Chapter Ten

The Efficient Market Hypothesis

Slide 10–3

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

Slide 10–4

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)

Slide 10–5

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)

Slide 10–6

Price Earnings Valuation Method

P

EE P (6)

Slide 10–7

Reasons for Errors in Valuation

1. Problems with estimating dividend growth

2. Problems with estimating risk

3. Problems with forecasting dividends

Slide 10–8

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)

Slide 10–9

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*

Slide 10–10

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

Slide 10–11

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

Slide 10–12

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