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# Stock Market Valuation Why would you invest in the stock market?

## on Jul 05, 2010

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## Stock Market Valuation Why would you invest in the stock market?Presentation Transcript

• Stock Market Valuation
• Why would you invest in the stock market?
• What’s been happening in the stock market lately? Why?
• Research evidence:
• From 1951-2000 the equity premium (or return over and above the T-bill rate) has been about 7.5% per year.
• Dividend growth rate over this period is 2.50%.
• Earnings growth rate over this period is 4.30%.
• If stock prices are the present value of future cash flows, why is the actual return on stocks so much higher than the growth rate of potential cash flows?
• (Hint: P = D/(r-g) is well-known stock valuation formula.
• Stock Valuation Models
• P = E(EPS) x P/E ratio, where E(EPS) is expected future EPS.
• P = D/(r-g)
• Capital Asset Pricing Model (CAPM) by Sharpe, Lintner, Mossin
• R(jt) = RF(t) + B[RM(t) – RF(t)] + e(jt)
• where B is beta, R(jt) is the return on stock j at time t, RM is the market return (e.g., S&P500 index), RF is the risk-free rate (e.g., the T-bill rate), and e is an error term with mean zero.
• According to research evidence by Fama and French (1992, 1993, 1996), the CAPM does not work! B is zero!
• RF R(jt) x x x x x x x x x x x x x B = 0 CAPM fails! say Fama and French RM(t) – RF(t) Should get B > O
• Stock Valuation Models
• Fama French propose new 3-factor model R(jt) = RF(t) + B1[RM(t) – RF(t)] + B2[Size Factor] +
• B3[Value Factor] + e(jt),
• where Size Factor = returns on small firms minus large firms
• Value Factor = returns on value firms minus growth firms
• This model explains more than 90% of variation in stock returns.
• Some people are now adding a Momentum Factor (= returns on firms whose stocks are increasing over time minus firms whose stocks are decreasing over time.
• Stock Valuation Models
• Arbitrage Pricing Theory (APT)
• R(jt) = RF(t) + B1[RM(t) – RF(t)] + B2[GDP] + B3[Employment] + B4[Inflation] …. + e(jt)
• where other factors are so-called “state variables” that describe the overall macroeconomy.
• Advantage – very general model that includes economic conditions that surely affect stock market returns.
• Disadvantage – not clear which factors to use exactly.
• Stock Valuation Models
• Behavorial school – they argue that financial markets are not always efficient. That is, at times prices do not reflect all available information accurately and rapidly.
• Information uncertainty causes slow market responses to information that leads to price continuation
• Irrational investors cause prices to move in ways not expected by rational investors.
Stock Price Time Arrival of good news to the market Slow market response, or price continuation
• Investment Strategies
• Active strategies
• Technical analysis – examine charts of stock prices to find trends in them over time. Buy and sell stocks based on trends. (Problem: Stock prices are a random walk according to weak form tests of market efficiency.)
• Fundamental analysis – examine the accounting statements, financial position, and industry and economic conditions to buy and sell stocks. (Problem: Stock prices cannot be predicted based on available public information according to semi-strong tests of market efficiency.)
• Investment Strategies
• Passive strategies
• Diversification – reduce risk by spreading investments in financial instruments that are not perfectly correlated with one another.
• Dollar-cost averaging – invest regularly in the stock market so that you buy at some average price and earn the long-run average rate of return on stocks.
• Portfolio rebalancing – fix some target percentages for your diversified portfolio (e.g., 60% stocks and 40% bonds) and once a year buy and sell to realign this percentages. In this way you sell assets that increase in value and buy assets that have decreased in value.