Stock Valuation: A Second Look

Stock Valuation: A Second Look
Chapter 10 Stock Valuation: A Second Look

Chapter Outline 10.1 The Discounted Free Cash Flow Model 10.2 Valuation Based on Comparable Firms 10.3 Information, Competition, and Stock Prices 10.4 Individual Biases and Trading

Learning Objectives Value a stock as the present value of the company’s free cash flows Value a stock by applying common multiples based on the values of comparable firms Understand how information is incorporated into stock prices through competition in efficient markets Describe some of the behavioral biases that influence the way individual investors trade

10.1 The Discounted Free Cash Flow Model
The Discounted Free Cash Flow Model focuses on the cash flows to all of the firm’s investors, both debt and equity holders (Eq. 10.1)

Valuing the Enterprise To estimate a firm’s enterprise value, we compute the present value of the firm’s free cash flow available to pay all investors (Eq 10.2)

V0=PV(Future Free Cash Flow of Firm) (Eq. 10.3) Given the enterprise value, use Eq to solve for the value of equity and divide by the total number of shares outstanding (Eq. 10.4)

Implementing the Model Since we are discounting the cash flows to all investors, we use the weighted average cost of capital (WACC), denoted by WACC Forecast free cash flow up to some horizon, together with a terminal value of the enterprise: (Eq. 10.5)

Estimate the terminal value by assuming a constant long-run growth rate gFCF for free cash flows beyond year N The long-run growth rate gFCF is typically based on expected long-run growth rate of revenues (Eq. 10.6)

Example 10.1 Valuing Nike, Inc., Stock Using Free Cash Flow
Problem: Nike had sales of $25.3billion in 2012. Suppose you expect its sales to grow at a rate of 10% in 2013, but then slow by 1% per year to the long-run growth rate that is characteristic of the apparel industry—5%—by 2018. Based on Nike’s past profitability an investment needs, you expect EBIT to be 10% of sales, increases in net working capital requirements to be 10% of any increase in sales, and capital expenditures to equal depreciation expenses. If Nike has $3.3 billion in cash, $1.2 billion in debt, million shares outstanding, a tax rate of 24%, and a weighted average cost of capital of 10%, what is your estimate of the value of Nike’s stock in early 2013? 9

Summary 1. Nike had sales of $25.3billion in 2012.
2. Sales to grow at a rate of 10% in 2013, but then slow by 1% per year 3. Long-run growth rate —5%—by 2018. 4. EBIT to be 10% of sales 5. Increases in net working capital requirements to be 10% 6. If Nike has $3.3 billion in cash, 7. Debt$1.2 billion 8. Shares outstanding million 10. Tax rate of 24% 11. Weighted average cost of capital of 10%,

Solution: Plan: We can estimate Nike’s future free cash flow by constructing a pro forma statement as we did for HomeNet in Chapter 9. The only difference is that the pro forma statement is for the whole company, rather than just one project. Further, we need to calculate a terminal (or continuation) value for Nike at the end of our explicit projections. 11

Plan (cont’d): Because we expect Nike’s free cash flow to grow at a constant rate after 2015, we can use Eq to compute a terminal enterprise value. The present value of the free cash flows during the years 2013–2018 and the terminal value will be the total enterprise value for Nike. Using that value, we can subtract the debt, add the cash, and divide by the number of shares outstanding to compute the price per share (Eq. 10.4). 12

The spreadsheet below presents a simplified pro forma for Nike based on the information we have: Year 2012 2013 2014 2015 2016 2017 2018 FCF Forecast ($ million) Sales 25,300 27,830 30,335 32,762 35,055 37,158 39,016 Growth Versus Prior Year 10% 9% 8% 7% 6% 5% EBIT (10% of sales) 2,783.00 3,033.50 3,276.10 3,505.50 3,715.80 3,901.60 Less: Income Tax (24%) 667.9 728 786.3 841.3 891.8 936.4 Plus: Depreciation Less: Capital Expenditures Less: Increase in NWC (10% Δ Sales) 253 250.5 242.7 229.3 210.3 185.8 Free Cash Flow 1,862.10 2,055.00 2,247.20 2,434.80 2,613.70 2,779.40 13

Execute (cont’d): Because capital expenditures are expected to equal depreciation, lines 7 and 8 in the spreadsheet cancel out. We can set them both to zero rather than explicitly forecast them. Given our assumption of constant 5% growth in free cash flows after 2018 and a weighted average cost of capital of 10%, we can use Eq to compute a terminal enterprise value: 14

Execute (cont’d): From Eq. 10.5, Nike’s current enterprise value is the present value of its free cash flows plus the firm’s terminal value: We can now estimate the value of a share of Nike’s stock using Eq. 10.4: 15

Evaluate: The total value of all of the claims, both debt and equity, on the firm must equal the total present value of all cash flows generated by the firm, in addition to any cash it currently has. The total present value of all cash flows to be generated by Nike is $42,881.5 million and it has 3,300 million in cash. Subtracting off the value of the debt claims (1,200 million), leaves us with the total value of the equity claims and dividing by the number of shares produces the value per share. 16

Example 10.1a Valuing Nike, Inc., Stock Using Free Cash Flow
Problem: Change in the expected value of EBIT Nike had sales of $25.3 billion in 2012. Suppose you expect its sales to grow at a rate of 8% in 2013, but then slow by 1% per year to the long-run growth rate that is characteristic of the apparel industry—5%—by 2016. Based on Nike’s past profitability an investment needs, you expect EBIT to be 9% of sales, increases in net working capital requirements to be 10% of any increase in sales, and capital expenditures to equal depreciation expenses. If Nike has $3.3 billion in cash, $1.2 billion in debt, million shares outstanding, a tax rate of 24%, and a weighted average cost of capital of 10%, what is your estimate of the value of Nike’s stock in early 2013? 17

Execute: The spreadsheet below presents a simplified pro forma for Nike based on the information we have: Year 2012 2013 2014 2015 2016 FCF Forecast ($ million) Sales 25,300 27,324 29,237 30,991 32,540 Growth Versus Prior Year 8% 7% 6% 5% EBIT (9% of sales) 2,459.2 2,631.3 2,789.2 2,928.6 Less: Income Tax (24%) 590.2 631.5 669.4 702.9 Plus: Depreciation Less: Capital Expenditures Less: Increase in NWC (10% Δ Sales) 202.4 191.3 175.4 155 Free Cash Flow 1,666.60 1,808.50 1,944.40 2,070.80 18

Execute (cont’d): Because capital expenditures are expected to equal depreciation, those lines in the spreadsheet cancel out. We can set them both to zero rather than explicitly forecast them. Given our assumption of constant 5% growth in free cash flows after 2016 and a weighted average cost of capital of 10%, we can use Eq to compute a terminal enterprise value: 19

Execute (cont’d): From Eq. 10.5, Nike’s current enterprise value is the present value of its free cash flows plus the firm’s terminal value: We can now estimate the value of a share of Nike’s stock using Eq. 10.4: 20

Evaluate: The total value of all of the claims, both debt and equity, on the firm must equal the total present value of all cash flows generated by the firm, in addition to any cash it currently has. The total present value of all cash flows to be generated by Nike is 35,587 million and it has 3,300 million in cash. Subtracting off the value of the debt claims (1.2 billion), leaves us with the total value of the equity claims and dividing by the number of shares produces the value per share. 21

Connection to Capital Budgeting Free cash flow is the sum of the free cash flows from the firm’s current and future investments, so enterprise value is the sum of the present value of existing projects and the NPV of future new ones NPV of any investment represents its contribution to the firm’s enterprise value To maximize share price, we should accept projects that have a positive NPV

We must forecast all the inputs to free cash flow This process gives us flexibility to incorporate many details However, some uncertainty surrounds each assumption Given this fact, sensitivity analysis is important Translates the uncertainty into a range of values for the stock

Example 10.2 Sensitivity Analysis for Stock Valuation
Problem: In Example 10.1, Nike’s EBIT was assumed to be 10% of sales. If Nike can reduce its operating expenses and raise its EBIT to 11% of sales, how would the estimate of the stock’s value change? 24

Solution: Plan: In this scenario, EBIT will increase by 1% of sales compared to Example From there, we can use the tax rate (24%) to compute the effect on the free cash flow for each year. Once we have the new free cash flows, we repeat the approach in Example 10.1 to arrive at a new stock price. 25

Execute: In year 1, EBIT will be 1% X $27,830 million = $278.3 million higher. After taxes, this increase will raise the firm’s free cash flow in year 1 by (1-0.24) X $278.3 million = $211.5 million, to $2,073.6 million. Doing the same calculation for each year, we get the following revised FCF estimates: Year 2013 2014 2015 2016 2017 2018 FCF 2,073.6 2,285.5 2,496.2 2,701.2 2,896.1 3,075.9 26

27

Evaluate: Nike’s stock price is fairly sensitive to changes in the assumptions about its profitability. A 1% permanent change in its margins affects the firm’s stock price by 10%. 28

Example 10.2a Sensitivity Analysis for Stock Valuation
Problem: In Example 10.1a, Nike’s EBIT was assumed to be 9% of sales. If Nike management believes there is a chance that operating expenses will increase, so that EBIT will be 8% of sales, how would the estimate of the stock’s value change? 29

Solution: Plan: In this scenario, EBIT will decrease by 1% of sales compared to Example 10.1a. From there, we can use the tax rate (24%) to compute the effect on the free cash flow for each year. Once we have the new free cash flows, we repeat the approach in Example 10.1a to arrive at a new stock price. 30

Execute: In year 1, EBIT will be 1% X $27,324 million = $ million lower. After taxes, this decline will decrease the firm’s free cash flow in year 1 by (1-0.24) X $ million = $207.7 million, to $1,107.1 million. Doing the same calculation for each year, we get the following revised FCF estimates: Year 2013 2014 2015 2016 FCF 1,458.9 1,586.3 1,708.8 1,823.5 31

Execute: We can now reestimate the stock price as in Example 10.1a. The terminal value is V2016=[1.05/( ) X 1,823.5=$38,293.6 million, so The new estimate for the value of the stock is P0=(31, ,300-1,200)/893.6=$37.40 per share, a difference of about -11% compared to the result found in Example 10.1a 32

Evaluate: Nike’s stock price is fairly sensitive to changes in the assumptions about its profitability. A 1% permanent change in its margins affects the firm’s stock price by 11%. 33

Figure 10.1 A Comparison of Discounted Cash Flow Models of Stock Valuation

10.2 Valuation Based on Comparable Firms
Another application of the valuation principle is the method of comparables Estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future

Consider the case of a new firm that is identical to an existing publicly traded firm The Valuation Principle implies that two securities with identical cash flows must have the same price If these firms will generate identical cash flows, we can use the market value of the existing company to determine the value of the new firm We can adjust for scale differences using valuation multiples

Valuation Multiples A ratio of a firm’s value to some measure of the firm’s scale or cash flow Price-Earnings ratio Enterprise Value Multiples Other multiples Multiples of sales Price-to-book value of equity Industry- specific ratios

Price-Earnings Ratio Most common valuation multiple Usually included in basic statistics computed for a stock (see Figure 10.2) Share price divided by earnings per share

Figure 10.2 Stock Price Quote for Nike (NKE)

Example 10.3 Valuation Using the Price-Earnings Ratio
Problem: Suppose furniture manufacturer Herman Miller, Inc., has earnings per share of $1.38. If the average P/E of comparable furniture stocks is 21.3, estimate a value for Herman Miller’s stock using the P/E as a valuation multiple. What are the assumptions underlying this estimate? 40

Solution: Plan: We estimate a share price for Herman Miller by multiplying its EPS by the P/E of comparable firms: 41

Execute: P0=$1.38 × 21.3 = $29.39. This estimate assumes that Herman Miller will have similar future risk, payout rates, and growth rates to comparable firms in the industry. 42

Evaluate: Although valuation multiples are simple to use, they rely on some very strong assumptions about the similarity of the comparable firms to the firm you are valuing. It is important to consider whether these assumptions are likely to be reasonable—and thus to hold—in each case. 43

Example 10.3a Valuation Using the Price-Earnings Ratio
Problem: Suppose office supply retailer, Staples, Inc. has earnings per share of $0.74. If the average P/E of comparable office supply retailer stocks is 18.8, estimate a value for Staples’ stock using the P/E as a valuation multiple. What are the assumptions underlying this estimate? 44

Solution: Plan: We estimate a share price for Staples by multiplying its EPS by the P/E of comparable firms: 45

Execute: P0=$0.74× 18.8 = $13.91. This estimate assumes that Staples will have similar future risk, payout rates, and growth rates to comparable firms in the industry. 46

Evaluate: Although valuation multiples are simple to use, they rely on some very strong assumptions about the similarity of the comparable firms to the firm you are valuing. It is important to consider whether these assumptions are likely to be reasonable—and thus to hold—in each case. 47

We can compute a firm’s P/E ratio using: Trailing earnings Forward earnings The resulting ratio is either: Trailing P/E Forward P/E For valuation purposes, the forward P/E is generally preferred, as we are most concerned about future earnings

P/E ratios are related to other valuation techniques In the case of constant dividend growth (Eq. 7.6), we had Dividing through by EPS1:

Figure 10.3 Relating the P/E Ratio to Expected Future Growth

Example 10.4 Growth Prospects and the Price-Earnings Ratio
Problem: Amazon.com and Macy’s are both retailers. In 2013, Amazon had a price of $ and forward earnings per share of $3.18. Macy’s had a price of $49.85 and forward earnings per share of $4.47. Calculate their forward P/E ratios and explain the difference. 51

Solution: Plan: We can calculate their P/E ratios by dividing each company’s price per share by its forward earnings per share. The difference we find is most likely due to different growth expectations. 52

Execute: Forward P/E for Amazon = $306.87/$3.18= 96.5 Forward P/E for Macy’s = $49.75/$4.47=11.13 Amazon’s P/E ratio is higher because investors expect its earnings to grow more than Macy’s. 53

Evaluate: Although both companies are retailers, they have very different growth prospects, as reflected in their P/E ratios. Investors in Amazon.com are willing to pay 96.5 times this year’s expected earnings because they are also buying the present value of high future earnings created by expected growth. 54

Example 10.4a Growth Prospects and the Price-Earnings Ratio
Problem: Office Depot and Staples are both specialty retailers. In 2013, Office Depot had a price of $69 and forward earnings per share of $1.36. Staples had a price of $15.96 and forward earnings per share of $1.31. Calculate their forward P/E ratios and explain the difference. 55

Solution: Plan: We can calculate their P/E ratios by dividing each company’s price per share by its forward earnings per share. The difference we find is most likely due to different growth expectations. 56

Execute: Forward P/E for Office Depot= $69/$1.36 = 50.74 Forward P/E for Staples = $15.96/1.31 = 12.18 Office Depot’s P/E ratio is higher because investors expect its earnings to grow more than Staples’. 57

Evaluate: Although both companies are specialty retailers, they have very different growth prospects, as reflected in their P/E ratios. Investors in Office Depot are willing to pay times this year’s expected earnings because they are also buying the present value of high future earnings created by expected growth. 58

Enterprise Value Multiples P/E ratio relates exclusively to equity, ignoring the effect of debt Enterprise value multiples use a measure of earnings before interest payments are made EBIT EBITDA Free cash flow Because capital expenditures can vary between years, most common is to use enterprise value to EBITDA multiples

When expected free cash flow growth is constant, we can write EV to EBITDA as: (Eq. 10.8)

Example 10.5 Valuation Using the Enterprise Value Multiple
Problem: Fairview, Inc., is an ocean transport company with EBITDA of $50 million, cash of $20 million, debt of $100 million, and 10 million shares outstanding. The ocean transport industry as a whole has an average EV/EBITDA ratio of 8.5. What is one estimate of Fairview’s enterprise value? What is a corresponding estimate of its stock price? 61

Solution: Plan: Fairview, Inc., is an ocean transport company with EBITDA of $50 million, cash of $20 million, debt of $100 million, and 10 million shares outstanding. The ocean transport industry as a whole has an average EV/EBITDA ratio of 8.5. What is one estimate of Fairview’s enterprise value? What is a corresponding estimate of its stock price? 62

Execute: Fairview’s enterprise value is $50 million × 8.5 = $425 million Next, subtract the debt from its enterprise value and add in its cash: $425 million - $100 million + $20 million = $345 million, which is the equity value. Its stock price is equal to its equity value divided by the number of shares outstanding: $345 million ÷ 10 million = $34.50 63

Evaluate: If we assume that Fairview should be valued similarly to the rest of the industry, then $425 million is a reasonable estimate of its enterprise value and $34.50 is a reasonable estimate of its stock price. However, we are relying on the assumption that Fairview’s expected free cash flow growth is similar to the industry average. If that assumption is wrong, so is our valuation. 64

Other multiples Multiples of sales can be useful if it is reasonable to assume margins are similar in the future Price-to-book value of equity can be used for firms with substantial tangible assets Some multiples are specific to an industry e.g. Cable TV – Enterprise value per subscriber

Limitations of Multiples Firms are not identical Usefulness of a valuation multiple will depend on the nature of the differences and the sensitivity of the multiples to the differences Differences in multiples can be related to differences in Expected future growth rate Risk (cost of capital) Differences in accounting conventions between countries

Limitations of Multiples Comparables provide only information regarding the value of the firm relative to other firms in the comparison set Cannot help determine whether an entire industry is overvalued Internet boom example

Table 10.1 Stock Prices and Multiples for the Footwear Industry (excluding Nike), July 2013

Comparison with Discounted Cash Flow Methods Valuation multiple does not take into account material differences between firms Talented managers More efficient manufacturing processes Patents on new technology

Comparison with Discounted Cash Flow Methods Discounted cash flow methods allow us to incorporate specific information about cost of capital or future growth Potential to be more accurate

Stock Valuation Techniques: The Final Word No single technique provides a final answer regarding a stock’s true value Practitioners use a combination of these approaches Confidence comes from consistent results from a variety of these methods

Figure 10.4 Range of Valuations for Nike Stock Using Various Valuation Methods

10.3 Information, Competition, and Stock Prices
Information in Stock Prices For a publicly traded firm, market price should already provide very accurate information regarding the true value of its shares A valuation model is best applied to tell us something about future cash flows or cost of capital, based on current stock price Only in the relatively rare case in which we have some superior information that other investors lack would it make sense to second-guess the stock price

Figure 10.5 The Valuation Triad

Example 10.6 Using the Information in Market Prices
Problem: Suppose Tecnor Industries will have free cash flows next year of $40 million. Its weighted average cost of capital is 11%, and you expect its free cash flows to grow at a rate of approximately 4% per year, though you are somewhat unsure of the precise growth rate. Tecnor has 10 million shares outstanding, no debt, and $20 million in cash. If Tecnor’s stock is currently trading for $55.33 per share, how would you update your beliefs about its dividend growth rate? 75

Solution: Plan: If we apply the growing perpetuity formula for the growing FCF based on a 4% growth rate, we can estimate a stock price using Eq and Eq If the market price is higher than our estimate, it implies that the market expects higher growth in FCF than 4%. Conversely, if the market price is lower than our estimate, the market expects FCF growth to be less than 4%. 76

Execute: Applying the growing perpetuity formula, we have PV(FCF)=40 ÷ ( )= $ million. Applying Eq. 10.4, the price per share would be ($ million – 0 + $20 million ) ÷ 10 million shares = $59.14 per share. The market price of $55.33, however, implies that most investors expect FCF to grow at a somewhat slower rate. 77

Evaluate: Given the $55.33 market price for the stock, we should lower our expectations for the FCF growth rate from 4% unless we have very strong reasons to trust our own estimate. 78

Example 10.6a Using the Information in Market Prices
Problem: Suppose SWGSB Industries will pay a dividend this year of $6.50 per share. Its equity cost of capital is 11.5%, and you expect its dividends to grow at a rate of about 5% per year, though you are somewhat unsure of the precise growth rate. If SWGSB’s stock is currently trading for $63.32 per share, how would you update your beliefs about its dividend growth rate? 79

Solution: Plan: If we apply the constant dividend growth model based on a 5% growth rate, we can estimate a stock price using Eq If the market price is higher than our estimate, it implies that the market expects higher growth in dividends than 5%. Conversely, if the market price is lower than our estimate, the market expects dividend growth to be less than 5%. We can use Eq. 7.7 to solve the growth rate instead of price, allowing us to estimate the growth rate the market expects. 80

Execute: Using Eq. 7.6 Div1 of $6.50, equity cost of capital (rE) of 11.5%, and a dividend growth rate of 5%, we get P0 = $6.50/(0.115 – 0.05) = $ per share. The market price of $63.32, however, implies that investors expect dividends to grow at a slower rate. 81

Execute (cont’d): In fact, if we continue to assume a constant growth rate, we can solve for the growth rate consistent with the current market price using Eq. 7.7: This 1.2% growth rate is lower than our expected growth rate of 5%. 82

Evaluate: Given the $63.32 market price for the stock, we should lower our expectations for the dividend growth rate from 5% unless we have very strong reasons to trust our estimate. 83

Competition and Efficient Markets Efficient markets hypothesis: Implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors Public, Easily Available Information: Information available to all investors includes information in news reports, financial statements, corporate press releases, or other public data sources Private or Difficult-to-Interpret Information

Example 10.7 Stock Price Reactions to Public Information
Problem: Myox Labs announces that it is pulling one of its leading drugs from the market, owing to the potential side effects associated with the drug. As a result, its future expected free cash flow will decline by $85 million per year for the next 10 years. Myox has 50 million shares outstanding, no debt, and an equity cost of capital of 8%. If this news came as a complete surprise to investors, what should happen to Myox’s stock price upon the announcement?

Solution: Plan: In this case, we can use the discounted free cash flow method. With no debt, rwacc = rE = 8%. The effect on the Myox’s enterprise value will be the loss of a ten-year annuity of $85 million. We can compute the effect today as the present value of that annuity.

Execute: Using the annuity formula, the decline in expected free cash flow will reduce Myox’s enterprise value by Thus the share price should fall by $570.36/50 = $11.41 per share.

Evaluate: Because this news is public and its effect on the firm’s expected free cash flow is clear, we would expect the stock price to drop by $11.41 per share nearly instantaneously.

Example 10.7a Stock Price Reactions to Public Information
Problem: Foundation Labs announces that it is pulling one of its leading drugs from the market, owing to the potential side effects associated with the drug. As a result, its future expected free cash flow will decline by $70 million per year for the next 8 years. Foundation has 30 million shares outstanding, no debt, and an equity cost of capital of 7%. If this news came as a complete surprise to investors, what should happen to Foundation’s stock price upon the announcement?

Solution: Plan: In this case, we can use the discounted free cash flow method. With no debt, rwacc = rE = 7%. The effect on the Foundation’s enterprise value will be the loss of an eight-year annuity of $70 million. We can compute the effect today as the present value of that annuity.

Execute: Using the annuity formula, the decline in expected free cash flow will reduce Foundation’s enterprise value by: Thus the share price should fall by $417.99/30 = $13.93 per share.

Evaluate: Because this news is public and its effect on the firm’s expected free cash flow is clear, we would expect the stock price to drop by $13.93 per share nearly instantaneously.

Private or Difficult-to-Interpret Information Example: Phenyx Pharmaceuticals had just announced the development of a new drug for which the company is seeking approval from the FDA If the drug is approved future profits will increase Phenyx’s market value by $15 per share Suppose the announcement comes as a surprise to investors, and average likelihood of FDA approval is 10% The announcement should lead to a 10% × $15.00= $1.50 per share immediate stock price increase

Over time, investors will make their own assessments of the probable efficacy of the drug If they conclude that the drug looks more (less) promising than average, they will buy (sell) the stock and the price will drift higher (lower) over time At the time of the announcement, uninformed investors do not know which way it will go

Figure 10.6 Possible Stock Price Paths for Phenyx Pharmaceuticals

Lessons for Investors and Corporate Managers Consequences for Investors Must have some competitive advantage Expertise or access to information known to only a few people Lower trading costs than others If stocks are fairly priced according to valuation models, then investors who buy stocks can expect fair compensation for the risk they take

Lessons for Investors and Corporate Managers Implications for Corporate Managers Cash flows paid to investors determine value Focus on NPV and free cash flows Avoid accounting illusions Use financial transactions to support investment

The Efficient Markets Hypothesis Versus No Arbitrage An arbitrage opportunity is a situation in which two securities (or portfolios) with identical cash flows have different prices Because anyone can earn a sure profit in this situation by buying the low-priced security and selling the high-priced one, we expect investors to immediately exploit and eliminate these opportunities Thus, in a normal market, arbitrage opportunities will not be found

The Efficient Markets Hypothesis Versus No Arbitrage The efficient markets hypothesis states that securities with equivalent risk should have the same expected return The efficient markets hypothesis is, therefore, incomplete without a definition of “equivalent risk”

The Efficient Markets Hypothesis Versus No Arbitrage Different investors may perceive risks and returns differently (based on their information and preferences) There is no reason to expect the efficient markets hypothesis to hold perfectly; rather, it is best viewed as an idealized approximation for highly competitive markets

10.4 Individual Biases and Trading
Excessive Trading and Overconfidence Trading is expensive because of commissions and the difference between the bid and ask Given the difficulty of finding over- and under-valued stocks, you might expect individual investors to trade conservatively However, a study of the trading behavior of individual investors at a discount brokerage found individual investors trade very actively Average turnover almost 50% above overall rates during the time of the study

Overconfidence hypothesis Tendency of individual investors to trade too much based on the mistaken belief that they can pick winners and losers better than investment professionals Implication is that investors who trade more will not earn higher returns Performance will actually be worse because of trading costs Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Figure 10.7 Individual Investor Returns Versus Portfolio Turnover

Hanging On to Losers and the Disposition Effect Investors tend to hold on to stocks that have lost value and sell stocks that have risen in value We call this tendency the disposition effect. Researchers Hersch Shefrin and Meir Statman suggest that this effect arises due to investors’ increased willingness to take on risk in the face of possible losses May also reflect a reluctance to admit a mistake by taking the loss

From a tax perspective, this behavioral tendency is costly Capital gains are taxed only when an asset is sold, so delaying the tax payment reduces its present value Capital losses are tax deductible (to a certain extent), so investors should capture tax losses early

Keeping losers and selling winners might make sense if losing stocks would outperform the winners going forward This belief does not appear to be justified – if anything losing stocks that investors continue to hold underperform the winners they sell According to one study, losers underperformed winners by 3.4% over the next year

Investor Attention, Mood, and Experience Individual investors are not generally full-time traders They have limited time and attention More likely to buy stocks that have been in the news, advertised more, had very high trading volume, or recently had extreme (high or low) returns Investor mood affects investment behavior Annualized market returns at the location of the stock exchange is higher on sunny days than on cloudy days

Investor Attention, Mood, and Experience Investors appear to put too much weight on their own experience rather than considering historical evidence People who grow up and live during a time of high stock returns are more likely to invest in stocks

Chapter Quiz What is the relation between capital budgeting and the discounted free cash flow model? What implicit assumptions do we make when valuing a firm using multiples based on comparable firms? What are the implications of the efficient markets hypothesis for investors? What are the implications of the efficient markets hypothesis for corporate managers? What are several systematic behavioral biases that individual investors fall prey to? Why would excessive trading lead to lower realized returns?

Stock Valuation: A Second Look

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