Stock Valuation and Risk

1
Stock Valuation and Risk

• Chapter 11

2
Stock Valuation Methods

• The price-earnings (PE) method assigns the mean
  PE ratio based on expected earnings of all traded
  competitors to the firms expected earnings for
  the next year
• Assumes future earnings are an important
  determinant of a firms value
• Assumes that the growth in earnings in future
  years will be similar to that of the industry

3
Stock Valuation Methods (contd)

• Price-earnings (PE) method (contd)
• Reasons for different valuations
• Investors may use different forecasts for the
  firms 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
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
  firms shares according to the PE method?

5
Stock Valuation Methods (contd)

• Dividend discount model
• John Williams (1931) stated that the price of a
  stock should reflect the present value of the
  stocks future dividends
• t period
• Dt dividend in period t
• k discount rate, required rate of return

6
Stock Valuation Methods (contd)

• Dividend discount model (contd)
• For a constant dividend, the cash flow is a
  perpetuity
• For a constantly growing dividend, the cash flow
  is a growing perpetuity

7
Valuing A Stock Using the Dividend Discount Model

• Example 1 A firm is expected to pay a dividend
  of 2.10 per share every year in the foreseeable
  future. Investors require a return of 15 on the
  firms stock. According to the dividend discount
  model, what is a fair price for the firms stock?

8
Valuing A Stock Using the Dividend Discount Model

• Example 2 A firm is expected to pay a dividend
  of 2.10 per share in one year. In every
  subsequent year, the dividend is expected to grow
  by 3 percent annually. Investors require a return
  of 15 on the firms stock. According to the
  dividend discount model, what is a fair price for
  the firms stock?

9
Stock Valuation Methods (contd)

• Dividend discount model (contd)
• 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 positive relationship between a firms growth
  rate and its value exists in both models

10
Stock Valuation Methods (contd)

• Dividend discount model (contd)
• 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
Stock Valuation Methods (contd)

• Adjusting the dividend discount model
• The value of the stock is
• The PV of the future dividends over the
  investment horizon, plus
• The PV of the forecasted price at which the stock
  will be sold
• Must estimate the firms EPS in the year they
  plan to sell the stock by applying an annual
  growth rate to the prevailing EPS

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Using the Adjusted Dividend Discount Model

• Parker Corp. currently has earnings of 10 per
  share. Investors expect that the EPS will growth
  by 3 percent per year and expect to sell the
  stock in four years. What is the EPS in four
  years?

13
Using the Adjusted Dividend Discount Model
(contd)

• Other firms in Parkers industry have a mean PE
  ratio of 7. What is the estimated stock price in
  four years?

14
Using the Adjusted Dividend Discount Model
(contd)

• Parker is expected to pay a dividend of 2 per
  share over the next four years. Investors require
  a return of 13 on their investment. Based on
  this information, what is a fair value of the
  stock according to the adjusted dividend discount
  model?

15
Determining the Required Rate of Return 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
  stocks return and the markets return

16
Using the CAPM

• Fantasia Corp. has a beta of 1.7. The prevailing
  risk-free rate is 5 and the market risk premium
  is 5. What is the required rate of return of
  Fantasia Corp. according to the CAPM?

17
Determining the Required Rate of Return to Value
Stocks (contd)

• Arbitrage pricing model
• Suggests that a stocks 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

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Factors That Affect Stock Prices

• Economic factors
• Impact of economic growth
• An increase in economic growth increases expected
  cash flows and value
• 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

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Factors That Affect Stock Prices (contd)

• Economic factors (contd)
• Impact of the dollars 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
  dollars changing value on cash flows
• Some U.S. firms are involved in exporting
• U.S.-based MNCs have some earnings in foreign
  currencies

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Factors That Affect Stock Prices (contd)

• 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

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Factors That Affect Stock Prices (contd)

• Firm-specific factors
• Dividend policy changes
• An increase in dividends may reflect the firms
  expectation that it can more easily afford to pay
  dividends
• Earnings surprises
• When a firms announced earnings are higher than
  expected, investors may raise their estimates of
  the firms future cash flows
• Acquisitions and divestitures
• Expected acquisitions typically result in an
  increased demand for the targets 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

22
Stock Risk

• Measures of risk
• The volatility of a stock
• May indicate the degree of uncertainty
  surrounding the stocks future returns
• Reflects total risk because it reflects movements
  in stock prices for any reason

23
Stock Risk (contd)

• Measures of risk (contd)
• 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

24
Stock Risk (contd)

• Measures of risk (contd)
• 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

25
Stock Risk (contd)

• Measures of risk (contd)
• 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
• The risk of a high-beta portfolio can be reduced
  by replacing some of the high-beta stocks with
  low-beta stocks

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Stock Performance Measurement

• The Sharpe index is appropriate when total
  variability is thought to be the appropriate
  measure of risk
• 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

27
Using the Sharpe Index

• Patrick stock has an average return of 15 and an
  average standard deviation of 13. The average
  risk-free rate is 8. What is the Sharpe index
  for Patrick stock?

28
Stock Performance Measurement (contd)

• The Treynor index is appropriate when beta is
  thought to be the most appropriate type of risk
• The higher the Treynor index, the higher the
  return relative to the risk-free rate, per unit
  of risk

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Using the Treynor Index

• Patrick stock has an average return of 15 and a
  beta of 1.8. The average risk-free rate is 8.
  What is the Sharpe index for Patrick stock?

30
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

31
Stock Market Efficiency (contd)

• 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)

32
Stock Market Efficiency (contd)

• 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