Chapter 4 Multivariable and Factor Valuation

Extended CAPM Allowance for a tax effect The presence of inflation Market capitalization P/E and M/B value effects

Allowance for the Tax Effect Dividends Tax wedge Capital gain or loss PV advantage Systematic bias effect Three-dimensional relationship Yield tilt

Three-Dimensional Security Market Surface Illustrating a Tax Effect Figure 4-1 Security Market Surface Expected return Systematic risk (beta) Dividend yield

The Presence of Inflation Add an inflation premium Unanticipated changes Covariance of uncertainty with the stock is desirable Adding an inflation variable Covariance with inflation Desirable Undesirable

Market Capitalization Size Number of shares outstanding x share price Small stock effect Provides less utility Requires a higher return

P/E and M/B Value Effects P/E ratio Observed returns Higher for low P/E ratio stocks Lower for high P/E ratio stocks Form of mean reversion Important in tempering return estimates M/B ratio Higher for low M/B ratio stocks Lower for high M/B ratio stocks Fama and French

Final Observations Size Consistent & Significance P/E M/B Dividend-Yield Effect Most Controversial Precise Measurements Extensions Market Equilibrium Beta Dominant

Factor Models in General Two-factor model Only the factor risks are important Unanticipated changes matter Equilibrium conditions to be upset Security prices to change More than two factors Economic variables Behavioral variables

Arbitrage Pricing Theory The arbitrage process Roll-Ross and their five factors Other empirical testing Implications of the APT for this book

APT An equilibrium model Developed by Ross Arbitrage eliminates itself Profit opportunities become exhausted Security Returns Relationship Limited Number of Factors

The Arbitrage Process Buy the security with the higher expected return Sell short the security with the lower expected return Price adjustment will occur Foundation for equilibrium pricing is arbitrage

Roll-Ross and Their Five Factors Change in expected inflation Unanticipated changes In inflation In industrial production In the yield differential Between low- and high-grade bonds The default-risk premium Between long-term and short-term bonds The term structure of interest rates Affect primarily cash flows Affect market capital-ization

Other Empirical Testing No agreement on important risk factors No agreement on the number of factors Inconclusive testing No superior models Estimates are subject to wide error

Implications of the APT for This Book Intuitively appealing Relating security returns to underlying risk factors Provide better understanding of the economic forces that affect share price APT has not displaced the CAPM