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Practical factors affecting share prices.
The dividend valuation model gives a
theoretical value, given the assumptions inherent in the model, for shares and
debentures.
In practice there will be many factors other than the present value of cash flows from a security that play a part in its valuation. These are likely to include:
The dividend valuation model helps us to understand how a change in these variables (or, to be more accurate, an expected change) should effect the market value of the security.
The value of a share or of the equity shareholders funds is based upon expectations of future cash flows either in the form of dividends or NPVs of investment projects. The strength of the link between the performance of the company and the share price will depend upon the efficiency of the capital markets. How much does the market know about a company? In other words, how good is it at incorporating information into the share price?
An issue that is the subject of intense debate among academics and financial professionals is the Efficient Market Hypothesis (EMH). The Efficient Market Hypothesis states that at any given time, security prices fully reflect all available information. The implications of the efficient market hypothesis are truly profound. Most individuals that buy and sell securities (stocks in particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price. But if markets are efficient and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill.
"An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."
The random walk theory asserts that price movements will not follow any patterns or trends and that past price movements cannot be used to predict future price movements.
There are three forms of the efficient market hypothesis
The "Weak" form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use.
The "Semistrong" form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.
The "Strong" form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.
Securities
markets are flooded with thousands of intelligent, well-paid, and well-educated
investors seeking under and over-valued securities to buy and sell. The more
participants and the faster the dissemination of information, the more
efficient a market should be.
The
debate about efficient markets has resulted in hundreds and thousands of
empirical studies attempting to determine whether specific markets are in fact
"efficient" and if so to what degree. Many novice investors are
surprised to learn that a tremendous amount of evidence supports the efficient
market hypothesis. Early tests of the EMH focused on technical analysis and it
is chartists whose very existence seems most challenged by the EMH. And in
fact, the vast majority of studies of technical theories have found the
strategies to be completely useless in predicting securities prices. However,
researchers have documented some technical anomalies that may offer some
hope for technicians, although transactions costs may reduce or eliminate any
advantage.
Researchers
have also uncovered numerous other stock market anomalies that seem to
contradict the efficient market hypothesis. The search for anomalies is
effectively the search for systems or patterns that can be used to outperform
passive and/or buy-and-hold strategies. Theoretically though, once an anomaly
is discovered, investors attempting to profit by exploiting the inefficiency
should result its disappearance. In fact, numerous anomalies that have been
documented via back-testing have subsequently disappeared or proven to be
impossible to exploit because of transactions costs.
The
paradox of efficient markets is that if every investor believed a market was
efficient, then the market would not be efficient because no one would analyze
securities. In effect, efficient markets depend on market participants who believe
the market is inefficient and trade securities in an attempt to outperform the
market.
In
reality, markets are neither perfectly efficient nor completely inefficient.
All markets are efficient to a certain extent, some more so than others. Rather
than being an issue of black or white, market efficiency is more a matter of
shades of gray. In markets with substantial impairments of efficiency, more
knowledgeable investors can strive to outperform less knowledgeable ones.
Government bond markets for instance, are considered to be extremely efficient.
Most researchers consider large capitalization stocks to also be very
efficient, while small capitalization stocks and international stocks are
considered by some to be less efficient. Real estate and venture capital, which
don't have fluid and continuous markets, are considered to be less efficient
because different participants may have varying amounts and quality of
information.
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