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Chapter Ten
The Stock Market and The Efficient Market Hypothesis
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Copyright © 2003 Pearson Education, Inc. Slide 10–3
Stock
1. Represents ownership in a firm
2. Earn a return in two ways– Price of the stock rises
over time– Dividends are paid to the
stockholder
3. Stockholders have claim on all assets
4. Right to vote for directors and on certain issues
5. Two types– Common stock
• Right to vote• Receive dividends
– Preferred stock• Receive a fixed dividend• Do not usually vote
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Copyright © 2003 Pearson Education, Inc. Slide 10–4
Figure 9-9: Wien Consolidated Airlines Stock
Sample Corporate Stock Certificate
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Copyright © 2003 Pearson Education, Inc. Slide 10–5
Stock Prices
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Copyright © 2003 Pearson Education, Inc. Slide 10–6
30 Stocks in the Dow Jones Industrial Average
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Copyright © 2003 Pearson Education, Inc. Slide 10–7
Stock Market Indexes
Graph of Dow Jones Industrial Averagehttp://finance.yahoo.com/q?s=^DJI&d=c&k=c1&a=v&p=s&t=my&1=on&z=m&q=l
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Copyright © 2003 Pearson Education, Inc. Slide 10–8
Public Issues of Stocks and Bonds
• Two principal ways to sell securities to the public
– Investment bankers – Private placement
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Copyright © 2003 Pearson Education, Inc. Slide 10–9
Computing the Price of Common Stock
• Basic Principle of Finance
Value of Investment = Present Value of Future Cash Flows
• One-Period Valuation Model
P0 Div1
1 ke
P11 ke
(1)
Stock market interest chartshttp://stockcharts.com/charts/historical
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Copyright © 2003 Pearson Education, Inc. Slide 10–10
Generalized Dividend Valuation Model
• Since last term of equation is small, Equation 2 can be written as
P0 D1
1 ke 1
D2
1 ke 2 ... Dn
1 ke n
Pn1 ke n
P0 Dt
1 ke tt1
(2)
(3)
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Copyright © 2003 Pearson Education, Inc. Slide 10–11
Gordon Growth Model
• Assuming dividend growth is constant, Equation 3 can be written as
P0 D0 1 g 1
1 ke 1 D0 1 g 2
1 ke 2 ... D0 1 g
1 ke (4)
• Assuming the growth rate is less than the required return on equity, Equation 4 can be written as
P0 D0 1 g ke g
D1
ke g (5)
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Copyright © 2003 Pearson Education, Inc. Slide 10–12
Price Earnings Valuation Method
P
EE P (6)
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Copyright © 2003 Pearson Education, Inc. Slide 10–13
Reasons for Errors in Valuation
1. Problems with estimating dividend growth
2. Problems with estimating risk
3. Problems with forecasting dividends
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Copyright © 2003 Pearson Education, Inc. Slide 10–14
Efficient Market Hypothesis
• Expectations equal to optimal forecasts implies
R Pt1 Pt C
Pt(7)
Pt1e Pt1
of Re Rof
• Market equilibrium
(8)
• Put (8) and (9) together: efficient market hypothesis
Re Pt1e Pt CPt
Re R*(9)
Rof R*(10)
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Copyright © 2003 Pearson Education, Inc. Slide 10–15
Efficient Market Hypothesis
• Why efficient market hypothesis makes sense
• All unexploited profit opportunities eliminated
• Efficient market condition holds even if there are uninformed, irrational participants in market
If Rof R* Pt Rof
If Rof R* Pt Rof
until Rof R*
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Copyright © 2003 Pearson Education, Inc. Slide 10–16
Evidence on Efficient Market Hypothesis
• Favorable Evidence
1. Investment analysts and mutual funds don't beat the market
2. Stock prices reflect publicly available info: anticipated announcements don't affect stock price
3. Stock prices and exchange rates close to random walk; if predictions of ∆P big, Rof > R* predictions of ∆P small
4. Technical analysis does not outperform market
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Copyright © 2003 Pearson Education, Inc. Slide 10–17
Evidence on Efficient Market Hypothesis
• Unfavorable Evidence1. Small-firm effect: small firms have abnormally high returns
2. January effect: high returns in January
3. Market overreaction
4. Excessive volatility
5. Mean reversion
6. New information is not always immediately incorporated into stock prices
• Overview1. Reasonable starting point but not whole story
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Copyright © 2003 Pearson Education, Inc. Slide 10–18
Implications for Investing
1. Published reports of financial analysts not very valuable
2. Should be skeptical of hot tips
3. Stock prices may fall on good news
4. Prescription for investor– Shouldn't try to outguess market
– Therefore, buy and hold
– Diversify with no-load mutual fund