Financial Markets Notes.docx

7/30/2019 Financial Markets Notes.docx

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Financial MarketsUnit 5: Equity Valuation James Birnbaum

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Equity Valuation:

The evaluation of any investment needs to incorporate:

The value of today And all the cash flows generated throughout its life time1.Price/Earnings ratio (P/E) method:

Simply put, the p/e ratio is the price an investor is paying for $1 of a

company's earnings or profit. In other words, if a company is

reporting basic or diluted earnings per share of $2 and the stock is

selling

for $20 per share, the p/e ratio is 10 ($20 per share divided by $2

earnings per share = 10 p/e).

A relatively simple method to apply the mean price-earnings (PE) ratio

(expected) of all publicly traded competitors in the respective industry to

the firms expected earning.

Valuation per share = (Expected earnings of firm per share) x (Mean industry P/E)

Implicit assumption: The growth in earnings in future years will besimilar to that of the industry.

NOTE:There are three reasons why investors may get different values:

Investors may use different forecast models. Different measure of earnings (ex. EBITDA or EBIT or CF etc.). Different ideas about which firm can represent the industry

average.

Limitations of P/E Method:

- Inaccurate valuation due to:

Forecasting error Mistake in composing industry composite- Reliability of P/E over time is not for certain.

2.The one-period valuation model:


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P0 =D1

(1+ ke)+

P1

(1+ ke)

P0= The current price of the stock

D1 = The dividend paid at the end of year 1

P1 = The price at the end of the first period

3. The generalized dividend valuation model:Simply said this model is like model (2) but extended to any number of

time periods.

P0 =

t=1Dt

(1+ ke )t

4. The Gordon Growth Model: Assumption: Dividend grows continuously at the constant rate forever.

P0 = D0

(1+

g)(k0 - g)

= D1(k0 - g)

D0 = The most recent dividend paid

k0= The required return on investment equity

g = The expected constant growth rate in dividends

D1 = The dividend paid at the end of year 1

Required rate of return:

To value a firm based on discounted cash flows, the required rate of

return (discount rate) is required.

A rate of return, reflects the risk free interest rate + a risk premium.

Generally: Higher risk = Higher return

No complete agreement on:

The ideal measure of risk The way risk should be used to derive the required rate of return


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Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory.

Market risk (or nondiversifiable risk or systematic risk):

The possibility for an investor to experience losses due to factors that affect

the overall performance of the financial markets. Market risk, also called

"systematic risk," cannot be eliminated through diversification, though it

can be hedged against. The risk that a major natural disaster will cause a

decline in the market as a whole is an example of market risk.

Idiosyncratic risk (or diversifiable risk or unsystematic risk):

Company or industry specific risk that is inherent in each investment. The

amount of unsystematic risk can be reduced through appropriate

diversification.

1. Capital Asset Pricing Model (CAPM):Based upon Markowitz on diversification and modern portfolio theory.

Enables economists and investors to measure quantitatively the

tradeoffs

Between asset return and risk.

The focus of CAPM is precisely on the systematic risk.

ERi =RF + b i E(RM) - RF[ ] ERi= The expected return on the asset

RF= The risk-free rate of return

i= The sensitivity of the asset returns to market return

ERM= The expected return of the market

[E(RM) RF] = Expected market risk premium

Assumptions behind CAPM:a. Rational Expectationsb. Investors have a single-period investment horizonc. Perfect, frictionless markets:

No Transaction cost No personal income tax Stock prices are not affected by the buying and selling

actions of individual investors.

The quantities of assets are fixed and assets are perfectly


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divisible.

d. There exists a risk-free rate at which investors can lend andborrow unlimited amounts.

e. Investments are limited to a universe of publicly traded financialassets.

f. Homogeneous expectations (ie. Everyone has the same stockexpectation).

2. Arbitrage Pricing Theory (APT):The APT assumes that returns on assets are generated by a number of

industry wide and market wide factors. The APT views risk more generally

than just the beta of a security with the market portfolio.

NOTE: APT isan asset pricing model based on the idea that an asset's

returns can be predicted using the relationship between that same asset

and many common risk factors. Created in 1976 by Stephen Ross, this

theory predicts a relationship between the returns of a portfolio and the

returns of a single asset through a linear combination of many

independent macro-economic variables.

APT relies on three key propositions:

I. A factor modelII. Sufficient securities to diversify away idiosyncratic risk

III. Persistence of arbitrage opportunities are not allowed.The principal strength of the APT:

No arbitrage conditions should hold for any subset of securities. Not necessary to identify all risky assets or a market portfolio, Rolls

critique.

Use the APT to describe relative prices for a set of securities of interestrather than the whole population of risky assets.

NOTE: Systematic risk can arise from various sources such as:

Uncertainty of the business cycle, Monetary policies, etc.


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CAPM assumes implicitly (and maybe wrongly!) that each stock has the

same relative sensitivity to each systematic risk. CAPM may ignore the

subtle differences between individual securities.

The APT model:

E(ri ) = RF + bijj=1

J

l jor

E(ri ) = RF +[E(R1) - RF] b 1 +...+[E(Rn ) - RF] b n The expected return of security i equals to:

A risk-free rate plus risk premium for bearing un-diversifiablesystematic risks.

jis the extra expected return required because of the securityssensitivity to the jth factor.

Problems associated with APT:

o Extremely generalo No evidence as to what might be an appropriate multi-factor model.o Factor analysiso A joint test of the APT and the relevancy of the factors.


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