2011Module Fall 3
Accounting & Finance
Lecture 3: Stocks, Portfolios, Mutual Funds & ETFs
David Robinson
D. Robinson, 2011
Accounting & Finance
Accounting
Managerial
Financial
Auditing
Three financial
statements
Finance
Income St.
Forms of business
Balance Sheet
How investors
use their money
How firms
raise money
St. Cash Flows
Lecture Outline
Valuing Common Stocks
The daily battle between greed and fear
Long-run valuation of future cash flows
Diversification
Unique risk versus Market risk
Portfolios
Introduction to Mutual Funds and ETFs
[Appendix: Price/Earnings Ratio]
Common Stock (shares)
A fraction of ownership in a company
You can buy and sell at any time
Company never expects to pay you back
the original money
Company _may_ give dividends (a small
paymentpart of the profitstypically
once a year
Common Stocks are Risky
But, over long periods of time they give a
better return than fixed income
investmestments (i.e. bonds)
Their rising prices reflect the growing economy
Why do People Invest in
Common Stocks ?
All investors want a good return
Total return:
Price +
dividends
Interest rates on Savings Accounts at
Banks are very lowabout 1 percent
Wouldnt even keep up with inflation
US Stocks are climbing back from a nearcatastrophic sell-off in 2008-9
Peak 14,000
Oct 2007
Low: early 2009,
about 6,500
This summer, not so
good: Oct 1: 10,913
End of Feb 2011,
12,130 (not all the way
back)
2008-9 was a classic Bear Market
Definition: Bear Market
A severe moderate-term decline in share
prices
The drop in prices causes a loss of
investor confidence
Many shareholders sell, decreasing prices
further
Over the long run, the market has
returned 10.5 to 11 percent
That beats safe
bonds, say 4 to 5
percent
Logarithmic
scale
Total return:
Price +
dividends
Long-run Return of the Stock Market
Decade
Average annual return
1950s
17.62%
1960s
9.15%
1970s
10.45%
1980s
14.72%
1990s
18.54%
2000s
Long-run Return of the Stock Market
Decade
Average annual return
1950s
17.62%
1960s
9.15%
1970s
10.45%
1980s
14.72%
1990s
18.54%
2000s
3.55%
Hmm
Is it just an
unlucky decade
or a move to
perpetual low
returns?
Valuing Common Stocks
Common stocks produce a
variable return
Common Stock is even more
risky than a corporate bond
We hope to get a bigger return,
But
Dividends are not guaranteed
If the company fails (goes bankrupt) well likely get
nothing at all
[Bond holders (owners) are creditors of the firm
and get paid in full before shareholders get whats
left.]
Where do stock prices come from ?
Book value? (Not likely)
Remember, this ignores going concern value
Value of the underlying assets (possibly)
If we shut down and sell off all those depreciated assets
Sophisticated investors discounting the
expected future cash flows (earnings, not
dividends) of the firm Long term
Supply and demand in the market place,
sentiment, herding Short term
(the daily battle between greed and fear)
Remember
this!
The daily battle (Friday) between
greed and fear
Is the stock worth $20.69 . . .
or $20.32?
Stock Prices Reflect
the Long-run Value
SBUX is facing more
competition!
Turn around? . . .
How stocks are valued
1. Financial analysts carefully predict a
companys earnings (not dividends)
several years into the future
2. They estimate what those future earnings
are worth by discounting them to the
present time
The Price/Earnings Ratio
Professional valuation of stocks depends
on estimating future earnings
Then, we compare using the
Price/Earnings Ratio
[If you are interested, see the slides at the
end labeled Appendix: Will not be
examined.]
An Introduction to
Stock Markets
Worth
about
$2,000
Suppose you were left
100 shares of GE
You can sell them to anyone you want
Just like selling a 1966 Corolla . . .
Problems: Suppose you were left
100 shares of GE
You can sell them to anyone you want
Just like selling a 1966 Corolla . . .
Not sure Im getting the best price
Havent done this before
Hassles of recording the new owner
Stock Markets are organized
auctions: Buy/Sell
As a practical matter, youd
hold the shares in an account
at a brokerage (not certificate
on your desk)
Youd instruct your broker:
Sell 100 GE
Youd probably do this online
A Stock Must be Listed
on an Exchange
Can be listed on
more than one
exch. e.g. Sony
Public company usually means that the
shares are listed:
NYSE (now owns American Exchange & EuroNext)
NASDAQ
Tokyo Exchange
London etc
NASDAQ is a virtual exchange
Computer network
Criteria for Listing (NYSE)
More than 400 public shareholders
Revenue > $50 million
Assets > $75 million
Fail? You get delisted
e.g. Sharper Image (Feb 2008)
What then? Trades over the counter only
Big Investors Dont have to
Trade Through the Exchanges
ECNs (Electronic Communications Networks)
Examples: Island owned by NASDAQ, Archipelago owned by
NYSE; Bloombergs Tradebook
Essentially peer to peer
(like posting on a private Craigslist)
Last month only 34 percent
of NYSE-listed shares were
actually traded on the NYSE
For big blocks of stock
Why they dont
trade on the
exchange
Sidebar on Flash Trading
60 percent of all
trades are executed
by computers and
the stocks are held
for less than 11
seconds
See Nickels p.
535 Program
Trading
Flash Trading
Good
Provides liquidity in the
market
= Someone (some
computer) to quickly buy
when you want to sell
Flash Trading
Good
Provides liquidity in the
market
= Someone (some
computer) to quickly buy
when you want to sell
Less Good
Computers can make
very large bets
Sometimes they bet in
the same direction
May 6th, 2010 flash crash
10 percent down in a few
minutes
One firm entered an order
for $4 billion of derivatives,
causing other computer to
detect panic
Flash Trading
What are the public policy issues
here?
Issuing Shares
Firm (Board of Directors) can decide how
many shares to divide the company into
They can issue more
(e.g. BHP takeover of Rio Tinto: Well give you
one of our shares)
Firm can buy back its own shares
(e.g. Gap buying back $1 billion)
Why not just pay
a dividend?
Definition: Market Capitalization
Definition: Shares trading X Price
You can look up an instant figure on
Yahoo! Finance
Example: GOOG (Google)
333 million shares outstanding
Trading at: $515.04
Market Cap is $166 billion
Market Cap of the Exchanges
Total Market Cap NYSE
Sum of all
shares listed
Total Market cap $14 Trillion (Jan 2011)
Total Market Cap NASDAQ
About $2 trillion
Both have about 3,000 companies listed
Point of reference, all of Japan and all of Chinas (ex-HK)
listed stocks each are about $3 Tr.
An Introduction to
Stock Indexes
Just like calculating your GPA
An Index is a Measure of the
Market: Howm I doin?
You could calculate all kinds of GPAs:
Cumulative GPA (all courses)
Current GPA
GPA in Haas pre-reqs
You can make an index of anything you
want, e.g. Morgan Stanley China Index
NASDAQ Composite
as an example
Add up all the market
caps (stock price X
shares outstanding)
of all the companies
listed
Divide by some
constant to get a
manageable number
Standard & Poors 500
Most common measure of the
broad market (NYSE, NASDAQ)
Not quite the largest 500 stocks
Nickels,
in the US markets
p. 534
Read the text on this
An Index is just like taking your
temperatureits an indicator,
but it doesnt you tell whats wrong
Dow Jones Industrial Average
30 stocks
Not market cap!
Just adds up the price
Weightlifting: A (0.5 units)
Organic Chem: C (6 units)
Is your GPA a B ?
Companies with high prices over-dominate
More
Then divide by a constant
Stocks are chosen by committee of Dow Jones
Representative
Of what? Industry? All US stock market activity?
(see The Apple problem, 2 slides ahead)
The Problem of price-weighted not
market cap weighted DJIA
Chevron closed at $92.59
Bank of Amer closed at $6.12
Moves in the
most expensive
stocks dominate
the index
current value of the DJIA Divisor is 0.132129493
CVX goes up 10 percent, DJIA rises $9.26/0.13 = 71 points
BAC goes up 10 percent, DJIA rises 1.6/0.13 = 5 points
Bank of America has been
dragging the Dow down
One year
Imagine if Apple had been in the
Dow Jones IA:
Broader Market Indices
Russell 3000
Largest 3,000 US listed companies
Dont confuse with Russell 2000 which is a small-cap
index (8 percent of total market capitalization)
Summed up, it is 98 percent of the US equity
market (large and small cap stocks)
Not as interesting to watch day-to-day, but
Better for investing [look for a total market ETF]
Diversification Manages Risk
Portfolios, Mutual Funds
and ETFs
Constructing a Portfolio
Owning shares of Google and Yahoo!
would be a bad idea
If GOOG does well, YHOO will do less well
If all Internet stocks are doing poorly, both shares
will go down
A portfolio means a group of shares that
are not in the same industry
A Portfolio Diversifies Risk
Market risk is the risk that the whole stock
market will go down
Unique risk is the risk that GOOG will go
down
Owning a portfolio of 9 or 10 companies in
different industries (e.g. Boeing, Gap,
Google) protects you from unique risk
When one stock is down, another is up
(Of course, you are still at risk for the whole market
tanking [going down])
Mutual Funds
Small investor gives money to company
(e.g., Fidelity, Franklin Investments)
MF Company pools with other investors money,
now has $1 Billion to invest
MF Company buys lots of different stocks
An instant portfolio!
They use professional advice to choose winners
Most popular way for retail investors (your
grandpa) to invest: $10.6 trillion
Criticisms of Mutual Funds
1. On the average they do no better than
buying the market (i.e. all Russell 3000
shares)in fact 85 percent of them underperform
2. High expenses (to pay for advertising!)
3. You can only sell at the close of trading
each day
4. Last quarters hot fund is likely to
underperform in the next quarter
Exchange Traded Funds (ETFs)
An important innovation of the 1990s
Like mutual funds, they also pool investments
Company acts only as a trustee
no stock picking
Hence, low fees
About $656 billion invested in about 700 ETFs
Definition: ETFs
A fund that tracks a particular stock index
(The index is chosen by someone else)
Trustee (bank) buys
all the stocks in the index
Buys more if more inflows of cash to the ETF
Sells in the market if people want cash back
Traded on the exchange
No active management
No attempt to pick the best stocks of the group
Advantages of (ETFs)
Many different funds
(for many investor demands)
E.g. SPDR (spiders) all stocks in the S&P 500
QQQQ (cubes) the top-100 of the NASDAQ
DIA (diamonds) stocks of the Dow-Jones IA 30
You can get a specialized ETF, e.g. one that only
has shares of companies in Thailand
They are suitable for your 401(k) or IRA
Disadvantages of (ETFs)
You avoid unique risk but you also dont pick a
winner
So, you are giving up some potential for a positive surprise
If one firm beats a rival, you own both the winner and the
loser
(All you are doing is betting on the success of the
industry (sector)
Some warnings about
certain types of ETF
1. Avoid funds that are too narrow
Highly specialized funds result in undiversified risk
Example, video-game only ETFthere are too few
companies, so it owns lots of shares in each one
1. Avoid leveraged ETFs
They take your $100 and borrow another $100 to invest.
Good news, if the market goes up you make nearly double,
Bad news: Guess what happens if the market goes down?
Summary about stock markets
and indexes
The day-to-day price is the result of supply/demand for a
particular stock (battle between greed and fear)
The long-run price is the markets judgment of the
companys earnings prospects in the future
Investors dont worry about dividends, they are
concerned about total return
An index is a summary of market conditions
You can avoid some risk by constructing a portfolio of
shares in different industries
ETFs will do this for you
Appendix
Price/Earnings Ratio
A way to compare the price of
different stocks
How Many Calories in a Slice of Pizza?
How Many Calories in a Slice of Pizza?
Well, it depends on:
1. How big is the pizza
2. How many slices you cut it into
Hey! Walmart is cheaperit must be a
better investment
Google
Stock price: $610.04
Walmart
Stock price: $51.75
Different slices, different pizzas:
Google
Market cap: $196.14 Bn
Walmart
Market cap: $183.66 Bn
Shares outstanding:
321.52 million
Shares outstanding:
3.55 billion
Stock price: $610.04
Stock price: $51.75
Hmm, how do I
know which one
is the better
investment ?
Hmm, how do I
know which one
is the better
investment ?
Remember, what investors care about is
earnings, not dividends
Lets ask:
How much earnings for each share?
No! Better:
How much earnings for each $1 I invest?
Definition: Price/Earnings Ratio
Price of one share, divided by the
earnings-per-share
Look up the earnings per share
Google
Market cap: $196.14 Bn
Walmart
Market cap: $183.66 Bn
Shares outstanding:
321.52 million
Shares outstanding:
3.55 billion
Stock price: $610.04
Stock price: $51.75
Earnings per share: $26.31
Earnings per share: $4.46
Calculate the P/E Ratio
Google
Market cap: $196.14 Bn
Walmart
Market cap: $183.66 Bn
Shares outstanding:
321.52 million
Shares outstanding:
3.55 billion
Stock price: $610.04
Stock price: $51.75
Earnings per share: $26.31
Earnings per share: $4.46
P/E Ratio 23.19
P/E Ratio
11.60
How to understand the P/E Ratio
Google
P/E Ratio 23.19
Walmart
P/E Ratio
Hmm, Id have to pay $23.19
for a dollar-a-year earnings
from Google, but only $11.60
for a dollar of earnings of
Walmart.
11.60
Some cautions on:
Price/Earnings Ratio
1. The usual figure quoted is the trailing
P/E (based on todays stock price and the
trailing 12 months earnings (ttm)
2. Of course, what we should really care
about is the future 12 months earnings
Y! Finance calculates this for you
Obviously its only an estimate or guess
Y! Finance shows the forward P/E Ratio
Google
Future P/E Ratio 15.19
Walmart
Future P/E Ratio
Remember these are
estimates. While these
numbers are closer, you can
see that investors are betting
that Google will in fact grow
faster in the future than in the
past.
10.60
Better than forward P/E Ratio:
the PEG Ratio (P/E Growth Ratio
! This is beyond the scope* of ugba-10
just a preview for future finance classes !
Instead of just look ahead to next year,
adjust the P/E ratio:
Divide by the estimated rate-of-growth of earnings
per share
Rate of growth next 5 years is typical
Its also shown on Y! Finance
[The Wikipedia article on this is quite good]
* You will not be tested on this