sell short.
D. Investors use Fundamental analysis of both the historical quantitative and qualitative aspects of a company to buy shares in a company.
1. Quantitative analysis looks at the historical trends of the company's stock in terms of prices and dividends
2 Qualitative analysis looks at the business, management, and philosophy of the company as a whole to predict future trends.
3. Value stocks are held by investors for the long term accumulation of consistent dividends; growth stocks are held by investors in anticipation of long term capital gains from increase in the price of the company's stock.