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