Stock Market Valuation

1
Stock Market Valuation
Why would you invest in the stock market?
Whats been happening in the stock market
lately? Why? Research evidence From 1951-200
0 the equity premium (or return over and above
the T-bill rate) has been about 7.5 per year.
Dividend growth rate over this period is 2.50.
Earnings growth rate over this period is 4.30.
If stock prices are the present value of future
cash flows, why is the actual return on stocks so
much higher than the growth rate of potential
cash flows? (Hint P D/(r-g) is well-known sto
ck valuation formula.
2
Stock Valuation Models
P E(EPS) x P/E ratio, where E(EPS) is expected
future EPS. P D/(r-g) Capital Asset Pricing
Model (CAPM) by Sharpe, Lintner, Mossin
R(jt) RF(t) BRM(t) RF(t) e(jt)
where B is beta, R(jt) is the return on stock j
at time t, RM is the market return (e.g., SP500
index), RF is the risk-free rate (e.g., the
T-bill rate), and e is an error term with mean
zero. According to research evidence by Fama and
French (1992, 1993, 1996), the CAPM does not
work! B is zero!
3
CAPM fails! say Fama and French
x
x
R(jt)
x
x
Should get B O
x
x
RF
x
x
x
x
x
x
B 0
x
RM(t) RF(t)
4
Stock Valuation Models
Fama French propose new 3-factor modelR(jt)
RF(t) B1RM(t) RF(t) B2Size Factor
B3Value Factor e(jt),
where Size Factor returns on small firms minus
large firms Value Factor returns on val
ue firms minus growth firms This model explains m
ore than 90 of variation in stock returns.
Some people are now adding a Momentum Factor (
returns on firms whose stocks are increasing over
time minus firms whose stocks are decreasing over
time.
5
Stock Valuation Models
Arbitrage Pricing Theory (APT)
R(jt) RF(t) B1RM(t) RF(t) B2GDP
B3Employment B4Inflation . e(jt)
where other factors are so-called state
variables that describe the overall
macroeconomy. Advantage very general model th
at includes economic conditions that surely
affect stock market returns.
Disadvantage not clear which factors to use
exactly.
6
Stock Valuation Models
Behavorial school they argue that financial
markets are not always efficient. That is, at
times prices do not reflect all available
information accurately and rapidly.
Information uncertainty causes slow market
responses to information that leads to price
continuation Irrational investors cause pri
ces to move in ways not expected by rational
investors.
Slow market response, or price continuation
Stock Price
Arrival of good news to the market
Time
7
Investment Strategies
Active strategies Technical analysis examine
charts of stock prices to find trends in them
over time. Buy and sell stocks based on trends.
(Problem Stock prices are a random walk
according to weak form tests of market
efficiency.) Fundamental analysis examine the
accounting statements, financial position, and
industry and economic conditions to buy and sell
stocks. (Problem Stock prices cannot be
predicted based on available public information
according to semi-strong tests of market
efficiency.)
8
Investment Strategies
Passive strategies Diversification reduce ris
k by spreading investments in financial
instruments that are not perfectly correlated
with one another. Dollar-cost averaging invest
regularly in the stock market so that you buy at
some average price and earn the long-run average
rate of return on stocks. Portfolio rebalancing
fix some target percentages for your
diversified portfolio (e.g., 60 stocks and 40
bonds) and once a year buy and sell to realign
this percentages. In this way you sell assets
that increase in value and buy assets that have
decreased in value.