Introduction
It is prudent to say that the performance of stock cannot perform as initially thought or predicted. Stocks can either perform as expected or underperform contrary to the expectations of stock managers of different companies. These two scenarios are brought forward due to variation in time horizons and market inefficiencies (Leigh, et al, 2008).
Inefficient markets
An efficient market for stocks is relatively stable with true, perceivable, and predictable growth horizons of stock in the future. It is quite difficult to find undervalued or overvalued stocks. In efficient markets, the future stock values can be forecasted in short and long run horizons. Inefficient markets can be caused by inflationary behaviours of stock prices and other factors (Leigh, et al, 2008; Haugen, 1995).
Expensive growth stock is a stock that trades at a higher price relative to its book value, cash flow, and earnings. In this case, dividends are expected to be faster than average growth in the future for efficient markets (Haugen, 1995). On the other hand, cheap stock has a cheap price relative to its book value, cash flow, and earnings. In this regard, dividends are expected to have slower-than-average growth in the future in efficient markets (Haugen, 1995). In an efficient market within the short and long term, expensive stocks are expected to yield high returns on investment, and that is why investors are usually attracted to purchase expensive stocks. Conversely, undervalued stocks are expected to produce low returns on investment in the future due to low stock prices. However, the market tends to overreact and due to its volatility it tends to be contrary to the expectation as earlier perceived. In this case, cheap stocks tend to have faster and larger returns compared to expensive stocks. This is due to the risk involved while investing in expensive stocks. This leads to positive surprises and high returns for cheap stocks. Downward price adjustments that are unexpected may cause slower returns on expensive stocks, which were initially thought to have higher value (Haugen, 1995).
Many considerations have been given to explain this happening. According to the explanations by old Ancient Finance, the market is usually irrational and inefficient to allow precise prediction of the perceived growth in returns of expensive and cheap stocks based on the growth horizons. According to Bird and Casavecchia (2007), lack of emphasis on determining the turning points in the market about the values of stocks at certain times in the future is taken as a major cause of surprises in the rate of return on expensive and cheap stocks. It is easy to predict growth in stocks within the short horizon by using price momentum indicators. The difficulties of predicting the horizon of turnaround in prices or value of stocks of a firm contribute to these events (Bird &Casavecchia, 2007).
There is another explanation for shock surprise in low returns on expensive stocks and positive surprise for cheap stocks. In this case, managers and investors base their decision on single measures instead of multiple measures based on a certain value and momentum measures. In their argument about stock valuation, Gray and Joyce (2002) opined that predicting the rate of return in the future basing on book values of stocks is futile and misleading to investors. Competitive pressure in the markets is sufficiently strong to cause everyone to earn according to the invested capital due to erosion of the profits to meet the market equilibrium (Gray& Joyce, 2002).
Conclusion
In modern times, stock valuation should not be limited to valuation of the book values. However, it should also rely on other factors. Market competition and volatility are thought to be the principal contributors to declines or improvements in stock values. Therefore, value managers should varyly consider these factors in valuation and forecasting of stock prices.
Reference List
Bird, R &Casavecchia, L 2007, “Value enhancement using momentum indicators: the European experience,” International Journal of Managerial Finance, vol. 3, no. 3, pp.229 – 262.
Haugen, R 1995, The new finance: a case against efficient markets, Prentice Hall, Englewood Cliffs, N.J.
Joyce, C&Gray, J 2002, “Goodbye to book value investing,” Balance Sheet, vol. 10, no. 2, pp.15 – 16.
Leigh, W, Frohlich, C, Hornik, S, Purvis, R, & Roberts, T 2008, “Trading With a Stock Chart Heuristic,”IEEE Transactions On Systems, Man & Cybernetics: Part A, vol. 38, no. 1, pp. 93-104.