Stock Market Valuation

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## Stock Market Valuation

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**Stock Market Valuation**• Why would you invest in the stock market? • What’s been happening in the stock market lately? Why? • Research evidence: • From 1951-2000 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 stock valuation formula.**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) + B[RM(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., S&P500 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!**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)**Stock Valuation Models**• Fama French propose new 3-factor modelR(jt) = RF(t) + B1[RM(t) – RF(t)] + B2[Size Factor] + • B3[Value Factor] + e(jt), • where Size Factor = returns on small firms minus large firms • Value Factor = returns on value firms minus growth firms • This model explains more 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.**Stock Valuation Models**• Arbitrage Pricing Theory (APT) • R(jt) = RF(t) + B1[RM(t) – RF(t)] + B2[GDP] + B3[Employment] + B4[Inflation] …. + e(jt) • where other factors are so-called “state variables” that describe the overall macroeconomy. • Advantage – very general model that includes economic conditions that surely affect stock market returns. • Disadvantage – not clear which factors to use exactly.**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 prices 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**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.)**Investment Strategies**• Passive strategies • Diversification – reduce risk 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.