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Chapter Ten

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 charts http://stockcharts.com/charts/historical.

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Chapter Ten

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  1. Chapter Ten The Efficient Market Hypothesis

  2. 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

  3. Generalized Dividend Valuation Model • Since last term of equation is small, Equation 2 can be written as (2) (3)

  4. 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)

  5. Price Earnings Valuation Method (6)

  6. Reasons for Errors in Valuation • Problems with estimating dividend growth • Problems with estimating risk • Problems with forecasting dividends

  7. Efficient Market Hypothesis (7) • Expectations equal to optimal forecasts implies (8) • Market equilibrium (9) • Put (8) and (9) together: efficient market hypothesis (10)

  8. 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

  9. 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

  10. 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

  11. 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

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