• Investors conduct valuations of

stocks when making their

investment decisions. They consider
investing in undervalued stocks and
selling their holdings of stocks that
they consider to be overvalued.
There are many different methods
of valuing stocks.
• Fundamental analysis relies on
fundamental financial characteristics
of the firm and its corresponding
industry that are expected to
influence stock values. Technical
analysis relies on stock price trends
to determine stock values.
 REQUIRED RATE OF RETURN ON STOCKS

• When investors attempt to value a firm based

on discounted cash flows, they must determine
the required rate of return by investors who
invest in that stock. Investors require a return
that reflects the risk-free interest rate plus a risk
premium. Although investors generally require a
higher return on firms that exhibit more risk,
there is no complete agreement on the ideal
measure of risk or the way risk should be used
to derive the required rate of return.
FACTORS THAT AFFECT STOCK PRICES

• Economic Factors
– A firm's value should reflect the present
value of its future cash flows. Investors
therefore consider various economic
factors that affect a firm's cash flows
when valuing a firm to determine
whether its stock is over- or
undervalued.
FACTORS THAT AFFECT STOCK PRICES

• Economic Factors
– An increase in economic growth is expected to
increase the demand for products and services
produced by firms and thereby increase a firm's
cash flows and valuation. Participants in the
stock markets monitor economic indicators such
as employment, gross domestic product, retail
sales, and personal income because these
indicators may signal information about
economic growth and therefore affect cash
flows.
FACTORS THAT AFFECT STOCK PRICES

• Economic Factors
– One of the most prominent economic forces driving
stock market prices is the risk-free interest rate.
Investors should consider purchasing a risky asset
only if they expect to be compensated with a risk
premium for the risk incurred. Given a choice of risk-
free Treasury securities or stocks, investors should
purchase stocks only if they are appropriately priced
to reflect a sufficiently high expected return above the
risk-free rate.
FACTORS THAT AFFECT STOCK PRICES

• Economic Factors
– The relationship between interest rates and stock
prices can vary over time. In theory, a high interest
rate should raise the required rate of return by
investors and therefore reduce the present value of
future cash flows generated by a stock. However,
interest rates commonly rise in response to an
increase in economic growth, so stock prices may rise
in response to an increase in expected cash flows
even if investors' required rate of return rises.
FACTORS THAT AFFECT STOCK PRICES

• Economic Factors
– Conversely, a lower interest rate should boost the
present value of cash flows and therefore boost stock
prices. However, lower interest rates commonly occur
in response to weak economic conditions, which tend
to reduce expected cash flows of firms. Overall, the
effect of interest rates should be considered along
with economic growth and other factors when
seeking a more complete explanation of stock price
movements.
FACTORS THAT AFFECT STOCK PRICES

• Market-Related Factors
– A key market-related factor is investor sentiment,
which represents the general mood of investors in
the stock market. Since stock valuations reflect
expectations, in some periods the stock market
performance is not highly correlated with existing
economic conditions. Even though the economy is
weak, stock prices may rise if most investors expect
that the economy will improve in the near future. In
other words, there is a positive sentiment because of
optimistic expectations.
FACTORS THAT AFFECT STOCK PRICES

• Market-Related Factors
– Movements in stock prices may be
partially attributed to investors'
reliance on other investors for stock
market valuation. Rather than making
their own assessment of a firm's value,
many investors appear to focus on the
general investor sentiment.
FACTORS THAT AFFECT STOCK PRICES

• Market-Related Factors
– Because many portfolio managers are
evaluated over the calendar year, they prefer
investing in riskier, small stocks at the
beginning of the year and then shifting to
larger, more stable companies near the end
of the year in order to lock in their gains.
This tendency places upward pressure on
small stocks in January each year, resulting
in the January effect.
FACTORS THAT AFFECT STOCK PRICES

• Market-Related Factors
– Some studies have found that most of the
annual stock market gains occur in January.
Once investors discovered the January
effect, they attempted to take more positions
in stocks in the prior month. This has placed
upward pressure on stocks in mid-
December, causing the January effect to
begin in December.
FACTORS THAT AFFECT STOCK PRICES

• Firm-Specific Factors
– A firm's stock price is affected not only by
macroeconomic and market conditions but
also by firm-specific conditions. Some firms
are more exposed to conditions within their
own industry than to general economic
conditions, so participants monitor industry
sales forecasts, entry into the industry by
new competitors, and price movements of
the industry's products.
FACTORS THAT AFFECT STOCK PRICES

• Firm-Specific Factors
– Stock market participants may focus
on announcements by specific firms
that signal information about a firm's
sales growth, earnings, or other
characteristics that may cause a
revision in the expected cash flows to
be generated by that firm.
FACTORS THAT AFFECT STOCK PRICES

• Firm-Specific Factors
– Change in Dividend Policy - An increase in
dividends may reflect the firm's expectation
that it can more easily afford to pay
dividends. In contrast, a decrease in
dividends may reflect the firm's expectation
that it will not have sufficient cash flow.
FACTORS THAT AFFECT STOCK PRICES

• Firm-Specific Factors
– Earnings Surprises - Recent earnings are used to
forecast future earnings and thus to forecast a firm's
future cash flows. When a firm's announced
earnings are higher than expected, some investors
raise their estimates of the firm's future cash flows
and hence revalue its stock upward. However, an
announcement of lower-than-expected earnings can
cause investors to reduce their valuation of a firm's
future cash flows and its stock.
FACTORS THAT AFFECT STOCK PRICES

• Firm-Specific Factors
– Acquisitions and Divestitures - The expected
acquisition of a firm typically results in an
increased demand for the target's stock, which
raises its price. Investors recognize that the target's
stock price will be bid up once the acquiring firm
attempts to acquire the target's stock. The effect on
the acquiring firm's stock is less clear, as it depends
on the perceived synergies that could result from
the acquisition.
FACTORS THAT AFFECT STOCK PRICES

• Firm-Specific Factors
– Acquisitions and Divestitures -
Divestitures tend to be regarded as a
favorable signal about a firm if the
divested assets are unrelated to the
firm's core business. The typical
interpretation by the market in this
case is that the firm intends to focus on
its core business.
FACTORS THAT AFFECT STOCK PRICES

• Firm-Specific Factors
– Expectations - Investors do not necessarily
wait for a firm to announce a new policy
before they revalue the firm's stock. Instead,
they attempt to anticipate new policies so
that they can make their move in the market
before other investors. In this way, they may
be able to pay a lower price for a specific
stock or sell the stock at a higher price.
FACTORS THAT AFFECT STOCK PRICES

• Firm-Specific Factors
– Expectations - For example, they may use
the firm's financial reports or recent
statements by the firm's executives to
speculate on whether the firm will adjust its
dividend policy. The disadvantage of trading
based on incomplete information is that an
investor may not correctly anticipate the
firm's future policies.
FACTORS THAT AFFECT STOCK PRICES

• Tax Effects
– The difference between the price at which a
stock is sold versus the price at which it was
purchased is referred to as the capital gain.
When investors hold a stock position less
than one year, the gain is referred to as a
short-term capital gain, whereas the gain on
a stock position held for one year or longer
is referred to as a long-term capital gain.
FACTORS THAT AFFECT STOCK PRICES

• Tax Effects
– Tax laws affect the after-tax cash flows that
investors receive from selling stocks, and
therefore can affect the demand for stocks.
Holding other factors constant, stocks
should be valued higher when capital gains
tax rates are relatively low. Tax laws can
also cause some stocks to be more desirable
than others.
 FACTORS THAT AFFECT STOCK PRICES

• Tax Effects
– Some stocks have more potential for large
capital gains, and therefore may be more
sensitive to the tax laws on capital gains.
Conversely, other stocks that pay steady
dividends typically have smaller capital
gains and therefore may not be affected as
much by tax laws on capital gains.
However, stocks that pay dividends are
affected by dividend tax laws.
 FACTORS THAT AFFECT STOCK PRICES

• Tax Effects
– A low tax rate imposed on dividends
will cause dividend-paying stocks to be
more desirable, and will increase the
valuation of these stocks. A high tax rate
imposed on dividends will cause these
stocks to be less desirable, and will
reduce the valuation of these stocks.
FACTORS THAT AFFECT STOCK PRICES

• Integration of Factors Affecting Stock Prices

– As with the pricing of debt securities, the
required rate of return is relevant, as are the
economic factors that affect the risk-free
interest rate. Stock market participants also
monitor indicators that can affect the risk-
free interest rate, which in turn affects the
required return by investors who invest in
stocks.
FACTORS THAT AFFECT STOCK PRICES

• Integration of Factors Affecting Stock Prices

– Indicators of inflation (such as the consumer price
index and producer price index) and of government
borrowing (such as the budget deficit and the
volume of funds borrowed at upcoming Treasury
bond auctions) also affect the risk-free rate and
thereby the required return of investors. In general,
whenever these indicators signal the expectation of
higher interest rates, there is upward pressure on the
required rate of return by investors and downward
pressure on a firm's value.
 STOCK MARKET EFFICIENCY

• If stock markets are efficient, the prices of stocks

at any point in time should fully reflect all
available information. As investors attempt to
capitalize on new information that is not already
accounted for, stock prices should adjust
immediately. Investors commonly over- or
underreact to information. This does not mean that
markets are inefficient unless the reaction is
biased. Investors who can recognize such bias will
be able to earn abnormally high risk-adjusted
returns.
 Forms of Efficiency

• Weak-Form Efficiency
– Weak-form efficiency suggests that security
prices reflect all market-related information,
such as historical security price movements
and volume of securities trades. Thus
investors will not be able to earn abnormal
returns on a trading strategy that is based
solely on past price movements.
 Forms of Efficiency
• Semi strong-Form Efficiency
– Semi strong-form efficiency suggests that
security prices fully reflect all public
information. The difference between public
information and market-related information
is that public information also includes
announcements by firms, economic news or
events, and political news or events. Market-
related information is a subset of public
information.
 Forms of Efficiency
• Semi strong-Form Efficiency
– Therefore, if semi strong-form efficiency
holds, weak-form efficiency must also hold.
It is possible, however, for weak-form
efficiency to hold even though semi strong-
form efficiency does not. In this case,
investors could earn abnormal returns by
using the relevant information that was not
immediately accounted for by the market.
 Forms of Efficiency

• Strong-Form Efficiency
– Strong-form efficiency suggests that
security prices fully reflect all information,
including private or insider information. If
strong-form efficiency holds, semi strong-
form efficiency must hold as well. If insider
information leads to abnormal returns,
however, semi strong-form efficiency could
hold even though strong-form efficiency
does not.
Tests of the Efficient Market Hypothesis - Categories

• Test of Weak-Form Efficiency - Weak-form

efficiency has been tested by searching for a
nonrandom pattern in security prices. If the
future change in price is related to recent
changes, historical price movements could be
used to earn abnormal returns. In general,
studies have found that historical price changes
are independent over time. This means that
historical information is already reflected by
today's price and cannot be used to earn
abnormal profits.
Tests of the Efficient Market Hypothesis - Categories

• Test of Weak-Form Efficiency Even when some

dependence was detected, the transaction costs offset
any excess return earned. There is some evidence that
stocks have performed better in certain time periods.
For example, as mentioned earlier, small stocks have
performed unusually well in the month of January (the
“January effect"). Second, stocks have historically
performed better on Fridays than on Mondays (the
“weekend effect"). Third, stocks have historically
performed well on the trading days just before holidays
(the "holiday effect").
Tests of the Efficient Market Hypothesis - Categories

• Test of Weak-Form Efficiency To the extent

that a given pattern continues and can be used
by investors to earn abnormal returns, market
inefficiencies exist. In most cases, there is no
clear evidence that such patterns persist once
they are recognized by the investment
community. One could use the number of
market corrections to evaluate stock market
inefficiency.
Tests of the Efficient Market Hypothesis - Categories

• Test of Weak-Form Efficiency During the

twentieth century, there were more than 100
days on which the market (as measured by the
Dow Jones Industrial Average) declined by 10
percent or more. On more than 300 days, the
market declined by more than 5 percent. These
abrupt declines frequently followed a market
run-up, which suggests that the run-up might
have been excessive. In other words, a market
correction was necessary to counteract the
excessive run-up.
Tests of the Efficient Market Hypothesis - Categories

• Test of Semi strong-Form Efficiency - Semi

strong-form efficiency has been tested by
assessing how security returns adjust to
particular announcements. Some
announcements are specific to a firm, such as
an announced dividend increase, an
acquisition, or a stock split. Other
announcements are related to the economy,
such as an announced decline in the federal
funds rate.
Tests of the Efficient Market Hypothesis - Categories

• Test of Semi strong-Form Efficiency -

In general, it was found that security
prices immediately reflected the
information from the announcements.
Hence the securities were not
consistently over- or undervalued, so
abnormal returns could not consistently
be achieved. This is especially true when
transaction costs are accounted for.
Tests of the Efficient Market Hypothesis - Categories

• Test of Semi strong-Form Efficiency -

There is evidence of unusual profits from
investing in initial public offerings
(IPOs). In particular, the return over the
first day following the IPO tends to be
abnormally high. One reason for this
underpricing is that the securities firms
underwriting an IPO intentionally
underprice to ensure that the entire issue
can be placed.
Tests of the Efficient Market Hypothesis - Categories

• Test of Semi strong-Form Efficiency -

Underwriters also are required to
exercise due diligence in ensuring the
accuracy of the information they provide
to investors about the corporation. For
this reason, underwriters tend to err on
the low side when setting a price for
IPOs.
Tests of the Efficient Market Hypothesis - Categories

• Test of Semi strong-Form Efficiency - Some

analysts contend that, given the imperfect
information associated with IPOs investors
would not participate unless prices are low. In
other words, the potential return must be high
enough to compensate not only for the risk
incurred but also for the lack of information
about these corporations. From this perspective,
IPO underpricing does not imply market
inefficiencies but rather reflects the high degree
of uncertainty involved.
Tests of the Efficient Market Hypothesis - Categories

• Test of Strong-Form Efficiency - Tests

of strong-form efficiency are difficult
because the inside information used is
not publicly available and cannot be
properly tested. Nevertheless, many
forms of insider trading could easily
result in abnormally high returns. For
example, there is clear evidence that
share prices of target firms rise
substantially when the acquisition is
announced.
Tests of the Efficient Market Hypothesis - Categories

• Test of Strong-Form Efficiency - If

insiders purchased stock of targets
prior to other investors, they would
normally achieve abnormally high
returns. Insiders are discouraged
from using this information because
it is illegal, not because markets are
strong-form efficient.