Understanding the Efficient Market Hypothesis and Stock Valuation Techniques
This chapter delves into the Efficient Market Hypothesis (EMH) and its implications on stock pricing and investment strategies. It discusses the valuation of common stocks, focusing on present value of future cash flows, including models like the Gordon Growth Model and Price Earnings valuation method. The chapter addresses challenges in estimating dividend growth, risk, and forecasting. It evaluates both favorable and unfavorable evidence for EMH, highlighting its strengths and limitations for investors. The conclusion offers practical advice on investment strategies, advocating for a buy-and-hold approach and diversification.
Understanding the Efficient Market Hypothesis and Stock Valuation Techniques
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Presentation Transcript
Chapter Ten The Efficient Market Hypothesis
Computing the Price of Common Stock • Basic Principle of Finance Value of Investment = Present Value of Future Cash Flows • One-Period Valuation Model (1) Stock market interest chartshttp://stockcharts.com/charts/historical
Generalized Dividend Valuation Model • Since last term of equation is small, Equation 2 can be written as (2) (3)
Gordon Growth Model • Assuming dividend growth is constant, Equation 3 can be written as (4) • Assuming the growth rate is less than the required return on equity, Equation 4 can be written as (5)
Reasons for Errors in Valuation • Problems with estimating dividend growth • Problems with estimating risk • Problems with forecasting dividends
Efficient Market Hypothesis (7) • Expectations equal to optimal forecasts implies (8) • Market equilibrium (9) • Put (8) and (9) together: efficient market hypothesis (10)
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
Evidence on Efficient Market Hypothesis • Favorable Evidence • Investment analysts and mutual funds don't beat the market • Stock prices reflect publicly available info: anticipated announcements don't affect stock price • Stock prices and exchange rates close to random walk; if predictions of ∆P big, Rof > R* predictions of ∆P small • Technical analysis does not outperform market
Evidence on Efficient Market Hypothesis • Unfavorable Evidence • Small-firm effect: small firms have abnormally high returns • January effect: high returns in January • Market overreaction • Excessive volatility • Mean reversion • New information is not always immediately incorporated into stock prices • Overview • Reasonable starting point but not whole story
Implications for Investing • Published reports of financial analysts not very valuable • Should be skeptical of hot tips • Stock prices may fall on good news • Prescription for investor • Shouldn't try to outguess market • Therefore, buy and hold • Diversify with no-load mutual fund
