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Chapter 5 Solution Essay

6798 words - 28 pages

Chapter 5
Basic Stock Valuation
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS

5-1 See the model or the printout of the model provided at the end of this set of answers. There we show how to find the stock price under some assumed conditions.

5-2 Again, see the model or the model printout. We show some alternative conditions, or scenarios, and the stock price under those scenarios.

5-3 Again, see the model or the model printout. We show how to use Excel to find the stock price under conditions of nonconstant growth. Note, though, that we do assume constant growth after some number of years.

5-4 Again, see the model or the model printout. Everything up to this point could be ...view middle of the document...

Security analysts are using this model increasingly.

5-6 The three forms of the EMH are weak form, semi-strong form, and strong form. Weak form says efficiency only applies to looking at past stock prices, but other types of analysis might be valid. Semi-strong EMH adds that fundamental analysis is also useless, because stock prices reflect all published data. Strong form says that all information possessed by anyone, including corporate insiders, is reflected in prices, so even insiders trading on inside information cannot make an abnormal profit.
Technical trading rules would be ineffective under all three forms—if the EMH is correct in any of its forms, technical analysis is just a waste of time. Most academicians who have researched the EMH agree with this proposition, though many technical analysts still exist and earn high salaries on Wall Street.
Fundamental analysis would be ineffective under both weak and semi-strong form efficiency. Semi-strong form efficiency is probably true for people who have limited resources and when applied to the largest and most widely followed companies. However, analysts for the large investment banks and institutions have data, computer processing capabilities, and rapid access to information that are not available to most of us. Moreover, they are highly educated, often in the sciences as well as in finance, and they spend their lives following a relatively few companies in one or two industries. So, it is possible for fundamental analysis as practiced by some analysts to produce results that are worth the effort.
Also, fundamental analysis is more likely to have a positive payoff for smaller, less widely followed companies than for large companies like GE and Microsoft, which are followed by many analysts.
Still, academic research indicates that most professional analysts such as those who work for mutual funds don’t do any better than the averages, so the evidence on semi-strong form efficiency is mixed.
Note too that the theoretical support for semi-strong efficiency assumes that markets are transparent in the sense of the term that we described in Chapter 1. Events in the late 1990s and early 2000s demonstrated that less transparency exists than the early academicians thought, or, probably, that the degree of transparency eroded during the 1990s. Events that took place in 2001 and 2002—like Enron and WorldCom—have resulted in a call for more transparency and more honesty by analysts and accountants. So, we believe that semi-strong efficiency will be more prevalent in the future than perhaps it was in the recent past.
Insider trading can definitely be profitable for those with good inside information on such things as merger offers about to take place, oil strikes, profit trends, and even the fact that the reported accounting statements don’t really reveal what they seem to reveal. Thus, strong form efficiency is definitely not valid.
All of the above...

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