Now the idea is the price of a stock should be the present discounted value of expected dividends. We'll come back to present values last, but what we have here is that, oops, the price is equal to what I'm assuming earnings equals dividends. Price equals earnings divided by a discount factor, which is the discount rate minus the growth rate of earnings. So price equals earnings over some number. This is called the Gordon model. So and these are not necessarily exactly today's earnings, but we'll use that as an approximation. So what it implies then is that unless the risk factor is different from some stock to another making for a different discount rate, the price earnings ratio should be the same in every stock, that's the Gordon model. So efficient market theory has to explain why some companies are priced higher relative to their earnings than others. And it would have to be, if you believe the Gordon model, it have to be something about risk or growth opportunities. So if you're company is price high relative to earnings it would either have to be because it's low risk as measured by beta, so we willing to pay more for it because it's low risk. Or would have to be that people have reason to think that they're earning path the gross rate g is high. So that you're dividing by a smaller number. So the efficient markets here able to tribute, it would explain differences in price relative to earnings. In terms of either the discount rate or the growth rate of earnings. So that this markets are all priced right, even though in some markets the price is high relative to earnings. So if this then gets that some stocks are much more expensive than others. Some sell at a price earnings ratio of as much as, sometimes is even more, but let's say 100 times earnings. And you might ask, why would anyone pay 100 times earnings for a stock? Well, efficient market theory would say, well, in its infinite wisdom, the market has decide either that this stock is very good, in terms of risk, that's r, or that the growth rate of the earnings of this company is going to be phenomenal. So that high price-earnings ratio should predict high growth rates of earnings. So these are ideas, why do people think markets ought to be efficient? There's the marginal investor. The smart guys are the ones that trade regularly. They trade fast and immediately, and they dominate trading. There's also a survival of the fittest argument. That some people go to Wall Street who look smart, but they're really not smart. [LAUGH] >> On the P/E ratios though, do you think that different industries should have different P/E ration averages? >> Good question. There are historic long run differences across industries, and across countries in price earnings ratios. A good example is Japan. Which if you go back to the 1980s had, the overall Japanese market had a price earnings ratio almost up to 100. People back then were saying in everywhere, but Japan, they were saying this is crazy, what with those Japanese? That's too high, but if you go to Japan, it seemed different. I actually did a questionnaire survey comparing US and Japan, attitudes towards the Japanese market, and I know this is true that US people where as highly skeptical, but the Japanese were very enthusiastic. So the price earnings ratios did come way down in Japan after that. I think it's because the Japanese, they're human like all, I'm not criticizing the Japanese, but they got kind of carried away with their success and they bid the price up. And that can be a psychological cause for differences and it can be prolonged differences in price earnings ratios. There could also be other of course differences, like differences in accounting standards.
