barcode in vb.net source code The 10 Principles of Finance and How to Use Them in Software

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The 10 Principles of Finance and How to Use Them
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Mean reversion suggests that the stock market run of the late 1990s could not be sustained indefinitely, and that much lower or negative returns were on the horizon to bring stock prices back into line with their long-term trend. When stock prices are at relatively low levels as measured by priceto-sales, price-to-book value, or price-to-earnings ratios, the probability of a very good stock return has the market screaming buy, and we buy. Conversely, when price-to-book values and price-to-earnings ratios approach levels of irrational exuberance, we sell overvalued stocks, flee to the sidelines, and invest in bonds or money markets. For instance, during the late 1990s the prices of technology stocks were at levels far higher than their operating profits could ever support. The downside risk of tech stocks appeared to be significantly higher than the upside potential. Consequently, we reduced our exposure to the equity market. Likewise, at the end of 2002, with the economy slowing and prices of many goods falling, a major concern among investors is the prospect of deflation. The 10-year U.S. Treasury rate was 3.82 percent near a 40-year low, and not a great time to buy long-term bonds. Because of the historically low yields, we were light in the bond market. Be prepared to take on additional risks to earn increased returns, but first make sure that the odds are in your favor. This is part of the asset allocation decision that we discuss in Principle 8.
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Principle 2: Efficient Capital Markets Are Tough to Beat
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According to finance theory, this is the short story on efficient capital markets (ECM). The stock market is brutally efficient; current stock prices reflect all publicly available information; and stock prices react completely, correctly, and almost instantaneously to incorporate the receipt of new information. Sound realistic If the stock market is efficient, it would be useless to analyze patterns of past stock prices and trading volume to forecast future prices which are what market technicians do in technical analysis. It also would be useless to analyze the economy, industries, and companies, and to study financial statements in an effort to find stocks that are
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STREETSMART GUIDE TO VALUING A STOCK
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undervalued or overvalued which are what most research analysts do in fundamental analysis. Many of Wall Street s investment professionals think that the concept of efficient capital markets is just the musing of some ivory tower academics and that the theory doesn t properly describe the real life action of the stock market. Many academics disagree and point to studies that support the notion that the stock market is efficient. The good news for Wall Street professionals is that serious chinks exist in the armor of proponents of efficient capital markets. Efficient capital markets, along with the random walk hypothesis of stock prices and the capital asset pricing model, form the cornerstone of modern portfolio theory (MPT). The development and championing of efficient capital markets is identified closely with the finance faculty at the University of Chicago, particularly Dr. Eugene F. Fama. In simple terms, an efficient capital market (ECM) is a market that efficiently processes information. Prices of securities fully reflect available information and are based on an accurate evaluation of all available information. A random walk is a path that a variable takes, such as the observed price of a stock, where the future direction of the path (up or down) can t be predicted solely on the basis of past movements. As far as the stock market is concerned, a random walk means that it is impossible to predict short-run changes in stock prices by looking at past price patterns and trading volume. In short, successive price changes are independent of each other, so the best estimate of tomorrow s stock price is today s stock price. In the long-run, researchers have found that most stock prices move in tandem with a stock s long-term growth of earnings and dividends. After adjusting for this growth trend, the random walk hypothesis assumes that the paths of stock prices are, in fact, random. The capital asset pricing model (CAPM) is a theory about the pricing of assets and the trade-off between the risk of the asset and the expected returns associated with the asset. In the CAPM, two types of risk are associated with a stock: unsystematic or firm-specific risk; and market or systematic risk, measured by a firm s beta. (We discuss CAPM and beta in greater detail at the end of this chapter and in 6.) Hundreds of doctoral dissertations and academic papers are based on various event studies2 that test the efficient capital market hypoth-
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