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
Stock Valuation MethodsStock Valuation Methods
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
Stock Valuation MethodsStock Valuation Methods
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
Stock Valuation MethodsStock Valuation Methods
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
Stock Valuation MethodsStock Valuation Methods
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
Dividend Discount Method
Stock Valuation MethodsStock Valuation Methods
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
Dividend Discount Method
Stock Valuation MethodsStock Valuation Methods
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
Dividend Discount Method
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)
Determining the Required Rate of Return Determining the Required Rate of Return to Value Stocksto Value Stocks
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.
Determining the Required Rate of Return Determining the Required Rate of Return to Value Stocksto Value Stocks
Rj = Rf + j(Rm – Rf)
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
Determining the Required Rate of Return Determining the Required Rate of Return to Value Stocksto Value Stocks
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
Factors that Affect Stock PricesFactors that Affect Stock Prices
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
Factors that Affect Stock PricesFactors that Affect Stock Prices
Firm-specific factors Expected +NPV investments Dividend policy changes Significant debt level changes Stock offerings and repurchases Earnings surprises Acquisitions and divestitures
Factors that Affect Stock PricesFactors that Affect Stock Prices
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
Measures of Stock RiskMeasures of Stock Risk
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
Measures of Stock RiskMeasures of Stock Risk
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
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