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Chapter 9

Stock Valuation

Learning Objectives
1. List and describe the four types of secondary markets. 2. Explain why many financial analysts treat preferred stock as a special type of bond rather than as a true equity security. 3. Describe how the general dividend-valuation model values a share of stock. 4. Discuss the assumptions that are necessary to make the general dividend-valuation model easier to use, and be able to use the model to compute the value of a firm’s stock. 5. Explain why g must be less than R in the constant-growth dividend model. 6. Explain how valuing a preferred stock with a stated maturity differs from valuing a preferred stock with no maturity date, and be able to calculate the price of a share of preferred stock under both conditions.

I.Chapter Outline
9.1The Market for Stocks
• Equity securities are certificates of ownership of a corporation. • Households dominate the holdings of equity securities, owning more than 36 percent of outstanding corporate equities. A. Secondary Markets

• In secondary markets, outstanding shares of stock are bought and sold among investors. • An active secondary market enables firms to sell their new debt or equity issues at a lower funding cost than firms selling similar securities that have no secondary market. B. Secondary Markets and Their Efficiency

• In the United States, most secondary market transactions are conducted on one of the many stock exchanges. ▪ In terms of total volume of activity and total capitalization of the firms listed, the NYSE is the largest in the world and NASDAQ is the second largest. ▪ In terms of the number of companies listed and shares traded on a daily basis, NASDAQ is larger than the NYSE. ▪ Firms listed on the NYSE tend to be, on average, larger in size and their shares trade more frequently than firms whose securities trade on NASDAQ. • There are four types of secondary markets, and each type differs according to the amount of price information available to investors, which in turn, affects the efficiency of the market. 1. Direct Search

▪ The secondary markets farthest from our ideal of complete price information are those in which buyer and seller must seek each other out directly. ▪ It is too costly to perform a thorough search among all possible partners done to locate the best price. ▪ Securities that sell in direct search markets are usually bought and sold so infrequently that no third party, such as a broker or dealer, finds it profitable to serve the market. ▪ The sales of common stock of small private companies and private placement transactions are good examples of direct search markets. 2. Broker

▪ Brokers bring buyers and sellers together to earn a fee, called a commission. ▪ Brokers’ extensive contacts provide them with a pool of price information that individual investors could not economically duplicate themselves. ▪ By charging a commission fee less than the cost of direct search, brokers give investors an incentive to make use of the information by hiring them as brokers. 3. Dealer

▪ Market efficiency is improved if there is someone in the marketplace to provide continuous bidding (selling or buying) for the security. ▪ Dealers provide this service by holding inventories of securities, which they own, then buying and selling from the inventory to earn a profit. ▪ Dealers earn their profits from the spread on the securities they trade—the difference between their bid price (the price at which they buy) and their offer price (the price at which they sell). ▪ The advantage of a dealer over a brokered market is that brokers cannot guarantee that an order will be executed promptly, while dealers can because they have...
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