Learning Unit #14Stock Market Analysis

IntroductionStocks vs. Bonds• Stocks are another type of financial instruments

that make payments in future. • Like bonds in Learning Unit #8, a value of stocks

is a present value of future cash flows from stocks.

• One important difference between stocks and bonds is uncertainty of future cash flows from stocks (future cash flows from bonds are know, given face value, maturity, and coupon rate).

• It is important to make good guess on future cash flows from stocks to make a good estimate of value of stocks.

Objectives of Learning UnitThis Learning Unit explains how a value of stock is estimated and how a stock market operates. It extends the present value model of bonds and the bond market framework, including• Valuation Model• Rational Expectations • Efficient Market Hypothesis• Stock Market Crash

How Stock Price Is Determined

Two basic approaches•Fundamental analysis: Evaluate value of stock based on fundamentals - the future cash flows and profitability of the business, and determine whether the market price is over- or under-valued. •Technical analysis: Predict a stock price from historical patterns. It does not care the value of stock.

Fundamental Analysis

Fundamental analysis has three components:•Rational Expectations: Predict the future cash flows and profitability of the business•Valuation Model: Determine the value of stock by discounting the predicted cash flows•Efficient Market Hypothesis: Buyers and sellers of stocks act based on the predicted value of stock – if the price is less than the predicted value (undervalued), it should be bought – and affect the demand and supply of stocks in market. As a result, the stock price reaches an equilibrium price equal to the predicted value.

Cash Flows on Stock

• Like bonds a value of stock is a present value of future cash flows from stock.

• Unlike bonds, stocks do not pay fixed coupon payments. Instead, they pay dividends.

• Unlike bonds, stocks do not have maturity, so dividends will be paid as long as corporations exit.

• Future cash flows from the stock:

0 1 2 3 ........

∞

P0

Div1 Div2 Div3

Dividend Valuation Model

• Dividend valuation model: The value of stock is the present value of future cash flows from the stock (dividends).

P0 : value of stock todayDivi: annual dividend payment between Year i-1 an Year ike : a required rate of return on stock

.....)k(1

Div)k(1

Div)k(1

DivP 3e

32

e

2

e

10

Required Rate of Return

• Required rate of return on stock is a risk-adjusted yield (interest rate) that saver/lenders demand for holding risky stocks. ke = if + RP where if is an interest rate on risk-free bonds and

RP is a risk premium on stock.• Stocks are riskier than bonds, because of more

uncertainty of future payments − Dividends will be paid only if firms make sufficient

profits.− In case of bankruptcy of firm, stockholders are

paid only after all creditors are paid out.

Valuation Models of Bond vs. Stock

The formula of dividend valuation model of stock is similar to the PV formula of bond, but they are different in• No maturity of stock means cash flows

to continue as long as a firm exist.• Future dividends on stock are not

known now, while future cash flows are known for bonds. More uncertainty on stock return. Higher return on stock.

One Period Valuation Model

• Instead of holding stocks indefinitely, if saver/lenders hold stocks for only one period (purchase today and sell next year), then a cash flow from stock will be

0 1

Div1 + P1

@ keP0

Div1: dividend payment from today to next year.P1: price of stock next yearKe: a required rate of return on stock

Value of Stock on One Period Valuation Model

• One Period Valuation Model: A value of stock today (P0) is a present value of dividend payment (Div1) from the stock between today and next year and a sales price of the stock next year (P1) discounted by the required rate of return (ke).

)1()1(11

0ee k

Pk

DivP

Note: If you purchase the stock at P0 today, receive Div1, and sell it at P1 next year, then according to the rate of return formula in Learning Unit #9 (rr = [c+Pt+1-Pt]/Pt) how much will be a rate of return from the investment? You should receive a rate of return of ke!

Example of One Period Valuation Model

• You want to purchase an IBM stock today. You plan to sell it at $87.99 next year and expect to receive $0.80 of dividends from today until next year. If the required rate of return on the IBM stock is 10%, the value of IBM stock today is

• If the default-risk free one-year T-bill yields 4% (if) and you want 6% risk premium on the risky IBM stock, then you ask for 10% required rate of return (ke) on the IBM stock.

Constant Dividend Valuation Model

• Constant Dividend Valuation Model: Dividend valuation model assumes variable dividends from one year to another. If dividends are assumed to be constant every year, the formula becomes

ekDiv

P 0

ekDiv

P 0

where Div is a constant annual dividend.

Note: If you purchase a stock at P0 today and expect to receive a constant dividend (Div) each year forever, then according to the current yield formula in Learning Unit #9 (i = C/P), you will earn an interest rate at ke.

Example of Constant Dividend Valuation Model• You want to purchase a stock of XYZ Corporation

today. You expect to receive $8.07 of dividends each year forever. If the required rate of return on the XYZ stock is 10%, the value of XYZ stock today is

70.80$10.007.8$P0

Alternatively, if you plan to sell this stock at $80.70 next year, then according to the one period valuation model the price of stock today must be

Thus, if the required rate of return remains constant, then the price of stock will not change in future.

Increasing Dividend Valuation Model

• Gordon growth model: If you expect a dividend from a stock increase each year at rate of g, then the cash flows will become

gkDiv

Pe

0 gkDiv

Pe

0 gkDiv

Pe

0

gkDiv.....

)k(1)g1(Div

)k(1g)(1Div

)k(1DivP

e3

e

2

2ee

0

0 1 2 3 ........

∞

P0

Div Div x (1+g) Div x (1+g)2

And the value of stock today should be

Example of Increasing Dividend Valuation Model• You want to purchase a stock of PQR Corporation

today. You expect to receive $4.84 of dividends next year and it will increase by 4% each year. The cash flows are

0 1 2 3 ........

∞

P0

$4.84 $5.03 $5.23

67.80$04.00.10

$4.84P0

If the required rate of return on the PQR stock is 10%, the value of PQR stock today is

Role of Expectations

• So far, to compute a value of stock we assume that we know future cash flows (dividends and price of stock in future).

• However, in reality we must make good guess (estimation) on future cash flows.

• Expectations are important in every sector and market in the economy.

− Saver/lenders’ demand for bonds − Spender/borrowers’ supply of bonds− Risk and term structure of interest rates− Inflation expectation (Fisher equation)− Future dividends on stock

How Expectations are Made

There are two ways to form expectations.• Adoptive expectations: Expectations are formed

from past experience only.– Changes in expectations are made slowly over time as past

information changes.• Rational expectations: Optimal forecasts (the

best guess of the future) using all available information.− Changes in expectations are made every time new

information arrives.• Do people make adoptive or rational expectations?

How about you? How about meteorologist?

Examples of Adoptive Expectations

• Under adoptive expectations people ignore new information relevant to decisions, but only concern with past behavior of variables to predict what will happen next on the variables.− Example #1: Quiz #1 through #3 were easy, so a student

expects the final examination will be easy also and decides not to prepare for it even though his teacher has told students that the final examination will be much more difficult. Will he do well or bomb the final examination?

− Example #2: Aggie baseball team won first two easy games against Greensboro College and Guilford college, so it is expected to win the third game against North Carolina (NCAA national champion). Will it happen?

− Example #3: Enron stock price continued to go up and up in 2000s, so savers expected its price to go up furthermore throughout 2001 even though its auditor confessed that it helped Enron to hide huge losses. So, what would happen to Enron stocks?

Rational Expectations

• Rational Expectations use all available information to form expectations.

• All available information include − the past information− all other economic and financial

information useful to predict the future outcome

− all techniques to predict futures

Examples of Rational Expectations

− Example #1: Quiz #1 through #3 were easy, however a student uses valuable information from his teacher (his teacher has told students that the final examination will be much more difficult) and prepares hard for the final examination.

− Example #2: Even though Aggie baseball team had two easy wins, they prepare hard for the next game against North Carolina since it will be very tough opponent (NCAA national champion).

− Example #3: Although Enron stock price continued to go up and up in 2000s, as soon as its auditor confessed that it helped Enron to hide huge losses, investors expected its price to fall and decided to get rid of Enron stocks.

Rational Expectations and Optimal Forecasts

A prediction based on rational expectations may not always be perfectly accurate.• Even if you use all available information, there is no

way to predict future perfectly.• The forecast errors of rational expectations will on

average be zero.− You should not systematically underestimate or

overestimate over a period of time.− You learns from the past mistakes.

• By using most recent information, forecast errors are most likely smaller than those from adoptive expectations.

Example #1 of Optimal Forecasts

• A student thought Quiz #1 was easy, so he did not prepare for it and bombed it. − Non-optimal forecast: He believed that it could

not be such difficult again, so he decided not to prepare for Quiz #2. Contrary to his expectation, Quiz #2 is as difficult as Quiz #1, so he bombs again (makes the same mistake again and again).

− Optimal forecast: He knew that he underestimated the difficulty, so he adjusted his expectation on Quiz #2 to be much more difficult and decided to prepare hard for Quiz #2. As expected, Quiz #2 is as difficult as Quiz #1, and this time he does well on Quiz #2, thanks to his preparation.

Example #2 of Optimal Forecasts

• Savers just heard a bad news about Enron (large hidden losses and illegal accounting practice).− They adjusted their expectations on dividends

from Enron to fall, so as the value of Enron stock.− Without knowing whole story, not many savers

expected Enron to be bankrupted and its stocks would become worthless.

• It is impossible to forecast perfectly stock prices in future.− There is always risk on stock investment.

Stock Market and Demand

• A price of stocks is determined by the demand and supply of the stocks in the market.

• The market price of stocks is equal to the value of the stocks.− If a market price of stocks is less than the value of the stocks (you

believe that Microsoft stock worth $50, but a market price of Microsoft stock is only $40), savers will purchase the stocks and the demand for the stocks increases. As a result, a market price of the stock rises to the value of the stocks.

− If a market price of stocks is higher than the value of the stocks (you believe that Yahoo stock worth $30, but a market price of Yahoo stock is $40), holders of the stocks will sell the stocks and the demand for the stocks decreases. As a result, a market price of the stocks falls to the value of the stocks.

Information and Market Price of Stock

• When a new information arrives, savers revise their expectations of cash flows from the stock and the value of the stocks accordingly, then compare it with a market price of the stocks and react accordingly. This will change the demand for the stocks and the market price of the stock

Example of Information and Market Price of Stock

• Originally, the market is at an equilibrium (market price of stock = value of stock)

• A bad news about a firm’s business Profits of the firm are expected to decline in

future. The firm is expected to decrease dividends on

its stocks in future. The value of firm’s stock The value of stock < Market price of stock Demand for the stock A market price of stock to its value Stock market restores its equilibrium.

Changes in Demand and Stock Price

• When the demand for stocks changes, the market (equilibrium) price of the stocks changes.

S

D0

D1

P0

P1

Price of stock

E0

E1

Example of Stock Price Quotation on Barron’s

• Dow Jones’ publishes quotations of various stock prices traded in New York Stock Exchange and NASDAQ every day on the Wall Street Journal and weekly on Barron’s. – See “How to Interpret Stock Price Quotation

of Barron’s” on Blackboard

Expectations and Stock Price

Stock prices are more volatile than bond prices.• Future dividends are unknown.• Many factors such as information about firm’s

operation and profit and the condition of the economy which may affect firm’s profit affect the formation of expectations on future dividends.

• Information arrive market any moment and affect expectations on future dividends.

• Every time information arrive, savers react to the information and affect the stock price.

Efficient Market Hypothesis

• Efficient market hypothesis: The market price of any asset reflects all (publicly) available information.− When a good news about a firm arrives, savers revise their

expectations on future dividend payments and raise the value of the stock. As the value of the stock becomes greater than a market price of the stock, they want to purchase more stocks, increasing the demand for the stocks and raising the market price of the stock.

− When a bad news about a firm arrives, savers revise their expectations on future dividend payments and lower the value of the stock. As the value of the stock becomes less than a market price of the stock, they want to purchase less stocks (sell to other savers), decreasing the demand for the stocks and lowering the market price of the stock.

Efficient Market Hypothesis and Return on Stock

• In an efficient market, all unexploited profit opportunities will be eliminated.– Unexploited profit opportunity: a saver can

earn a higher than normal return for given risk.

– In an efficient market, every rational saver earns a required rate of return from stocks (no more, no less) on average.

– High return from some stocks reflects simply high risk premium for taking extra risk on the stocks.

Efficient Market Hypothesis and Irrational Savers

• Even in an efficient market, not everyone is well informed about stocks or has rational expectations.− Irrational savers may earn more or less than the required rate

of return on average (systematic underestimate or overestimate will result in lower return than the normal).

• Even with irrational savers (who do not know the value of stocks), the efficient market hypothesis may still hold.− Rational savers can take an advantage of irrational savers and

may make profits from discrepancy between market price and its value.

− Irrational savers are more likely to make losses from stock investment (since they do not know stock’s value), so they will eventually exit from the market.

Implications of Efficient Markets

Efficient market hypothesis has four important implications for stock investment.• Prices of (rate of return from) stocks are random

walk.• Prices of stocks change only for unexpected

information.• Technical analysis is useless.• Hot tips will not provide profits.

Implication #1 of Efficient Markets

• Prices of (rate of return from) stocks are random walk.− Random walk: the movements of stock price whose

future changes cannot be predicted.► If someone is heavily drunk, how will he walk?

− Because information arrives randomly (some time good news, other time bad news) and no way we can predict which news come next, the price of stock also changes randomly.► If news come in order of “good, bad, bad, good, bad, good,

and good,” then a stock price may “rise, fall, fall, rise, fall, rise, and rise.”

► Do you know which news come next?

Further Implication #1 of Efficient Markets

Because prices of (rate of return from) stocks are random walk,− Having performance well in the past does not indicate that

an investment adviser or a mutual fund will perform well in the future.

− High return may be mere luck or payment for taking excess risk rather than their superior investment ability.

− A monkey can choose stocks randomly and may end up to have a better return than investment advisors.

− Do not waste too much fees to receive advises from investment advisors which may not help you earn more than an average, but simply diversify your portfolio to lower risk. Easiest way to diversify your portfolio is to purchase mutual funds.

Implication #2 of Efficient Markets

Efficient market hypothesis implies that• Prices of stocks change only for unexpected

information.− Because all publicly available information including any

expectations has been reflected on the current price of stocks, any information which has been already known will not have any effect on stock prices.►If you see news that a firm is going out of business, you

should react now and such reaction will cause the stock price to fall now. Tomorrow, the CEO of the firm may announce the bankruptcy, but such information will not have any effect on stock price tomorrow because rational savers will have already sold the stocks.

− Expected information has been reflected on current price of stock.

Implication #3 of Efficient Markets

Because stock prices are unpredictable, the efficient market hypothesis further implies• Technical analysis is useless.

− Technical analysis uses the historical data to predict future stock price.

− Technical analysis is basically an adoptive expectation, and ignores many relevant information for the stock prices.

− You should not spend fees to get technical analysis, since it may not bring any additional profit.

− Catch: If you really know what will happen to stock prices by using technical analysis, will you sell your predictions to others at fees or use it for you own investment? So, why are they selling such information?

Further Implication #3 of Efficient Markets

• Some technical analysis looks at patterns of past stock prices, while others looks at phases of moon or sunspot. How reliable are such predictions?

stock price

Year

Prediction based on past pattern

Company announces bankruptcy

Implication #4 of Efficient Markets

Because prices of stocks change only for unexpected information, the efficient market hypothesis further implies• Hot tips will not provide profits.

− Hot tips: a “hot” advise from stock broker, dealer, or analyst about a particular stock.► Your stock broker calls you this morning about a firm (hot

tip). Should you follow his advise?► Do you think that you get the first call from your broker? If

he knows (and it is not insider information), should many other brokers know it and has already given hot tips to their clients? If so, the market price of the stock has already reflected the “hot tip” and you will not gain any extra profits.

Insider Trading and Efficient Market

• Efficient market hypothesis holds for publicly available information.

• Insider information: Some relevant information not available to the public, but only insiders of a firm knows.

• Insider information give an opportunity to insiders to make huge profits.− If you work as accountant at a firm, know firm’s financial

problem and own thousands of stocks of the firm, and if the CEO of the firm plans to announce this bad news tomorrow, what will you do? If you use this insider information before becoming public, you may avoid losses from investment.

• Because insider information potentially provide huge profits to insiders in expense of the public stockholders), a use of insider information is illegal in the U.S.− What happened to Martha Stewart?

Stock Market and Efficiency

Stock markets have had many crashes (free fall of overall stock prices).• Stock market crash (1929, 1987, 1997)• Technology stock crash (2001)

Although there were some bad news prior to each stock market crash, those bad news do not justify such a massive stock price fall in rational stock markets. • The efficient market hypothesis might not hold during

stock market crashes. Why?

Potential Reasons for Stock Market Crashes

Factors other than market fundamentals (information, rational expectations, and valuation) might cause stock market crashes.• Fads, overreaction, and social contagion• (Speculative) Bubbles • Trading mechanisms • Program trading

Noise Traders

• Noise traders are relatively uninformed stock traders.− Noise traders do not use the fundamental

approach (valuation model) or understand how news may affect prices of stocks.

− Noise traders tend to follow fads and rumors to make decisions.

• Most traders in stock markets are noise traders. − How many savers in the U.S. have education

or experience in business, finance, and accounting?

Day Traders

• Day-traders purchase and sell stocks frequently (usually hold stocks less than one day, often only few hours).− Many day-traders are noise-traders: Many day-

traders watch posts on Internet bulletin boards and make decisions on which stocks to purchase and when to purchase.

− Day-traders make profits from changes in stock prices (capital gain) rather than dividends.

− Day-traders speculates which stock price to rise quickly.

Fads, overreaction, and social contagion

Noise traders react to fads in stock markets, overreact to news about stocks, and follow others.• Fads: short-lived stock rally.

− Noise traders follow fads and rumors to make decisions.

• Overreaction: Noise traders overreact to news because they do not have any clue on its value.

• Social contagion: Noise traders follow other traders without understanding why others are purchasing.

Consequence of Fads, overreaction, and social contagion

• Noise traders tend to push market prices of stocks above or below their values.− When noise traders see other traders

purchasing a particular stock, they follow and purchase at any price, even above its value.

− When noise traders see other traders selling a particular stock, they follow and sell at any prices, even below its value.

• Such overreactions cause large swings in stock prices and create risk to the market.

Speculative Bubbles

• Speculative Bubbles: The price of an asset rises far above its value due to speculation.− Rational traders, who use the fundamental

approach and understand how news affect stock prices, engage in speculation.

− They know that there are many noise traders in stock market.

− They purchase stocks even though they know they are overpriced, speculating that noise traders will purchase the stocks at even higher price.

− Such speculation raises a stock price far above its value.

Greatest Fool Theory

• Rational traders knowingly engage in speculative bubble, hoping there are some fools in stock market who will purchase stocks at higher price.

• As stock price (bubble) rises, less and less fools engage in speculation (since they know it’s getting too expensive).

• Eventually, the greatest fool (who thought there would be still more fools in market) cannot find any buyers of the stocks.

• The greatest fool realizes his problem and panics to sell the stocks at any price.

• The stock price falls greatly and suddenly.

Trading Mechanisms and Program Trading

• Problem in trading mechanisms− When traders try to sell a large volume of

stocks, specialists at New York Stock Exchange cannot make market (not able to find enough buyers to handle the sales orders).

• Program trading: Computerized automated trading by professional traders− To avoid huge losses from a large price fall,

stocks are sold automatically by professional traders regardless of its value.

Internet and Technology Stock Market Crash of 2000s

• During 1990s, many traders believed that Internet and technology firms would take over existing (brick and mortar) business and make huge profits, even though they have not made any profits.− Amazon.com was once believed to take over all book-sales

business in the U.S.• Such expectations raised values of stocks of Internet and

technology firms and their prices accordingly.• As stock prices rose, many traders speculated and created

bubbles.• Seeing many years of no profits, eventually they realized that

they overestimated values of stocks of Internet and technology firms, causing stock prices to free fall.

• In 2000s many Internet and technology stock prices fell by more than 75%.

Fundamental Analysis in Practice

You can apply the fundamental analysis to explain changes in stock prices. For example, this morning the CEO of Apple announces unexpectedly a new iPhone. Prior to the announcement, the price of Apple stock was $600.How should this announcement affect the price of Apple stock?

Fundamental Analysis in Practice: Step 1• Apply the rational expectations to predict

the future profits of Apple with new iPhone.─ For example, Apple’s profits will increase by 10%

next three years.• Determine the expected dividends cash

flows on Apple stock.─ For example, Apple will raise its annual

dividends from $60 to $100 for next three years.

0 1 2 3 4 ........

∞

P0

$100 $100 $100 $60

Fundamental Analysis in Practice: Step 2

• Apply the generalized dividend valuation model to predict the value of Apple stock.

.....)k(1

Div)k(1

Div)k(1

DivP 3e

32

e

2

e

10

For example,Div1 = Div2 = Div3 = $100Div4 = Div5 = … = $60ke = 10%Then, P0 = $699.47

Fundamental Analysis in Practice: Step 3

• Apply the demand & supply model to predict the price change in market.─ For example, compared with the predicted

value is $699.47, the market price of Apple stock prior to the announcement was $600. Thus, the Apple stock was undervalued.

─ Rational investors purchase the undervalued Apple stocks in market, raising the demand for the Apple stocks. This pushes the Apple stock price to go up ($600 → $650 → $680 …). Investors continue to purchase the Apple stocks as long as it is undervalued.

Fundamental Analysis in Practice Step 3 (Continued)

─ Investors will stop buying the Apple stock once the stock price reaches the predicted value ($699.47).

S

D0

D1$600

$699

Price of stock

E0

E1

Fundamental Analysis in Practice: Overshooting and Market Crash

• Then, the market price of Apple stock reflects the announcement of new iPhone by its CEO this morning (Efficient market hypothesis).

• However, if day-traders, not knowing the announcement or the value of Apple stock, see the sudden price increase of Apple stock and may join the hoopla (bandwagon effect).

• Their actions will push the demand for the Apple stocks further right and raise the price of Apple stocks above the predicted value (Overshooting).

• n addition, some rational investors may speculate and create a bubble in the market, which may result in the market crash later.

Disclaimer

Please do not copy, modify, or distribute this presentation without author’s consent.

This presentation was created and owned byDr. Ryoichi Sakano

North Carolina A&T State University