5.1 Equity Markets and Stock Valuation

Equity markets are the lifeblood of stock trading, connecting companies with investors. They include primary markets for new stock issues and secondary markets for trading existing shares, all facilitated by exchanges and various market participants.

Stock valuation methods help investors determine a company's worth. From fundamental analysis techniques like the Dividend Discount Model to technical analysis approaches, these tools guide investment decisions by considering both company-specific factors and broader market influences.

Equity Markets: Features and Functions

Primary and Secondary Markets

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• Equity markets serve as platforms for buying and selling publicly traded company shares
• Primary markets facilitate initial public offerings (IPOs) allowing companies to raise capital by issuing new shares
• Secondary markets enable trading of existing shares among investors providing liquidity and price discovery
• Both markets contribute to economic growth by facilitating capital allocation and promoting corporate governance

Stock Exchanges and OTC Markets

• Stock exchanges (NYSE, NASDAQ) act as organized marketplaces for equity trading
• Exchanges enforce regulations and listing requirements ensuring market integrity
• Over-the-counter (OTC) markets allow trading of unlisted stocks providing an alternative to traditional exchanges
• OTC markets offer flexibility for smaller companies or those not meeting exchange listing requirements

Market Participants and Their Roles

• Individual investors participate in equity markets to build personal wealth and achieve financial goals
• Institutional investors (mutual funds, pension funds) manage large portfolios on behalf of clients
• Market makers provide liquidity by continuously quoting buy and sell prices for specific stocks
• Brokers facilitate trades between buyers and sellers earning commissions on transactions
• Analysts research companies and provide investment recommendations to guide decision-making

Stock Valuation Methods

Fundamental Analysis Techniques

• Dividend Discount Model (DDM) values stocks based on present value of expected future dividend payments
• Price-to-Earnings (P/E) ratio compares stock price to earnings per share providing relative valuation metric
• Price-to-Book (P/B) ratio evaluates stock price relative to book value per share useful for asset-intensive companies
• Discounted Cash Flow (DCF) analysis estimates intrinsic value by projecting and discounting future free cash flows
• Comparable Company Analysis compares financial ratios of similar companies to determine relative valuation

Advanced Valuation Models

• Gordon Growth Model assumes constant dividend growth rate in perpetuity for valuing stocks with stable dividend policies
• Multi-stage growth models account for varying growth rates during different phases of a company's lifecycle
• Residual income model focuses on economic profit rather than dividends or cash flows
• Option pricing models (Black-Scholes) used to value stock options and assess equity value in complex capital structures

Technical Analysis Approaches

• Chart patterns (head and shoulders, double tops) used to identify potential price reversals or continuations
• Moving averages help smooth price data and identify trends (50-day, 200-day moving averages)
• Relative Strength Index (RSI) measures momentum and identifies overbought or oversold conditions
• Volume analysis examines trading volume to confirm price movements and gauge market sentiment

Factors Influencing Stock Prices

Company-Specific Factors

• Earnings reports and guidance significantly impact stock prices (quarterly earnings surprises)
• Revenue growth and profit margins indicate company's financial health and growth prospects
• Management quality and corporate governance practices influence investor confidence
• Product pipeline and innovation potential affect long-term growth expectations (new iPhone releases)
• Capital structure and debt levels impact financial flexibility and risk profile

Macroeconomic and Industry Factors

• Interest rates affect borrowing costs and relative attractiveness of stocks versus bonds
• Inflation rates impact purchasing power and company profit margins
• GDP growth indicates overall economic health influencing consumer spending and business investment
• Industry-specific trends shape competitive dynamics (shift to electric vehicles in automotive industry)
• Regulatory changes can significantly impact specific sectors (healthcare reform, environmental regulations)

Market Sentiment and External Events

• Investor psychology drives short-term price fluctuations (fear and greed cycles)
• Analyst reports and recommendations influence investor perceptions
• Social media and news coverage can rapidly spread information affecting stock prices
• Geopolitical events impact market stability (trade wars, political unrest)
• Natural disasters or pandemics can disrupt supply chains and consumer behavior

Intrinsic Value Calculation: Dividend Discount Model

DDM Formula and Components

• DDM expressed as $P_0 = \frac{D_1}{r - g}$ where:
  • $P_0$ represents current stock price
  • $D_1$ denotes expected dividend in next period
  • $r$ signifies required rate of return
  • $g$ indicates constant dividend growth rate
• Required rate of return (r) calculated using Capital Asset Pricing Model (CAPM) or risk-free rate plus risk premium
• Constant dividend growth rate (g) estimated based on historical growth, company fundamentals, and industry outlook

Model Assumptions and Limitations

• DDM assumes constant dividend growth rate in perpetuity
• Model requires stable payout ratio and dividend policy
• Assumes required rate of return exceeds growth rate ($r > g$)
• May not be suitable for non-dividend paying stocks or companies with irregular dividend patterns
• Sensitive to input assumptions particularly growth rate and required return estimates

Practical Application and Interpretation

• Calculate intrinsic value using DDM formula and compare to current market price
• Interpret results:
  • If intrinsic value > market price, stock considered undervalued
  • If intrinsic value < market price, stock considered overvalued
  • If intrinsic value ≈ market price, stock considered fairly valued
• Perform sensitivity analysis by varying key inputs (r and g) to understand range of possible intrinsic values
• Use DDM in conjunction with other valuation methods for more comprehensive analysis