Finance I - Lesson 6: Stock Valuation and Equity Markets
Stocks represent ownership stakes in companies, conferring upon shareholders a residual claim on assets and earnings as well as voting rights (depending on the class of shares). Unlike bonds, which offer fixed coupon payments and a set maturity, stocks deliver uncertain future dividends and potential capital gains. This lesson examines the essential features of equity, methods of stock valuation, and how shares trade in primary and secondary markets.
Differences between Stocks and Bonds
- Ownership vs. Lending: Stocks denote part-ownership in a company, whereas bondholders are creditors.
- Cash Flow Variability: Stock dividends are not guaranteed and may vary. Bond coupons are typically fixed.
- Priority of Claims: In liquidation, bondholders and other creditors are paid before shareholders.
- Potential Returns: Stocks offer higher upside if the firm grows, but also higher risk of loss.
Equity Valuation Concepts
The value of a stock is theoretically the present value of its expected future cash flows—often dividends or free cash flow. Several valuation models exist, each with its own assumptions.
Market Structure and Terminology
- Shares Outstanding: The total number of shares held by all shareholders, used to calculate market capitalization (price × shares outstanding).
- Market Capitalization: The firm’s total stock market value, useful for comparing companies of different sizes.
- Stock Indexes: Baskets of selected stocks (e.g., S&P 500, Dow Jones Industrial Average) that represent broader market performance.
- Primary Market: Where new shares are first sold to the public, typically via an IPO.
- Secondary Market: Where existing shares are bought and sold among investors (e.g., NYSE, NASDAQ).
Initial Public Offerings (IPOs)
When a private company decides to go public, it issues shares in the primary market. Underwriters (investment banks) help determine the offering price, buy shares from the company, and then sell them to the public for a spread or fee.
IPOs raise capital for the firm, enabling expansion or debt repayment, but the process can be costly and introduces public scrutiny and regulatory requirements.
Secondary Market Trading
The secondary market is where most stock transactions occur, allowing shareholders to buy or sell existing shares. Stock exchanges match buy and sell orders, establishing continuous price discovery. Key elements include:
- Limit Orders vs. Market Orders: Limit orders specify a maximum purchase or minimum sale price, while market orders execute immediately at the best available price.
- Bid-Ask Spread: The difference between the highest bid price and the lowest ask price; part of the transaction cost.
- Liquidity: A key factor in equity markets—stocks with higher trading volumes tend to have smaller bid-ask spreads and more stable prices.
Stock Price Influences
A host of factors affect stock prices. Broadly, they revolve around supply and demand forces, driven by:
- Earnings expectations, dividends, and growth potential
- Macroeconomic conditions, interest rates, and market sentiment
- Company-specific news (product launches, mergers, regulatory changes)
Example of Stock Price Movement
Below is a simplified chart illustrating hypothetical price movements for two different stocks over five trading sessions. Even short-term price patterns can vary significantly across firms, reflecting differing market perceptions and fundamentals.
Basic Stock Valuation Examples
| Scenario | Information | Valuation Approach |
|---|---|---|
| Constant Growth Dividend | Next dividend (D1) = $2, required return (r) = 10%, growth (g) = 4% | Value = D1 ÷ (r − g) = 2 ÷ (0.10 − 0.04) = $33.33 |
| Relative Valuation (P/E) | EPS = $3, sector average P/E = 15 | Stock Value = P/E × EPS = 15 × 3 = $45 |
Summary
Stock investing involves analyzing both the firm’s underlying fundamentals (expected dividends or cash flows) and market dynamics (investor sentiment, economic indicators). By grasping how equities differ from fixed-income instruments, understanding core valuation methods (dividend discount models, multiples), and appreciating the mechanisms of primary and secondary markets, learners acquire the tools to make more informed investment or financing decisions. Building this foundation in equity valuation sets the stage for risk-return analysis, portfolio construction, and advanced investment strategies in subsequent lessons.
Suggested Reading:
Investments by Zvi Bodie, Alex Kane, and Alan Marcus (chapters on stock valuation and market mechanics).
