They invariably relied on a few implicit and explicit
assumptions:
1. That the fair "value" of a share is closely correlated to its market
price;
2. That price movements are mostly random, though somehow related to
the aforementioned "value" of the share. In other words, the price of a
security is supposed to converge with its fair "value" in the long
term;
3. That the fair value responds to new information about the firm and
reflects it - though how efficiently is debatable. The strong
efficiency market hypothesis assumes that new information is fully
incorporated in prices instantaneously.
But how is the fair value to be determined?
A discount rate is applied to the stream of all future income from the
share - i.e., its dividends. What should this rate be is sometimes
hotly disputed - but usually it is the coupon of "riskless" securities,
such as treasury bonds. But since few companies distribute dividends -
theoreticians and analysts are increasingly forced to deal with
"expected" dividends rather than "paid out" or actual ones.
The best proxy for expected dividends is net earnings. The higher the
earnings - the likelier and the higher the dividends.
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