Stocks, bonds. Market efficiency

Value of Stock

The value of a stock is nothing more than the time value of the future cash flows. In the case of a stock, it is the discounted value of all the future dividends and other returns. The future returns of a stock are not as predictable as those of a bond. However, we still can use the concepts of TVM. The value of stock is the present value of all expected dividends plus the present value of the terminal value at the end of the life of the company. A preferred stock pays a constant dividend. The value of preferred stock is determined by treating it as perpetuity.

The value or price of a stock, assuming constant dividend growth (greater than the required rate of return), is determined by the Gordon growth model. This model, developed by Myron J. Gordon, is also known as the constant growth model. This would be similar to discounting the dividend payment into infinity.

If you have uneven cash-flow streams, a financial calculator and Microsoft Excel can help you to handle these problems without having to individually calculate each discounted cash flow.

In the case where we are trying to double our funds, we can also use the rule of 72. The rule of 72 says that when the rate times the years is 72; you can use the ratio to determine the time to doubling. In other words, if we want the stock to double in 9 years, we need to earn a rate of return of 8%, or 72/9.

Market Efficiency

Market efficiency is an important concept in finance. It addresses the necessity for new, pertinent information to be incorporated or responded to quickly by the markets.

Generally speaking, markets are said to be efficient when:

1. Prices adjust quickly in response to new information.

2. There is a continuous market where each successive trade is consummated at a price that is very close to the previous price.

3. The market can absorb a large capital influx without having large swings in stock prices.

4. Insider information is not relevant, or has no impact in the market.

As prices respond faster to new information, the market becomes more efficient. One key factor affecting efficiency is the uncertainty of cash flow streams. However, cash flow streams are more stable than volatile price changes.

Conversely, when cash flow streams are more stable, fewer volatile price changes will occur. U.S. government securities are said to be the most efficient market. Moreover, the efficiency of common stock markets is still being debated.

The efficient market hypothesis (EMH) suggests that markets adjust rapidly and completely to new information, and it is very difficult for investors to create or select portfolios of securities which will outperform the market over a period of time.

The EMH assumes buyers and sellers have accounted for all available information about a given stock. Thus, a stock's current market price reflects its true market value. In its strongest form, the EMH claims investors' returns cannot exceed general market returns over a long-time horizon. Based upon this premise, it would be useless to search for undervalued and overvalued stocks.

Most investors subscribe to a more moderate form of the EMH. These investors believe that a stock's market value is based upon—at least to some extent—forces of supply and demand in the overall stock market and/or a firm's earnings potential and quantifiable risk. Accordingly, most investors believe they can potentially increase their returns and outperform the general market (at least in some periods and over some time horizon).

Financial managers and investors should realize that there is a direct relationship between information on market participants and the efficiency of the market. Uncertainty in a market obscures the process of information interpretation and valuation of securities.

Bonds

A bond is a long-term debt contract under which a borrower agrees to make payments of interest and principal on specific dates to investors. There are four major types of bonds: treasury, corporate, municipal, and foreign.

Bonds have several key characterizes. Some of these characteristics include:

• Par value: Also called face value, par value is the stated value of the bond, which is usually $1,000. The par value represents the amount of money the issuer borrows and promises to pay at the maturity date.

• Coupon interest rate: The stated annual rate of interest on a bond—also referred to as nominal rate.

• Maturity date: the date on which the face value of the bond should be repaid. Bonds generally have a specified maturity. The specified maturity of the bond is called its original maturity, or the number of years to maturity at the time a bond is issued.

• Yield to maturity: the rate of return earned on a bond if it is held to maturity. It is also the effective interest rate earned by the bond.

• Debentures: long-term bonds that are not secured by a claim on specific assets. Debentures are unsecured bonds that depend on the general credit strength of the issuing corporation

• Sinking fund: a fund created to retire bond issues. The existence of a sinking fund reduces the risk of default, and hence, it increases the value of the bond issue.

• Hybrid security: a security that has features of both equity and debt. An example is a convertible bond.

• Convertible bond: a bond that is exchangeable, at the option of the bondholder, for common stock of the issuing firm.

Investors in bonds receive periodic coupon payments and principal after the maturity date. Just like stocks, the price of a bond is equal to the discounted value of all future cash flows. For bonds, the cash flows include the coupon interest payment and the par value. Unlike stocks, these cash flows are predictable.