It is prudent to say that the performance of stock can sometimes not perform as initially thought or predicted. Stocks can either perform as expected or at the same time underperform contrary 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).
An efficient market for stocks is relatively stable with true and 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 precisely 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 by description is a stock that trades at a higher price relative to its book value, cash flow, earnings, and dividends are expected to have faster than average growth in the future in efficient markets (Haugen, 1995). Cheap stock on the other hand is a stock that has with cheap price relative to its book value, cash flow, earnings, and dividends, is expected to have slower than average growth in the future in efficient markets (Haugen, 1995). In an efficient market, in short and long term, expensive stocks are expected to yield high returns on investment, and that why more 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 tend to be contrary to the expectation as earlier perceived. That is, cheap stocks tend have faster and larger returns as compared to expensive stocks due to risk involved investing in expensive stocks in the long run. This results in positive surprises and higher returns in for cheap stocks. Downward price adjustments that are unexpected may cause slower returns on expensive stocks that were initially thought to have higher value (Haugen, 1995).
So many considerations are given to explain this happening. The explanations by old Ancient Finance, market is usually irrational and inefficient to allow precise prediction of the perceived growth in returns of expensive and cheap stocks basing on the growth horizons. According to Bird and Casavecchia (2007), the lack of emphasis on determining the turning points in the market about the values of stocks at particular times in the future is taken as a major cause of surprises in rate of return on expensive and cheap stocks. By using price momentum indicators, it is easier to predict growth in stocks in the short horizon. The difficulties of predicting the horizon of turnaround in prices or value of stocks of a firm are seen to contribute to these events (Bird & Casavecchia, 2007)
Another explanation for shock surprise in low returns in the long run on expensive stocks and positive surprise for cheap stocks is that managers and investors base their decision on single measures instead of multiple of measures on the basis of 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. The two argue that 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).
Stock valuation in the modern times should not only be limited to valuation of the book values but rather empirically rely on other factors. Market competition and volatility are thought to be the principal contributors to declines or improvements in stock values. Value managers should therefore, variedly consider these factors in valuation and forecasting of stock prices.
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