What Determines Stock Prices PDF

Canadian University of Dubai What determines stock prices? Facilitator: Dr. Elgilani Elshareif, Ph.D.; ACCA; CA Professor of Finance and Accounting  In general, stock prices tend to go up when there is good news about prospects of a company (future expected cash flows ), and th...

Canadian University of Dubai What determines stock prices? Facilitator: Dr. Elgilani Elshareif, Ph.D.; ACCA; CA Professor of Finance and Accounting  In general, stock prices tend to go up when there is good news about prospects of a company (future expected cash flows ), and they go down when there is bad news about prospects of a company. Stock price movements are also affected by speculation or investor sentiment.  The efficient market hypothesis (EMH) states that securities prices accurately reflect future expected cash flows and are based on all information available to investors.  Efficient market hypothesis is based on the assumption that investors, as a group, are rational.  An efficient market is a market in which all the available information is fully incorporated into the Forms of the Efficient Market Hypothesis  The weak-form efficient market hypothesis asserts that all past security market information is fully reflected in securities prices.  The semi-strong form efficient market hypothesis asserts that all publicly available information is fully reflected in securities prices.  The strong form efficient market hypothesis asserts that all information, whether public or private, is fully reflected in securities prices. Do We Expect Financial Markets To Be Perfectly Efficient?  In general, markets are expected to be at least weak-form and semi-strong form efficient.  If there did exist simple profitable strategies, then the strategies would attract the attention of investors, who by implementing their strategies would compete away the profits. The Behavioral View  If investors do not rationally process information, then markets may not accurately reflect even public information.  For example, overconfident investors may under react when management announces earnings as they have too much confidence in their own views of the company’s true value and place little weight on new information released by management. As a result, this new information, even though it is publicly and freely available, is not completely reflected in stock prices.  Historically, there has been some evidence of inefficiencies in the financial markets. Evidence and observations of market inefficiency: Anomaly Anomaly 1. Value stocks outperforming growth Value stocks, which are stocks with tangible stocks assets that generate current earnings, have tended to outperform growth stocks, which are stocks with low current earnings that are expected to grow in the future. More specifically, stocks with low price-to-earnings ratios, low price-to-cash-flow ratios, and low price-to-book- value ratios tend to outperform the market. 2. Momentum in stock returns Stocks that have performed well in the past 6 to 12 months tend to continue to outperform other stocks. 3. Over- and under-reaction to corporate The market has tended to make dramatic moves announcements in response to many corporate events. For example, stock prices react favorably on dates when firms announce favorable earnings news, which is exactly what we would expect in an efficient market. However, on the days after favorable earnings news, stock returns continue to be positive, on average. This is known as post–earnings announcement drift. Similarly, there is evidence of some degree of predictability in stock returns following other  If equity markets are inefficient, it means that investors can earn returns that are greater than the risk of their investment by taking advantage of mispricing in the market.  More recent evidence suggests that strategies that exploit these patterns have been quite risky and have not been successful after 2000.  The initial success and eventual demise of strategies using these patterns shows that once the pattern is known, investors will trade aggressively on these patterns and thereby eliminate the inefficiencies.  Thus, financial markets are likely to be efficient, at least in the semi-strong form Thank You