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- 1. Chapter 11 Stock Valuation and RiskFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 1
- 2. Chapter Outline Stock valuation methods Determining the required rate of return to value stocks Factors that affect stock prices Role of analysts in valuing stocks Stock risk Applying value at risk Forecasting stock price volatility and beta Stock performance measurement Stock market efficiency Foreign stock valuation, performance, and efficiency 2
- 3. Stock Valuation Methods The price-earnings (PE) method assigns the mean PE ratio based on expected earnings of all traded competitors to the firm’s expected earnings for the next year Assumes future earnings are an important determinant of a firm’s value Assumes that the growth in earnings in future years will be similar to that of the industry 3
- 4. Stock Valuation Methods (cont’d) Price-earnings (PE) method (cont’d) Reasons for different valuations Investors may use different forecasts for the firm’s earnings or the mean industry earnings Investors disagree on the proper measure of earnings Limitations of the PE method May result in inaccurate valuation for a firm if errors are made in forecasting future earnings or in choosing the industry composite Some question whether an investor should trust a PE ratio 4
- 5. Valuing A Stock Using the PE Method A firm is expected to generate earnings of $2 per share next year. The mean ratio of share price to expected earnings of competitors in the same industry is 14. What is the valuation of ?the firm’s shares according to the PE methodValuation per share = (Expected earnings of firm per share) × (Mean industry PE ratio) = $2 × 14 = $28 5
- 6. Stock Valuation Methods (cont’d) Dividend discount model John Williams (1931) stated that the price of a stock should reflect the present value of the stock’s future dividends: k ∞ Dt Price = ∑ t =1 (1 + k )t D can be revised in response to uncertainty about the firm’s cash flows k can be revised in response to changes in the required rate of return by investors 6
- 7. Stock Valuation Methods (cont’d) Dividend discount model (cont’d) For a constant dividend, the cash flow is a perpetuity: ∞ Dt D Price = ∑ t =1 = (1 + k )t k For a constantly growing dividend, the cash flow is a growing perpetuity: ∞ Dt D1 Price = ∑ t =1 = (1 + k )t k − g 7
- 8. Valuing A Stock Using theDividend Discount ModelExample 1: A firm is expected to pay a dividendof $2.10 per share every year in theforeseeable future. Investors require a returnof 15% on the firm’s stock. According to thedividend discount model, what is a fair price?for the firm’s stock ∞ Dt D $2.10 Price = ∑ t =1 (1 + k ) t = = k 15% = $14 8
- 9. Valuing A Stock Using theDividend Discount ModelExample 2: A firm is expected to pay a dividendof $2.10 per share in one year. In everysubsequent year, the dividend is expected togrow by 3 percent annually. Investorsrequire a return of 15% on the firm’s stock.According to the dividend discount model,?what is a fair price for the firm’s stock ∞ Dt D1 $2.10 Price =∑t =1 (1 + k ) t = = k − g 15% − 3% = $17.50 9
- 10. Stock Valuation Methods (cont’d) Dividend discount model (cont’d) Relationship between dividend discount model and PE ratio The PE multiple is influenced by the required rate of return and the expected growth rate of competitors The inverse relationship between required rate of return and value exists in both models The positive relationship between a firm’s growth rate and its value exists in both models 10
- 11. Stock Valuation Methods (cont’d) Dividend discount model (cont’d) Limitations of the dividend discount model Errors can be made in determining the: Dividend to be paid Growth rate Required rate of return Errors are more pronounced for firms that retain most of their earnings 11
- 12. Stock Valuation Methods (cont’d) Adjusting the dividend discount model The value of the stock is: The PV of the future dividends over the investment horizon The PV of the forecasted price at which the stock will be sold Must estimate the firm’s EPS in the year they plan to sell the stock by applying an annual growth rate to the prevailing EPS 12
- 13. Using the Adjusted DividendDiscount ModelParker Corp. currently has earnings of $10 pershare. Investors expect that the EPS willgrowth by 3 percent per year and expect tosell the stock in four years. What is the EPS?in four years Forecasted earnings in n years = E (1 + G )n = $10 × (1.03)4 = $11.26 13
- 14. Using the Adjusted DividendDiscount Model (cont’d)Other firms in Parker’s industry have a mean PEratio of 7. What is the estimated stock price in?four yearsStock price in 4 years = (Earnings in 4 years) × (PE ratio of industry) = $11.26 × 7 = $78.82 14
- 15. Using the Adjusted DividendDiscount Model (cont’d)Parker is expected to pay a dividend of $2 pershare over the next four years. Investorsrequire a return of 13% on their investment.Based on this information, what is a fair valueof the stock according to the adjusted?dividend discount model $2 $2 $2 $2 $78.82 PV = + + + + (1.13 )1 (1.13 )2 (1.13 )3 (1.13 )4 (1.13 )4 = $54.29 15
- 16. Stock Valuation Methods (cont’d) Adjusting the dividend discount model (cont’d) Limitations of the adjusted dividend discount model Errors can be made in deriving the PV of dividends over the investment horizon or the forecasted price at which the stock can be sold Errors can be made if an improper required rate of return is used 16
- 17. Determining the Required Rate ofReturn to Value Stocks The capital asset pricing model: Assumes that the only important risk is systematic risk Is not concerned with unsystematic risk Suggests that the return on an asset is influenced by the prevailing risk-free rate, the market return, and the covariance between a stock’s return and the market’s return: R j = Rf + B j ( R m − Rf ) 17
- 18. Determining the Required Rate ofReturn to Value Stocks (cont’d) The capital asset pricing model (cont’d) Estimating the risk-free rate and the market risk premium The yield on newly issued T-bonds is commonly used as a proxy for the risk-free rate The terms within the parentheses measure the market risk premium Historical data over 30 or more years can be used to determine the average market risk premium over time Estimating the firm’s beta Beta reflects the sensitivity of the stock’s return to the market’s overall return Beta is typically measured with monthly or quarterly data over the last four years or so 18
- 19. Using the CAPMFantasia Corp. has a beta of 1.7. The prevailingrisk-free rate is 5% and the market riskpremium is 5%. What is the required rate ofreturn of Fantasia Corp. according to the?CAPM R j = R f + B j ( R m − Rf ) = 5% + 1.7(10% − 5%) = 13.5% 19
- 20. Determining the Required Rate ofReturn to Value Stocks (cont’d) The capital asset pricing model (cont’d) Limitations of the CAPM A study by Fama and French found that beta is unrelated to the return on stock over the 1963–1990 period Chan and Lakonishok: Found that the relation between stock returns and beta varied with the time period used Concluded that it is appropriate to question whether beta is the driving force behind stock returns Found that firms with the highest betas performed much worse than firms with low betas Found that high-beta firms outperformed low-beta firms during market upswings 20
- 21. Determining the Required Rate ofReturn to Value Stocks (cont’d) Arbitrage pricing model Suggests that a stock’s price can be influenced by a set of factors in addition to the market e.g., economic growth, inflation In equilibrium, expected returns on assets are linearly related to the covariance between assets returns and the factors: m E (R ) = B0 + ∑B F i =1 i i 21
- 22. Factors That Affect Stock Prices Economic factors Impact of economic growth An increase in economic growth increases expected cash flows and value Indicators such as employment, GDP, retail sales, and personal income are monitored by market participants Impact of interest rates Given a choice of risk-free Treasury securities or stocks, stocks should only be purchased if they offer a sufficiently high expected return 22
- 23. Factors That Affect Stock Prices(cont’d) Economic factors (cont’d) Impact of the dollar’s exchange rate value The value of the dollar affects U.S. stocks because: Foreign investors purchase U.S. stocks when the dollar is weak Stock prices are affected by the impact of the dollar’s changing value on cash flows Some U.S. firms are involved in exporting U.S.-based MNCs have some earnings in foreign currencies Exchange rates may affect expectations of other economic factors 23
- 24. Factors That Affect Stock Prices(cont’d) Market-related factors Investor sentiment In some periods, stock market performance is not highly correlated with existing economic conditions Stocks can exhibit excessive volatility because their prices are partially driven by fads and fashions A study by Roll found that only one-third of the variation in stocks returns can be explained by systematic economic forces January effect Many portfolio managers invest in riskier small stocks at the beginning of the year and shift to larger companies near the end of the year Places upward pressure on small stocks in January 24
- 25. Factors That Affect Stock Prices(cont’d) Firm-specific factors Some firms are more exposed to conditions within their own industry than to general economic conditions, so participants monitor: Industry sales forecasts Entry into the industry by new competitors Price movements of the industry’s products Market participants focus on announcements that signal information about a firm’s sales growth, earnings, or characteristics that cause a revision in the expected cash flows 25
- 26. Factors That Affect Stock Prices(cont’d) Firm-specific factors (cont’d) Dividend policy changes An increase in dividends may reflect the firm’s expectation that it can more easily afford to pay dividends Earnings surprises When a firm’s announced earnings are higher than expected, investors may raise their estimates of the firm’s future cash flows Acquisitions and divestitures Expected acquisitions typically result in an increased demand for the target’s stock and raise the stock price The effect on the acquiring firm is less clear Expectations Investors attempt to anticipate new policies so they can make their move before other investors 26
- 27. Factors That Affect Stock Prices(cont’d) Integration of factors affecting stock prices Whenever economic indicators signal the expectation of higher interest rates, there is upward pressure on the required rate of return Firms’ expected future cash flows are influenced by economic conditions, industry conditions, and firm- specific conditions 27
- 28. Role of Analysts in Valuing Stocks Many investors rely on opinions of stock analysts employed by securities firms or other financial firms Many analysts are assigned to specific stocks and issue ratings that can indicate whether investors should buy or sell the stock A 2001 study by Thomson Financial determined that analysts at the largest brokerage firms typically recommended “sell” for less than 1 percent of all the stocks for which they provided ratings 28
- 29. Role of Analysts in Valuing Stocks(cont’d) Conflicts of interest Many analysts are employed by securities firms that have other investment banking relationships with rated firms Some analysts may own the stock of some of the firms they rate Impact of disclosure regulations In October 2000, the SEC enacted Regulation FD, which requires firms to disclose any significant information simultaneously to all market participants Unbiased analyst rating services Popular rating services include Morningstar, Value Line, and Investor’s Business Daily Analyst rating services typically charge subscribers between $100 and $600 per year 29
- 30. Stock Risk Risk reflects the uncertainty about future returns such that the actual return may be less than expected The holding period return is measured as: (SP − INV ) + D R= INV The main source of uncertainty is the price at which the stock can be sold Dividends tend to be much more stable than stock price 30
- 31. Stock Risk (cont’d) Measures of risk The volatility of a stock: May indicate the degree of uncertainty surrounding the stock’s future returns Reflects total risk because it reflects movements in stock prices for any reason 31
- 32. Stock Risk (cont’d) Measures of risk (cont’d) The volatility of a stock portfolio depends on: The volatility of the individual stocks in the portfolio The correlations between returns of the stocks in the portfolio The proportion of total funds invested in each stock A portfolio containing some stocks with low or negative correlation will exhibit less volatility σ p = w i2σ i2 + w 2σ 2 + 2w i w j σ i σ j CORRij j j 32
- 33. Stock Risk (cont’d) Measures of risk (cont’d) The beta of a stock: Measures the sensitivity of its returns to market returns Is used by many investors who have a diversified portfolio of stocks Can be estimated by obtaining returns of the firm and the stock market and applying regression analysis to derive the slope coefficient: R jt = B0 + B1Rmt + ut 33
- 34. Stock Risk (cont’d) Measures of risk (cont’d) The beta of a stock portfolio: Is useful for investors holding more than one stock Can be measured as a weighted average of the betas of stocks in the portfolio, with the weights reflecting the proportion of funds invested in each stock: Bp = ∑w B i i The risk of a high-beta portfolio can be reduced by replacing some of the high-beta stocks with low-beta stocks 34
- 35. Stock Risk (cont’d) Measures of risk (cont’d) Value at risk: Is a risk measurement the estimates the largest expected loss to a particular investment position for a specified confidence level Became very popular in the late 1990s after some mutual funds and pension funds experienced abrupt large losses Is intended to warn investors about the potential maximum loss that could occur Focuses on the pessimistic portion of the probability distribution of returns Is commonly used to measure the risk of a portfolio 35
- 36. Applying Value at Risk Methods of determining the maximum expected loss Use of historical returns to derive the maximum expected loss e.g., an investor may determine that out of the last 100 trading days, a stock experienced a decline of greater than 7 percent on 5 different days The investor could infer a maximum daily loss of no more than 7 percent for that stock based on a 95 percent confidence level 36
- 37. Applying Value at Risk (cont’d) Methods of determining the maximum expected loss (cont’d) Use of standard deviation to derive the maximum expected loss The standard deviation of daily returns over the previous period can be used and applied to derive boundaries for a specific confidence level Use of beta to derive the maximum expected loss 37
- 38. Using the Standard Deviation toDerive the Maximum Expected LossThe standard deviation of daily returns for astock in a recent period is 1%. The 95%confidence level is desired for the maximumloss. The stock has an expected daily returnof .1%. What is the lower boundary of?expected returns .1% − [1.65 × (1%)] = −1.55% 38
- 39. Using Beta to Derive the MaximumExpected LossA stock’s beta over the last 100 days is 1.3. Thestock market is expected to perform no worse than–2.1% on a daily basis based on a 95%confidence level. What is the maximum lossto the stock over a given day based on this?information 1.3 × ( −2.1%) = −2.73% 39
- 40. Applying Value at Risk (cont’d) Deriving the maximum dollar loss The maximum percentage loss for a given confidence level can be applied to derive the maximum dollar loss of a particular investment Value at risk is commonly applied to assess the maximum possible loss for an entire portfolio Common adjustments to value at risk applications Investment horizon desired Length of historical period used Time-varying risk Restructuring the investment portfolio 40
- 41. Forecasting Stock Price Volatilityand Beta Methods of forecasting stock price volatility The historical method uses a historical period to derive a stock’s standard deviation of returns and uses that estimate as the forecast for the future The time-series method uses volatility patterns in previous periods Places more weight on the most recent data Normally uses the weights and number of periods that were the most accurate in previous periods The implied standard deviation derives the estimate from the stock option pricing model Represents the anticipated volatility of the stock over a future period by investors trading the stock 41
- 42. Forecasting Stock Price Volatilityand Beta (cont’d) Forecasting a stock portfolio’s volatility Portfolio volatility can be forecast by first deriving forecasts of individual volatility levels Next, the correlation coefficient for each pair of stock in the portfolio is forecast by estimating the correlation in recent periods Forecasting a stock portfolio’s beta Firstforecast the betas of the individual stocks and then take a weighted average 42
- 43. Stock Performance Measurement The Sharpe index is appropriate when total variability is thought to be the appropriate measure of risk: R − Rf Sharpe index = σ The higher the stocks’ mean return relative to the mean risk- free rate and the lower the standard deviation, the higher the Sharpe index Measures the excess return above the risk-free rate per period 43
- 44. Using the Sharpe IndexPatrick stock has an average return of 15% andan average standard deviation of 13%. Theaverage risk-free rate is 8%. What is the?Sharpe index for Patrick stock R − Rf Sharpe index = σ 15% − 8% = = 0.54 13% 44
- 45. Stock Performance Measurement(cont’d) The Treynor index is appropriate when beta is thought to be the most appropriate type of risk: R − Rf Treynor index = B The higher the Treynor index, the higher the return relative to the risk-free rate, per unit of risk 45
- 46. Using the Treynor IndexPatrick stock has an average return of 15% anda beta of 1.8. The average risk-free rate is8%. What is the Sharpe index for Patrick?stock R − Rf Treynor index = B 15% − 8% = = 0.04 1.8 46
- 47. Stock Market Efficiency Forms of efficiency Weak-form efficiency suggests that security prices reflect all trade-related information Semistrong-form efficiency suggests that security prices fully reflect all public information Includes announcements by firms, economic news or events, and political news or events If semistrong-form efficiency holds, weak-form efficiency holds as well Strong-form efficiency suggests that security prices fully reflect all information, including private or insider information 47
- 48. Stock Market Efficiency (cont’d) Tests of the efficient market hypothesis Test of weak-form efficiency Tested by searching for a nonrandom pattern in security prices Studies have generally found that historical price changes are independent over time There is some evidence that stocks: Have performed better in January (January effect) Have performed better on Fridays than on Mondays (weekend effect) Have performed well on the trading days just before holidays (holiday effect) 48
- 49. Stock Market Efficiency (cont’d) Tests of the efficient market hypothesis Test of semistrong-form efficiency Tested by assessing how security returns adjust to particular announcements Generally, security prices immediately reflect the information from announcements There is evidence of unusual profits from investing in IPOs Test of strong-form efficiency Difficult to test There is evidence that share prices of target firms rise substantially when the acquisition is announced Insiders are discouraged from using inside information because it is illegal 49
- 50. Foreign Stock Valuation,Performance, and Efficiency Valuation of foreign stocks PE method The expected EPS of the foreign firm are multiplied by the appropriate PE ratio based on the firm’s risk and local industry The PE ratio for a given industry may change continuously in some foreign markets The PE ratio for a particular industry may need to be adjusted for the firm’s country Dividend discount model An adjustment for expected exchange rate movements is required The value of foreign stocks from a U.S. perspective is subject to more uncertainty than the value of the stock from a local investor’s perspective 50
- 51. Foreign Stock Valuation, Performance,and Efficiency (cont’d) Measuring performance from investing in foreign stocks The performance measurement should control for general market movements and exchange rate movements in the region where the portfolio managers has been assigned to invest funds 51
- 52. Foreign Stock Valuation, Performance,and Efficiency (cont’d) Performance from global diversification Stock investors can benefit by diversifying internationally Economies do not move in tandem Stock markets across countries may respond to some of the same expectations In general, correlations between stock indexes have been higher in recent years than they were several years ago 52
- 53. Foreign Stock Valuation, Performance,and Efficiency (cont’d) Performance from global diversification (cont’d) Integration of markets during the 1987 crash There was a high correlation among country stock markets during the crash This suggests that the underlying cause of the crash systematically affected all markets Integration of markets during mini-crashes On August 27, 1998 (“Bloody Thursday”) most stock markets around the world experienced losses Illustrates that even a well-diversified international portfolio is not insulated from some events Diversification among emerging stock markets These markets have lower correlations with developed countries, but also higher risk 53
- 54. Foreign Stock Valuation, Performance,and Efficiency (cont’d) International market efficiency Some foreign markets are inefficient because of the small number of analysts and portfolio managers Market inefficiencies are more common in small foreign stock markets Insider trading is more prevalent in many foreign markets Political and exchange rate risk may be high in some foreign markets 54

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