1. © 2004 Pearson Addison-Wesley. All rights reserved 7-1 (1) Computing the Price of Common Stock Basic Principle of Finance Value of Investment = Present Value of Future Cash Flows One-Period Valuation Model

2. © 2004 Pearson Addison-Wesley. All rights reserved 7-2 Generalized Dividend Valuation Model Since last term of the equation is small, Equation 2 can be written as (3) (2)

3. © 2004 Pearson Addison-Wesley. All rights reserved 7-3 Gordon Growth Model Assuming dividend growth is constant, Equation 3 can be written as Assuming the growth rate is less than the required return on equity, Equation 4 can be written as (5) (4)

4. © 2004 Pearson Addison-Wesley. All rights reserved 7-4 Theory of Rational Expectations Rational expectation (RE) = expectation that is optimal forecast (= X of = best prediction of future) using all available information: X e = X of Rational expectation, though optimal prediction, may not be accurate It is costly not to have optimal forecast, not to be rational Implications: 1.Change way variable moves  change way expectations are formed 2.Forecast errors on average = 0 and are not predictable  random walk

5. © 2004 Pearson Addison-Wesley. All rights reserved 7-5 Efficient Markets Hypothesis P t+1 – P t + C R = P t P e t+1 – P t + C R e = P t Rational Expectations implies: P e t+1 = P of t+1  R e = R of (1) Market equilibrium return = R* R e = R*(2) Put (1) and (2) together: Efficient Markets Hypothesis R of = R*, i.e., figure out what the market equilibrium should be Why the Efficient Markets Hypothesis makes sense If R of > R*  BUY NOW!  P t , R of  If R of < R*  SELL NOW!  P t , R of  until R of = R* 1.All unexploited profit opportunities eliminated 2.Efficient Market holds even if are uninformed, irrational participants in market

6. © 2004 Pearson Addison-Wesley. All rights reserved 7-6 Evidence on Efficient Markets Hypothesis Favorable Evidence 1.Investment analysts and mutual funds don’t beat the market 2.Stock prices reflect publicly available information: anticipated announcements don’t affect stock price 3.Stock price and exchange rate movements close to random walk 4.Technical analysis does not outperform market Unfavorable Evidence 1.Small-firm effect: small firms have abnormally high returns 2.January effect: high returns in January 3.Market overreaction 4.Excessive volatility 5.Mean reversion 6.New information not always incorporated into stock prices right away Overview Reasonable starting point but not whole story

7. © 2004 Pearson Addison-Wesley. All rights reserved 7-7 Implications for Investing 1.Published reports of financial analysts not very valuable 2.Should be skeptical of hot tips 3.Stock prices may fall on good news 4.Prescription for investor 1.Shouldn’t try to outguess market 2.Therefore, buy and hold 3.Diversify with no-load mutual fund Evidence on Rational Expectations in Other Markets 1.Bond markets appear efficient 2.Evidence with survey data is mixed Skepticism about quality of data 3.The following implication is supported: change in way variable moves, way expectations are formed changes