Last Day

1
Last Day

• EMH

2
Today

• EMH contd
• Valuation

3
EMH Technical vs. Fundamental Analysis

• It may be difficult to accept the EMH in its
  purest form, nonetheless the different degrees to
  which it can be applied to markets can help one
  understand the nature of those markets
• Degrees of Efficiency
• Strong efficiency ALL information in a market,
  whether public or private, is accounted for in a
  stock price. Not even insider information could
  give an investor an advantage.
• Semi-strong efficiency all public information
  is calculated into a stock's current share price.
  Neither fundamental nor technical analysis can be
  used to achieve superior gains.
• Weak efficiency - all past prices of a stock are
  reflected in today's stock price. Therefore,
  technical analysis cannot be used to predict and
  beat a market.

4
EMH Wrap up

• Proponents say that abnormalities leading to
  profits in the market will be exploited until
  they disappear.
• What about something like the January Effect?
• Argument goes, since transactions are not
  costless, these costs will likely outweigh the
  benefits of trying to take advantage of such a
  trend.
• In the real world, markets cannot be absolutely
  efficient or wholly inefficient.
• In essence markets a mixture of both
• Meaning, daily decisions and events cannot always
  be reflected immediately into a market.
• Put it this way
• if all participants were to believe that the
  market is efficient, no one would seek
  extraordinary profits, which is the force that
  keeps the wheels of the market turning.

5
EMH Wrap up

• Have markets changed through time?
• Definitely!
• Information technology (IT) is making markets
  more efficient all the time and all over the
  world.
• IT allows for a more effective, faster means to
  disseminate information, and electronic trading
  allows for prices to adjust more quickly to news
  entering the market.
• However, while the pace at which we receive
  information and make transactions quickens, IT
  also restricts the time it takes to verify
  the information used to make a trade.
• Thus, IT may inadvertently result in less
  efficiency if the quality of the information we
  use no longer allows us to make profit-generating
  decisions.

6
EMH - - One final thought

• Heres the irony of such a controversial
  hypothesis
• In order for a market to become efficient,
  investors must perceive that a market is
  inefficient and possible to beat.
• But, investment strategies intended to take
  advantage of inefficiencies are actually the fuel
  that keeps a market efficient

7
Valuation

• The search for the correct way to value common
  stocks begins

8
How to pick winners?

• This has been a question posed numerous
  researchers over the years
• Techniques range from simple rules of thumb to
  elaborate hypotheses about broad influences
  affecting stock prices
• The theory of efficient markets tells us there is
  no simple mechanical way to pick winners in the
  stock market
• OR, at least, one doesnt exist that will allow
  us to recover the cost of using it.

9
BUT, people persist

• Despite what the previous slide contends, people
  continue to spend enormous amounts of time trying
  to pick winners and recover their costs
• NOTE determinants of stock prices are quite easy
  to specify, generally.
• Valuation is an entirely different matter

10
Determinants of Stock Prices

• Stock prices depend on or are a function of
• Companys earnings
• Dividends
• Risk
• Cost of money
• Future growth rates
• Etc.

11
Now for the difficult part

• Specifying the determinants of stock prices is
  easy, the difficult part comes in trying to use
  these concepts to successfully value or select
  common stocks.
• This is what valuation models purport to do
• These convert a set of forecasts (or
  observations) on a series of companies and
  economic variables into a forecast of market
  value for a companys stock.

12
Valuation Models Input/Output

• Inputs
• Economic variables future earnings, dividends,
  variability of earnings, etc.
• Output
• Expected market value or return from holding the
  stock
• OR at the very least, a buy, sell, hold
  recommendation

13
Valuation Model contd

• Relationship between market, economic variables
  and businesses
• These models are a formulation of the
  relationship that is expected to exist between a
  set of corporate and economic factors and the
  markets valuation of these factors

14
Valuation Model contd

• EVERY financial organization employs a valuation
  model
• NOTE this model may not be explicit, but rather
  implicit in the way the organization makes
  decisions
• Example 1
• A company that holds an index fund is implicitly
  accepting the simple form of the CAPM
• This is in spite of the fact that they may not
  explicitly invoke the model every time a decision
  is made

15
Valuation Model contd

• Example 2
• A company that buys low price earnings ratio
  stocks is implicitly stating that only the
  present price earnings ratios, and not
  predictions of future growth or risk, affect the
  return that can be earned on stocks.

16
Valuation Model contd

• Are there advantages to explicitly employing a
  valuation model?
• Explicit use of valuation models
• Requires the definition of relevant inputs
• Therefore, it assures that these inputs will be
  systematically collected and used in a consistent
  manner over time

17
Valuation Model contd

• Explicit use of valuation models contd
• Allows for feedback and control in the
  functioning of a financial institution
• Breaks the process of portfolio analysis into
  forecasting inputs, valuing securities, and
  forming portfolios
• This permits the organization to measure their
  performance in each of these areas and realize
  areas where they can capitalize.

18
Valuation Model contd

• Example
• An organization can have superior ability to
  forecast corporate variables. BUT, the
  informational content of the forecasts can be
  lost either in the valuation process or when
  securities are formed into portfolios.
• By breaking the process up into logical steps the
  company can identify what it is doing well, and
  not so well.

19
Valuation Model contd

• Discounted cash flow models
• These models are based on the notion that the
  value of a share of stock is equal to the present
  value of the cash flow that the stockholder
  expects to receive from it.
• You would have been introduced to these types of
  models in ACS310 (e.g. Gordon Growth Model)

20
Valuation Models contd

• Assume you hold a stock for one period.
• In this case, your valuation will be based on the
  dividend you will receive (assumed to happen at
  the end of the period) and the value of the stock
  when you sell it.

21
Valuation Models contd

• To value the share, the stock holder must
  estimate the price at which the stock will sell
  one period hence.

22
Valuation Models contd

• Substituting the preceding equation into our
  earlier one and continuing with the same logic,
  we find the following

23
Valuation Models contd

• If we sum the preceding equation to infinity and
  assume constant growth, with a little
  manipulation we arrive at the Gordon Growth Model,