324 PART 2 Important Financial Concepts
- The need to consider an infinite time horizon is not critical, because a sufficiently long period—say, 50 years—
will result in about the same present value as an infinite period for moderate-sized required returns. For example, at
15%, a dollar to be received 50 years from now, PVIF15%,50yrs, is worth only about $0.001 today.
3. Because stocks are fully and fairly priced, investors need not waste their time
trying to find and capitalize on mispriced (undervalued or overvalued)
securities.
Not all market participants are believers in the efficient-market hypothesis.
Some feel that it is worthwhile to search for undervalued or overvalued securities
and to trade them to profit from market inefficiencies. Others argue that it is
mere luck that would allow market participants to anticipate new information
correctly and as a result earn excess returns—that is, actual returns greater than
required returns. They believe it is unlikely that market participants can over the
long runearn excess returns. Contrary to this belief, some well-known investors
such as Warren Buffett and Peter Lynch haveover the long run consistently
earned excess returns on their portfolios. It is unclear whether their success is the
result of their superior ability to anticipate new information or of some form of
market inefficiency.
Throughout this text we ignore the disbelievers and continue to assume mar-
ket efficiency. This means that the terms “expected return” and “required
return” are used interchangeably,because they should be equal in an efficient
market. This also means that stock prices accurately reflect true value based on
risk and return. In other words, we will operate under the assumption that the
market price at any point in time is the best estimate of value. We’re now ready to
look closely at the mechanics of stock valuation.The Basic Stock Valuation Equation
Like the value of a bond, which we discussed in Chapter 6, the value of a share of
common stock is equal to the present value of all future cash flows (dividends)
that it is expected to provide over an infinite time horizon.^4 Although a stock-
holder can earn capital gains by selling stock at a price above that originally paid,
what is really sold is the right to all future dividends. What about stocks that are
not expected to pay dividends in the foreseeable future? Such stocks have a value
attributable to a distant dividend expected to result from sale of the company or
liquidation of its assets. Therefore, from a valuation viewpoint, only dividends
are relevant.
By redefining terms, the basic valuation model in Equation 6.5 can be speci-
fied for common stock, as given in Equation 7.2:P 0 .. . (7.2)whereP 0 value of common stock
Dtper-share dividend expectedat the end of year t
ksrequired return on common stockD∞
(1ks)∞D 2(1ks)^2D 1(1ks)^1