Stock Market Indicators Stock market indicators have come to perform a variety of functions,
Stock Market Indicators Stock market indicators have come to perform a variety of functions,
from serving as benchmarks for evaluating the performance of profes- sional investors to answering the question “How did the market do today?” Thus, stock market indicators (indexes or averages) have become
a part of everyday life. The most commonly quoted stock market indicator is the Dow Jones Industrial Average (DJIA). Other stock market indicators cited in the financial press are the Standard & Poor’s 500 Composite (S&P 500), the New York Stock Exchange Composite Index (NYSE Composite), the Nasdaq Composite Index, and the Value Line Composite Average (VLCA). Other stock market indicators include the Wilshire stock indexes and the Russell stock indexes, which are followed primarily by institutional money managers.
In general, market indexes rise and fall in fairly similar patterns. Although the correlation is high, the indexes do not move in exactly the same ways at all times. The differences in movement reflect the different ways in which the indexes are constructed. Three factors enter into that construction: the universe of stocks represented by the sample underly- ing the index, the relative weights assigned to the stocks included in the index, and the method of averaging across all the stocks.
Some indexes represent only stocks listed on an exchange. Examples are DJIA and the NYSE Composite, which represent only stocks listed on the Big Board. By contrast, the Nasdaq Composite Index includes only stocks traded over the counter. A favorite of professionals is the S&P 500 because it contains both NYSE-listed and OTC-traded shares.
FOUNDATIONS
Each index relies on a sample of stocks from its universe, and that sam- ple may be small or quite large. The DJIA uses only 30 of the largest corporations, while the NYSE Composite includes every one of the NYSE listed shares. The Nasdaq Composite Index also includes all shares in its universe, while the S&P 500 has a sample that contains only 500 of the more than 8,000 shares in the universe it represents.
The stocks included in a stock market indicator must be combined in certain proportions, and each stock must be given a weight. The three main approaches to weighting are these: (1) weighting by the market capitaliza- tion of the stock’s company, which is the value of the number of shares times price per share; (2) weighting by the price of the stock; and (3) equal weight- ing for each stock, regardless of its price or its firm’s market value. With the exception of the Dow Jones averages (such as the DJIA) and the VLCA, all of the most widely used indices are market-value weighted. The DJIA is a price-weighted average, and the VLCA is an equally weighted index.
Stock market indicators can be classified into three groups: (1) those produced by stock exchanges based on all stocks traded on the exchanges; (2) those produced by organizations that subjectively select the stocks to be included in indices; and (3) those where stock selection is based on an objective measure, such as the market capitalization of the company. The first group includes the New York Stock Exchange Composite Index, which reflects the market value of all stocks traded on the exchange. Although it is not an exchange, the Nasdaq Composite Index falls into this category because the index represents all stocks tracked by the Nasdaq system.
The three most popular stock market indicators in the second group are the Dow Jones Industrial Average, the Standard & Poor’s 500, and the Value Line Composite Average. The DJIA is constructed from 30 of the largest blue-chip industrial companies. The companies included in the average are those selected by Dow Jones & Company, publisher of the Wall Street Journal. The S&P 500 represents stocks chosen from the two major national stock exchanges and the over-the-counter market. The stocks in the index at any given time are determined by a committee of Standard & Poor’s Corporation, which may occasionally add or delete individual stocks or the stocks of entire industry groups. The aim of the committee is to capture present overall stock market conditions as reflected in a very broad range of economic indicators. The VLCA, produced by Value Line, Inc., covers a broad range of widely held and actively traded NYSE, AMEX, and OTC issues selected by Value Line.
In the third group, we have the Wilshire indexes produced by Wilshire Associates (Santa Monica, California) and Russell indexes produced by the Frank Russell Company (Tacoma, Washington), a consultant to pension funds and other institutional investors. The criterion for inclusion in each of these indexes is solely a firm’s market capitalization. The most comprehen-
Securities and Markets
sive index is the Wilshire 5000, which currently includes more than 6,500 stocks, up from 5,000 at its inception. The Wilshire 4500 includes all stocks in the Wilshire 5000 except for those in the S&P 500. Thus, the shares in the Wilshire 4500 have a smaller capitalization than those in the Wilshire 5000. The Russell 3000 encompasses the 3,000 largest companies in terms of their market capitalization. The Russell 1000 is limited to the largest 1,000 of those, and the Russell 2000 has the remaining smaller firms.
Does it matter in which market a corporation’s securities are traded? Yes and no. It is desirable to have your securities traded in a market where there is sufficient activity so that an investor who wants to buy or sell the security can do so readily. Therefore, the marketability that the market provides to the security is important. The more easily a security can be bought and sold, the less its marketability risk, which is the risk than an owner will not be able to sell the security when he or she wants to sell it. Investors are willing to take a lower return when the marketability risk is lower, allowing the corporation to raise additional funds at a lower cost. Therefore, firms want to list their stocks in a mar- ket that provides marketability for the stock.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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