Econ315 Money and Banking: Learning Unit 14: Stock market Analysis

Learning Unit #14
Stock Market Analysis

Introduction
Stocks vs. Bonds
• Stocks are another type of financial instruments
that make payments in future.
• Like bonds in Learning Unit #8, a value of stocks
is a present value of future cash flows from
stocks.
• One important difference between stocks and
bonds is uncertainty of future cash flows from
stocks (future cash flows from bonds are know,
given face value, maturity, and coupon rate).
• It is important to make good guess on future
cash flows from stocks to make a good estimate
of value of stocks.

Objectives of Learning Unit
This Learning Unit explains how a value
of stock is estimated and how a stock
market operates. It extends the present
value model of bonds and the bond
market framework, including
• Valuation Model
• Rational Expectations
• Efficient Market Hypothesis
• Stock Market Crash

How Stock Price Is Determined
Two basic approaches
•Fundamental analysis: Evaluate value of
stock based on fundamentals - the future
cash flows and profitability of the business,
and determine whether the market price is
over- or under-valued.
•Technical analysis: Predict a stock price
from historical patterns. It does not care
the value of stock.

Fundamental Analysis
Fundamental analysis has three components:
•Rational Expectations: Predict the future cash flows
and profitability of the business
•Valuation Model: Determine the value of stock by
discounting the predicted cash flows
•Efficient Market Hypothesis: Buyers and sellers of
stocks act based on the predicted value of stock – if
the price is less than the predicted value
(undervalued), it should be bought – and affect the
demand and supply of stocks in market. As a result,
the stock price reaches an equilibrium price equal to
the predicted value.

Cash Flows on Stock
• Like bonds a value of stock is a present value of
future cash flows from stock.
• Unlike bonds, stocks do not pay fixed coupon
payments. Instead, they pay dividends.
• Unlike bonds, stocks do not have maturity, so
dividends will be paid as long as corporations exit.
• Future cash flows from the stock:
0 1 2 3 ....
....
∞
P0
Div1 Div2 Div3

Dividend Valuation Model
• Dividend valuation model: The value
of stock is the present value of future
cash flows from the stock (dividends).
P0 : value of stock today
Divi: annual dividend payment between Year i-1 an Year i
ke : a required rate of return on stock
.....
)k(1
Div
)k(1
Div
)k(1
Div
P 3
e
3
2
e
2
e
1
0 +
+
+
+
+
+
=

Required Rate of Return
• Required rate of return on stock is a risk-adjusted
yield (interest rate) that saver/lenders demand for
holding risky stocks.
ke = if
+ RP
where if
is an interest rate on risk-free bonds and
RP is a risk premium on stock.
• Stocks are riskier than bonds, because of more
uncertainty of future payments
− Dividends will be paid only if firms make sufficient
profits.
− In case of bankruptcy of firm, stockholders are
paid only after all creditors are paid out.

Valuation Models of Bond vs. Stock
The formula of dividend valuation model
of stock is similar to the PV formula of
bond, but they are different in
• No maturity of stock means cash flows
to continue as long as a firm exist.
• Future dividends on stock are not
known now, while future cash flows are
known for bonds.
⇒More uncertainty on stock return.
⇒Higher return on stock.

One Period Valuation Model
• Instead of holding stocks indefinitely, if
saver/lenders hold stocks for only one period
(purchase today and sell next year), then a
cash flow from stock will be
0 1
Div1 + P1
@ ke
P0
Div1: dividend payment from today to next year.
P1: price of stock next year
Ke: a required rate of return on stock

Value of Stock on One Period Valuation
Model
• One Period Valuation Model: A value of stock today
(P0) is a present value of dividend payment (Div1)
from the stock between today and next year and a
sales price of the stock next year (P1) discounted by
the required rate of return (ke).
)1()1(
11
0
ee k
P
k
Div
P
+
+
+
=
Note: If you purchase the stock at P0 today, receive Div1, and sell
it at P1 next year, then according to the rate of return formula in
Learning Unit #9 (rr = [c+Pt+1-Pt]/Pt) how much will be a rate of
return from the investment?
You should receive a rate of return of ke!

Example of One Period Valuation Model
• You want to purchase an IBM stock today. You plan to sell
it at $87.99 next year and expect to receive $0.80 of
dividends from today until next year. If the required rate of
return on the IBM stock is 10%, the value of IBM stock
today is
72.80$
1.01
99.87$
1.01
80.0$
P0 =
+
+
+
=
• If the default-risk free one-year T-bill yields 4% (if
) and you want
6% risk premium on the risky IBM stock, then you ask for 10%
required rate of return (ke) on the IBM stock.

Constant Dividend Valuation Model
• Constant Dividend Valuation Model: Dividend
valuation model assumes variable dividends from
one year to another. If dividends are assumed to
be constant every year, the formula becomes
ek
Div
P =0
ek
Div
P =0
where Div is a constant annual dividend.
Note: If you purchase a stock at P0 today and expect to receive
a constant dividend (Div) each year forever, then according to
the current yield formula in Learning Unit #9 (i = C/P), you will
earn an interest rate at ke.

Example of Constant Dividend Valuation
Model
• You want to purchase a stock of XYZ Corporation
today. You expect to receive $8.07 of dividends
each year forever. If the required rate of return on
the XYZ stock is 10%, the value of XYZ stock today
is
70.80$
10.0
07.8$
P0 ==
Alternatively, if you plan to sell this stock at $80.70 next year, then
according to the one period valuation model the price of stock today
must be
70.80$
1.01
70.80$
1.01
07.8$
P0 =
+
+
+
=
Thus, if the required rate of return remains constant, then the price
of stock will not change in future.

Increasing Dividend Valuation Model
• Gordon growth model: If you expect a dividend from
a stock increase each year at rate of g, then the cash
flows will become
gk
Div
P
e −
=0
gk
Div
P
e −
=0
gk
Div
P
e −
=0
gk
Div
.....
)k(1
)g1(Div
)k(1
g)(1Div
)k(1
Div
P
e
3
e
2
2
ee
0
−
=+
+
+×
+
+
+×
+
+
=
0 1 2 3 ....
....
∞
P0
Div Div x (1+g) Div x (1+g)2
And the value of stock today should be

Example of Increasing Dividend
Valuation Model
• You want to purchase a stock of PQR Corporation
today. You expect to receive $4.84 of dividends
next year and it will increase by 4% each year.
The cash flows are
0 1 2 3 ....
....
∞
P0
$4.84 $5.03 $5.23
67.80$
04.00.10
$4.84
P0 =
−
=
If the required rate of return on the PQR stock is
10%, the value of PQR stock today is

Role of Expectations
• So far, to compute a value of stock we
assume that we know future cash flows
(dividends and price of stock in future).
• However, in reality we must make good
guess (estimation) on future cash flows.
• Expectations are important in every sector
and market in the economy.
− Saver/lenders’ demand for bonds
− Spender/borrowers’ supply of bonds
− Risk and term structure of interest rates
− Inflation expectation (Fisher equation)
− Future dividends on stock

How Expectations are Made
There are two ways to form expectations.
• Adoptive expectations: Expectations are formed
from past experience only.
– Changes in expectations are made slowly over time as past
information changes.
• Rational expectations: Optimal forecasts (the
best guess of the future) using all available
information.
− Changes in expectations are made every time new
information arrives.
• Do people make adoptive or rational expectations?
How about you? How about meteorologist?

Examples of Adoptive Expectations
• Under adoptive expectations people ignore new
information relevant to decisions, but only concern
with past behavior of variables to predict what will
happen next on the variables.
− Example #1: Quiz #1 through #3 were easy, so a student
expects the final examination will be easy also and decides
not to prepare for it even though his teacher has told
students that the final examination will be much more
difficult. Will he do well or bomb the final examination?
− Example #2: Aggie baseball team won first two easy games
against Greensboro College and Guilford college, so it is
expected to win the third game against North Carolina
(NCAA national champion). Will it happen?
− Example #3: Enron stock price continued to go up and up
in 2000s, so savers expected its price to go up furthermore
throughout 2001 even though its auditor confessed that it
helped Enron to hide huge losses. So, what would happen
to Enron stocks?

Rational Expectations
• Rational Expectations use all
available information to form
expectations.
• All available information include
− the past information
− all other economic and financial
information useful to predict the future
outcome
− all techniques to predict futures

Examples of Rational Expectations
− Example #1: Quiz #1 through #3 were easy,
however a student uses valuable information
from his teacher (his teacher has told students
that the final examination will be much more
difficult) and prepares hard for the final
examination.
− Example #2: Even though Aggie baseball team
had two easy wins, they prepare hard for the
next game against North Carolina since it will be
very tough opponent (NCAA national champion).
− Example #3: Although Enron stock price
continued to go up and up in 2000s, as soon as
its auditor confessed that it helped Enron to hide
huge losses, investors expected its price to fall
and decided to get rid of Enron stocks.

Rational Expectations and Optimal
Forecasts
A prediction based on rational expectations
may not always be perfectly accurate.
• Even if you use all available information, there is
no way to predict future perfectly.
• The forecast errors of rational expectations will
on average be zero.
− You should not systematically underestimate
or overestimate over a period of time.
− You learns from the past mistakes.
• By using most recent information, forecast errors
are most likely smaller than those from adoptive
expectations.

Example #1 of Optimal Forecasts
• A student thought Quiz #1 was easy, so he did not
prepare for it and bombed it.
− Non-optimal forecast: He believed that it could
not be such difficult again, so he decided not to
prepare for Quiz #2. Contrary to his expectation,
Quiz #2 is as difficult as Quiz #1, so he bombs
again (makes the same mistake again and again).
− Optimal forecast: He knew that he
underestimated the difficulty, so he adjusted his
expectation on Quiz #2 to be much more difficult
and decided to prepare hard for Quiz #2. As
expected, Quiz #2 is as difficult as Quiz #1, and
this time he does well on Quiz #2, thanks to his
preparation.

Example #2 of Optimal Forecasts
• Savers just heard a bad news about Enron
(large hidden losses and illegal accounting
practice).
− They adjusted their expectations on dividends
from Enron to fall, so as the value of Enron stock.
− Without knowing whole story, not many savers
expected Enron to be bankrupted and its stocks
would become worthless.
• It is impossible to forecast perfectly stock
prices in future.
− There is always risk on stock investment.

Stock Market and Demand
• A price of stocks is determined by the demand and supply
of the stocks in the market.
• The market price of stocks is equal to the value of the
stocks.
− If a market price of stocks is less than the value of the stocks (you
believe that Microsoft stock worth $50, but a market price of
Microsoft stock is only $40), savers will purchase the stocks and
the demand for the stocks increases. As a result, a market price
of the stock rises to the value of the stocks.
− If a market price of stocks is higher than the value of the stocks
(you believe that Yahoo stock worth $30, but a market price of
Yahoo stock is $40), holders of the stocks will sell the stocks and
the demand for the stocks decreases. As a result, a market price
of the stocks falls to the value of the stocks.

Information and Market Price of Stock
• When a new information arrives, savers
revise their expectations of cash flows
from the stock and the value of the stocks
accordingly, then compare it with a
market price of the stocks and react
accordingly. This will change the demand
for the stocks and the market price of the
stock

Example of Information and Market Price
of Stock
• Originally, the market is at an equilibrium
(market price of stock = value of stock)
• A bad news about a firm’s business
⇒ Profits of the firm are expected to decline in
future.
⇒ The firm is expected to decrease dividends on
its stocks in future.
⇒ The value of firm’s stock ↓
⇒ The value of stock < Market price of stock
⇒ Demand for the stock ↓
⇒ A market price of stock ↓ to its value
⇒ Stock market restores its equilibrium.

Changes in Demand and Stock Price
• When the demand for stocks changes, the
market (equilibrium) price of the stocks
changes.
S
D0
D1
P0
P1
Price of stock
E0
E1

Example of Stock Price Quotation on
Barron’s
• Dow Jones’ publishes quotations of various
stock prices traded in New York Stock
Exchange and NASDAQ every day on the Wall
Street Journal and weekly on Barron’s.
– See “How to Interpret Stock Price Quotation
of Barron’s” on Blackboard

Expectations and Stock Price
Stock prices are more volatile than bond
prices.
• Future dividends are unknown.
• Many factors such as information about firm’s
operation and profit and the condition of the
economy which may affect firm’s profit affect
the formation of expectations on future
dividends.
• Information arrive market any moment and
affect expectations on future dividends.
• Every time information arrive, savers react to
the information and affect the stock price.

Efficient Market Hypothesis
• Efficient market hypothesis: The market price
of any asset reflects all (publicly) available
information.
− When a good news about a firm arrives, savers revise their
expectations on future dividend payments and raise the value
of the stock. As the value of the stock becomes greater than a
market price of the stock, they want to purchase more stocks,
increasing the demand for the stocks and raising the market
price of the stock.
− When a bad news about a firm arrives, savers revise their
expectations on future dividend payments and lower the
value of the stock. As the value of the stock becomes less
than a market price of the stock, they want to purchase less
stocks (sell to other savers), decreasing the demand for the
stocks and lowering the market price of the stock.

Efficient Market Hypothesis and
Return on Stock
• In an efficient market, all unexploited profit
opportunities will be eliminated.
– Unexploited profit opportunity: a saver can
earn a higher than normal return for given
risk.
– In an efficient market, every rational saver
earns a required rate of return from stocks
(no more, no less) on average.
– High return from some stocks reflects simply
high risk premium for taking extra risk on the
stocks.

Efficient Market Hypothesis and
Irrational Savers
• Even in an efficient market, not everyone is well
informed about stocks or has rational expectations.
− Irrational savers may earn more or less than the required rate
of return on average (systematic underestimate or overestimate
will result in lower return than the normal).
• Even with irrational savers (who do not know the value
of stocks), the efficient market hypothesis may still hold.
− Rational savers can take an advantage of irrational savers and
may make profits from discrepancy between market price and
its value.
− Irrational savers are more likely to make losses from stock
investment (since they do not know stock’s value), so they will
eventually exit from the market.

Implications of Efficient Markets
Efficient market hypothesis has four
important implications for stock investment.
• Prices of (rate of return from) stocks are random
walk.
• Prices of stocks change only for unexpected
information.
• Technical analysis is useless.
• Hot tips will not provide profits.

Implication #1 of Efficient Markets
• Prices of (rate of return from) stocks are random
walk.
− Random walk: the movements of stock price whose
future changes cannot be predicted.
► If someone is heavily drunk, how will he walk?
− Because information arrives randomly (some time good
news, other time bad news) and no way we can predict
which news come next, the price of stock also changes
randomly.
► If news come in order of “good, bad, bad, good, bad, good,
and good,” then a stock price may “rise, fall, fall, rise, fall,
rise, and rise.”
► Do you know which news come next?

Further Implication #1 of Efficient
Markets
Because prices of (rate of return from) stocks are
random walk,
− Having performance well in the past does not indicate that
an investment adviser or a mutual fund will perform well in
the future.
− High return may be mere luck or payment for taking excess
risk rather than their superior investment ability.
− A monkey can choose stocks randomly and may end up to
have a better return than investment advisors.
− Do not waste too much fees to receive advises from
investment advisors which may not help you earn more
than an average, but simply diversify your portfolio to lower
risk. Easiest way to diversify your portfolio is to purchase
mutual funds.

Efficient market hypothesis implies that
• Prices of stocks change only for unexpected
information.
− Because all publicly available information including any
expectations has been reflected on the current price of
stocks, any information which has been already known
will not have any effect on stock prices.
►If you see news that a firm is going out of business, you
should react now and such reaction will cause the stock
price to fall now. Tomorrow, the CEO of the firm may
announce the bankruptcy, but such information will not
have any effect on stock price tomorrow because rational
savers will have already sold the stocks.
− Expected information has been reflected on current price
of stock.

Because stock prices are unpredictable, the efficient
market hypothesis further implies
• Technical analysis is useless.
− Technical analysis uses the historical data to predict
future stock price.
− Technical analysis is basically an adoptive expectation,
and ignores many relevant information for the stock
prices.
− You should not spend fees to get technical analysis, since
it may not bring any additional profit.
− Catch: If you really know what will happen to stock
prices by using technical analysis, will you sell your
predictions to others at fees or use it for you own
investment? So, why are they selling such information?

Further Implication #3 of Efficient Markets
• Some technical analysis looks at patterns of
past stock prices, while others looks at
phases of moon or sunspot. How reliable are
such predictions?
stock price
Year
Prediction based on
past pattern
Company announces
bankruptcy

Because prices of stocks change only for unexpected
information, the efficient market hypothesis further
implies
• Hot tips will not provide profits.
− Hot tips: a “hot” advise from stock broker, dealer, or
analyst about a particular stock.
► Your stock broker calls you this morning about a firm (hot
tip). Should you follow his advise?
► Do you think that you get the first call from your broker? If
he knows (and it is not insider information), should many
other brokers know it and has already given hot tips to
their clients? If so, the market price of the stock has
already reflected the “hot tip” and you will not gain any
extra profits.

Insider Trading and Efficient Market
• Efficient market hypothesis holds for publicly
available information.
• Insider information: Some relevant information
not available to the public, but only insiders of a
firm knows.
• Insider information give an opportunity to insiders
to make huge profits.
− If you work as accountant at a firm, know firm’s financial
problem and own thousands of stocks of the firm, and if the
CEO of the firm plans to announce this bad news tomorrow,
what will you do? If you use this insider information before
becoming public, you may avoid losses from investment.
• Because insider information potentially provide huge
profits to insiders in expense of the public
stockholders), a use of insider information is illegal
in the U.S.
− What happened to Martha Stewart?

Stock Market and Efficiency
Stock markets have had many crashes (free fall
of overall stock prices).
• Stock market crash (1929, 1987, 1997)
• Technology stock crash (2001)
Although there were some bad news prior to
each stock market crash, those bad news do not
justify such a massive stock price fall in rational
stock markets.
• The efficient market hypothesis might not hold during
stock market crashes. Why?

Potential Reasons for Stock Market
Crashes
Factors other than market fundamentals
(information, rational expectations, and
valuation) might cause stock market
crashes.
• Fads, overreaction, and social contagion
• (Speculative) Bubbles
• Trading mechanisms
• Program trading

Noise Traders
• Noise traders are relatively uninformed
stock traders.
− Noise traders do not use the fundamental
approach (valuation model) or understand
how news may affect prices of stocks.
− Noise traders tend to follow fads and rumors
to make decisions.
• Most traders in stock markets are noise
traders.
− How many savers in the U.S. have education
or experience in business, finance, and
accounting?

Day Traders
• Day-traders purchase and sell stocks
frequently (usually hold stocks less than
one day, often only few hours).
− Many day-traders are noise-traders: Many
day-traders watch posts on Internet bulletin
boards and make decisions on which stocks to
purchase and when to purchase.
− Day-traders make profits from changes in
stock prices (capital gain) rather than
dividends.
− Day-traders speculates which stock price to
rise quickly.

Fads, overreaction, and social contagion
Noise traders react to fads in stock markets,
overreact to news about stocks, and follow
others.
• Fads: short-lived stock rally.
− Noise traders follow fads and rumors to make
decisions.
• Overreaction: Noise traders overreact to news
because they do not have any clue on its value.
• Social contagion: Noise traders follow other
traders without understanding why others are
purchasing.

Consequence of Fads, overreaction, and
social contagion
• Noise traders tend to push market prices of
stocks above or below their values.
− When noise traders see other traders
purchasing a particular stock, they follow and
purchase at any price, even above its value.
− When noise traders see other traders selling a
particular stock, they follow and sell at any
prices, even below its value.
• Such overreactions cause large swings in
stock prices and create risk to the market.

Speculative Bubbles
• Speculative Bubbles: The price of an asset
rises far above its value due to speculation.
− Rational traders, who use the fundamental
approach and understand how news affect
stock prices, engage in speculation.
− They know that there are many noise traders
in stock market.
− They purchase stocks even though they know
they are overpriced, speculating that noise
traders will purchase the stocks at even
higher price.
− Such speculation raises a stock price far
above its value.

Greatest Fool Theory
• Rational traders knowingly engage in
speculative bubble, hoping there are some fools
in stock market who will purchase stocks at
higher price.
• As stock price (bubble) rises, less and less fools
engage in speculation (since they know it’s
getting too expensive).
• Eventually, the greatest fool (who thought there
would be still more fools in market) cannot find
any buyers of the stocks.
• The greatest fool realizes his problem and
panics to sell the stocks at any price.
• The stock price falls greatly and suddenly.

Trading Mechanisms and Program
Trading
• Problem in trading mechanisms
− When traders try to sell a large volume of
stocks, specialists at New York Stock
Exchange cannot make market (not able to
find enough buyers to handle the sales
orders).
• Program trading: Computerized automated
trading by professional traders
− To avoid huge losses from a large price fall,
stocks are sold automatically by professional
traders regardless of its value.

Internet and Technology Stock Market
Crash of 2000s
• During 1990s, many traders believed that Internet and
technology firms would take over existing (brick and mortar)
business and make huge profits, even though they have not
made any profits.
− Amazon.com was once believed to take over all book-sales
business in the U.S.
• Such expectations raised values of stocks of Internet and
technology firms and their prices accordingly.
• As stock prices rose, many traders speculated and created
bubbles.
• Seeing many years of no profits, eventually they realized that
they overestimated values of stocks of Internet and
technology firms, causing stock prices to free fall.
• In 2000s many Internet and technology stock prices fell by
more than 75%.

Fundamental Analysis in Practice
You can apply the fundamental analysis to
explain changes in stock prices.
For example, this morning the CEO of Apple
announces unexpectedly a new iPhone.
Prior to the announcement, the price of
Apple stock was $600.
How should this announcement affect the
price of Apple stock?

Fundamental Analysis in Practice:
Step 1
• Apply the rational expectations to predict
the future profits of Apple with new iPhone.
─ For example, Apple’s profits will increase by 10%
next three years.
• Determine the expected dividends cash
flows on Apple stock.
─ For example, Apple will raise its annual dividends
from $60 to $100 for next three years.
0 1 2 3 4 ....
....
∞
P0
$100 $100 $100 $60

Step 2
• Apply the generalized dividend valuation
model to predict the value of Apple stock.
.....
)k(1
Div
)k(1
Div
)k(1
Div
P 3
e
3
2
e
2
e
1
0 +
+
+
+
+
+
=
For example,
Div1 = Div2 = Div3 = $100
Div4 = Div5 = … = $60
ke = 10%
Then, P0 = $699.47

Step 3
• Apply the demand & supply model to
predict the price change in market.
─ For example, compared with the predicted
value is $699.47, the market price of Apple
stock prior to the announcement was $600.
Thus, the Apple stock was undervalued.
─ Rational investors purchase the undervalued
Apple stocks in market, raising the demand for
the Apple stocks. This pushes the Apple stock
price to go up ($600 → $650 → $680 …).
Investors continue to purchase the Apple
stocks as long as it is undervalued.

Fundamental Analysis in Practice
Step 3 (Continued)
─ Investors will stop buying the Apple stock once
the stock price reaches the predicted value
($699.47).
S
D0
D1
$600
$699
Price of stock
E0
E1

Overshooting and Market Crash
• Then, the market price of Apple stock reflects the
announcement of new iPhone by its CEO this
morning (Efficient market hypothesis).
• However, if day-traders, not knowing the
announcement or the value of Apple stock, see
the sudden price increase of Apple stock and may
join the hoopla (bandwagon effect).
• Their actions will push the demand for the Apple
stocks further right and raise the price of Apple
stocks above the predicted value (Overshooting).
• n addition, some rational investors may speculate
and create a bubble in the market, which may
result in the market crash later.

Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University

Econ315 Money and Banking: Learning Unit 14: Stock market Analysis

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Econ315 Money and Banking: Learning Unit 14: Stock market Analysis