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

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

  1. 1. Stock Market Valuation <ul><li>Why would you invest in the stock market? </li></ul><ul><li>What’s been happening in the stock market lately? Why? </li></ul><ul><li>Research evidence: </li></ul><ul><ul><li>From 1951-2000 the equity premium (or return over and above the T-bill rate) has been about 7.5% per year. </li></ul></ul><ul><ul><li>Dividend growth rate over this period is 2.50%. </li></ul></ul><ul><ul><li>Earnings growth rate over this period is 4.30%. </li></ul></ul><ul><ul><li>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? </li></ul></ul><ul><ul><li>(Hint: P = D/(r-g) is well-known stock valuation formula. </li></ul></ul>
  2. 2. Stock Valuation Models <ul><li>P = E(EPS) x P/E ratio, where E(EPS) is expected future EPS. </li></ul><ul><li>P = D/(r-g) </li></ul><ul><li>Capital Asset Pricing Model (CAPM) by Sharpe, Lintner, Mossin </li></ul><ul><li>R(jt) = RF(t) + B[RM(t) – RF(t)] + e(jt) </li></ul><ul><li>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. </li></ul><ul><li>According to research evidence by Fama and French (1992, 1993, 1996), the CAPM does not work! B is zero! </li></ul>
  3. 3. 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
  4. 4. Stock Valuation Models <ul><li>Fama French propose new 3-factor model R(jt) = RF(t) + B1[RM(t) – RF(t)] + B2[Size Factor] + </li></ul><ul><li>B3[Value Factor] + e(jt), </li></ul><ul><li>where Size Factor = returns on small firms minus large firms </li></ul><ul><li>Value Factor = returns on value firms minus growth firms </li></ul><ul><li>This model explains more than 90% of variation in stock returns. </li></ul><ul><li>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. </li></ul>
  5. 5. Stock Valuation Models <ul><li>Arbitrage Pricing Theory (APT) </li></ul><ul><li>R(jt) = RF(t) + B1[RM(t) – RF(t)] + B2[GDP] + B3[Employment] + B4[Inflation] …. + e(jt) </li></ul><ul><li>where other factors are so-called “state variables” that describe the overall macroeconomy. </li></ul><ul><li>Advantage – very general model that includes economic conditions that surely affect stock market returns. </li></ul><ul><li>Disadvantage – not clear which factors to use exactly. </li></ul>
  6. 6. Stock Valuation Models <ul><li>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. </li></ul><ul><ul><li>Information uncertainty causes slow market responses to information that leads to price continuation </li></ul></ul><ul><ul><li>Irrational investors cause prices to move in ways not expected by rational investors. </li></ul></ul>Stock Price Time Arrival of good news to the market Slow market response, or price continuation
  7. 7. Investment Strategies <ul><li>Active strategies </li></ul><ul><ul><li>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.) </li></ul></ul><ul><ul><li>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.) </li></ul></ul>
  8. 8. Investment Strategies <ul><li>Passive strategies </li></ul><ul><ul><li>Diversification – reduce risk by spreading investments in financial instruments that are not perfectly correlated with one another. </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>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. </li></ul></ul>

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