# OHCh7 - Chapter 7: The Stock Market, the Theory of Rational...

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Chapter 7: The Stock Market, the Theory of Rational Expec- tations, and the E&cient Market Hypothesis

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1 Computing the Price of Common Stock common stock: a share of ownership of a corporation stockholders own an interest in the corporation consistent with the percentage of outstanding shared owned Dividends: payments made periodically (usually every quarter) to stock- holders Net earnings: The corporation pays dividends from net earnings of the corporation
1.1 The One-Period Valuation Model maturities are the same (denoted by i ), and later relax this assumption. The current price of the stock will be equal to the present value of the cash ±ow obtained from holding a common stock for one year. P t = D t +1 1 + k e + P t +1 1 + k e (1) P t : the current price of the stock. The t subscript refers to time period t , or the present. D t +1 : the dividend expected to be paid at the end of year

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t + 1. P t +1 : the expected price at the end of year t + 1. k e : the required return on investments in equity k e = i + r (2) r : risk premium (determined in the market) 1.2 The Generalized Dividend Valuation Model P t = D t +1 1 + k e + D t +2 (1 + k e ) 2 + D t +3 (1 + k e ) 3 + : : : (3)
1.3 The Gordon Growth Model P t = D t (1 + g ) 1 + k e + D t (1 + g ) 2 (1 + k e ) 2 + D t (1 + g ) 3 (1 + k e ) 3 + : : : (4) P t = D t (1 + g ) k e g = D t +1 k e g (5)

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1.4 The Earning Valuation Models Assume that all net earnings are paid out stockholders over time. Then D t +1 1 + k e + D t +2 (1 + k e ) 2 + D t +3 (1 + k e ) 3 + : : : = E t +1 1 + k e + E t +2 (1 + k e ) 2 + E t +3 (1 + k e ) 3 + : : : (6) E t : (Net) earnings at time t Hence, we obtain another formula for the stock price based on the present value of earnings:
P t = E t +1 1 + k e + E t +2 (1 + k e ) 2 + E t +3 (1 + k e ) 3 + : : : (7) If the earnings grow at the constant rate, g , then P t = E t (1 + g ) k e g = E t +1 k e g (8) 1.5 The Generalized Dividend Valuation Model with Dif- ferent Interest Rates If interest rates on bonds of di&erent matrurities are di&erent,

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t = D t +1 1 + i t + r + D t +2 (1 + i 2 t + r ) 2 + D t +3 (1 + i 3 t + r ) 3 + : : : (9) 1.6 Monetary Policy and Stock Prices Use the most appropriate valuation model to think about how monetary the short-term interest rate. Problem 1:
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## OHCh7 - Chapter 7: The Stock Market, the Theory of Rational...

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