Company's Stock Prices example essay topic

"A Random Walk Down Wall Street " There is a sense of complexity today that has led many to believe the individual investor has little chance of competing with professional brokers and investment firms. However, Malkiel states this is a major misconception as he explains in his book "A Random Walk Down Wall Street". What does a random walk mean? The random walk means in terms of the stock market that, "short term changes in stock prices cannot be predicted".

So how does a rational investor determine which stocks to purchase to maximize returns? Chapter 1 begins by defining and determining the difference in investing and speculating. Investing defined by Malkiel is the method of "purchasing assets to gain profit in the form of reasonably predictable income or appreciation over the long term". Speculating in a sense is predicting, but without sufficient data to support any kind of conclusion. What is investing? Investing in its simplest form is the expectation to receive greater value in the future than you have today by saving income rather than spending.

For example a savings account will earn a particular interest rate as will a corporate bond. Investment returns therefore depend on the allocation of funds and future events. Traditionally there have been two approaches used by the investment community to determine asset valuation: "the firm-foundation theory" and the "castle in the air theory". The firm foundation theory argues that each investment instrument has something called intrinsic value, which can be determined analyzing securities present conditions and future growth.

The basis of this theory is to buy securities when they are temporarily undervalued and sell them when they are temporarily overvalued in comparison to there intrinsic value One of the main variables used in this theory is dividend income. A stocks intrinsic value is said to be "equal to the present value of all its future dividends". This is done using a method called discounting. Another variable to consider is the growth rate of the dividends.

The greater the growth rate the more valuable the stock. However it is difficult to determine how long growth rates will last. Other factors are risk and interest rates, which will be discussed later. Warren Buffet, the great investor of our time, used this technique in making his fortune.

The second theory is known as the "castle in the air theory". This method is more psychological in nature rather than value based. Investors using this theory would buy securities early when exciting news and growth is speculated, then sell them when the securities temporarily increased in value. I used the term speculated because often times these forecasts were not based on any kind of asset valuation or operating game plan.

It was purely based on the "hype" surrounding the security. These were short-term investments and were based on the premise "that a buyer could pay any price for a stock as long as they expected future buyers to assign a higher value". This theory is also known as the "greater fool" theory. Now that the two theories have been explained, let's look at some historical examples from Malkiel that really paint the picture in chapter 2.

The first speculative craze noted was over tulips in the seventeenth century in Holland. The tulips were brought from Turkey and the Dutch valued the beauty and rarity of the new flowers. Thus the prices for the flowers inflated. As the prices rose merchants would by stockpiles to sell to the public.

The more expensive they got the more the public believed they were making smart investments. People would sell off the personal belongings to get their hands on the bulbs. The mania surrounding the bulbs created a bubble that would soon burst. The prices got so high some people decided to cash in and sell them to make a handsome profit. Soon others joined in causing a snowball effect and the prices tumbled. Eventually there was no demand and they were worthless.

Many went bankrupt. So what happened? The speculative craze increased prices well beyond any reasonable level, and at some point prices had to regain stability. I believe prices can remain high as long as demand supports it, but demand is not constant and will rise and fall until equilibrium is reached. A more modern version of the bubble is known as Black Thursday. During little more than a year period from 1928 to 1929 the market experienced unprecedented growth, more than that of the prior five years combined.

There was a speculative market and everyone was getting in. Stocks were being bought on margin, thus exemplifying the crazes. Furthermore, the investment pool strategy became popular around this time. This involved a group of traders banding together to manipulate a stock. The process entailed a pool manager who would buy large portions of stock over a period of time. The pool manager would recruit a stock's specialist on the exchange floor.

The specialist had excess to all the buy and sell prices above and below the current market price. Then the pool members would trade among themselves at slightly higher prices, therefore manipulating the stock price. It gave the appearance that the stocks had a lot of activity and rising prices. Also, the media would play a part as pool managers would tell of ground breaking news and exciting new developments Once the public saw the activity they jumped in thinking this was a hot stock. Then the public did all the buying and the pool did the selling. Thus the pool was rewarded significant profits.

This manipulation of stock prices is only partly to blame for the crash of 1929. Business had slowed for months yet stock prices were steadily increasing. This was the set-up for disaster. How could prices be increasing when business in general was slowing down? It would catch up with them. Soon prices began to decline as company's earning and projections faltered.

The declines in price had caused margin calls and customers were forced to sell there stock. As the prices dipped lower, more and more of the public sold shares. Finally, the volume of shares being sold dropped prices so low the market crashed. Malkiel states, "history teaches us that very sharp increases in stock prices are seldom followed by a gradual return to relative price stability", thus a sharp decline. Chapter 3 expands more on stock valuation from the sixties through the nineties. Most people today including myself have put their money in the hands of professionals at institutions whose sole purpose is to manage money.

The perception would be that the professionals would not be induced to act on the speculative crazes and schemes that the general public would naively dive into. However, past history shows this is not the case. The soaring sixties was the time of the IPO. Also called the tropics boom. As long a company had the word tropics in its name it was considered a good buy. Some of these companies had nothing to do with the electronics industry.

The IPO's would rise fast and fall even faster. There was market manipulation as well. Investment bankers would only issue small amounts of IPO into the market, thus making the stocks price rise quickly. When the stock price rose the remaining shares were then issued and sold at an inflated price. There was also insider trading.

Officers, relatives, and friends of the firm were given large portions of the IPO's. The general public was last to get in. The main problem however was that the public would go for any stock that promised to be next big thing. The companies usually had not even made a single sale. Again, speculation took hold of the general public. Prices could not be justified on firm foundation principles.

Then there was the concept of synergism which I can only describe using the same example as Malkiel. Synergism is the notion that "2 plus 2 equals 5". Companies somehow believed that by acquiring another company and consolidating, the businesses would produce greater profits than if both were run separately. It was this practice that also gave rise to the term conglomerate. Companies were acquiring businesses however they knew nothing about. For example, a pharmaceutical company might purchase a textile company to increase profits, but they knew nothing about operating in this industry.

Eventually management would figure this out and be forced to sell the company to avoid further losses. In the seventies, blue chip stocks were the hot ticket, as investors believe these were safe bets they could purchase and hold on to for life not worrying about a decline in stock price. Yet again the institutions began to speculate over the blue chip stocks and crowds followed, prices rose. These companies were believed to be infallible. Again, prices rose to high and were greatly overpriced. Economic conditions eventually hit the blue chip companies one by one and prices fell.

The eighties were similar to past decades, but the new hot spot was biotechnology stocks and new issues. Prices were reflected in a speculative fashion, as many companies had no earnings. Stock valuation was based on products in development that could take years to complete and might never actually be produced. There was no rational explanation as to why the prices were so high, but the institutions and public invested heavily. Then there was the nineties and the one the biggest bust was in Japanese real estate. "Stock prices were 5 times the value of assets".

The Japanese explained this "by both the density of the Japanese population and the various regulations and tax laws restricting the use of habitable land". Some factors that played a part in the collapse were that "profitability had been declining in Japan and the strong yen was making it difficult to export."Rental income had been rising far more slowly than land values, and finally interest rates were on the rise". The low interest rates allowed many to borrow, but when the bank of Japan raised the interest rates to help curb rising property prices it caused the market to crash. The crash returned inflated prices back to book values, but caused severe financial damage around the world. Chapter 4 explains the bubble of the Internet that most everyone today is familiar with. New technological advances were unprecedented, but speculation led to financial disaster for many investors.

It has been said many times already and proven historically that by "building castles in the air" tragedy will likely follow. Internet companies sprang up around every corner promising to be the next corporate giant. The investment firms ate it up and marketed the companies heavily thus supporting the speculative spirit. How were the company's stock prices determined? Analysts developed new ways to validate the ever-increasing prices of the Internet companies. Valuation methods such as "price to earnings, price to book value, and even price to sales were abandoned".

Measurements were now made based on the "number of people viewing a page" or usage per month. However, many of the web surfers were not actually buying anything and hundreds of dot com's declared bankruptcy. The media also played an important part in the frenzy as the "Internet became a media outlet in it self". Information was but a click of the mouse away.

Online brokers became popular and offered instant research, charts, and graphs. But "customers orders were not always routed to the market where the best price could be obtained but rather to the market that paid the online broker the most for routing the order flow". The online brokerage firms boasted to be cheaper, but did not always have the investor's interest at mind. The online trading system also marked an enormous increase in day traders. Many quit their jobs in order to make quick riches, but only few succeeded.

The speculative market also influenced many of the fraudulent cases of the early 2000's, the biggest being Enron. As analysis looked for firms that could forecast high short-term earnings to boost stock prices, companies were eager to comply. Enron for example manipulated its books to increase earning and hide losses defrauding its investors. But even more appalling was the fact that top executives encouraged its employees to invest heavily in the company while they sold off shares knowing the end was near. The conclusion of chapter 4 reminds us that "the consistent losers in the market are those who are unable to resist being swept up in some kind of tulip-bulb craze". The get rich quick schemes simply don't work.

Also, the market will eventually correct itself from any irrationality, speculative crazes, and return to its true market value. Chapter 5 begins with a reminder from the firm foundation theorists regarding "castles in the air."Purely psychic support for market valuations has proven a most undependable pillar, and skyrocketing markets have invariably succumbed to the financial laws of gravity". The next discussion entails the principles of the firm foundation theory. The focus is on the "stream of cash dividends a company pays."The worth of a share is taken to be the present or discounted value of all future dividends the firm is expected to pay". With this said, Malkiel believes that there are in fact four determinants affecting share value The first is the expected growth rate of the dividend. Although difficult to estimate precisely, a reasonable assertion can be estimated.

First, lets examine the life cycle of a corporation. There is growth in the beginning, followed by stability, then decline unless new developments are introduced. These factors are important when estimating the growth rate. As a corporation enters the stability cycle, growth may continue but certainly not at the pace of its beginning cycle. Also, how long can the growth rate be sustained? Usually a short-term approach say for five years will be more accurate than a twenty-year prediction.

The first rule of the firm-foundation theorists' is that "a rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings". However the corollary to rule 1 is "a rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last. The second determinant is the expected dividend payout. Basically with all other things being equal the higher the dividend payout the more valuable the stock.

However, if the dividend payout is high in comparison to earnings then the company may not be investing in future growth. The third determinant is risk. The premise is that the less risky the stock, the investor should be willing to pay a higher price. Finally, determinant four considers market interest rates. High interest rates can make other investments more attractive than stocks, but lower interest rates make stocks very attractive to investors.

Using these four determinants an investor can reasonably estimate a stocks intrinsic value according to the firm foundation theory. However, the process is flawed because investors cannot predict future outcomes and estimates on undetermined data will not be accurate. However, all of the factors mentioned do play a part in a stocks price, but so do expectations, which tie stocks to market psychology as well. Chapter 6 considers technical versus fundamental analysis. The main problem facing investors is determining when to buy and when to sell a stock.

The technical approach is similar to the castle in the air view. One particular technique is using charts. "Chartist" as we call them track a particular stock and look for trends to develop. If a stocks price is rising over a period the technical analysis expects this growth to continue and therefore would opt to buy the stock. There decision to buy is therefore based on what the crowd is doing. Factors such as the business the company is in along with financial data is thrown out of the picture.

The downside to this approach is that often times when a downward trend develops it is often sharp and the chartist is too late. The fundamental analysis again is concerned with the stocks value. The company along with financial data must be analyzed and can be a tedious process. The difficulties with this approach I have already summarized in chapter 5.

Chapter 7 revisits technical analysis and compares it to a random walk. There are several strategies technicians' use such as the filter system, the Dow theory, relative-strength system, and price volume systems in which there are guidelines to when to buy and sell a stock. The technician is a short-term investor and using these techniques the investor is constantly buying and selling on market trends. The transaction cost in trading usually offsets any gains.

These strategies attempt to find patterns among random events. That is what the stock market is random events. Malkiel states an investor can choose stocks by flipping a coin and do just a well as the technicians. For example, Malkiel described the roulette table in gambling. People would watch the numbers that came and try to predict the next number. They may find one, but then do not retest the pattern and lose.

This is the basis of the random walk. There are three assumptions to the random walk theory the first being the weak form. It concludes past prices cannot predict future prices as the technicians use. The other forms will be discussed in chapter 8. Malkiel instead proposes a buy hold strategy.

Two benefits of a buy-hold strategy are the elimination of transaction cost and avoidance of capital gains and losses until stocks are sold. This theory will be revisited shortly. Chapter 8, a closer look at fundamental analysis. Most of the Wall Street pros are fundamentalist in nature. The security analysts' examines past earnings, growth, and dividends in order to predict future earnings and growth, which is the basis of the intrinsic value. However, Malkiel states that studies concluded that analysts were no better predicting performance than the technicians.

Malkiel explains further there are five reasons analyst cannot predict the future. The first being random events, in which economic conditions, legislature, earthquakes for example cannot be predicted. Second is a firms reported earnings. As discussed earlier with Enron, books can be doctored to appease the crowds.

Third is the unreliability of analysts themselves, such as mathematical errors. Fourth and fifth are that often the best security analysts are in sales positions, thus there interest lies in bringing in commissions on trades, not spending there time researching companies. Finally, the conclusion of chapter 8 brings us back to the random walk theory or also called efficient-market theory and the two remaining forms, semi strong and strong. The strong and semi strong position holds that all information and new information introduced to the public will already be reflected in the stock price. These two premises attack the very foundation of the fundamentalist theory. Chapter 9 introduces the modern portfolio theory and the element of risk.

First, lets assume that all investors are risk averse, meaning investors want to minimize risk, but still see higher returns. A stock is said to be more risky the more dispersed its returns from its average return. However, it has been documented that investors receive higher rates of return by bearing more risk. Individual stocks can range from low risk to high risk. This brings us to the concept of portfolio theory and diversification. The theory states that by diversifying stocks, risk may be reduced.

When the market as a whole moves up and down, not all stocks move in the direction of the market. When a stock does move with the market, this is an example of a positive correlation. The key to diversification is to invest in stocks that are negatively correlated. For example, as one stock moves down in the portfolio another moves up and counters the loss. Correlation is difficult to determine among companies, but in general the concept teaches us to invest in different industries or even foreign markets to spread out the investment. Chapter 10 discusses the relationship between risk and reward and the CAPM.

The advantages of diversification were discussed in the last chapter, but we will dig deeper and add risk and reward into the equation. Most investors would choose not to increase their risk if higher rewards were not offered. However, higher returns are associated with increased risk. How can we increase risk on a diversified portfolio? First, lets examine the two forms of risk associated with a portfolio. The first is known as systemic risk.

This is the risk that is associated with market swings. The concept of Beta attempts to find a relationship between risk and return. Beta measures the movement of an individual stock or portfolio with that of the market. Beta is calculated by finding the variance of the returns of a security.

So Beta measures the volatility of portfolios or individual stocks against the market and establishes a risk indicator. This type of risk cannot be diversified away. The other type of risk is called unsystematic risk. It involves factors that may affect an individual stock or group of stocks, but not the market as a whole.

Diversification reduces this risk. As one stock moves up, another moves down and a good portion of the risk is eliminated. The basis behind the CAPM is "that there is no premium for bearing risks that can be diversified away". That is how the concept of beta is incorporated into the study. By increasing the level of risk that cannot be diversified in a portfolio, one should get a higher rate of return on average.

However, is beta an accurate indicator of risk? Malkiel and others say no. Studies concluded that the relationship between beta and return are flat. So the theory does not hold, but it is a useful investment tool.

Again other factors should be considered, while using the beta approach as a guide. Returns may also rely on general market swings, changes in interest rates and inflation, to changes in national income and other economic factors. Chapter 11 closes our discussion with several insights into the efficient market theory. There have been many attempts to discredit the random walk theory, but none of the theories hold against empirical evidence.

Any pattern that is noticed by investors will disappear as investors try to exploit it and the valuation methods of growth rate are far too difficult to predict. As we said before the random walk concludes that no patterns exist in the market, pricing is accurate and all information available is already incorporated into the stock price. Therefore the market is efficient. Even if errors do occur in short-run pricing, they will correct themselves in the long run. The random walk suggest that short-term prices cannot be predicted and to buy stocks for the long run. Malkiel concludes the best way to consistently be profitable is to buy and hold a broad based market index fund.

As the market rises so will the investors returns since historically the market continues to rise as a whole.