2. Chapter Ten The Efficient Market Hypothesis

3. Copyright © 2004 Pearson Education Canada Inc. Slide 10–3 Computing the Price of Common Stock Basic Principle of Finance Value of Investment = Present Value of Future Cash Flows One-Period Valuation Model (1) Stock market interest charts http://stockcharts.com/charts/historical http://stockcharts.com/charts/historical

4. Copyright © 2004 Pearson Education Canada Inc. Slide 10–4 Generalized Dividend Valuation Model Since last term of equation is small, Equation 2 can be written as (2) (3)

5. Copyright © 2004 Pearson Education Canada Inc. Slide 10–5 Gordon Growth Model Assuming dividend growth is constant, Equation 3 can be written as (4) Assuming the growth rate is less than the required return on equity, Equation 4 can be written as (5)

6. Copyright © 2004 Pearson Education Canada Inc. Slide 10–6 Price Earnings Valuation Method (6)

7. Copyright © 2004 Pearson Education Canada Inc. Slide 10–7 Reasons for Errors in Valuation 1.Problems with estimating dividend growth 2.Problems with estimating risk 3.Problems with forecasting dividends

8. Copyright © 2004 Pearson Education Canada Inc. Slide 10–8 Efficient Market Hypothesis Expectations equal to optimal forecasts implies (7) Market equilibrium (8) Put (8) and (9) together: efficient market hypothesis (9) (10)

9. Copyright © 2004 Pearson Education Canada Inc. Slide 10–9 Efficient Market Hypothesis Why efficient market hypothesis makes sense All unexploited profit opportunities eliminated Efficient market condition holds even if there are uninformed, irrational participants in market

10. Copyright © 2004 Pearson Education Canada Inc. Slide 10–10 Evidence on Efficient Market Hypothesis Favorable Evidence 1.Investment analysts and mutual funds don't beat the market 2.Stock prices reflect publicly available info: anticipated announcements don't affect stock price 3.Stock prices and exchange rates close to random walk; if predictions of ∆P big, R of > R*  predictions of ∆P small 4.Technical analysis does not outperform market

11. Copyright © 2004 Pearson Education Canada Inc. Slide 10–11 Evidence on Efficient Market Hypothesis 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 is not always immediately incorporated into stock prices 7.Chaos and fractals Overview 1.Reasonable starting point but not whole story

12. Copyright © 2004 Pearson Education Canada Inc. Slide 10–12 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 –Shouldn't try to outguess market –Therefore, buy and hold –Diversify with no-load mutual fund