Chapter 13
The Stock Market
Investing in Stocks
Common Stock vs. Preferred Stock
How Stocks Are Sold
Computing the Price of Common Stock
The One-Period Valuation Model
The Generalized Dividend Valuation Model
The Gordon Growth Model
Price Earnings Valuation Method
How the Market Sets Security Prices
Errors in Valuation
Problems with Estimating Growth
Problems with Estimating Risk
Problems with Forecasting Dividends
Case: The 2007–2009 Financial Crisis and the Stock Market
Case: The September 11 Terrorist Attack, the Enron Scandal, and the Stock Market
Stock Market Indexes
Mini-Case Box: History of the Dow Jones Industrial Average
Buying Foreign Stocks
Regulation of the Stock Market
The Securities and Exchange Commission
◼ Overview and Teaching Tips
Because the market for stocks is of such great interest to students, this chapter has been expanded over
previous editions. It discusses theories of how stocks are priced and how information is incorporated into
stock prices. Laying out the simple models of the one-period valuation model, the generalized dividend
model, the Gordon model, and the P/E Valuation Method gives students the tools to understand how stock
prices are determined. However, stock market valuation is by no means simple, and this is emphasized to the
students in the section on errors in valuation which outlines why it is so tricky to use these simple models.
Begin this chapter by defining equity and show the difference between stocks which represent ownership
and bonds which represent no ownership of the company. Investors receive a return on their investment in
one of two ways: (1) price of stock rises or (2) firms issue stockholder dividends. Stock is either common
70 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
stock or preferred stock. With the increase of international trading, investors have gone to other countries
to buy securities. This is a growing market to the United States.
Trading of the capital securities will occur in two types of exchanges: organized exchanges and over-the-
counter exchanges. Popular organized exchanges are the New York Stock Exchange, also the largest, the
American Stock Exchange, and the London Stock Exchange.
This chapter contains extensive discussion of stock valuation. This provides an excellent opportunity to
discuss the efficient market hypothesis presented in Chapter 6.
Students should be instructed on the strengths and weaknesses of the stock indexes as well as the role of
the SEC in their regulation.
◼ Answers to End-of-Chapter Questions
1. The value of any asset is the present value of its future cash flows. The value of a bond is the PV of
2. There are two cash flows from stock, periodic dividends, and a future sales price. Dividends are
frequently changed when firm earnings either rise or fall. The future sales price is also difficult to
3. Organized exchanges have a physical building where business is conducted. They generally have a
4. NASDAQ is a computer network that allows traders to monitor stocks traded on the over-the-counter
market. It provides current bid and ask prices on about 4000 actively traded securities.
◼ Quantitative Problems
Ebay, Inc. went public in September of 1998. The following information on shares outstanding was listed
in the final prospectus filed with the SEC
1
.
In the IPO, the Ebay issued 3,500,000 new shares. The initial price to the public was $18.00 per share.
The final first-day closing price was $44.88.
1
This information is summarized from http://www.sec.gov/Archieves/edgar/data/1065088/0001012870–98–002475.txt
72 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
Solution:
0
0
(1 ) 0.80(1 )
, or 22.00 . Solving, 7.1%
0.11
e
Dg g
Pg
k g g
++
= = =
−−
7. Huskie Motor’s just paid an annual dividend of $1.00 per share. Management has promised
shareholders to increase dividends a constant rate of 5%. If the required return is 12%, what is the
current price per share?
