Stock Valuation

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efficient-market hypothesis
Theory describing the behavior
of an assumed “perfect” market
in which (1) securities are typically
in equilibrium, (2) security
prices fully reflect all public
information available and react
swiftly to new information, and,
(3) because stocks are fairly
priced, investors need not waste
time looking for mispriced
securities.
CHAPTER 7 Stock Valuation 279
7–7 Explain the cumulative feature of preferred stock. What is the purpose of
a call feature in a preferred stock issue?
7–8 What is the difference between a venture capitalist (VC) and an angel capitalist
(angel)?
7–9 Into what bodies are institutional VCs most commonly organized? How
are their deals structured and priced?
7–10 What general procedures must a private firm go through in order to go
public via an initial public offering (IPO)?
7–11 What role does an investment banker play in a public offering? Explain
the sequence of events in the issuing of stock.
7–12 Describe the key items of information included in a stock quotation. What
information does the stock’s price/earnings (P/E) ratio provide?
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 Efficiency
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.
The Efficient-Market Hypothesis
As noted in Chapter 1, active markets such as the New York Stock Exchange are
efficient—they are made up of many rational investors who react quickly and
objectively to new information. The efficient-market hypothesis, which is the basic
theory describing the behavior of such a “perfect” market, specifically states that
1. Securities are typically in equilibrium, which means that they are fairly priced
and that their expected returns equal their required returns.