3 those market participants who have

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Unformatted text preview: y 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 public information available about the firm and its securities,3 and these prices react swiftly to new information. 3. Those market participants who have nonpublic—inside—information may have an unfair advantage that enables them to earn an excess return. Since the mid-1980s disclosure of the insider-trading activities of a number of wellknown financiers and investors, major national attention has been focused on the “problem” of insider trading and its resolution. Clearly, those who trade securities on the basis of inside information have an unfair and illegal advantage. Empirical research has confirmed that those with inside information do indeed have an opportunity to earn an excess return. Here we ignore this possibility, given its illegality and that given enhanced surveillance and enforcement by the securities industry and the government have in recent years (it appears) significantly reduced insider trading. We, in effect, assume that all relevant information is public and that therefore the market is efficient. 324 PART 2 Important Financial Concepts 3. Because stocks are fully and fairly priced, investors need not waste their time trying to find and capitalize on mispriced (undervalued or overvalued) securities. Not all market participants are believers in the efficient-market hypothesis. Some feel that it is worthwhile to search for undervalued or overvalued securities and to trade them to profit from market inefficiencies. Others argue that it is mere luck that would allow market participants to anticipate new information correctly and as a result earn excess returns—that is, actual returns greater than required returns. They believe it is unlikely that market participants can over the long run earn excess returns. Contrary to this belief, some well-known investors such as Warren Buffett and Peter Lynch have over the long run consistently earned excess returns on their portfolios. It is unclear whether their success is the result of their superior ability to anticipate new information or of some form of market inefficiency. Throughout this text we ignore the disbelievers and continue to assume market efficiency. This means that the terms “expected return” and “required return” are used interchangeably, because they should be equal in an efficient market. This also means that stock prices accurately reflect true value based on risk and return. In other words, we will operate under the assumption that the market price at any point in time is the best estimate of value. We’re now ready to look closely at the mechanics of stock valuation. The Basic Stock Valuation Equation Like the value of a bond, which we discussed in Chapter 6, the value of a share of common stock is equal to the present value of all future cash flows (dividends) that it is expected to provide over an infinite time horizon.4 Although a stockhol...
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