Transcript Chapter 9

Chapter 9
Valuing Stocks
9.1 The Dividend Discount Model
• A One-Year Investor
– Potential Cash Flows
• Dividend
• Sale of Stock
– Timeline for One-Year Investor
 Div1  P1 
P0  

 1  rE 
• Since the cash flows are risky, we must discount them
at the equity cost of capital.
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9-2
Dividend Yields, Capital Gains,
and Total Returns
rE
Div1  P1

 1 
P0
Div1
P0

Dividend Yield
P1  P0
P0
Capital Gain Rate
• Dividend Yield
• Capital Gain
– Capital Gain Rate
• Total Return
– Dividend Yield + Capital Gain Rate
• The expected total return of the stock should equal the
expected return of other investments available in the market
with equivalent risk.
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9-3
Textbook Example 9.1
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9-4
The Dividend-Discount Model
Equation
• What is the price if we plan on holding the
stock for N years?
Div1
Div2
P0 


2
1  rE
(1  rE )
DivN
PN


N
(1  rE )
(1  rE ) N
– This is known as the Dividend Discount Model.
Div3
Div1
Div2
P0 



2
3
1  rE
(1  rE )
(1  rE )



n 1
Divn
(1  rE )n
– The price of any stock is equal to the present
value of the expected future dividends it will
pay.
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9-5
9.2 Applying the DiscountDividend Model (cont'd)
• Constant Dividend Growth Model
Div 0 1  g
Div 1
P0 

rE  g
rE  g
rE
Div1

 g
P0
– The value of the firm depends on the current
dividend level, the cost of equity, and the
growth rate.
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9-6
Textbook Example 9.2
KS
g
D1
Stock Value
To Find Ks
RF
Km
Beta
Ks
Dividend Yield
7.50%
1.50%
$2.36
$39.33
Stock Price
Expected return
Dividends (TV)
First
Last (D0)
N
g (if not given)
0.00%
published
$59.00
5.500%
#DIV/0!
If D1 given enter here
Earnings Growth Rate
Dividends (Retention)
b (retention ratio)
Dividend Payout Ratio
ROE
g (if not given)
2.36
Stock Valuation
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9-7
Constant Growth
• The XYZ Corp recently paid a $3.00 dividend.
Dividends are expected to grow at the historic
growth rate of 7%. The required return for the
company’s equity is 16%. What is the value of the
stock?
• If the stock traded at $37, what would you do?
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9-8
Dividends Versus Investment
and Growth
• A Simple Model of Growth
– Dividend Payout Ratio
• The fraction of earnings paid as dividends each year
Earningst
Divt 
 Dividend Payout Ratet
Shares Outstanding t
EPSt
– Assuming the number of shares outstanding is
constant, the firm can do two things to increase
its dividend:
• Increase its earnings (net income)
• Increase its dividend payout rate
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9-9
Dividends Versus Investment
and Growth (cont'd)
• A Simple Model of Growth
Change in Earnings  New Investment  Return on New Investment
New Investment  Earnings  Retention Rate
Change in Earnings
Earnings Growth Rate 
Earnings
 Retention Rate  Return on New Investment
g  Retention Rate  Return on New Investment
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9-10
Dividends Versus Investment
and Growth (cont'd)
• If the firm keeps its retention
rate constant, then the growth
rate in dividends will equal the
growth rate of earnings.
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9-11
Dividends Versus Investment
and Growth (cont'd)
• Profitable Growth
– If a firm wants to increase its share price,
should it cut its dividend and invest more, or
should it cut investment and increase its
dividend?
– The answer will depend on the profitability of
the firm’s investments.
– Cutting the firm’s dividend to increase investment will
raise the stock price if, and only if, the new investments
have a positive NPV.
– If and only if, there is information describing why they
want to do this.
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9-12
Textbook Example 9.3
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9-13
Textbook Example 9.3 (cont'd)
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9-14
TAP – Dividend Discount Model
Yahoo Finance
RF
3.67%
DIV
Km
12%
2012
1.28
Beta
.93
2011
1.28
Div Yield 2.5
2010
1.16
ROE
5.07
2009
1.00
DIV
payout
58%
2008
.84
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9-15
KS
g
D1
Stock Value
10.00%
6.50%
$1.36
$38.95
To Find Ks
RF
Km
Beta
Ks
3.67%
12.00%
0.93
11.42%
Dividend Yield
Capital Gains
Ks
Stock Price
Expected return
Dividends (TV)
First
Last (D0)
N
g (if not given)
2.50%
6.50%
9.00%
$53.20
9.062%
$0.84
$1.28
4
11.10%
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Earnings Growth Rate
Dividends (Retention)
b (retention ratio)
Dividend Payout Ratio
ROE
g (if not given)
42.00%
58.00%
5.07%
2.13%
9-16
Changing Growth Rates
• We cannot use the constant dividend
growth model to value a stock if the growth
rate is not constant.
– For example, young firms often have very high
initial earnings growth rates. During this period
of high growth, these firms often retain 100% of
their earnings to exploit profitable investment
opportunities. As they mature, their growth
slows. At some point, their earnings exceed their
investment needs and they begin to pay
dividends.
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9-17
Differential Growth (Variable)
• Due to an innovative production process the
company will be able to pay dividends at an above
normal rate of 12% for the next 4 years. After that
the growth will return to the industry standard of
9%. The most recent dividend was 4.25 and the
required return for the company’s equity is 20%.
What is the value?
Current Dividend
Normal Growth Rate
Supernormal Growth Rate
Supernormal Growth Period
Required Return
Current Stock Price
$4.25
9.00%
12.00%
4.0
20.00%
Future Dividend
PV of Dividend
1
2
3
4
5
6
7
15
Value of the Stock
$3.967
$3.702
$3.455
$3.225
$0.000
$0.000
$0.000
$0.000
$14.349
$31.957
$46.307
Super-Normal stock valuation
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9-18
Limitations of the
Dividend-Discount Model
• There is a tremendous amount of
uncertainty associated with forecasting a
firm’s dividend growth rate and future
dividends.
• Small changes in the assumed dividend
growth rate can lead to large changes in
the estimated stock price.
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9-19
9.3 Total Payout and Free Cash
Flow Valuation Models
• Share Repurchases and the Total Payout
Model
– Share Repurchase
• When the firm uses excess cash to buy back its own
stock
– Implications for the Dividend-Discount Model
• The more cash the firm uses to repurchase shares, the
less it has available to pay dividends.
• By repurchasing, the firm decreases the number of
shares outstanding, which increases its earnings per
and dividends per share.
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9-20
9.3 Total Payout and Free Cash
Flow Valuation Models (cont'd)
• Share Repurchases and the Total Payout Model
– Total Payout Model
PV (Future Total Dividends and Repurchases)
PV0 
Shares Outstanding 0
• Values all of the firm’s equity, rather than a single share. You
discount total dividends and share repurchases and use the
growth rate of earnings (rather than earnings
per share) when forecasting the growth of the firm’s
total payouts.
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9-21
TAP – Total Payout Model
Yahoo Finance
Shares
repurchased
0
WACC
8.83
Number of shares
182.6
Dividends Paid
Est (EPS) growth
231.04
3.10
Dividends paid out
Stock Repurchases
WACC
# shares
Growth of Earnings
Value of Stock
231.04
0
8.83%
182.6
3.10%
22.77
Total Payout Model
Get the WACC from
thatswacc.com/
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9-22
The Discounted Free Cash Flow
Model
• Discounted Free Cash Flow Model
– Determines the value of the firm to all investors,
including both equity and debt holders
Enterprise Value  Market Value of Equity  Debt  Cash
– The enterprise value can be interpreted as the
net cost of acquiring the firm’s equity, taking its
cash, paying off all debt, and owning the
unlevered business.
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9-23
The Discounted Free Cash
Flow Model (cont'd)
• Valuing the Enterprise
Unlevered Net Income
Free Cash Flow  EBIT  (1  c )  Depreciation
 Capital Expenditures  Increases in Net Working Capital
– Free Cash Flow
• Cash flow available to pay both debt holders and
equity holders
– Discounted Free Cash Flow Model
V0  PV (Future Free Cash Flow of Firm)
V0  Cash 0  Debt 0
P0 
Shares Outstanding0
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9-24
The Discounted Free Cash
Flow Model (cont'd)
• Implementing the Model
FCF1
FCF2
V0 


2
1  rwacc
(1  rwacc )
FCFN
VN


N
(1  rwacc )
(1  rwacc ) N
– Often, the terminal value is estimated by
assuming a constant long-run growth rate gFCF
for free cash flows beyond year N, so that:
VN
 1  g FCF 
FCFN  1

 
  FCFN
rwacc  g FCF
 (rwacc  g FCF ) 
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9-25
Stock Valuation Models
• The free cash flow valuation model
estimates the value of the entire company
and uses the cost of capital as the discount
rate.
VF  Vs  VD  cash
• to estimate the value of equity:
Vs  VF  VD  cash
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9-26
Free Cash Flow Model
• The firm has estimated the growth of FCF to be 7%
over the foreseeable future. The most recent FCF
was $700,000. The firms WACC = 13%.
– What is the firms value?
700,000 * 1  .07  749,000
VF 

 12,483,333
.13 .07
.06
• The firm has 1,000,000 in cash and market value of
debt at 7,500,000. The firm has 100,000 shares.
– What is the value of equity? Per share?
VS  VF - VD  cash
 12,483,333 7,500,000 1,000,000
 5,983,333
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9-27
WACC
g
FCF1
Value of Corp
Free CF
First
Last (FCF0)
N
g (if not given)
13.00%
7.00%
$749,000
$12,483,333
Market Value of Debt
Cash Available
Market Value of Common
Number of Shares
Value per share
$
$
$
7,500,000.00
1,000,000.00
$5,983,333
100,000
59.83
$700,000
#DIV/0!
If FCF1 given enter here
Free Cash Flow Valuation
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9-28
TAP FCF Model
Yahoo Finance
Cash
624
FCF
Total
debt
8245
2012
# shares
187.
1
2011
Growth
of FCF
3.7%
2010
Estimate
next
years
FCF
1000
2009
WACC
g
FCF1
Value of Corp
8.83%
3.70%
$1,000
$19,493
Free CF
First
Last (FCF0)
N
g (if not given)
$1,839
(ratios)
1839
792
-74
714
#DIV/0!
If FCF1 given enter here
Market Value of Debt
Cash Available
Market Value of Common
Number of Shares
Value per share
$1,000.00
$
$
$
8,245.00
624.00
$11,872
187
63.49
Free Cash Flow Valuation
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9-29
The Discounted Free Cash
Flow Model (cont'd)
• Connection to Capital Budgeting
– The firm’s free cash flow is equal to the sum of
the free cash flows from the firm’s current and
future investments, so we can interpret the
firm’s enterprise value as the total NPV that the
firm will earn from continuing its existing
projects and initiating new ones.
• The NPV of any individual project represents its
contribution to the firm’s enterprise value.
• To maximize the firm’s share price, we should accept
projects that have a positive NPV.
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9-30
Figure 9.1 A Comparison of Discounted
Cash Flow Models of Stock Valuation
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9-31
9.4 Valuation Based on
Comparable Firms
• Method of Comparables (Comps)
– Estimate the value of the firm based on the
value of other, comparable firms or investments
that we expect will generate very similar cash
flows in the future.
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9-32
Valuation Multiples
• Valuation Multiple
– A ratio of firm’s value to some measure of the
firm’s scale or cash flow
• The Price-Earnings Ratio
– P/E Ratio
• Share price divided by earnings per share
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9-33
Textbook Example 9.9
PE Multiplier
Company PE
Estimated EPS
21.300
$1.380
Value of Stock
$29.394
Multiplier models
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9-34
TAP – PE Multiplier Model
Yahoo Finance
PE (industry)
37.49
PE (forward)
12.41
EPS1
3.98
Mutlipler Model
Estimated PE
Estimated EPS
3.98
$12.410
Estimated PE
Estimated EPS
Estimated Value
$49.392
Estimated Value
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3.98
$37.490
$149.210
9-35
Valuation Multiples (cont'd)
• Enterprise Value Multiples
V0
FCF1 / EBITDA1

EBITDA1
rwacc  g FCF
– This valuation multiple is higher for firms with
high growth rates and low capital requirements
(so that free cash flow is high in proportion to
EBITDA).
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9-36
Textbook Example 9.10
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9-37
Enterprise Value Multipliers
Company EV Multiplier (EBITDA)
EBITDA
Debt
Cash
# of shares
Value of Stock
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7.400
$30.700
$125.000
5.400
$18.922
9-38
TAP – EBITDA Value Multiplier
Yahoo Finance
EV Multiplier
17.54
EBITDA
765
Debt
4650
Cash
511.1
# shares
182.61
Enterprise Value Multipliers
Company EV Multiplier (EBITDA)
EBITDA
Debt
Cash
# of shares
Value of Stock
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17.400
$765.000
$4,650.000
$511.100
182.610
$50.228
9-39
Valuation Multiples (cont'd)
• Other Multiples
– Multiple of sales
– Price to book value of equity per share
– Enterprise value per subscriber
• Used in cable TV industry
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9-40
Valuation Multiples (cont'd)
• Price to Sales
Price to Sales
Yahoo Finance
Price to sales
2.41
Estimated Sales
4310
# shares
182.61
Company P / S
Estimated Sales
# of shares
Est sales / share
Value of Stock
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$
2.410
$4,310.000
182.610
23.602
$56.881
9-41
Limitations of Multiples
• When valuing a firm using multiples, there
is no clear guidance about how to adjust for
differences in expected future growth rates,
risk, or differences in accounting policies.
• Comparables only provide information
regarding the value of a firm relative to
other firms in the comparison set.
– Using multiples will not help us determine if an
entire industry is overvalued,
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9-42
Comparison with Discounted
Cash Flow Methods
• Discounted cash flows methods have the
advantage that they can incorporate
specific information about the firm’s cost of
capital or future growth.
– The discounted cash flow methods have the
potential to be more accurate than the use of a
valuation multiple.
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9-43
Growth Opportunities (not in text)
• Growth opportunities are opportunities to
invest in positive NPV projects.
• The value of a firm can be conceptualized as
the sum of the value of a firm that pays out
100% of its earnings as dividends plus the
net present value of the growth
opportunities.
– Value as a cash cow
– Value of investment opportunities
EPS
P
 NPVGO
R
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9-44
The NPVGO Model: Example
Consider a firm that has EPS of $5 at the end of the
first year, a dividend-payout ratio of 30%, a
discount rate of 16%, and a return on retained
earnings of 20%.
• The dividend at year one will be $5 × .30 = $1.50
per share.
• The retention ratio is .70 ( = 1 -.30), implying a
growth rate in dividends of 14% = .70 × 20%.
From the dividend growth model, the price of a share
is:
D iv 1
$ 1 .5 0
P0 

 $75
R  g .1 6  .1 4
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9-45
The NPVGO Model: Example
First, we must calculate the value of the firm as a cash
cow.
EPS $5
P0 

 $ 3 1 .2 5
R
.1 6
Second, we must calculate the value of the growth
opportunities. (3.50 = 5.00 – 1.50) = retained earn per share.
g = retention calculation
3 . 50  . 20 


3
.
50



$. 875
. 16
P0 

 $ 43 . 75
Rg
. 16  . 14
Finally, P 0  3 1 . 2 5  4 3 . 7 5  $ 7 5
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9-46
TAP - NPVGO Model
NPVGO Model
EPS1
Value as Cash Cow
NPVGO
Stock Value
$3.98
$39.800
-$0.851
$38.949
What does a negative NPVGO value mean?
What would a negative stock value imply?
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9-47
Retention Rate and Firm Value
• An increase in the retention rate will:
– Reduce the dividend paid to shareholders
– Increase the firm’s growth rate
• These have offsetting influences on stock
price
• Which one dominates?
– If ROE>R, then increased retention increases
firm value since reinvested capital earns more
than the cost of capital.
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9-48
Dividends-and-Earnings
Approach (not in text)
• Very similar to variable-growth DVM
• Uses present value to value stock
• Assumes stock value is capitalized value of
its annual dividends and future sale price
• Works well with companies who pay little or
no dividends
Present value of
Present value of
Present value of

 the price of the stock
a share of stock
future dividends
at date of sale
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9-49
TAP – Earnings Dividend Model
Current EPS
EPS Growth Rate
Required Return
Est Dividend Payout
$2.440
4.000%
11.417%
35.000%
Risk Free Rate
Beta
Km
Required Return (ks)
3.670%
0.93
12.000%
11.417%
2008
2009
2010
2011
2012
Year
1
2
3
4
5
Est EPS
2013
2014
2015
2016
2017
$2.538
$2.639
$2.745
$2.854
$2.969
EPS
Est Div Payout Estimated Dividends PV of Dividend
35.000%
$0.888
35.000%
$0.924
35.000%
$0.961
35.000%
$0.999
35.000%
$1.039
PV of Estimated Div
PE Ratio
$2.969
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Historical Data
EPS
DPS
Dividend Payout
$2.090
$0.760
36.364%
$3.880
$0.920
23.711%
$3.780
$1.080
28.571%
$3.630
$1.240
34.160%
$2.440
$1.280
52.459%
Average Dividend Payout
35.053%
Historical EPS Growth
3.947%
Price
12.41
$36.841
Value of Stock
$0.888
$0.924
$0.961
$0.999
$1.039
$4.811
PV of Price
$21.457
$26.268
9-50
Stock Valuation Techniques:
The Final Word
• No single technique provides a final answer
regarding a stock’s true value. All
approaches require assumptions or
forecasts that are too uncertain to provide a
definitive assessment of the firm’s value.
– Most real-world practitioners use a combination
of these approaches and gain confidence if the
results are consistent across a variety of
methods.
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9-51
Comparison of models
Current Price
43.43
Dividend Discount
43.52
Total Payout
54.35
FCF
63.49
PE (company)
43.53
PE (industry)
59.07
Enterprise multiplier
44
Price to sales multiplier
45.61
NPVGO
-19.85
Earnings – Dividend
26.27
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9-52
9.5 Information, Competition,
and Stock Prices
• Information in Stock Prices
– Our valuation model links the firm’s future cash
flows, its cost of capital, and its share price.
Given accurate information about any two of
these variables, a valuation model allows us to
make inferences about the third variable.
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9-53
Figure 9.3 The Valuation Triad
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9-54
9.5 Information, Competition,
and Stock Prices (cont'd)
• Information in Stock Prices
– For a publicly traded firm, its current stock price
should already provide very accurate
information, aggregated from a multitude of
investors, regarding the true value of its shares.
• Based on its current stock price, a valuation model will
tell us something about the firm’s future cash flows or
cost of capital.
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9-55
Competition and Efficient
Markets
• Efficient Markets Hypothesis
– Implies that securities will be fairly priced, based
on their future cash flows, given all information
that is available to investors.
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9-56
Competition and Efficient
Markets (cont'd)
• Public, Easily Interpretable Information
– If the impact of information that is available to
all investors (news reports, financials
statements, etc.) on the firm’s future cash flows
can be readily ascertained, then all investors can
determine the effect of this information on the
firm’s value.
• In this situation, we expect the stock price to react
nearly instantaneously to such news.
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9-57
Textbook Example 9.12
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9-58
Competition and Efficient
Markets (cont'd)
• Private or Difficult-to-Interpret Information
– Private information will be held by a relatively
small number of investors. These investors may
be able to profit by trading on their information.
• In this case, the efficient markets hypothesis will not
hold in the strict sense. However, as these informed
traders begin to trade, they will tend to move prices,
so over time prices will begin to reflect their
information as well.
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9-59
Competition and Efficient
Markets (cont'd)
• Private or Difficult-to-Interpret Information
– If the profit opportunities from having private
information are large, others will devote the
resources needed to acquire it.
• In the long run, we should expect that the degree of
“inefficiency” in the market will be limited by the costs
of obtaining the private information.
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Figure 9.4 Possible Stock Price
Paths
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Lessons for Investors
and Corporate Managers
• Consequences for Investors
– If stocks are fairly priced, then investors who
buy stocks can expect to receive future cash
flows that fairly compensate them for the risk of
their investment.
• In such cases the average investor can invest with
confidence, even if he is not fully informed.
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Lessons for Investors
and Corporate Managers (cont'd)
• Implications for Corporate Managers
– Focus on NPV and free cash flow
– Avoid accounting illusions
– Use financial transactions to support investment
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The Efficient Markets Hypothesis
Versus No Arbitrage
• The efficient markets hypothesis states that
securities with equivalent risk should have
the same expected return.
• An arbitrage opportunity is a situation in
which two securities with identical cash
flows have different prices.
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