Chapter 6
The stock market, the theory of rational expectations, and
the efficient market hypothesis
We begin by discussing the fundamental theories that underlie the valuation
of stocks. These theories are critical to understanding the forces that cause
the value of stocks to rise and fall minute by minute and day by day. Once
we have learned the methods for stock valuation, we need to explore how
expectations about the market affect its behavior. We do so by examining
the theory of rational expectations. When this theory is applied to financial
market, the outcome is the efficient market hypothesis.
A. Computing the price of common stock
Basic principle of Finance
Value of Investment = Present value of future cash flows
The oneperiod valuation model
)
1
(
1
1
0
k
P
D
P
+
+
=
Where
0
P
: the current price of the stock. The zero subscript refers to time period
zero, or the present.
1
D
: the dividend paid at the end of Year 1
1
P
: the price at end of the first period; the assumed sales price of the stock.
k
: the required return on investments in equity
The generalized dividend valuation model
Using the same concept, the oneperiod dividend valuation model can be
extended to any number of periods: The value of stock is the present value
of all future cash flows. The only cash flows that an investor will receive
are dividends and a final sales price when the stock is ultimately sold in
period n. the generalized multiperiod formula for stock valuation can be
written as:
61
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n
n
n
k
P
D
k
D
k
D
P
)
1
(
)
1
(
)
1
(
2
2
1
0
+
+
+
+
+
+
+
=
Since
n
P
is far in the future, it will not affect
0
P
. The generalized dividend
model could be rewritten with the final sales price:
+
+
+
+
=
2
2
1
0
)
1
(
)
1
(
k
D
k
D
P
∑
∞
=
+
=
1
0
)
1
(
t
t
t
k
D
P
The Gordon Growth Model
The generalized dividend valuation model required that we compute the
present value of an infinite stream of dividends, a process that could be
difficult. Thus simplified models have been developed to make the
calculations easier. One such model is the Gordon growth model, which
assumes constant dividend growth.
g
k
D
g
k
g
D
P

=

+
=
1
0
0
)
1
(
Where
g
: the expected constant growth rate in dividends
B. How the market sets security prices
The players in the market, bidding against each other, establish the market
price. When new information is released about a firm, expectations change
and with them, prices change. New information can cause changes in
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 Spring '08
 Ken
 Financial Markets, Efficientmarket hypothesis

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