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09Class16 - Two Questions on the Stock Market Investors are...

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1 Two Questions on the Stock Market Investors are looking for advice on two questions: A. Which individual stocks to invest in? B. Market Timing. Is now a good time to buy stocks ?(Or should the investor put her money into bonds or something else.)
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2 Stock Picking Idea using Residual Income Valuation: For stocks of interest, calculate V, the value per share using residual income valuation which relies on earnings forecasts. Then calculate the ratio of V to P, the current price per share. For example for Microsoft we have a ratio of 38.19/15.97 = 2.39 (If only we could believe the earnings forecast!) Idea : Buy stocks which have the highest ratio of V/P.
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3 Academic Studies of Stock Picking Idea Academic studies have shown that this stock picking idea has worked in the past. Although the academic studies used the same per share approach that we used to calculate V, they were more sophisticated in how they treated continuing value.
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4 Continuing value began with year +5. However it was divided into two parts: Years +5 to +15 and year +16 onward. For year +5 to +15 the authors assumed that the firms return on equity (net income/(average book value)) converged to the current industry median return on equity.
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