Stockholders are owners of a corporation.Rights of stockholders- Right to vote- Be the residual claimant- Right to sell the stockStockholders are paid dividends from the net earnings of the corporation.Cash flows a stockholder might earn from stock- Dividends- Sales priceOne-period valuation ModelPurchase stock today, hold it for one period and get paid a dividend, then sell the stock.P₀ = current price of the stockDiv₁= dividend paid at the end of year 1k = required return on investments in equityP₁ = price at the end of the first period (assumed sales price)P₀ = Div₁ / (1 + k ) + P₁ / (1 + k )Example: What price would you be willing to pay today for a stock that pays a $1/year dividend and that you expect to sell in a year for $20? Assume a required return of 15%.Generalized Dividend Valuation ModelThe value today is the present value of all future cash flows i.e. the sum of dividends and the final sales priceIf P is far in the future it will not impact P₀.Valuing an infinite stream of dividend payments is challenging!Gordon Growth modelP₀ = Div₁/(k – g)Where g = expected constant growth rate in dividends.Assumptions1. dividends grow at a constant rate forever2. growth rate of dividends is less than the requiredreturn on equityHow the market sets security prices1.The price is set by the buyer willing to pay the highest price.2.The market price will be set by the buyer who can take best advantage of the asset.3.Superior information about an asset can increase its value by reducing its risk. The buyer who has the best information about these cash flows will discount them at a lower interest rate than will a buyer who is very uncertain.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.Adaptive expectations – use past experience only. Changes in expectations will occur slowly over time as past data changes.Rational expectations – use all available information. Expectations will be identical to optimal forecasts (the best guess of the future) using all available information.A rational forecast may not always be perfectly accurate.Two reasons a forecast may not be rational1.Ignoring available information2.Unaware of available informationNote that if information is unavailable (cannot be attained) an incorrect forecast is still rational.Implications of rational expectations theory1.If there is a change in the way a variable moves, the way in which expectations of this variable are formed will change also.2.Forecast errors of expectations will on average be zero and cannot be predicted ahead of time.Efficient Markets Theory -- Application of rational expectations to the pricing of securities.Prices of securities in financial markets fully reflect all available information. All unexploited profit opportunities will be eliminated. In an efficient market, all prices are always correct and reflect market fundamentals.If the stock market is efficient, then ---Publicly available information cannot help you outperform the market. Information in published reports is readily available to many market participants and is already reflected in the market price.Only the first individuals to gain information such as a hot tip will be able to benefit from it. The market price will adjust very quickly to any new information.Stock prices move when expectations change. If theactual event is what had been expected, there will be no change in the stock price. If good news is not as good as had been expected, the stock price will fall.What does this mean for the average person?A “buy-and-hold” strategy may be the best choice.Buy-and-hold is purchasing stocks and holding themfor long periods of time. Usually results in higher profits since paying fewer brokerage commissions.Behavioral Finance – the application of concepts from other fields such as psychology and sociology to try to explain security pricing.Loss aversion – the pain of a dollar lost is greater than the pleasure from a dollar gained.Overconfidence in own judgments – we trade on beliefs rather than on pure facts.Social contagion – fads.Over confidence and social contagion might be a possible explanation for
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