What information about company stocks is regularlyreported in the financial pages of newspapers and onlinefinancial services?Firms that wish to raise new capital may either borrowmoney or bring new “partners” into the business by sellingshares of common stock. Large companies usuallyarrange for their stocks to be traded on a stock exchange.The stock listings report the stock’s dividend yield, price,and trading volume.
How can one calculate the present value of a stock givenforecasts of future dividends and future stock price?Shareholders generally expect to receive (1) cashdividends, and (2) capital gains or losses. The rate ofreturn that they expect over the next year is defined as theexpected dividend per share DIV1 plus the expectedincrease in price P1 – P0, all divided by the price at thestart of the year P0.Unlike the fixed interest payments that the firmpromises to bondholders, the dividends that are paid toshareholders depend on the fortunes of the firm. That’swhy a company’s common stock is riskier than its debt.The return that investors expect on any one stock is alsothe return that they demand on all stocks subject to thesame degree of risk. The present value of a stock equalsthe present value of the forecast future dividends andfuture stock price, using that expected return as thediscount rate.
How can stock valuation formulas be used to infer theexpected rate of return on a common stock?The present value of a share is equal to the stream ofexpected dividends per share up to some horizon dateplus the expected price at this date, all discounted at thereturn that investors require. If the horizon date is faraway, we simply say that stock price equals the presentvalue of all future dividends per share. This is thedividend discount model.If dividends are expected to grow forever at a constantrate g, then the expected return on the stock is equalto the dividend yield (DIV1/P0) plus the expected rate ofdividend growth. The value of the stock according to thisconstant-growth dividend discount model is P0 = DIV1/(r – g).
How should investors interpret price-earnings ratios?You can think of a share’s value as the sum of two parts—the value of the assets in place and the present value ofgrowth opportunities, that is, of future opportunities forthe firm to invest in high-return projects. The priceearnings(P/E) ratio reflects the market’s assessment ofthe firm’s growth opportunities.
How does competition among investors lead to efficientmarkets?Competition between investors will tend to produce anefficient market—that is, a market in which prices rapidlyreflect new information, and investors have difficultymaking consistently superior returns. Of course, we allhope to beat the market, but, if the market is efficient, allwe can rationally expect is a return that is sufficient onaverage to compensate for the time value of money andfor the risks we bear.The efficient market theory comes in three flavours.The weak form states that prices reflect all the informationcontained in the past series of stock prices. In this case it isimpossible to earn superior profits simply by looking forpast patterns in stock prices. The semi-strong form of thetheory states that prices reflect all published information, sothat it is impossible to make consistently superior returnsjust by reading the newspaper, looking at the company’sannual accounts, and so on. The strong form states thatstock prices effectively impound all available information.This form tells us that private information is hard to comeby, because in pursuing it you are in competition with thousands—perhaps millions—of active and intelligentinvestors. The best you can do in this case is to assume thatsecurities are fairly priced.The evidence for market efficiency is voluminousand there is little doubt that skilled professional investorsfind it difficult to win consistently. Nevertheless, thereremain some puzzling instances where markets do notseem to be efficient. Some financial economists attributethese apparent anomalies to behavioural foibles.
