Are Bull Markets Supported By Rational Growth in Stock Valuations? :: Finance Financial Economics Essays

Introduction â€Å"The rich get richer† is a frequently heard adage in the United States, a country quickly associated with capitalism. US financial markets make headline news on a daily basis, so people are well aware when the domestic stock market’s indices rise or fall. Given the widespread distribution of information on the stock market’s performance, much excitement can easily be generated during a bull market, broadly defined as a trend during which stock prices are climbing. Does the publicity and excitement surrounding a bull market further perpetuate rising stock prices? A look at historic daily closing values for the S&P 500 index from January 2, 1997 to December 31, 1999 reveals overall growth of 99.35%[i], which on average indicates similar growth in the stock prices of the companies included in the index. Clearly, this three year period falls within a bull market, since the S&P 500 is commonly utilized to represent average performance of the stock market on the whole. A return of 99.35% on an investment is excellent and far exceeds the general return on â€Å"risk-free† investments like FDIC insured savings accounts or Treasury bills. [i] Percent change calculation derived from widely published market data Examination of Common Stock Valuation to Account for Rising Share Prices Like most economic evaluations, the decision to purchase a share of a company’s stock is based on an individual’s willingness to pay versus the current selling price of the share. Fundamentally, the willingness to pay is determined by a valuation of that share of stock. For a given share of common stock, the willingness to pay is, or should be, linked to the present value of the stream of future cash flows that the investor will receive from expected dividends and through any expected capital gain for selling the share at a higher price than at which it was purchased.[i] Thus, there are three main factors the affect the valuation of a share of common stock: future dividends, future market price of the share, and the discount rate used. [i] Fundamentals of Financial Management, Eugene F. Brigham & Joel F. Houston, Harcourt College Publishers: Forth Worth, 2001. (p. 409) Future Dividends Are Bull Markets Supported By Rational Growth in Stock Valuations? :: Finance Financial Economics Essays Introduction â€Å"The rich get richer† is a frequently heard adage in the United States, a country quickly associated with capitalism. US financial markets make headline news on a daily basis, so people are well aware when the domestic stock market’s indices rise or fall. Given the widespread distribution of information on the stock market’s performance, much excitement can easily be generated during a bull market, broadly defined as a trend during which stock prices are climbing. Does the publicity and excitement surrounding a bull market further perpetuate rising stock prices? A look at historic daily closing values for the S&P 500 index from January 2, 1997 to December 31, 1999 reveals overall growth of 99.35%[i], which on average indicates similar growth in the stock prices of the companies included in the index. Clearly, this three year period falls within a bull market, since the S&P 500 is commonly utilized to represent average performance of the stock market on the whole. A return of 99.35% on an investment is excellent and far exceeds the general return on â€Å"risk-free† investments like FDIC insured savings accounts or Treasury bills. [i] Percent change calculation derived from widely published market data Examination of Common Stock Valuation to Account for Rising Share Prices Like most economic evaluations, the decision to purchase a share of a company’s stock is based on an individual’s willingness to pay versus the current selling price of the share. Fundamentally, the willingness to pay is determined by a valuation of that share of stock. For a given share of common stock, the willingness to pay is, or should be, linked to the present value of the stream of future cash flows that the investor will receive from expected dividends and through any expected capital gain for selling the share at a higher price than at which it was purchased.[i] Thus, there are three main factors the affect the valuation of a share of common stock: future dividends, future market price of the share, and the discount rate used. [i] Fundamentals of Financial Management, Eugene F. Brigham & Joel F. Houston, Harcourt College Publishers: Forth Worth, 2001. (p. 409) Future Dividends