1. Stock Valuation And Risk11
Stock Valuation
And Risk

2. Chapter 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

3. Stock 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

4. Stock Valuation Methods
Price-Earnings (PE) Method
Apply the mean PE ratio of publicly traded competitors
Use expected earnings rather than historical
Equation:
Firm’s
Stock = Expected EPS  Mean industry PE ratio
Price

5. Stock Valuation Methods
Price-Earnings (PE) Method
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

6. Stock Valuation Methods
Dividend Discount 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

7. Stock Valuation Methods
Dividend Discount Method
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

8. Stock Valuation Methods
Dividend Discount Method
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

9. Stock Valuation Methods
Dividend Discount Method
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

10. Determining the Required Rate of Return to 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)

11. Determining the Required Rate of Return to 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.

12. Determining the Required Rate of Return to 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

13. Determining the Required Rate of Return to 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

14. Factors 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

15. Factors 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

16. Factors 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

17. Factors 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

18. Exhibit 11.3 a International Economic Conditions U.S. Fiscal Policy
Monetary
Policy
U.S.
Economic
Conditions
Industry
Conditions
Firm-Specific
Conditions
Stock Market
Conditions
Firm’s
Systematic
Risk
(Beta)
Market
Risk
Premium
Risk-Free
Interest
Rate
Firm’s
Risk
Premium
Expected
Cash Flows
to Be
Generated
by the
Firm
Required Return
by Investors
Who Invest in
the Firm
Price of the
Firm’s
Stock

19. Analysts 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

20. 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

21. Measures 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

22. Measures of Stock Risk p = wi i 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

23. Measures 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

24. Applying 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

25. Applying 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

26. Forecasting Stock Price Volatility and Beta
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

27. Stock Performance Measurement
Sharpe Index
Assumes total variability is the appropriate measure of risk
A measure of reward relative to risk

28. Stock 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

29. Stock 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

30. Stock 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

31. Globalization 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

32. Investing 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

33. Foreign Stock Valuation, Performance, and 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