In simple Microeconomics Market efficiency is the unbiased estimate of the actual value of the investment. The stock price can be greater than or less than true value till the time these deviations are arbitrary. Market efficiency also states that even though investor has got any kind of precise inside information will be unable to beat the market.
Fama (1988) has defined three levels of market efficiency:
1. Weak-form efficiency
Asset prices instantly and completely reflect all information of the previous prices. This means future price variations can’t be foreseen by using preceding prices.
2. Semi-strong efficiency
Asset prices entirely reflect all of the publicly available data. Therefore, only investors with extra inside information can have an upper hand on the market.
3. Strong-form efficiency
Asset prices wholly reflect all of the public and inside information. Therefore, none can take advantage on the market in forecasting prices because there would be no additional data that would provide any advantage to the investors.
Stock Market Predictability
Stock market prediction is the method of predicting the price of a company’s stock. It is believed that stock price is lead by random walk hypothesis. Random walk hypothesis states that stock market price matures randomly and hence can’t be predicted. Pesaran (2003) states that it is often argued that if stock markets are efficient then it should not be possible to predict stock returns. In fact, it is easily seen that stock market returns will be non-predictable only if market efficiency is combined with risk neutrality. On the other hand it is also been concluded that using variance ratio tests long horizon stock market returns can be predicted. Researchers have named a large number of financial variables that can predict future stock returns. These include the price-earnings ratio, dividend-price ratio, book-to-market ratio, dividend-payout ratio, term and default spreads on bonds, market value-to-net worth ratio, short-term interest rate and consumption-wealth ratio. Campbell (2000) concludes that despite difficulties, the proof for predictability has rational significant level of statistics. Most financial economists have accepted that aggregate returns do contain an important predictable element.
1. Dividend Yield
Dividend price ratio of a stock is dividend received during a period divided by the price of the stock at the end of the period. Dividend yield is mathematically calculated by dividing the dividends received during the period by the price of the stock at the beginning of the period. Dividends yield is the measure of cash flow for each pound invested in an equity position. Supposedly, there are two companies C1 and C2. Both pay annual dividend of £1. Stock of C1 and C2 is traded at £10 and £20 respectively. Then C1 has 10% dividend yield whereas C2 has only 5% dividend yield. The investor will surely prefer investing in C1 rather than C2.