Stock Market Equilibrium (2)
by MaestriHad the stock initially sold for less than $27.27, say, at $25, events would have been reversed. Investors would have wanted to buy the stock because its expected rate of return would have exceeded its required rate of return, and buy orders would have driven the stock’s price up to $27.27.
To summarize, in equilibrium two related conditions must hold:
1. A stock’s expected rate of return as seen by the marginal investor must equal its required rate of return: ˆri ri.
2. The actual market price of the stock must equal its intrinsic value as estimated by the marginal investor: P0 ˆP0.
Of course, some individual investors may believe that ˆri r and ˆP0 P0, hence they would invest most of their funds in the stock, while other investors may have an opposite view and would sell all of their shares. However, it is the marginal investor who establishes the actual market price, and for this investor, we must have ˆri ri and P0 ˆP0. If these conditions do not hold, trading will occur until they do.
Taken From : Five-Minute MBA – Corporate Finance
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