Stocks and the Stock Market

Primary and Secondary Markets

Stocks are ownership shares in corporations, and their trading occurs in organized markets. Understanding the distinction between primary and secondary markets is fundamental in financial accounting and investing.

• Primary Market: The market for the sale of new securities by corporations. This is where companies raise capital by issuing new shares to investors.

• Initial Public Offering (IPO): The first offering of stock to the general public, marking a company's entry into public trading.

• Secondary Offering: Occurs when a corporation sells additional shares after the IPO.

• Secondary Market: The market in which previously issued securities are traded among investors. Examples include the New York Stock Exchange (NYSE) and NASDAQ.

Common Stock and Key Terms

Common stock represents ownership in a publicly held corporation and entitles shareholders to voting rights and dividends.

• Dividend: A periodic cash distribution from the firm to shareholders, typically paid out of profits.

• P/E Ratio (Price-Earnings Ratio): The ratio of stock price to earnings per share, used to assess valuation.

Bid and Ask Prices

Stock transactions occur at bid and ask prices, reflecting the willingness of buyers and sellers.

• Bid Price: The price at which investors are willing to buy shares.

• Ask Price: The price at which current shareholders are willing to sell their shares.

Example: Calculating Purchase Cost, P/E Ratio, and Dividend Yield

Suppose you wish to purchase 100 shares of FedEx at an ask price of $167.43.

• Investment: $100 \times 167.43 = $16,743

• P/E Ratio:

• Dividend Yield: , or 1.55%

Stock Price History

Stock prices fluctuate over time due to market forces, as illustrated by the price history chart for FedEx.

Market Values, Book Values, and Liquidation Values

Definitions

Understanding the different measures of a firm's value is essential for financial analysis.

• Book Value: The net worth of the firm according to the balance sheet (assets minus liabilities).

• Liquidation Value: The proceeds that could be realized by selling the firm's assets and paying off its creditors.

• Market Value Balance Sheet: A financial statement that uses market value of all assets and liabilities.

Comparison Table: Market Value versus Book Value (July 2020)

Going Concern Value

The difference between a firm's actual market value and its liquidation or book value is attributable to its "going-concern value." This reflects the firm's ability to continue operating and generating profits.

• Factors of Going Concern Value:

  • Extra earning power

  • Intangible assets (e.g., brand, patents)

  • Value of future investments

Valuing Common Stocks

Stock Valuation Methods

Stocks can be valued using several approaches, each with its own strengths and limitations.

• Valuation by Comparables: Comparing a firm's valuation ratios to those of similar companies.

• Ratios and Multiples: Common ratios include the P/E ratio and market-to-book ratio.

• Intrinsic Value: The present value of future cash payoffs from a stock or other security.

• Dividend Discount Model (DDM): A discounted cash-flow model that values a stock based on the present value of expected future dividends.

Comparison Table: Valuation by Comparables (May 2020)

Dividend Discount Model (DDM)

The DDM states that the value of a stock equals the present value of all expected future dividends. This is a key model in financial accounting for equity valuation.

• General Formula: Where is the current price, is the dividend in year , is the required rate of return, and is the expected price at the end of the horizon.

• Perpetuity (No Growth): Used when dividends are expected to remain constant indefinitely.

• Constant-Growth DDM (Gordon Growth Model): Where is the constant growth rate of dividends.

Example: Constant-Growth DDM

If a stock expects to pay a $0.86 dividend next year, with dividends growing at 4.75% per year and a required return of 7.0%:

Sustainable Growth Rate

The sustainable growth rate is the rate at which a firm can grow its earnings, assuming it retains a constant fraction of earnings and maintains its return on equity (ROE).

• Formula: Where the plowback ratio is the fraction of earnings retained by the firm.

Present Value of Growth Opportunities (PVGO)

PVGO represents the present value of a firm's future investments and growth opportunities, calculated as the difference between the value of a firm with growth and without growth.

Additional info:

• These notes cover topics directly relevant to Financial Accounting, including stock market operations, valuation methods, and the interpretation of key financial ratios and statements.

• Tables have been reconstructed from the images and text, with logical entries preserved.