Chapter 7 Stock Valuation PDF

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Chapter 7: Stock Valuation Friday, September 27, 2019

9:24 AM

What influences a Stock's Price? • Focus on fundamentals rather than news • Dividend - The share of profits paid to investors • Growth - Your expectation about the growth of a company, either in terms of the price or dividend • Form expectations about both, and choose to invest in a company based on them

Computing the Price of Common Stock

→ Basically the same as a coupon bond Generalized Dividend Valuation Model:

Example:

Div1 = $0.30 P1 = $12.00 Re = 0.02 (2%) 0.30 12 𝑃=# *+ # * = $12.05 1 + 0.02 1 + 0.02 … Therefore if the price of the stock is less than $12.05, you should buy today Gordon Growth "Pricing" Model:

How the Market Sets Stock Prices • The price is set by the buyer willing to pay the highest price • The market price will be set by the buyer who can take best advantage of the asset

• Superior information about an asset can increase its value by reducing its perceived risk

How the Market Sets Expectations • When new information is released about a firm; expectations and prices change • Market participants constantly receive information and revise their expectations, so stock prices change frequently Effect of Monetary Policy: • Fed lowers interest rates… required return, Re decreases 𝐷1 ○ 𝑃-𝑜 = 𝑅𝑒- − 𝑔

The Theory of Rational Expectations • Expectations will be identical to optimal forecasts using all available information • Even though a rational expectation = the optimal forecast using all available info, a prediction based on it may not always be perfectly accurate • No one will do better than someone else in predicting the activity of the market

The Efficient Market Hypothesis: Rational Expectations in Financial Markets...