Chapter 7 - 7.5 Flashcards
What is the valuation triad made of what?
1) Share value
2) Cost of capital
3) future cash flows
What does the valuation triad tell us?
It shows how a valuation model links between the firm’s expected future cash flows, its cost of capital (determined by risk) and the value of shares.
If we are given accurate information about any two of the variables above in figure 7.3 a valuation model allows us to make an estimate about the third variable.
The model is most useful when one of these pieces of information is less reliable, so it helps to estimate what you don’t know well.
What conclusions should we draw if the actual market price of a stock doesn’t appear consistent with our estimate of its value?
Is it more likely that the stock is mispriced or that we are mistaken about its risk and future cash flows?
What does market pries reflect?
Market prices reflect the collective judgment of many investors, including professionals with access to detailed information.
What happens if our valuation differs?
If your valuation differs significantly from the market price, it’s a sign that other investors disagree with your assessment.
This should prompt you to:
Reconsider your assumptions and analysis.
Look for what you might have missed.
When can a person challenge the market price?
Only challenge the market price if you have superior private information about the firm’s:
Future cash flows.
Cost of capital.
This is rare since the market typically reflects all publicly available information.
What does the stock price reflect?
Stock prices reflect all information that is available to investors and shows how investors are competing using this information to buy and sell.
If someone discovers new information showing that a stock would lead to profit (positive NPV) investors would start buying it.
As more people try to buy, the stock’s price would go up.
Similarly, if someone finds out that selling a stock would lead to profits, they would sell it. As more people sell, the stock’s price would go down.
This process shows that prices adjust to reflect new information.
What is the efficient market hypothesis?
The efficient market hypothesis is the idea that due to the competition that investors create for buying and selling stocks it essentially removes all opportunities for profit from “positive NPV trades”
This hypothesis shows all stock prices are fair and reflect all publicly available information about the company’s future cash flows.
Why are markets efficient?
Markets are efficient due to competition.
When new information comes out that affects a company’s value, investors act quickly to adjust prices.
The accuracy of this process depends on:
How much competition there is among investors.
How many investors have access to the new information?
What is public information?
This is anything that all investors can access, like news reports, financial statements, company press releases, or other public data.
If this information clearly shows how it will affect the company’s future cash flows, all investors can quickly figure out how it will change the company’s value.
In this case, we expect investors to compete heavily, and the stock price will adjust almost instantly to the news.
A few lucky investors might be able to buy or sell shares before the price fully changes, but for most people, the stock price will already reflect the new information by the time they act.
This shows that the efficient markets hypothesis works well when information is public and easy to understand.
How does the concept of private information affect markets?
In some cases only a small number of investors may have access to private information which they can profit on from trading it.
These situations the efficient markets hypothesis doesn’t work perfectly because prices don’t reflect this private information.
As these informed investors trade, their actions will move the stock prices closer to reflect the private information.
However if the profits from using private information are large, investors will work to gain that information and because of this competition increases and stock price adjust proportionately.
What is market efficiency?
Market efficiency refers to how well financial markets incorporate and reflect all available information in the prices of securities (like stocks, bonds, etc.).
What are the three forms of market efficiency and how does it work?
Weak-Form Efficiency:
Prices reflect only past trading data (e.g., historical stock prices and volumes).
Semistrong-Form Efficiency:
Prices reflect all publicly available information, such as financial statements or news.
Strong-Form Efficiency:
Prices reflect all information, both public and private.
How does the effect of competition based on information about stock prices affect investors?
Investors can only find profitable opportunities (called positive-NPV opportunities) if there is some barrier that limits competition, like:
Having access to special information that few others know.
Having lower trading costs than other investors.
If many investors have the same information or skills, these profitable opportunities will disappear because of competition.
Good News for Investors:
If stock prices are accurate and reflect all information, investors can expect fair returns for the risk they take.
This means most investors don’t need to worry about being at a disadvantage if the market is efficient and information is reliable.
Warning: In less efficient markets (like small or poorly regulated markets), uninformed investors may face higher risks because information might not be accurate or reliable.
How does the effect of competition based on information about stock prices affect managers?
If markets are efficient, a company’s value depends on the cash flows it generates for investors. This creates important lessons for managers:
Focus on NPV and Free Cash Flow:
Managers should make decisions that increase the company’s cash flows because this boosts the company’s stock price.
Avoid Accounting Tricks:
Some managers focus on boosting accounting numbers (like profits) instead of real cash flow.
In efficient markets, accounting numbers that don’t reflect real cash flow won’t fool investors and won’t increase the stock price.
Investors and managers should watch out for misleading accounting practices.
Use Financial Markets to Raise Money:
In efficient markets, companies can sell their stock at a fair price to fund new investments.
