The concept of market efficiency underpins almost all financial theory and decision models. When financial markets are efficient, the price of a security—such as a share of a particular corporation’s common stock—should bethe present value estimate of the firm’s expected cash flows discounted by its appropriate rate of return (also called the intrinsic value of the stock).
Almost all financial theory and decision models assume that the financial markets are efficient. The informational efficiency of financial markets determines the ability of investors to "beat" the market and earn excess (or abnormal) becomes available. Financial theorists have identified three levels of informational efficiency that reflect what information is incorporated in stock prices. Consider the following statement, and identify the form of capital market efficiency under the efficient market hypothesis based on this statement. Current market prices reflect all relevant publicly available information. This statement is consistent with:. A. Strong-form efficiency. B. Weak-form efficiency. C. Semistrong form efficiency. Consider that there is a semistrong-form of efficiency in the markets. A pharmaceutical company announces that it has received Federal Drug Administration approval for a new allergy drug that completely prevents hay fever The consensus analyst forecast for the company's earnings per share (EPS) is $4.50, but insiders know that, with this new drug, earnings will increase and drive the EPS to $5.00. What will happen when the company releases its next earnings report? A. There will be some volatility in the stock price when the earnings report is released: it is difficult to determine the impact on the stock price. B. The stock price will not change, because the market already incorporated that information in the stock price when the announcement was made. C. The stock price will increase and settle at a new equilibrium level.
When the price of a corporation's common stock is equal to the present value of discounted future cash flows, it will show a true representation of the value of the firm and in turn investors will have confidence in the company and its projected performance.
As new shares are issued from a company the company issues the shares at a forecasted future value based on the expected cash flows of the business.
For example if a company has estimated it will have cash flow of $12 million in the next one year, and it wants to issue 6 million shares. The value of the issued shares will be $12 million/6 million= $2. The firm is leveraging on it forecasted performance and cash flows.
The concept of market efficiency underpins almost all financial theory and decision models. when financial markets are efficient, the price of a security such as a share of a particular corporation's common stock-should be Equal To the present value estimate of the firms expected cash flows discounted by its appropriate rate of return (also called the intrinsic value of the stock).
Intrinsic Value of a stock:- The intrinsic value of a stock can be defined as a price for the stock based only on the internal factors of the company.
It eliminates the external factors that involved in market prices.
Another most widely used method is the discounted cash flow (DCF) method. This method uses cash flows from the business to come up with a value.
The calculation of intrinsic value formula of stock is done by dividing the value of the business by the number of outstanding shares of the company in the market.
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