Finance 205 Chapter 8

Stock Valuation

I) Difficulties of Common Stock Valuation

A) The first issue regarding common stock valuation is that the
cash flows investors will receive are not well defined
1) there are no preset dividend payments
dividends paid depend on earnings and on a vote each
year or quarter by the board of directors

2) dividends can go on forever and tend to grow

B) The second issue regarding common stock valuation is that the

rate of return required by the market on common stock is not
observable
can observe a stocks price, but not the cash flow the investor
expected to receive when he or she bought the stock
the expected cash flows are simply a belief, they are not
contractually stipulated the way they are for bonds
so cant determine the return required by any stockholder
because cant solve for a return linking the price a share of
stock sold for to the cash flows expected by the purchaser
when the price was settled

All rights reserved Kurt Wojdat

II) Dividend Discount Model

A) The current value of a share of stock to an investor who will
hold the stock for one year and then sell it is the present value of
any dividend received plus the present value of the price received
when the stock is sold
Example: How much would an investor pay for a share of
stock if the investor demanded a 25% return and knew the
stock would pay a $10 dividend after one year, after which it
could be sold for $70
Answer is PV of $80 to be received in one year or $80 / 1.25
= $64

In general P0 = (P1 + D1) / (1 + R)

where
P0 = stock price today (ex dividend, i.e., D0 not
included)
P1 = stock price in one period (ex dividend)
D1 = dividend paid in one period
R = markets required return
B) Stock returns over periods exceeding one year
1) In previous, need P1 to solve for P0.
But if there was a way to know P1 we could use it to
directly assess P0
All rights reserved Kurt Wojdat

2) So lets get rid of P1 which, using the above, equals

(P2 + D2) / (1 + R)
|
P0

|
P1
D1

|
P2
D2

|
P3
D3

|
P4
D4

subbing into P0 = (P1 + D1) / (1 + R) yields

P0 = [{(P2 + D2) / (1 + R)}+ D1] / (1 + R)
P0 = (P2 + D2) / (1 + R) 2 + D1 / (1 + R)
P0 = P2 / (1 + R) 2 + D2 / (1 + R) 2 + D1 / (1 + R)
3) But now need P2 which again we dont know so get rid of
P2 with P2 = (P3 + D3) / (1 + R)
P0 = P2 / (1 + R) 2 + D2 / (1 + R) 2 + D1 / (1 + R)
subbing above for P2
P0 = [(P3 + D3) / (1 + R)] / (1 + R) 2 + D2 / (1 + R) 2 +
D1 / (1 + R)
P0 = P3 / (1 + R) 3 + D3 / (1 + R) 3 + D2 / (1 + R) 2 +
D1 / (1 + R)
4) Then eliminate P3 P4 P5 etc. leaving
P0 = D1 / (1 + R) + D2 / (1 + R) 2 + D3 / (1 + R) 3 ++
D / (1 + R)

All rights reserved Kurt Wojdat

5) So stock price is the sum of discounted value of all the

expected dividends
a stock that was expected to never pay any dividends
would have zero value (the investor would never
receive anything, regardless of how valuable the firms
assets became)
although, a stock can be very valuable even if it pays no
dividends over some finite future period, as dividends
following that period could be huge
young, growing firms often pay no dividends in
their early life, to conserve cash to finance growth

III) Solving the dividend discount model: P0 = D1 / (1 + R) + D2 / (1 +

R) 2 + D3 / (1 + R) 3 ++ D / (1 + R)
For common stock, D may grow or shrink
But with some restrictions we get finite prices

IV) Case of constant dividend growth, but at a rate less than R;

i.e., g < R
A) Assuming constant growth in dividends yields
D1 = D0 (1 + g)
D2 = D1(1 + g) = [D0 (1 + g)] (1 + g) = D0 (1 + g)2
Dt= D 0(1 + g)t
D = D0 (1 + g)
All rights reserved Kurt Wojdat

B) This yields the following dividend discount model, assuming:

1) constant dividend growth (which companies often try to
achieve) and 2) that dividends will continue forever (for a long
time is sufficient)
P0 = D1 / (1 + R) + D2 / (1 + R)2 + + D / (1 + R) =
D0 (1 + g) / (1 + R) + D0 (1 + g)2 / (1 + R) 2 +
D0 (1 + g) / (1 + R)
the last term in the dividend discount model is then D0 (1 +
g) / (1 + R)
if g > R this term grows to infinity rather than diminishing to
zero, so we have no solution for P0 other than infinity
with g < R the later terms get very small and can be ignored,
which lets us solve for the dividend growth model: P0 = D1 /
(R g) {[D0 (1 + g)] / (R g)}, where P0 is the current ex
dividend price, and D1 is the next dividend, assumed to be
one period away
D1/(R-g) = of present value of all dividends
following D0

All rights reserved Kurt Wojdat

C) Example: what is the price of a share of common stock that will

pay a $3.15 dividend in one period if the stocks dividends grow
at 5% per period and the required return on the stock is 15%
3.15 / (.15 - .05) = $31.50
Note, D1 is given above
Could have asked what will be the ex dividend price of a
share of common stock that just paid a dividend (D0) of $3.00
(which new stockholder will not get), if the stocks dividends
are expected to grow at 5% per period and the required return
on the stock is 15%
answer of ($3.00 1.05) / (.15 - .05) = $31.50 is the
same as above given that ex dividend price at time t
excludes the time t dividend
D) Note, we can use the above model to solve for the price of
the stock on any date
Pt (ex dividend) = [Dt (1 + g)] / (R g) = Dt + 1 / (R g)
|
P0
D0

D1

D2

D3

|
P4
D4

D5

D6

D7

|.|
D8

Dt+1 = Dt (1+g)
P4 = D5 / (R - g)
= D4 (1 + g) / (R - g)

All rights reserved Kurt Wojdat

Example: Alpha Corporations next dividend (after one

period) will be $5. Dividends grow at 10% a year and the
market requires a 15% return on the stock of Alpha. What is
the current price (ex dividend) and what will be the price (ex
dividend) in 6 years?
|
P0
D0

$5

D2

D3

D4

D5

|
|
|.|
P6
D6 $8.86 D8
D

D7 = $8.86 = $5 (1.1)6 (six period between period one

and period seven)
P0 = D1 / (R - g) = $5 / .05 = $100
P6 = D7 / (R - g) = $8.86 / .05 = $177.20
E) Note that the ex dividend stock price now (P0) is D1 / (R g)
and the ex dividend stock price t periods hence (Pt) = Dt+1 / (R g)
therefore the growth in stock price over t periods equals
the growth in dividends over t periods, which is (1+g)t,
assuming constant growth and perpetual dividends
Pt = P0 (1+g)t
F) Also note, formula works for any growing perpetuity, as shown
in Chap 6
If C1 is next cash flow on a perpetuity having constant
growth, the present value = C1 / (R-g) as long as g < R
if g > R then present value is not negative, it is infinite
All rights reserved Kurt Wojdat

V) Case where dividends continue forever, and all dividends equal D0

In this case and we have an ordinary perpetuity with g = 0:
D / (1 + R) becomes very small and can be ignored.
P0 = D / R where D is the constant dividend (this is
formula for value of preferred stock)

VI) Nonconstant growth

Next consider a special case of pricing a stock for which there is a
period where dividend growth varies from year to year followed by
a period of constant dividend growth
Step 1: calculate the price that is based on the first dividend
that is part of the dividend stream with constant dividend
growth
then discount this price back to time 0

Step 2: add the present value of each dividend not included in

the above price, (i.e., paid during the period of varying
dividend growth)

All rights reserved Kurt Wojdat

Example: What is the current price of a share of stock that will pay
a $1 dividend in one year, followed by a $2 dividend in two years,
followed by a $2.50 dividend in three years, which dividend will
then grow at 5% a year? The required return on the stock is 10%.
The dividends are as follows
|
P0
D0

|
$1

|
P2
$2

$2.50 $2.50 $2.50 $2.50

x1.05 x1.052 x1.053

P2 = 2.50 / (.1 - .05) = $50 (book uses P3)

P0 = 50 / 1.12 + 2 / 1.12 + 1 / 1.1 = $43.88
Example (8.4): What is the current value of a stock if the dividend
just paid was $5 followed by three years of 30% growth in
dividends followed by 10% growth in dividends from then on?
The required return is 20%. (Note, growth can exceed required
return for a finite period of time, and still yield a finite stock price.)
|
$5

D1
D2
D3
D4
D5
|
|
|
|
|
$5
$5
$5 10.985 10.985
2
x1.3 x1.3 x1.33 x1.1 x1.12
6.50 8.45 10.985 12.0835

P2 = 10.985 / (.2 -.1) = 109.85

P0 = 109.85 / 1.22 + 8.45 / 1.22 + 6.50 / 1.2 = $87.57
NOTE: D4 would be $14.281 if 30% growth continued

All rights reserved Kurt Wojdat

Nonconstant growth consisting of two distinct growth rates can be

solved using a two stage growth model based on growing annuity
if dividends grow at g1 for t periods and then at g2 forever
then value of stock today (P0) is:
{[D0 (1+g1)] / (R g1)} {1 [(1+g1)/(1+R)]t} +
{[D0 (1+g1)t (1+ g2)] / (R g2)}/(1+R)t
g2 must be less than R, but g1 can be greater than R
equals present value of a perpetuity at g1 less present value of
missing portion of that perpetuity, plus present value of the
perpetuity replacing that which is missing
[$6.50 / (.2 - .3)] [1 (1.3 / 1.2)3] + [12.0835 / (.2 - .1)]/1.
= (-$65.00 -.27141) + (120.835/1.23) = $17.64 + $69.93 =
$87.5713
also equals:
[$6.50 / (.2 - .3)]
{[$14.281 / (.2 - .3)] / 1.23} +
[12.0835 / (.2 - .1)]/1.23

All rights reserved Kurt Wojdat

10

VII) Stock valuation using multiples

Stocks that dont pay dividends can be valued using ratios
Price earnings ratio can be used as follows:
Stock Price = Benchmark P/E ratio current earnings per
share
defining P/E ratio as stocks ending price divided by
earnings for the immediately preceding year
e.g., if earnings per share over the four most recent quarters
is $3 in total, and the benchmarked P/E is 30, then the
estimated value of the stock at the end of those four quarters
would be $90

the benchmark can be based on companies similar to the

subject company or it can be based on the subject companys
historical relationship between price and earnings
A target price can be estimated using this method
with the same benchmark P/E ratio, if earnings per
share for the upcoming year (next four quarters) is
expected to be $4, then the stock price in one year is
expected to be $120

All rights reserved Kurt Wojdat

11

The P/E ratio can be based on earnings expected to occur in

the future, called forward P/E ratio
calculation is same as above except it uses estimated
future earnings and a P/E ratio linking current stock
price to earnings for the immediately following year
(differs from discussion of target price)
e.g., if earnings for the next year are expected to
be $4, and the forward P/E ratio is 15, then the
stock price immediately prior to the beginning of
next year would be $60
For stocks without dividends or earnings a possibility is to use
sales per share in place of earnings per share and the price to sales
ratio in place of the benchmark P/E ratio

VIII) Stock valuation using dividends and a terminal price

Stocks may be valued by forecasting dividends for some time
period, and then using the stocks forecasted price at the end off
that time period, based on a method such as the P/E method
ending price captures all remaining dividends

Earnings tie to dividends by the payout ratio

payout ratio is: Dividends / Earnings
we will say, end of year dividend divided by the prior
years earnings

All rights reserved Kurt Wojdat

12

Example: A firm just paid a dividend of $2 per share. Dividends

are paid one year apart, and are expected to grow at a rate of 10%
per year for the next three years, and the growth rate after that has
not been evaluated. The payout ratio is 25%, and the benchmark
P/E ratio (end price (ex dividend) over preceding years earnings)
will remain at 15. What is the target stock price (ex dividend) in
three years? What is the stock price today if the required return on
the stock is 8%?
$2 (1.1)3 = $2.662 = D3;
.25 = $2.662 / $E3; E3 = $10.648
10.648 15 = $159.72 (terminal stock price, ex dividend; P3)
$2.20 / 1.08 + $2.42 / 1.082 + $2.662 / 1.083 + 159.72 / 1.083
= $133.02
IX) Components of a stocks return
We solved for P0 = D1 / (R g) [with continuous dividends and
constant dividend growth]
Solving for R yields: R = (D1 / P0) + g

All rights reserved Kurt Wojdat

13

The expected return on the stock for one period has two
components
1) Expected Dividend Yield: expected next cash dividend
paid at the end of 1 period divided by current price
2) Expected Capital Gains Yield: expected percentage growth
in price of stock during next period (price after next dividend
is paid encompasses all dividends paid after the next one)
we showed that expected percentage growth in price of
stock equals expected percentage growth in dividends,
if growth rate is constant
Example: A stock selling for $20 has an expected dividend of $1
in one year. Dividends on the stock have been growing at 13% for
the last ten years and dividends are expected to grow at 10% per
year into the future. What expected return does this stock offer
you?
1/20 + .1 = .15 = 15% which can be verified as below:
Price in one year will be based on dividend as of end of
second year, which is expected to be 10% higher than the $1
dividend expected in one year: (1 1.1) / (.15 - .1) = $22
Expected return over one year on $20 = $1 Dividend + ($22 $20) one years price appreciation:
$3 / $20 = 15%

All rights reserved Kurt Wojdat

14

X) Preferred Stock
1) Preferred stockholders must be paid a predetermined stated
liquidation value before common stockholders get paid in the
event firm is liquidated
2) Preferred stockholders are paid a pre-specified dividend
preferred dividend is a fixed amount stated in dollars per
share or as a percent of liquidation value, and generally does
not increase as the firm becomes more profitable
current preferred dividends must be paid before common
stockholder's can be paid current dividends
but common stock dividend this year is paid before
preferred dividend for next year
Cumulative preferred stock requires the payment of any
unpaid preferred dividends from previous periods, along
with the payment of the current preferred dividend, before
common shareholders can be paid current dividend.
Non cumulative preferred stock requires only current
preferred dividend to be paid before common shareholders
get current dividend.

All rights reserved Kurt Wojdat

15

Example: 100 shares of $100 par value preferred stock

paying a 5% dividend are issued on Jan. 1 2007. No
dividends are paid in 2007 or 2008. In 2009, the board plans
on paying dividends to the common stockholders.
What dividend must be paid to the preferred stockholders
before this can happen?
Cumulative preferred: ($5 for 2007 + $5 for 2008 + $5
for 2009) 100 = $1,500
Non cumulative preferred: ($5 for 2009) 100 = $500
3) Even though they are for a pre-specified amount, preferred
dividends are different from interest on bonds
Unpaid preferred dividends are not debts of firm
i) For non cumulative preferred they never need to be
paid
ii) For cumulative preferred stock, unpaid dividends
from previous periods are called Dividends in Arrears
not a legal liability but must be paid before
stockholders can get dividends
dividends in arrears do affect common
stock value but can not cause bankruptcy
there is no interest owed on dividends in
arrears

All rights reserved Kurt Wojdat

16

4) Preferred stock does not usually receive any voting right

but, preferred stockholders may receive voting rights if
preferred dividends go unpaid for a specified length of time
5) Some preferred stock is now issued with an obligatory sinking
fund
these preferred stock mature like debt, have fixed periodic
payments like debt, and entitle holder to a stated amount in
bankruptcy just like debt
although, differ from debt in that firm can suspend
payment of preferred dividends without causing
grounds for bankruptcy or incurring interest charge
by simply not declaring dividends
6) Other securities have been issued which look like preferred
stock but are treated as debt for tax purposes
makes payments tax deductible to firms; would not be if were
treated as preferred stock dividends for tax purposes
but payments are taxed to the investor as interest, which
currently is taxed at a higher rate than dividends

XI) Common Stock

A) Common stockholders have right to receive dividends
Dividends represent distribution of a firm's earnings and are
limited by a firms profitability
All rights reserved Kurt Wojdat

17

Firms not paying dividends are not in default and will not
have to enter bankruptcy
dividend payment and amount is based on decision of
board of directors
Common stockholders are residual claimants in that they
get dividends only after current interest is paid to creditors
and after preferred shareholders get current dividends plus
dividends in arrears (if preferred stock is cumulative)
but common stockholders are entitled to everything
remaining after other claims have been satisfied, and
common dividends can grow significantly over time
Note: current common stock dividend payment may affect
future interest payments and future preferred dividend
payments
extreme example, liquidate entire company, pay current
interest and current preferred dividend and then pay
entire remaining proceeds as a common dividend to
current common stockholders, leaving nothing for
following years interest or preferred dividend
bond covenants and courts limit this behavior
Dividends are taxable to individuals receiving them, but are
not tax deductible to the firm paying them
leads to double taxation, although the U.S. tax rate on
dividends for individuals is currently a reduced rate
All rights reserved Kurt Wojdat

18

But only 30% of common or preferred dividends received by

corporations are taxable income to the corporations that
received them, so only 30% is triple taxed
actually, if corp. owns more than 20% of other corp.,
exclusion is 80%, if corp. owns more than 20% but less
than 80% of other corp., exclusion is 80%, and if corp.
owns more than 80% of other corp. exclusion is 100%
B) Common shareholders also have the right to receive
distributions of firms value in the event of liquidation
This is a residual claim just as in the case of dividends
Common shareholders have the right, in the event of a
liquidation, to share proportionally in assets remaining after
liabilities, preferred shares liquidation value, any accrued
interest, and any dividends in arrears have been paid
C) Common stockholders control company via ability to control
who occupies management positions
Common stockholders vote for directors (usually at annual
shareholders meeting); directors appoint top executives
generally, one share one vote, not one shareholder one
vote, although see classes of stock
Some major issues, such as mergers, may be voted on by
stockholders directly

All rights reserved Kurt Wojdat

19

1) Straight Voting, each director position is voted on

separately
an owner of 50.000000001% of the stock can determine
who all the directors will be
owner of 49.999999999% of the stock may get no
representation on the board
2) Cumulative Voting, all director positions that are up for
election are voted on at the same time
each share gets a vote for each director running and
shareholder can pool votes
e.g. if four directors are up for election and you
own 100 shares you get 400 votes (generally)
which can all be cast for one director
If N directors are being selected, ownership of 1 / (N+1) of
the total outstanding shares plus one share by an
individual guarantees one director elected by that
individual if there is cumulative voting
Other stockholders would own {[N / (N + 1)] 1}
votes:
Split these votes across N directors
{[N / (N+1)] -1} / N = (1/ N+1) - some amount
at least one director position would get less
than 1 / N+1 of the votes of these other
stockholders
other stockholders cant win all N seats
All rights reserved Kurt Wojdat

20

Example: A Corp. has 18,000,000 shares outstanding and has

5 directors up for election. How many shares must Sue own
to guarantee one seat on the board if voting is cumulative?
1 / (5+1) 18,000,000 plus 1 = 3,000,001
Check: if each share gets 5 votes, 3,000,000 shares allow
15,000,000 votes for director Sue wants (ignoring the plus
one)
It would take 15,000,000 votes for each of five directors
other than Sues choice to prevent her choice from obtaining
a seat on the board
Other stockholders have 15,000,000 5 = 75,000,000 votes
(ignoring minus one)
spread as thin as possible to tie Sue's choice
Director A = 15,000,000
Director B = 15,000,000
Director C = 15,000,000
Director D = 15,000,000
Director E = 15,000,000
Creates 6 way tie, but Sue actually has 3,000,001 shares. She
has 5 more votes, and others have 5 less votes than above
Sue = 15,000,005
Director A = 15,000,005
Director B = 15,000,005
Director C = 15,000,005
Director D = 15,000,005
Director E = 14,999,975
All rights reserved Kurt Wojdat

21

Now change number of directors up for vote to 3. Sue needs

{[1 / (3+1)] 18,000,000} + 1 shares = 4,500,001 shares, at a
minimum, which, at three votes a share, gives her 13,500,003
votes
Sue = 13,500,003
Others have 13,499,999 3 = 40,499,997 votes
Director A = 13,500,003
Director B = 13,500,003
Director C = 13,499,991
If Sue had one less share her Director would get 3 less votes
and Director C could get 9 more votes as follows:
3 from share Sue no longer has, which will be owned
by others, and three each moved from votes for Director
A and Director B who would only need 13,500,000
votes to tie the votes Sues choice will get

The fewer directors elected each vote the higher the

percent of shares needed to guarantee one seat
need 50% of shares + 1 share to guarantee a seat on the
board if only one director is elected

State law often requires cumulative voting so owners of 40%

of stock don't get zero representation on board

All rights reserved Kurt Wojdat

22

Managers may wish to weaken effect of cumulative voting.

How can this be done?
Stagger elections; e.g., rather than vote for 12 directors
every 4 years, vote for 3 every year
this significantly raises amount of stock an
investor must acquire to guarantee a seat on the
board (N in each election is much smaller)
it can also make garnering immediate
control of board impossible even if
dissidents get their whole slate elected
further, staggered elections of board members can
be justified as serving the corporate interest via
providing some continuity of management from
year to year
staggered boards are often called classified boards as
directors are placed into different classes based on
when terns expire
corporations have faced pressure to declassify
their boards so all directors stand for election each
year

3) Proxy voting
A Proxy allows a shareholder to grant to another party
the right to vote the shareholder's shares of stock

All rights reserved Kurt Wojdat

23

Allows for a concentration of power

Can result in proxy fight where two or more
parties vie to get sufficient proxies to control a
vote, i.e., to elect their own directors
Current management will try to get as many
proxies as it can
Proxy can also serve as an absentee ballot where
shareholder states how the shares are to be voted

4) Voting rights for different classes of stock

Some stock classes may have more votes per share
than other classes, and some carry no votes at all
objective is to keep control of firm in one class
while raising equity capital by allowing investors
to purchase right to receive dividends
Ford Motor Company Class B, all owned by Ford
family interests and trusts, has 40% of voting power
even though it is less than 10% of the shares
NYSE does not allow dual classes but Ford trades on
NYSE
Google has Class A stock, held by outsiders, with one
vote per share, and Class B stock, held by insiders, with
ten votes per share

All rights reserved Kurt Wojdat

24

5) Preemptive Right
gives each share holder the right to buy a proportion of
any new stock issue equal to the percentage of all
outstanding stock that stockholder owns
limits managers ability to use stock issuances to dilute
control of firm exercised by an individual or group
Example: If Ed owns 200 shares of Alpha Corp. and
there are 1,000 shares of Alpha Corp. outstanding, then
Ed must be given the opportunity to buy 20% of any
new stock issue, if there is a preemptive right. If
management decides to issue an additional 1,000
shares, Ed must have the opportunity to buy 200,
assuming there is a preemptive right.
Ed can keep his ownership stake at 20% (400 /2,000) if
he can afford to purchase the additional 200 shares.

XII) Stock Markets

A) Distinction between primary and secondary markets
Primary market denotes when a firm obtains resources
such as cash by selling new securities such as stock (or
bonds, etc.) to investors; new claims
public offering: stock (or bonds) sold to general public
in the U.S., requires numerous SEC filings and
can entail expensive selling, accounting and legal
expense

All rights reserved Kurt Wojdat

25

private offering: stock (or bonds) sold to individual

party such as insurance company, or to a limited
number of parties
lower cost, no SEC registration required
Secondary market denotes when claims originally issued in the
primary market are traded among investors
issuing firm may be party in secondary market when
issuing firm is repurchasing its own stock, but issuing
firm is not receiving resources in secondary market
well established secondary market makes it easier for
firms to attract investors in the primary market
increases price firm can get for selling securities
in primary market as investor knows they can sell
investment in secondary market to recover at least
some cash
Primary versus secondary market distinction holds for bonds
and other securities as well as for stocks

All rights reserved Kurt Wojdat

26

B) Distinction between dealers, brokers

1) Dealers buy and sell on their own account
actually hold an inventory of securities, bearing the
associated risk
buy at bid price, sell at ask price, as discussed
previously, asked price will exceed bid price
bid ask spread is difference between bid price and
ask price and is one way dealers make a profit
2) Brokers serve to match buyers and sellers from clients
they represent

C) Distinction between auction markets and dealer markets

a) Auction market serves function of communication to link
buyers and sellers
Auction markets, such as NYSE, have had physical
location
note: technology has made this less critical

All rights reserved Kurt Wojdat

27

Auction markets such as NYSE are in business of

matching buyers with sellers of securities
brokers, or automated systems, match clients
wishing to sell with those wishing to buy
brokers involved in this market receive fees for
their service
broker does not own stock or bond being sold so
bears no direct loss if price of stock or bond goes
down
b) Dealer market consists of group of dealers who buy and
sell at their own risk
connected together electronically, e.g., Nasdaq
c) Products of above markets are:
1) knowledge of who is willing to buy and sell at
what prices and
2) actual transaction mechanisms
d) The objective of any exchange is to attract order flow
order flow is volume of trading conducted through the
exchange

All rights reserved Kurt Wojdat

28

D) NYSE
The NYSE was owned by its members, those with seats on
the exchange
Merger between NYSE and Archipelago Exchange, a large
electronic exchange involved members swapping seats for
shares in the new company, NYSE Group Inc
owners of Archipelago also received shares of stock
Merged with Euronext (Amsterdam based exchange with
subsidiaries in Belgium, France, U.K. and Portugal) to form
NYSE Euronext, which then merged with the American Stock
Exchange
Acquired by Intercontinental Exchange; which plans to spin
off Euronext
NYSE members (those with seats) had the right to participate
directly in the trades occurring within the exchange
buy and sell securities on the exchange floor without
paying commissions
In new corporate structure, ownership of the exchange is
imbedded in shares of the exchanges own stock, but trading
licenses sell separately from ownership interests
license is an annual fee

All rights reserved Kurt Wojdat

29

Different types of traders

1) commission brokers trade on behalf of clients who
pay the commission brokers to buy and sell stocks for
them, commission brokers have NYSE trading rights
commission brokers are responsible to trade at
best price available for their clients
2) floor broker is a party with NYSE trading rights that
executes the order of the commission broker, such as
when the commission broker is too busy to handle all
orders
SuperDOT system, which allows orders to be
transmitted electronically among brokers, has
reduced importance of floor brokers
3) designated market makers (DMMs) (formerly
specialists are firms with NYSE trading rights that act
as dealers for a particular stocks
they are market makers because they will buy or
sell for or from their inventory when buying and
selling investors can not be matched up
typically is one DMM per stock
they post, and continually update, bid and asked
prices; sell at asked price, buy at bid price
bid ask spread is their compensation
limits on quantity protect them from
mispricing
All rights reserved Kurt Wojdat

30

4) floor traders have NYSE trading rights and act on

their own account
try to anticipate temporary price fluctuations
Floor activity:
DMMs operate from posts on exchange floor
commission brokers can go to DMM posts to execute
orders for stocks assigned to each DMM
DMMs provide liquidity when commission
broker cant find counter-party to trade with
commission brokers can also try to directly find another
broker with a complementary position, e.g. selling what
first broker wants to buy or buying what first broker
wants to sell
direct dealing is mutually beneficial for both
brokers as selling broker can sell at price above
DMMs bid price to buying broker who can buy
below DMMs ask price
example: DMM bid price may be 25 and asked
price may be 25.10. Buying broker can buy
directly from selling broker at 25.05. Buying
broker pays less than would to DMM and selling
broker gets more than would from DMM

All rights reserved Kurt Wojdat

31

trading in the crowd refers to case where there are many

buying and selling commission brokers operating
around the designated market maker
DMMs then mostly function as referees to ensure
that all buyers and sellers receive a fair price

E) NASDAQ OMX Group

NASDAQ has been referred to as an over the counter market
because this term has been used for markets where dealers
buy and sell for their own inventories (used to do so over
counters, by phone, etc.)
NASDAQ (from acronym: National Association of Securities
Dealers Automated Quotation System) established computer
system to link securities dealers who posted bid and asked
prices and the number of shares that they are obligated to
trade on the system
dealers act as market makers by buying at the bid price
and selling at the ask price
NASDAQ has multiple market makers for each stock,
unlike NYSE
NASDAQ now has information from Electronic
Communications Networks (ECNs)
these are web sites that allow investors to directly trade
with one another
All rights reserved Kurt Wojdat

32

Investors buy and sell orders placed on the ECN are

transmitted to NASDAQ where they are displayed along with
market maker bid and ask price (although ECN does not see
all of Nasdaq)
allow investors to enter orders, not just market makers
An order book shows buy orders and sell orders available
these are limit orders designating number of shares and
most will be paid or least will be accepted (ECN order
book includes only ECN orders)
Order book also reveals the inside quotes, highest bid,
lowest ask:
Buy Orders
Shares
Price
500
$51.61
100
$51.54
100
$51.40
500
$51.36
1,000
$51.11

Sell Orders
Shares
Price
100
$51.64
500
$51.64
400
$51.65
400
$51.96
500
$51.96

For NASDAQ issues, can view bid and ask prices and recent
transactions on Web (See Investopedia.com Electronic
Trading: Level I, II and III Access)
bid and ask prices openly available for NASDAQ issues
represent the inside quotes (highest bid, lowest ask)
access to level II quotes, which may cost a fee, makes
available all the bid and ask quotes, which gives some
sense on what large size purchase may actually cost
All rights reserved Kurt Wojdat

33

NYSE DMMs also post bid and ask prices, but these have
not been disclosed to the public, and access has been costly
may change as NYSE integrates with electronic trading
NASDAQ purchased Swedish Finnish Financial Company
that controlled seven Baltic and Nordic Exchanges (OMX)
F) Stock Market Reporting (text version differs)
52-Week
YLD
VOL
NET
HI LO STOCK (DIV) % PE 100s CLOSE CHG
55.93 44.40 HarleyDav .84f 1.5 16 24726 54.25 +1.18
A
A
B (C)
D E
F
G
H
A) highest and lowest price in last 52 weeks
B) identifies the stock
C) annual dividend most recent dividend annualized (times 4
if dividend is quarterly as most are)
f means dividend was just increased
D) annual dividend (C) / closing price (G)
E) PE is a measure of how much is paid for the annual
earnings associated with one share of stock
closing price of one share of stock divided by earnings
per share (EPS) from most recent 4 quarters
EPS is firms total net income divided by the
number of shares outstanding
F) how many shares traded during the day (in hundreds)
G) last price at which trades occurred during the day
H) change in closing price from the previous day

All rights reserved Kurt Wojdat

34