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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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This document was uploaded on 01/19/2014.

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