Question

What roles do expectations play in pricing equity securities in general? What is the relations between security prices and expected returns (the discount rate, or WACC, in this case)?

Answer 1

Expectations play a crucial and significant role in pricing equity securities. There are expectations with regards to expected business and profitability of a company. This is related to expected free cash flows. The expected free cash flows are discounted to the present value using the cost of capital. The expectations are based on current and historical financial information and on the basis of this information expectations are built with regards to future financial performance of a company. The future guidance provided by a company’s management also builds up expectations and this in turn affects the pricing of equity securities.

There is an inverse relationship between security prices and expected returns (i.e. discount rate or WACC). This is because security price = present value of all future cash flows. Present value is determined by using the appropriate discount rate and the higher the discount rate the lower will be the present value and vice versa.