Download Understanding Stock Market: Valuing Stocks, Rational Expectations, Efficient Markets and more Slides Banking and Finance in PDF only on Docsity! Money, Banking & Finance Lecture 2 The Stock Market, Rational Expectations and Efficient Markets Docsity.com Aims • Explain the theory of valuing stocks. • Explore how expectations influence affect the value of stocks. • Understand the theory of rational expectations • Understand the concept of the Efficient Markets Hypothesis Docsity.com One period valuation )1()1( 11 0 ee k P k DP + + + = Docsity.com Generalised dividend valuation model 0 )1( lim )1( )1()1( ..... )1()1()1( 1 0 3 3 2 21 0 = + + = + + + ++ + + + + + = ∞→ ∞ = ∑ n n e n i i e i n e n n e n eee k P k DP k P k D k D k D k DP Docsity.com Dividend Model • The price of a stock depends only on the discounted flow dividend payments. • Some don’t pay out a dividend and so the valuation is based on the expectation of dividends to be paid out some time. • Some stock are zero dividend stocks. Valuation is based on expected capital gain. Docsity.com Gordon growth model continued )( )()( )1( )1()( )1( )1()1( 1 0 10 0 00 00 gk DP gk D gk gDP gDgkP D g gkP e ee e e − = − = − + =⇒ +=−⇒ = + +−+ Docsity.com Assumptions and Implications • Dividends are assumed to continue growing at a constant rate forever. • The growth rate is assumed to be less than the required return on equity. • We can see how this model can be applied to the setting of stock prices. • Let expected dividend payout next year be £2 per share. Market analysts expect firm growth to be 3% but there is uncertainty about the constancy of the dividend stream. • To compensate for the higher risk the required rate of return is 15% for investor A • Investor B has researched industry insiders and is more confident and therefore has a required rate of 12%. • Investor C has inside information and feels that 10% is acceptable to compensate for risk. Docsity.com Stock prices setting • Investor A valuation = [2/(.15-.03)]=£16.67 • Investor B valuation = [2/(.12-.03]=£22.22 • Investor C valuation = [2/(.10-.03]=£28.57 • If investor A holds stock, he/she would sell it to C. The market price would depend on which investor holds the stock, how much stock and the market orders for the stock. Docsity.com Expected return t t t tt P DE P PPErE )()()( 11 ++ +−= Docsity.com Example • The current price of a common stock is 100 • State contingency is, good, average, bad • Expected future price in each state is, 128,117, 105 respectively • Expected dividends are, 7, 3, 0 respectively • The state contingent expected returns are; [(128- 100)+7]/100=0.35; [(117-100)+3]/100=.2; [(105- 100)+0]100=.05. • Probability of each state; 0.3, 0.4, 0.3. Docsity.com Expected return over all contingencies ( ) 2 22 222 )()( )( σσ ρρ σ ρ = −⇒ −= = ∑∑ ∑ iii ii rr rErE rrE Docsity.com
