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1.
The Iowa Electronic Markets
Stock Valuation
Curriculum using the IEM
Prepared for the Spring 2001 IEM*IDEA/NSF Conference
By: Dr. Roger Ignatius
Associate Professor of Finance
Husson College
Dr. Thomas A. Rietz
Associate Professor of Finance
University of Iowa
April 2001
2.
Valuation Assignment
Introduction to the IEM
The Iowa Electronic Market (IEM for short) is a computerized market on which financial contracts can
be traded (bought or sold). For this assignment, you will be using a series of contracts based on three
popular companies, Apple Computers (AAPL), IBM (IBM) and Microsoft (MSFT), and an important
index called the S&P500 index. Shares of the firms trade over the counter (NASDAQ) and on the New
York Stock Exchange (NYSE). Similarly, a daily index value is determined for the S&P500 based upon
the stock prices of the 500 companies that compose of it.
The contracts you will be using are based on the shares of Apple computers, IBM and Microsoft, and
on the value of the S&P500. These contracts are listed on the IEM under the market label “Computer
Industry Returns Market” or “Comp_Ret” for short. These contracts are described briefly later in this
note and in more depth in the IEM prospectus for the market. The prospectus and other information for
these markets are available at the IEM website:
http://www.biz.uiowa.edu/iem/markets/computer.html
Objectives
The objectives of the IEM assignments are to help you apply class concepts in a "real world,"
unstructured way to learn how to:
1. Apply valuation models to “real world” companies.
2. Understand what factors influence value.
3. Combine predictions and information to develop a trading strategy.
Opening an IEM Account
All students need to open an account with the Iowa Electronic Market. This involves a minimum deposit
of ____ dollars. Funds remaining in your account are refundable at the end of the semester.
You can open an IEM account over the internet. To do so, go to the sign-up webpage:
http://iemweb.biz.uiowa.edu/signup/
and follow the instructions given to you by your instructor. (DO NOT use forms other than those given
to you by your instructor. Using other forms may result in fees or decreased deposits in your account.)
After filling out your signup forms, you may need to deposit cash with the IEM office (W283 PBAB,
phone 335-0881). Your instructor will give you details about any deposits you need to make.
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3.
Accessing the IEM
You can access the IEM through its website address:
http://www.biz.uiowa.edu/iem/
The IEM market has several contracts trading under it. The contracts of interest for our course are the
Computer Industry Returns Market (Comp_Ret, for short).
You access your trading account from the market pages or directly at:
http://iemweb.biz.uiowa.edu/
Computer Industry Returns Contracts
The Computer Industry Returns Contracts consist of a series of contracts. Every month, existing
contracts in the series are liquidated and payments are made as described below. Then, new
contracts are created as described below. These events occur on the Monday after the exchange-
traded options for the underlying stocks expire (the Monday after the third Friday of each month).
The liquidation values for the contracts in this market are determined solely by the rates of return of
Apple Computers Common Stock (AAPL), IBM Common Stock (IBM), Microsoft Common Stock
(MSFT) and the S&P500 index (SP500). Whichever of these has the highest rate of return as specified
below will payoff $1.00 per share. The remaining contracts will payoff zero. Thus, to do well in this
market, you will need to understand what determines real stock market returns.
Contracts are designated by a ticker symbol and a letter denoting the month of contract liquidation.
Thus, the contracts traded in this market for liquidation in month “m” are:
Code Underlying Asset Liquidation Value
AAPLm Apple Computers $1.00 if AAPL Return Highest
IBMm IBM $1.00 if IBM Return Highest
MSFTm Microsoft $1.00 if MSFT Return Highest
SP500m S&P 500 Market Index $1.00 if SP500 Return Highest
In these contract codes, “m” refers to the month of expiration as given by the following table:
Month Designation Month Designation Month Designation
January a May e September i
February b June f October j
March c July g November k
April d Augus h December l
t
For AAPLm, IBMm and MSFTm, the dividend-adjusted rate of return is computed based on closing
stock prices of the underlying listed firm between the third Friday in the liquidation month and the third
Friday in the previous month. For these purposes, closing prices as reported in the Midwest edition of
the Wall Street Journal are used. In particular, this return is calculated as follows. First, the raw return
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on the underlying stock is computed (as the closing price on the third Friday of the liquidation month,
minus the closing price from the third Friday of the previous month, plus any dividends on ex-dividend
dates). Then, we divide the raw return by the closing stock price from the previous month to arrive at
the dividend-adjusted rate of return. This is represented by the equation:
Pm − Pm −1 + Dm
k= ,
Pm −1
where k is the dividend adjusted return, Pm is the price on the third Friday of month m, Pm-1 is the price
on the third Friday of the previous month and Dm represents any dividends paid between these dates.
For the SP500 contract, the return is computed as the capital gains rate of return. To do this, subtract
the closing index value on the third Friday of the previous month from the closing index value on the
third Friday of the liquidation month. Then, divide by the previous month’s closing index value. This is
represented by the equation:
Pm − Pm −1
k= ,
Pm −1
where k is the capital gains index return, Pm is the index value on the third Friday of month m, and Pm-1
is the value on the third Friday of the previous month.
Trading on the IEM
You can trade on the IEM in several ways. First, you can buy or sell unit portfolios (called “bundles”). A
unit portfolio is a set of all contracts in the market such as AAPLm, IBMm, MSFTm and SP500m for the
Computer Industry Returns market. You can always buy or sell such portfolios for $1.00 each. Thus,
when you start to trade and do not own any contracts, you can buy a unit portfolio and then start to
trade. (To do this, select the appropriate contract under “Buy Bundles” or “Sell Bundles” in the “Market
Order” drop down menu. Enter a quantity and press the “Market Order” button.)
Second, you can buy or sell using a "market order." On the market screen, you will see that some
individuals have posted an order to buy or to sell a contract (e.g., MSFTi, the contract for September
liquidation in the Computer Industry Returns Market) at a specific price. If you believe that a posted
order represents a good deal, you can buy or sell at the posted price. (To do this, select the
appropriate contract under “Buy at Best Ask” or “Sell at Best Bid” in the “Market Order” drop down
menu. Enter a quantity and press the “Market Order” button.)
Third, you can buy or sell using a "limit order." To do so, you state the price at which you are willing to
buy or sell a contract and post a limit order on the screen. In doing so, you are waiting for someone
who is willing to buy or sell at your stated price. In this manner, when your order executes, it will
execute at your stated price, not at somebody else’s. The disadvantage is that the order may never
execute because nobody likes your price because it is too high or low. (To place a limit order, select the
appropriate contract under “Post a Bid” or “Post an Ask” in the “Limit Order” drop down menu. Enter a
price, quantity and expiration date and press the “Limit Order” button.)
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5.
Completing Your Assignments and Submitting Them
As you can see below, the IEM assignments are extensive, multi-part assignments that draw together
many concepts from the class. It would be wise to work on the various parts of the assignments as we
go over the relevant topics in class. To prepare the assignments for submission, please use the
following guidelines:
1. Each assignment must be typed. Label clearly each assignment with a cover page giving your
name, student number, and section number.
2. Complete each part in a separate section clearly labeling them Part 1, Part 2, etc.
3. Within each section, give the requested information, including sources of information gathered and
equations used to calculate results.
4. Turn in your completed assignment to your instructor on the date it is due.
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6.
Stock Valuation Assignment
Part 1: Discounted Dividend Models DUE: ___________
GOAL
In this part of the assignment, you will learn where to find information necessary to apply the discounted
dividend models discussed in class. You will use this information to see what discounted dividend
models imply for IBM.
Background Information
To complete this exercise, you will need to collect some basic information on IBM: the annual dividend,
an estimate for the risk free rate, the beta for IBM’s stock and some information to help estimate the
likely dividend growth rate. Most of what you need is available on the internet. You can collect this
information from a variety of sources. What follows are instructions for collecting it from Microsoft’s
MoneyCentral webpages.
To get information on IBM, go to the Microsoft MoneyCentral webpages at the address:
http://moneycentral.msn.com/
In the upper left corner, enter “IBM” as the ticker symbol and press the “go” button. Obtain the required
information as follows:
1. Recent IBM Price: The recent price per share is given on the default screen or the “Quotes—
Quote Detail” screen.
2. Dividend and Dividend Yield: The annual dividend per share and dividend yield are given on the
default screen or the “Quotes—Quote Detail” screen.
3. Beta: Beta is listed on the “Company Report” screen at the bottom of the right hand column.
4. Return on Equity (ROE): ROE is listed on the “Financial Results—Highlights” page.
5. Payout Ratio: The payout ratio is also listed on the “Financial Results—Highlights” page.
6. Historical Dividend Growth Rate: The 5 year historical dividend rate is given on the “Financial
Results—Key Ratios—Growth Rates” page.
7. Average Forecast Growth Rate from Analysts: The average forecast growth rates for the next
five years is given on the “Analyst Info—Estimates—Earnings Growth Rates” page.
8. Current 3-Month Treasury Rate: Enter the ticker symbol TB3M to obtain the current rate on 3
Month Treasury bills.
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7.
Question 1: Estimating the Required Return
Use the Capital Asset Pricing Model (CAPM) to estimate the required (annual) return for IBM stock.
Use the 3-month Treasury rate obtained above for the risk free rate, the beta obtained above for the
beta and a risk premium of 8.74% (which is the historical average from 1926-1996).
Recall that the CAPM equation is: k = rf + β × RP
Question 2: Constant Dividend Model
Suppose that IBM’s dividends will remain constant at their current level. Use the constant dividend
model to value IBM’s stock. Does this number seem too high or too low when comparing it to IBM’s
current stock price? Can you explain why that might be?
D
Recall that the Constant Dividend pricing relationship is: P0 =
k
Question 3: Estimating Dividend Growth
There are a variety of means of estimating IBM’s likely future dividend growth. Determine what the
estimated growth rate would be using each of the following methods:
a. If the past can be used as an indicator of the future, then the historical average is a good estimate.
What is the historical average dividend growth rate?
b. Analysts forecast growth and their average forecast is often used. What is the average estimated
5-year growth rate according to analysts?
c. Another commonly used estimate is the “sustainable growth” rate computed by the (1-Payout
Ratio) x ROE. What is the growth rate estimated by these means?
d. Finally, since capital gains are driven by growth they should be approximately the same as growth.
The total return in a stock (from Question 1) should equal the dividend yield plus the capital gain
yield. Thus, you can estimate the growth rate by subtracting the dividend yield from the required
return calculated in Question 1 above. What does this give for a growth rate?
Given all this information, what do you think is a reasonable long run growth rate for IBM’s dividend?
(Remember that, in the long run, growth cannot exceed the required return, which is calculated in
Question 1 above.)
Question 4: Constant Growth Model
Given the dividend, the required return calculated in Question1 and the growth rate calculated in
Question 2, what should the price of IBM stock be given the constant growth model? Does this number
seem too high or too low when comparing it to IBM’s current stock price? Can you explain why that
might be?
D1 D (1 + g )
Recall that the Constant Growth pricing relationship is: P0 = = 0
k −g k −g
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8.
Question 5: Implied Growth
There is one final way of forecasting the growth rate. Equate the price of the stock today to the value
that should exist according to the constant growth model. If you assume that next year’s dividend will
grow at the same rate as the projected growth rate and use the required return calculated in Question
1, you can solve for the growth rate. This is called the implied growth rate. What is it? How does it
compare to your estimate from Question 3 above?
Recall that the Constant Growth pricing relationship implies:
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9.
Stock Valuation Assignment
Part 2: Discounted Cash Flow Models DUE: ___________
GOAL
In this part of the assignment, you will learn where to find information necessary to apply the discounted
cash flow models discussed in class. You will use this information to see what discounted dividend
models imply for IBM, Apple and Microsoft.
Background Information
To complete this exercise, you will need to collect some basic information on all three companies to
help estimate cash flows the likely cash flow growth rate. Most of what you need is available on the
internet. You can collect this information from a variety of sources. What follows are instructions for
collecting it from Microsoft’s MoneyCentral webpages.
To get information, go to the Microsoft MoneyCentral webpages at the address:
http://moneycentral.msn.com/
For each of the companies, you will undertake the following steps to gather information. In the upper
left corner, enter the ticker symbol for the company (e.g., “IBM”) and press the “go” button. Obtain the
required information as follows:
1. Recent Price: The recent price per share is given on the default screen or the “Quotes—Quote
Detail” screen.
2. Beta: Beta is listed on the “Company Report” screen at the bottom of the right hand column.
3. Historical Income Statement Information: A five-year history of income statements is available
from “Financial Results—Statements.” If it does not come up as the default, select “Income
Statement” and “Annual” from the pull-down menus. Make a table like the one that appears below
and fill in (1), (2) and (3) below from the income statement and calculate the cash flow as (1) total
net income plus (2) depreciation and amortization minus (3) preferred dividends.
Year
(1) Total Net Income
(2) Depreciation & Amortization
(3) Preferred Dividends
Calculate Cash Flow (1)+(2)-(3)
Calculate the growth in cash flow for each year, t, as (CF t-CFt-1)/CFt-1 and calculate the average
growth rate for the available years.
4. Historical Growth Rate: The 5 year historical sales growth rate is given on the “Financial Results
—Key Ratios—Growth Rates” page. (We will use this as a proxy for cash flow growth.)
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10.
5. Average Forecast Growth Rate from Analysts: The average forecast growth rates for the next
five years is given on the “Analyst Info—Estimates—Earnings Growth Rates” page.
6. Current 3-Month Treasury Rate: Enter the ticker symbol TB3M to obtain the current rate on 3
Month Treasury bills.
Question 1: Estimating the Required Return
Use the Capital Asset Pricing Model (CAPM) to estimate the required (annual) return for each
company’s stock. Use the 3-month Treasury rate obtained above for the risk free rate, the beta
obtained above for the beta and a risk premium of 8.74% (which is the historical average from
1926-1996).
Recall that the CAPM equation is: k = rf + β × RP
Question 2: Estimating Cash Flow Growth
There are a variety of means of estimating likely future cash flow growth. Determine what the
estimated growth rate would be for each company using each of the following methods:
a. If the past can be used as an indicator of the future, then the historical average is a good estimate.
What is the historical average cash flow growth rate?
b. If the past can be used as an indicator of the future and cash flows vary directly with sales, then the
historical average sales growth rate is a good estimate. What is the historical average sales
growth rate?
c. Analysts forecast earnings growth and their average forecast is often used. Under the assumption
that cash flows vary directly with earnings. What is the average estimated 5-year growth rate
according to analysts?
Given all this information, what do you think is a reasonable long run growth rate for IBM’s cash flow?
(Remember that, in the long run, growth cannot exceed the required return, which is calculated in
Question 1 above.)
Question 3: Discounted Cash Flow Model
Given the most recent cash flow (calculated in the table used to collect income statement information
above), the required return calculated in Question 1 and the growth rate calculated in Question 2, what
should the price of each company’s stock be given current cash flows and the estimate growth rate?
Does this number seem too high or too low when comparing it to the company’s current stock price?
Can you explain why that might be?
CF1 CF0 (1 + g )
Recall that the discounted cash flow pricing relationship is: P0 = =
k −g k −g
10
11.
Stock Valuation Assignment
Part 3: Market Multiples Models DUE: ___________
GOAL
In this part of the assignment, you will learn where to find information necessary to apply the market
multiples valuation models discussed in class. You will use this information to see what these models
imply for IBM, Apple and Microsoft.
Background Information
To complete this exercise, you will need to collect some basic information on all three companies to
apply each model. Most of what you need is available on the internet. You can collect this information
from a variety of sources. What follows are instructions for collecting it from Microsoft’s MoneyCentral
webpages.
To get information, go to the Microsoft MoneyCentral webpages at the address:
http://moneycentral.msn.com/
For each of the companies, you will undertake the following steps to gather information. In the upper
left corner, enter the ticker symbol for the company (e.g., “IBM”) and press the “go” button. Obtain the
required information as follows:
1. Recent Price: The recent price per share is given on the default screen or the “Quotes—Quote
Detail” screen.
2. Company and Industry Ratios: For each company, collect the company and industry P/E, P/S
and P/CF ratios. These can be found under “Financial Results—Key Ratios—Price Ratios.” (Use
the current P/E ratio.) Also, note the industry for each company listed at the bottom of the page.
3. Average Earnings Forecast from Analysts for Next Year: The average forecast can be found
at “Analyst Info—Earnings Estimates.” Use the next fiscal year listed in the “FY” columns.
Question 1: Determining Current Earnings, Sales and Cash Flows
Since reported ratios are computed on the last 12 months of data and the most recent income
statement typically is not, we cannot use the income statements to figure out the earnings, sales and
cash flows used in the ratios. Instead, we need to figure out what the earnings per share, sales per
share and cash flows per share were from the ratios themselves. This is easy enough to do using the
reported ratios and the current price. For each company, undertake the following steps to do this:
(a) Determine the earnings for each company by dividing the current price by the P/E ratio.
(This works because you know that P = Earnings x P/E, so P/(P/E) = Earnings.)
(b) Determine the sales for each company by dividing the current price by the P/S ratio. (This
works because you know that P = Sales x P/S, so P/(P/S) = Sales.)
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12.
(c) Determine the cash flows for each company by dividing the current price by the P/CF ratio.
(This works because you know that P = Cash Flow x P/CF, so P/(P/CF) = Cash Flow.)
Question 2: P/E Valuation
Use earnings and P/E ratios to calculate three estimates for each company’s stock. These three
estimates are:
(1) Current earnings (from Question 1) times the industry P/E ratio. This gives the
company’s value at current earnings levels if it were valued as its industry peers
are relative to current earnings.
(2) Forecast earnings (from analysts) for next year times the company’s P/E ratio.
This gives the company’s future value at current P/E levels if the forecasts are
accurate.
(3) Forecast earnings (from analysts) for next year times the industry P/E ratio. This
gives the company’s future value if the forecasts are accurate and the company
is valued as its industry peers are relative to earnings in the future.
Question 3: P/S Valuation
Use sales and P/S ratios to calculate another estimate for each company’s stock. Take current sales
(from Question 1) times the industry P/S ratio. This gives the company’s value at current sales levels if
it were valued as its industry peers are relative to current sales.
Question 4: P/CF Valuation
Use cash flows and P/CF ratios to calculate another estimate for each company’s stock. Take current
cash flows (from Question 1) times the industry P/CF ratio. This gives the company’s value at current
cash flow levels if it were valued as its industry peers are relative to current cash flows.
Question 5: Interpretation
For each company, you have the current market price and a range of valuations depending on current
and forecast earnings, current sales and current cash flows. Of course, these numbers will not all be
the same. Do these differences appear random? Or, can you think of good reasons that these
valuations differ? Elaborate on any reasons that the company might be priced differently from the
valuations suggested by the industry ratios. Can you come up with specific reasons for the differences
of each company?
12
13.
Stock Valuation Assignment
Part 4: Implications and Actions DUE: ___________
GOAL
In this part of the assignment, you will use financial ratios and information to forecast returns for stocks
and turn those forecasts into actions on the IEM.
Prediction
Given all of your analysis in parts 1 to 5, predict what each stock's return and the SP&500 return will be
for the next month. Justify these predictions using the analysis techniques developed in class and in
this assignment.
Which of the securities do you predict will have the highest return? How confident are you of your
prediction?
Implication
Given your predictions above, which IEM contract (AAPLm, IBMm, MSFTm or SP500m) should be
priced the highest at the beginning of trading during the current trading month. Justify your prediction.
(Recall that the contract with the highest actual monthly return will liquidate at $1. The others will expire
worthless. Thus, you need to predict which stock will have the highest monthly return in order to
determine which IEM contract will have the greatest likelihood of payoff. This contract should be priced
the highest.)
Action
Make at least one additional trade in the IEM Computer Industry Returns market between ________
and ________. Log your trades. For each trade, report the date of the trade, the contract traded and
the prices. Attach a printout showing your trading activity. (You can either submit a “Processed
Orders” report or an ‘Order History” report. To get the first report, make sure that the “confirm” box is
checked on the trading screen. You will be asked to “execute” the order. Upon execution, the
“Processed Orders” report will appear. To get the second report, go to “My Account” information select
“view order history” and print the resulting report.)
Justify each trade you make using:
1. Your forecast returns
2. The actual returns to date
3. IEM prices at that time
4. Any other information and analysis you wish to include.
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14.
Valuation Assignment
The Lessons of the Assignment
The main lesson from the assignment is that stock valuation is complex, very difficult and quite tricky. A
variety of methods can be used to get a handle on what valuations should be, but, in the end, a great
deal of judgment is involved. In this exercise, you learned and applied some of the tools that
professionals use.
One could make substantial profits if one could regularly forecast stock prices better than the market.
However, efficient markets theory suggests that this is difficult, if not impossible to do. So, if your
predictions didn’t come true, don’t feel bad. If they did, ask yourself: “Was I really good at this, or just
lucky?”
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