FSA Study Notes - Midterm.pdf

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Accounting & Financial Management
AFM 492
Jiahua Chen

TERESA YEUNGSPRING 2012 AFM 492Financial Statement Analysis Midterm Study Notes9Market EfficiencyEfficient markets hypothesis security prices reflect all available info as if such information could be costlessly digested and translated immediately into demand for buys or sells without regard to frictions imposed by transaction costsAKA information is reflected in security prices and immediately upon its releaseEmpirical evidenceStock prices are hard to predictStock prices adjust quickly to new informationStock prices do not react to noninformationNo one consistently outperforms the marketTheoretical evidenceInvestors are rationalSome investors are irrational but biases can go both directions and cancels each other outSome systematic irrationality but eliminated by rational arbitrageursEmpirical challengesExcess volatility in returnsreturns are too volatile to be explained by a discounted dividend modelStock prices react to noninformationReturns predictabilitycrosssectional returns exhibit predictable patternsTheoretical challengesInvestors may have systematic cognitive bias such as conservatism or representative heuristicsArbitrage is almost always costlyriskyLack of substitutesFundamental risk of substitutesNoise trader riskArbitrage requires sufficient mispricing to function properlyarbitragemispricing must coexist7Valuation Theory The discounted dividends valuation methodsPresent value of future cash payments to shareholders DIVDIVDIV123 equity value 231r1r1reee r is the cost of equity capital eDIV1 equity valuerged For when dividend grows at a constant rate of g d AdvantagesEasy conceptdividends are what shareholders getPredictability since dividends are fairly stable in the short runeasy to forecastDisadvantagesDividend payout is not related to value in the short run and capital gain component is ignoredRequirement for forecast is long run and terminal values for shorter periods are hard to calculate with reliabilityThe discounted abnormal earnings valuation methodAbnormal earnings is the residual income from expected returnFirms can only create value by earning more than the expected cost of capital NIrBVENIrBVENIrBVE1e02e13e2 equity valueBVE0231r1r1reee Shortcut random walkassume AE is the same each year AE0 equity valueBVE 0re 1
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