Another way in which firms raise money is through stocks. Stocks are participations in the property
of a firm. They are different in at least two fundamental ways from stocks.
1. Holding a stock means bearing the risk of the business much more directly than for a bond-
holder. This implies that there are participation rights for stock-holders. Bond holder only have
participation when there is bankruptcy.
2. Stocks pay dividends which are decided by the firm. They come out of profits, when profits are
not payed out they are called RETAINED PROFITS.
The price of a stock will be the PV of its dividends:
∞
Qt = ∑ t
Dt
t =1 ∏(1 + is )
s =1
So, in theory the price of stocks should be a good signal of how a company is doing (what the outlook
for it should be). Since the people who hold the stocks have a right and interest to participate in the firm
and be informed, the price should reflect the information. This mechanism does not always work so
well. Stockholders are not always as well informed as we would expect and there are individuals with an
incentive and position for speculating and manipulating the price by distorting information.
A common way of looking at how expensive or cheap stocks are is the PRICE/DIVIDEND ratio.
Imagine a stock that produces a flow of dividends during its history. The price dividend ratio is
∞
Dt
∑ t
t =1 ∏(1+ is )
Pt
s=1
=
PDt = {Expected Dividends}
−T θ t Dt
∑ t
t =−1 ∏(1 + is )
s=1
where T is some period toward the past that we choose to estimate the dividends and θ is the weights
that we use to generate this number. There is always the argument against this measure that if a
company has not produced in the past it will in the future because it is investing at the beginning (that
was the argument arround most dotcoms). So we must choose a sufficiently long T that it is a good
representation of how the firms usually behave in the economy.
GENERAL POINTS ON STOCKS:
1. They are very hard to predict. There are many speculators trying to predict and arbitrag