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**Unformatted text preview: **n. What
information does the stock’s price/earnings (P/E) ratio provide? 322 PART 2 LG4 Important Financial Concepts LG5 7.3 Common Stock Valuation
Common stockholders expect to be rewarded through periodic cash dividends
and an increasing—or at least nondeclining—share value. Like current owners,
prospective owners and security analysts frequently estimate the firm’s value.
Investors purchase the stock when they believe that it is undervalued—when its
true value is greater than its market price. They sell the stock when they feel that
it is overvalued—when its market price is greater than its true value.
In this section, we will describe specific stock valuation techniques. First,
though, we will look at the concept of an efficient market, which questions
whether the prices of actively traded stocks can differ from their true values. Market Efficiency2
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 price that he or she would pay to acquire it; a seller views the asset’s
value as a 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.
This price reflects the collective actions that buyers and sellers take on the basis of
all available information. Buyers and sellers are assumed to digest new information immediately as it becomes available and, through their purchase and sale
activities, to create a new market equilibrium price quickly.
Hint Be sure to clarify in
your own mind the difference
between the required return
and the expected return.
Required return is what an
investor has to have to invest in
a specific asset, and expected
return is the return an investor
thinks she will get if the asset is
purchased.
ˆ
expected return, k
The return that is expected to be
earned on a given asset each
period over an infinite time
horizon. Hint This relationship
between the expected return
and the required return can be
seen in Equation 7.1, where a
decrease in asset price will
result in an increase in the
expected return. Market Adjustment to New Information
The process of market adjustment to new information can be viewed in terms of
rates of return. From Chapter 5, we know that for a given level of risk, investors
require a specified periodic return—the required return, k—which can be estimated by using beta and CAPM. At each point in time, investors estimate the
ˆ
expected return, k—the return that is expected to be earned on a given asset each
period over an infinite time horizon. The expected return can be estimated by
using a simplified form of Equation 5.1:
ˆ
k Expected benefit during each period
Current price of asset (7.1) Whenever investors find that the expected return is not equal to the required
ˆ
return (k k), a market price adjustment occurs. If the ex...

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