Document11

CHAPTER

1111Stock Valuation

And Risk

© 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter Objectives

Explain the general steps necessary to value stocks and the commonly used valuation models

Learn the factors that affect stock prices Explain methods of determining the required

rate of return on stocks Learn how to measure the risk of stocks Learn how to measure performance of stock Explain the concept of stock market efficiency

Stock Valuation MethodsStock Valuation Methods

The price of a share of stock is the total value of the company divided by the number of shares outstanding

Stock price by itself doesn’t represent firm value Number of shares outstanding

Stock price is determined by the demand and supply for the shares

Investors try to value stocks and purchase those that are perceived to be undervalued by the market

New information creates re-evaluation


Apply the mean PE ratio of publicly traded competitors

Use expected earnings rather than historical Equation:

Price-Earnings (PE) Method

Firm’sStock = Expected EPS Mean industry PE ratioPrice


Reasons for different valuations Different earnings forecasts Different PE multipliers

Different comparison or benchmark firms

Limitations of the PE method Errors in forecast or industry composite Based on PE, which some analysts question

Price-Earnings (PE) Method


The price of a stock reflects the present value of the stock's future dividends t = period Dt = dividend in period t

k = discount rate

Dividend Discount Method

1tt

t

k)(1

DPrice


Relationship between DDM and PE Ratio for valuing firms PE multiple is influenced by required rate of

return of competitors and their expected growth rate

When using PE multiple method, the investor implicitly assumes that k and g will be similar to competitors



Limitations of the Dividend Discount Model Potential errors in estimating dividends Potential errors in estimating growth rate Potential errors in estimating required return Not all firms pay dividends

Technology firms Biomedical firms



Adjusting the Dividend Discount Model Value of stock is determined by

Present value of dividends over investment horizon Present value of selling price at the end

To forecast the selling price, the investor can estimate the firm’s EPS in the year they plan to sell, then multiply by the industry PE ratio


Determining the Required Rate of Return Determining the Required Rate of Return to Value Stocksto Value Stocks

Capital Asset Pricing Model (CAPM) Used to estimate the required return on publicly traded

stock Assumes that the only relevant risk is systematic (market)

risk Uses beta to measure risk rather than standard deviation of returns

Rj = Rf + j(Rm – Rf)



Capital Asset Pricing Model (CAPM) Estimating the risk-free rate and the market risk

premium Proxy for risk-free rate is the yield on newly issued

Treasury bonds The market risk premium, or (Rm-Rf), can be estimated

using a long-term average of historical data.



Estimating the firm’s beta Beta measures systematic risk Reflects how sensitive individual stock’s returns are relative to

the overall market Example: beta of 1.2 indicates that the stock’s return is 20%

more volatile than the overall market Investor can look up beta in a variety of sources such as Value

Line or Yahoo! Finance (Profile) Computed by regressing stock’s returns on returns of the

market, usually represented by the S&P 500 index or other market proxy


Arbitrage Pricing Model Differs from CAPM in that it suggests a stock’s

price is influenced by a set of factors rather than just the return on the market

Factors may include things like: Economic growth Inflation Industry effects

Problem with APT: factors are unspecified and must be defined

Factors that Affect Stock PricesFactors that Affect Stock Prices

Economic factors Interest rates

Most of the significant stock market declines occurred when interest rates increased substantially

Market’s rise in 1990s: low interest rates; low required rates of return

Exchange rates Foreign investors purchase U.S. stocks when dollar is weak

or expected to appreciate Stock prices of U.S. companies also affected by exchange

rates


Market-related factors January effect Noise trading

Trading by uninformed investors pushes stock price away from fundamental value

Market maker spreads

Trends Technical analysis Repetitive patterns of price movements


Firm-specific factors Expected +NPV investments Dividend policy changes Significant debt level changes Stock offerings and repurchases Earnings surprises Acquisitions and divestitures


Integration of factors affecting stock prices Evidence on factors affecting stock prices

Fundamental factors influence stock prices, but they do not fully account for price movements Smart-money investors Noise traders Excess volatility

Indicators of future stock prices Things that affects cash flows and required returns Variance in opinions about indicators

Exhibit 11.3Exhibit 11.3

InternationalEconomicConditions

U.S.FiscalPolicy

IndustryConditions

Firm’sSystematic

Risk(Beta)

ExpectedCash Flows

to BeGenerated

by theFirm

Required Returnby InvestorsWho Invest in

the Firm

Firm-SpecificConditions

U.S.Monetary

Policy

U.S.EconomicConditions

Stock MarketConditions

MarketRisk

Premium

Firm’sRisk

Premium

Risk-FreeInterestRate

Price of theFirm’sStock

Analysts and Stock ValuationAnalysts and Stock Valuation

Stock analysts interpret “valuation effect” of new information for investors

Analysts’ opinions impact stock buying/selling

Analysts’ ratings seldom recommend sell Income of analyst may come from investment

banking side of business selling company shares Companies shun analysts who recommend “sell” Analyst may personally own shares of company

Analysts and Stock Valuation, cont.Analysts and Stock Valuation, cont.

Analyst may obtain “new” information with company executives in conference call Other investors are not privy to information Regulation FD (Fair Disclosure) from SEC

requires “release” of new significant information at the same time as teleconference calls with analysts.

Other analyst recommendations Value Line Investor’s Business Daily

Measures of Stock RiskMeasures of Stock Risk

Market price volatility of stock Indicates a range of possible returns Positive and negative Standard deviation measure of variability

Volatility of a stock portfolio depends upon: Volatility of individual stocks in the portfolio Correlation coefficients between stock returns Proportion of total funds invested in each stock


Beta of a stock Measures sensitivity of stock’s returns to

market’s returns Beta of a stock portfolio

Weighted average of the betas of the stocks that comprise the portfolio

p = wi i


Value at Risk Estimates the largest expected loss to a particular

investment position for a specified confidence level

Warns investors about the potential maximum loss that they may incur with their investment portfolio

Focuses on the “loss” side of possible returns Used to analyze risk of a portfolio

Applying Value at RiskApplying Value at Risk

Methods of determining the maximum expected loss Use of historical returns

Example: count the percent of total days that a stock drops a certain level

Use of standard deviation Used to derive boundaries for a specific confidence level

Use of beta Used in conjunction with a forecast of a maximum

market drop Beta serves as a multiplier of the expected market loss

Applying Value at RiskApplying Value at Risk

Deriving the maximum dollar loss Apply the maximum percentage loss to the value

of the investment Common adjustments to the value-at-risk

applications Investment horizon desired Length of historical period used Time-varying risk Restructuring the investment portfolio

Forecasting Stock Price Volatility and Forecasting Stock Price Volatility and BetaBeta

Methods of forecasting stock price volatility Historical method Time-series method Implied standard deviation

Derived from the stock option pricing model

Forecasting a stock portfolio's volatility One method involves forecasts of individual volatility

levels and using correlation coefficients Forecasting a stock portfolio’s beta

Forecast changes in individual stock betas

Stock Performance MeasurementStock Performance Measurement

Sharpe Index Assumes total variability is the appropriate

measure of risk A measure of reward relative to risk

fR-R

Index Sharpe

Stock Performance MeasurementStock Performance Measurement

Treynor Index Assumes that beta is the appropriate type of risk Measure of risk-adjusted return Higher the value; the higher the return relative to the

risk-free rate

fR-R

Index Treynor

Stock Market Forms of EfficiencyStock Market Forms of Efficiency

Weak-form efficiency Security prices reflect all historical price

and volume information Implication: investors cannot earn abnormal

returns based on past price movements Semistrong-form efficiency

Security prices reflect all public information Strong-form efficiency

Security prices reflect all information

Stock Market EfficiencyStock Market Efficiency

Tests of the Efficient Market Hypothesis (EMH) Test of weak-form

Searches for non-random patterns in prices Cannot find dependencies that can overcome transaction

costs

Test of semistrong-form Event studies General support for semi-strong efficiency

Test of strong-form Insiders can earn excess returns Strong-form efficiency does not appear to hold

Globalization of Stock MarketsGlobalization of Stock Markets

U.S. investors desire foreign stocks Diversification effects High real rates in parts of world

Corporations desire to finance in all markets Diversified sources of funds Stock traded where operating Enhance global image

Investing In Foreign StocksInvesting In Foreign Stocks

Deregulation increases access to foreign markets

New stock markets in emerging economies Investors seek underpriced stocks in less

efficient markets Investors seek diversification Higher average returns and variability

Foreign Stock Valuation, Performance, Foreign Stock Valuation, Performance, and Efficiencyand Efficiency Valuation of foreign stocks

Price-earnings (PE) method Dividend discount model

Adjusted for expected exchange rate movements

Measuring performance from investing in foreign stocks

International market efficiency Some countries appear to be inefficient Beware of the associated volatility and exchange rate

risks