Share Prices and Efficient Markets

We have seen that the price of a share of stock today is the present value of the dividends and share price the investor expects to receive in the future. What if these expectations change?

Suppose you buy a share of stock of IBM. The price you are willing to pay is the present value of future cash flows you expect from dividends paid on one share of IBM stock and from the eventual sale of that share. This price reflects the amount, the timing, and the uncertainty of these future cash flows. Now what happens if some news—good or bad—is announced that changes the expected IBM dividends? If the market in which these shares are traded is efficient, the price will fall very quickly to reflect that news.

In an efficient market, the price of assets—in this case shares of stock—reflects all publicly available information. As information is received by investors, share prices change rapidly to reflect the new information. How rapidly? In U.S. stock markets, which are efficient markets, information affecting a firm is reflected in share prices of its stock within minutes.

What are the implications for financing decisions? In efficient markets, the current price of a firm's shares reflects all publicly available information. Hence, there is no good time or bad time to issue a security. When a firm issues stock, it will receive what that stock is worth—no more and no less. Also, the price of the shares will change as information about the firm's activities is revealed. If the firm announces a new product, investors will use whatever information they have to figure out how this new product will change the firm's future cash flows and, hence, the value of the firm—and the share price—will change accordingly. Moreover, in time, the price will be such that investors' economic profit approaches zero.

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