EQUITY MARKET – Part 2

MARKET EFFICIENCY
Economically rational buyers and sellers use their assessment of an asset’s risk and return to
determine its value. To a buyer, the asset’s value represents the maximum purchase price, and to
a seller it represents the minimum sale price.
In competitive markets with many active participants, such as the New York Stock Exchange,
the interactions of many buyers and sellers result in an equilibrium price—the market value—for
each security.
Market Value - This price reflects the collective actions that buyers and sellers take on the
basis of all available information.
Buyers and sellers digest new information quickly as it becomes available and, through their
purchase and sale activities, create a new market equilibrium price.
Because the flow of new information is almost constant, stock prices fluctuate, continuously
moving toward a new equilibrium that reflects the most recent information available. This
general concept is known as market efficiency.
THE EFFICIENT-MARKET HYPOTHESIS
The efficient-market hypothesis (EMH), which is the basic theory describing the behavior of
such a “perfect” market, specifically states that:
1. Securities are typically in equilibrium, which means that they are fairly priced and that
their expected returns equal their required returns.
2. At any point in time, security prices fully reflect all information available about the firm
and its securities, and these prices react swiftly to new information.
3. Because stocks are fully and fairly priced, investors need not waste their time trying to find
mispriced (undervalued or overvalued) securities.
Undervalued —the true value of the shares is greater than the current market price
Overvalued - the market price is greater than the true value

The Behavioral Finance Challenge

Although considerable evidence supports the concept of market efficiency, a growing body
of academic evidence has begun to cast doubt on the validity of this notion. The research
documents various anomalies—outcomes that are inconsistent with efficient markets—in
stock returns.
A number of academics and practitioners have also recognized that emotions and other
subjective factors play a role in investment decisions. This focus on investor behavior has
resulted in a significant body of research, collectively referred to as behavioral finance.
Advocates of behavioral finance are commonly referred to as “behaviorists.”

STOCK VALUATION
In order to make investment decisions investors conduct valuation of stocks. They search for
undervalued stocks for investing and sell holdings of stocks if they are considered
overvalued.
There are two approaches to what information is useful in the selection of stocks and the
timing of the purchase of stocks:
  fundamental analysis and
 technical analysis.

 Fundamental analysis
Fundamental analysis is one of the methods of valuing stocks, which involves the analysis of
a company’s operations to assess its economic prospects.
It is based on fundamental financial characteristics (e.g. earnings) about the company and its
corresponding industry that are expected to influence stock values.
The analysis is based on financial statements of the company in order to investigate the
earnings, cash flow, profitability, and financial leverage. The fundamental analysis includes
analysis of the major product lines, the economic outlook for the products (including existing
and potential competitors), and the industries in which the company operates.
This analysis results in projections of earnings growth. Based on the growth prospects of
earnings, the fair value of the stock using one or more of the equity valuation models is
determined. The fair value is based on present value calculations.
Present value – the current value of a future cash flow. It is obtained by discounting future
cash flow by the market – required rate of return.
There are various models to estimate the fundamental value of company shares.
 One approach is to estimate expected earnings and then multiply by expected price/
earnings ratio.
 Another approach is to estimate the value of the assets of the company.
The estimated fair value is compared to the market price to determine if the stock is fairly
priced in the market.
 cheap - a market price below the estimated fair value
 rich - a market price above the estimated fair value
Traditional fundamental analysis has several limitations. It does not quantify the risk factors
associated with a stock and how those risk factors affect its valuation.
 Technical analysis
Technical analysis – a forecasting method for asset prices based solely on information about the
past prices.
The aim of the technical analysis is to identify stocks that are candidates for purchase or sale,
and the investor can employ technical analysis to define the time of the purchase or sale.
Technical analysis ignores company fundamental information, focusing instead on the study of
internal stock market information on price and trading volume of individual stocks, groups of
stocks, and the overall market, resulting from shifting supply and demand. Technical analysts
believe that stock markets have a dynamic of their own, independent of outside economic
forces.
Technical analysis is aimed to determine past market trends and patterns from which predictions
of future market behavior are derived. It attempts to forecast short-term price movements.
The study of past patterns of variables such as prices and trading volumes allows investors to
identify times when particular stocks (or sectors, or the overall market) are likely to fall or rise
in price. The focus tends to be on the timing of purchases and sales.
H. Levy has suggested that technical analysis is based on the following assumptions:
1. The market price of securities (such as shares and bonds) is determined by supply and
demand.
2. Supply and demand are determined by numerous rational and irrational factors. These include
both objective and subjective factors.
3. Apart from minor fluctuations the prices of individual securities, and the level of the market
as a whole, tend to move in trends which persist for significant periods of time.
4. Trends change in reaction to shifts in supply and demand. These shifts in supply and demand
can be detected in the action of the market itself.
There are many technical analysis and trading techniques, including chart and non-chart ones.
Price charts are a more frequent technique. Price charts are made for each day, or other chosen
time interval, with the help of a vertical line. The top of the vertical line indicates the highest
price reached during the day and the bottom shows the lowest price. A short horizontal line on
each vertical line indicates the closing price on the day.
Technical analysts use a vast number of chart patterns.
 Price channels (Trend channels). Trend channels can be horizontal, upward or
downward sloping. The share price remains within the channel, and some points in time
breaks out of the channel. If it breaks out of the channel in a downward direction, the
chartist may interpret this as a signal to sell the stock since it is seen as forecasting a fall
in the stock price, and vise versa. Price channels are often interpreted in terms of the
bounds providing limits to the extent of variation of share prices, such that share prices
tend to remain within the bounds
 Reversal patterns. Chartists frequently believe that when the direction of a share price
(or market index) changes, characteristic chart patterns may develop as the turn occurs.
One of those reversal patterns is head-and-shoulders configuration. The highest peak is
the head, and the lower peaks are the shoulders. When the share price falls below the
lower peak, further price fall is forecasted and eventually constitutes a sell signal.
 Moving averages. Technical analysts use not only prices relating to individual dates,
but also moving averages. A moving average is an average of a series of previous prices,
for example the average of the last 200 daily prices. (Each day the oldest price is
removed from the calculation of the average and the most.
One popular technique is to use moving averages and daily prices on the same
chart. A daily price chart that crosses a moving average chart from below might be seen
as providing a buy signal.

Dow theory. This is one of the oldest technical tools, aimed to forecast the future direction of
the overall stock market.
Dow theory is based on the belief that market movements are analogous to movements of the
sea. It sees three simultaneous movements in the market.
Daily and weekly fluctuations correspond to ripples.
Secondary movements (which last a few months) are the waves.
Primary trends of a year or more are analogous to tides.
It is the primary trend that is referred to as either a bull or a bear market. The daily or weekly
movements are seen as having little or no predictive value. However, secondary movements in
stock indices are used to forecast changes in the direction of the primary trend. A bull market is
characterized by both high and low points of successive secondary movements moving in an
upward trend, especially if this were accompanied by rising volumes of stocks traded.

Elliot wave theory. The theory sees markets as moving in cycles.

Elliot wave theory assumes that markets are driven by investor psychology. After a fall in
prices, investor optimism is seen as growing slowly at first but later the optimism becomes
excessive and leads to a bubble at which prices peak. The bubble bursts and the market is then
carried lower in the wave pattern.

Technical analysts also use other indicators.

  Filter rule states that an investor should buy when a stock price (or market index) has
risen by a predetermined percentage above a previous low point. Conversely, the
investor should sell when the price or index falls by a particular percentage below a
previous high. The percentages are decided by the investor, but they should be
established prior to the market movements.
 Relative strength is measured by the ratio of a stock price to a market index. Changes
in the ratio are taken to indicate buy or sell opportunities. For a momentum trader a rise
in the ratio is a signal to buy the stock (and a fall is a signal to sell).A contrarian trader
would interpret a rise in the ratio as a sell signal (and a fall as a buy signal).
 The short interest ratio is the ratio of short sales to total trading. A rise in the ratio has
two opposite interpretations. First, a rise in the ratio as indicative of bearish sentiment,
and hence is a sell signal. Second, a rise is a buy signal, since it is believed that the short
positions will have to be covered by stock purchases. These stock purchases would tend
to push up stock prices.
 Trin statistic is the ratio of the average trading volume in stocks with declining prices
to average volume in stocks rising prices. Ratio above 1 show a bearish market, since a
relatively high volume of trades in declining stocks is indicating net selling pressure.
Conversely, ratios below 1 are seen as indications of a bullish market.
 Trading volume is considered an indication of the strength of a trend. If a price
movement is accompanied by a relatively high quantity of trades, it is considered more
significant than the price movement in a low trading volume market.
 Breadth of the market shows the extent to which movement in a market index is
reflected widely in the price movements of individual stocks. The most common
measure of breadth is the difference between the numbers of stocks that rise and the
number that fall. If the difference is large, the market movement is considered to be
strong, since it is widespread. A market rise is viewed stronger, if prices of large
majority of stocks are rising. Conversely, market rise is viewed as weaker, when only
prices of stocks of a few large capitalization companies are increasing.
 Mutual fund cash holdings, if they increase, might an indication of a market rise based
on belief that the cash will be used to buy shares. This demand for shares would tend to
push prices up. Conversely, low mutual fund cash holdings are seen as a bearish signal.
 Put-call ratio. Put options give the right to sell shares at a specified price, and are
bought by investors who expect share prices to fall. Call options give the right to buy
shares at a specified price, and are bought by investors who expect share prices to rise.
The ratio of puts bought to calls bought is used as an indicator of the expectations of
investors.
However technical analysts have different interpretations of the ratio. Some see a
high put-call ratio as a sign of a bearish market based on the belief that it indicates that
investors in general expect stock price falls. Others have a contrarian view, and see a
high put-call ratio as a buy signal. Contrarian analysts base their analysis on the belief
that investors are usually wrong.

Basic Common Stock Valuation Equation

 Free Cash Flow Valuation Model
The free cash flow valuation model is based on the same basic premise as dividend valuation
models: The value of a share of common stock is the present value of all future cash flows it is
expected to provide over an infinite time horizon. However, in the free cash flow valuation
model, instead of valuing the firm’s expected dividends, we value the firm’s expected free cash
flows. They represent the amount of cash flow available to investors—the providers of debt
(creditors) and equity (owners)—after all other obligations have been met.
The free cash flow valuation model estimates the value of the entire company by finding the
present value of its expected free cash flows discounted at its weighted average cost of capital,
which is its expected average future cost of funds.
Example:
Dewhurst, Inc., wishes to determine the value of its stock by using the free cash flow valuation
model. To apply the model, the firm’s CFO developed the data given in Table 7.4. Application
of the model can be performed in four steps.

Step 1 Calculate the present value of the free cash flow occurring from the end of 2018 to
infinity, measured at the beginning of 2018 (that is, at the end of 2017). Because a constant rate
of growth in FCF is forecast beyond 2017, we can use the constant-growth dividend valuation
model to calculate the value of the free cash flows from the end of 2018 to infinity:

Note that to calculate the FCF in 2018, we had to increase the 2017 FCF value of $600,000
by the 3% FCF growth rate, gFCF.
Step 2 Add the present value of the FCF from 2018 to infinity, which is measured at the end
of 2017, to the 2017 FCF value to get the total FCF in 2017.

Step 3 Find the sum of the present values of the FCFs for 2013 through 2017 to determine
the value of the entire company, VC. This calculation is shown in Table 7.5.

Step 4 Calculate the value of the common stock using Equation 7.7. Substituting into
Equation 7.7 the value of the entire company, VC, calculated in Step 3, and the market values
of debt, VD, and preferred stock, VP, given in Table 7.4, yields the value of the common
stock, VS:
VS = VC - VD - VP
The value of Dewhurst’s common stock is therefore estimated to be $4,726,426. By dividing
this total by the 300,000 shares of common stock that the firm has outstanding, we get a
common stock value of $15.76 per share ($4,726,426/300,000).

 Other Approaches To Common Stock Valuation

Book Value
Book value per share is simply the amount per share of common stock that would be
received if all of the firm’s assets were sold for their exact book (accounting) value and the
proceeds remaining after paying all liabilities (including preferred stock) were divided
among the common stockholders. This method lacks sophistication and can be criticized on
the basis of its reliance on historical balance sheet data. It ignores the firm’s expected
earnings potential and generally lacks any true relationship to the firm’s value in the
marketplace.

Example
At year-end 2012, Lamar Company’s balance sheet shows total assets of $6 million, total
liabilities (including preferred stock) of $4.5 million, and 100,000 shares of common stock
outstanding. Its book value per share therefore would be

Because this value assumes that assets could be sold for their book value, it may not
represent the minimum price at which shares are valued in the marketplace. As a matter of
fact, although most stocks sell above book value, it is not unusual to find stocks selling below
book value when investors believe either that assets are overvalued or that the firm’s
liabilities are understated.

Liquidation Value
Liquidation value per share is the actual amount per share of common stock that would be
received if all of the firm’s assets were sold for their market value, liabilities (including
preferred stock) were paid, and any remaining money were divided among the common
stockholders. This measure is more realistic than book value— because it is based on the
current market value of the firm’s assets—but it still fails to consider the earning power of
those assets.
Example
Lamar Company found on investigation that it could obtain only $5.25 million if it sold its
assets today. The firm’s liquidation value per share therefore would be

Ignoring liquidation expenses, this amount would be the firm’s minimum value.

Price/Earnings (P/E) Multiples

The price/earnings multiple approach is a popular technique used to estimate the firm’s
share value; it is calculated by multiplying the firm’s expected earnings per share (EPS) by
the average price/earnings (P/E) ratio for the industry.
Example
Ann Perrier plans to use the price/earnings multiple approach to estimate the value of Lamar
Company’s stock, which she currently holds in her retirement account. She estimates that
Lamar Company will earn $2.60 per share next year (2013). This expectation is based on an
analysis of the firm’s historical earnings trend and of expected economic and industry
conditions. She finds the price/earnings (P/E) ratio for firms in the same industry to average
7. Multiplying Lamar’s expected earnings per share (EPS) of $2.60 by this ratio gives her a
value for the firm’s shares of $18.20, assuming that investors will continue to value the
average firm at 7 times its earnings.

DECISION MAKING AND COMMON STOCK VALUE

Changes In Expected Dividends
Assuming that economic conditions remain stable, any management action that would cause
current and prospective stockholders to raise their dividend expectations should increase the
firm’s value. Any action of the financial manager that will increase the level of expected
dividends without changing risk (the required return) should be undertaken, because it will
positively affect owners’ wealth.
Example
Financial analysts previously found Lamar Company to have a share value of $18.75. On the
following day, the firm announced a major technological breakthrough that would
revolutionize its industry. Current and prospective stockholders would not be expected to
adjust their required return of 15%, but they would expect that future dividends will increase.
Specifically, they expect that although the dividend next year, D1, will remain at $1.50, the
expected rate of growth thereafter will increase from 7% to 9%.
P = 1.50 / (.15 - .09)
P = 25
The increased value therefore resulted from the higher expected future
dividends reflected in the increase in the growth rate.

Changes In Risk
Any measure of required return consists of two components, a risk-free rate and a risk
premium. Any action taken by the financial manager that increases the risk shareholders must
bear will also increase the risk premium required by shareholders, and hence the required
return. Additionally, the required return can be affected by changes in the risk free rate—
even if the risk premium remains constant.
Example
Assume that Lamar Company’s 15% required return resulted from a risk-free rate of 9% and
a risk premium of 6%. With this return, the firm’s share value was calculated to be $18.75.
Now imagine that the financial manager makes a decision that, without changing expected
dividends, causes the firm’s risk premium to increase to 7%. Assuming that the risk-free rate
remains at 9%, the new required return on Lamar stock will be 16% (9% + 7%)
P = 1.50 / (.16 - .07)
P = 16.67
As expected, raising the required return, without any corresponding increase in expected
dividends, causes the firm’s stock value to decline. Clearly, the financial manager’s action
was not in the owners’ best interest.
Combined Effect
A financial decision rarely affects dividends and risk independently; most decisions affect
both factors often in the same direction. As firms take on more risk, their shareholders expect
to see higher dividends.
Example:
If we assume that the two changes illustrated for Lamar Company in the preceding examples
occur simultaneously, the key variable values would be D1 = $1.50, rs = 0.16, g = 0.09
P = 1.50 / (.16 - .09)
P = 21.43
The net result of the decision, which increased dividend growth (g, from 7% to 9%) as well
as required return (rs, from 15% to 16%), is positive. The share price increased from $18.75
to $21.43. Even with the combined effects, the decision appears to be in the best interest of
the firm’s owners because it increases their wealth.

Sources:
Darskuviene, Valdone, Financial Market, 2010 Edition
Gitman, L.J. and Zutter, C.J., Principles of Managerial Finance, 13th Edition