1. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 11 Stock Valuation and Risk explain methods of valuing stocks explain how to determine the required rate of return on stocks identify the factors that affect stock prices explain how to measure the risk of stocks explain the concept of stock market efficiency Chapter Objectives

2. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Valuation Methods The Price-Earnings (PE) Method uses the mean price-earnings (PE) ratio based on the expected earnings of all traded competitors in the same industry as the firm’s expected earnings for the next year.  Valuation = Expected earnings per share x Mean industry PE ratio  Assumes future earnings are an important determinant of a firm’s value  Assumes that the growth in earnings in future years will be similar to that of the industry 2

3. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P/E method example ■Consider a firm that is expected to generate earnings of $3/share next year. If the mean PE ratio of competitors in the same industry is 15, then the value of the firm’s share is: = expected earnings of the firm x mean PE =3 x 15 =$45 3

4. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Valuation Methods Dividend Discount Model where t=period D t =dividend in period t k=discount rate 4

5. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Dividend Discount Model with no dividend growth ■PV of stock = D/k ■Consider a stock that is expected to pay a dividend of $7 per share annually forever. Assume that the required rate of return k is 14%, the value of the stock is =7/0.14 =$50 5

6. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Dividend Discount Model with constant dividend growth ■PV of stock = D1/(k-g) D1 is the expected dividend per share over the next year, g is the dividend growth rate. ■Consider a stock that is expected to pay a dividend of $7 next year, and dividend will grow by 4% per year. Assume that the required rate of return k is 14%, the value of the stock is =7/(0.14-0.04)=$70 6

7. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Valuation Methods Adjusted Dividend Discount Model  The dividend discount model can be adapted to assess the value of any firm, even those that retain most or all of their earnings.  The value of the stock is equal to the present value of the future dividends plus the present value of the forecasted selling price. 7

8. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adjusted Dividend Discount Model example ■Assume that a firm currently has earnings of $12 per share and the earnings will grow by 2% annually. The firm is expected to pay $4 dividend per share over the next three years. If the mean PE ratio of all other firms in the same industry is 6, what is the stock price in three years? If an investor’s required rate of return is 14% and he wants to hold the stock for only three years, what is the maximum price he would like to pay now? 8

9. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Valuation Methods Free Cash Flow Model (not required)  For firms that do not pay dividends:  estimate the free cash flows that will result from operations.  “Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.” 9

10. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Required Rate of Return on Stocks Capital Asset Pricing Model  Sometimes used to estimate the required rate of return for any firm with publicly traded stock.  The only important risk of a firm is systematic risk.  Suggests that the return of a stock (R j ) is influenced by the prevailing risk-free rate (R f ), the market return (R m ), and the beta (B j ): R j = R f + B j (R m – R f ) where B j is measured as the covariance between R j and R m, which reflects the asset’s sensitivity to general stock market movements. 10

11. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Required Rate of Return on Stocks Capital Asset Pricing Model (Cont.)  Estimating the Market Risk Premium  The yield on newly issued Treasury bonds is commonly used as a proxy for the risk-free rate.  The term, (R m – R f ), is the market risk premium: the return of the market in excess of the risk-free rate.  Historical data for 30 or more years can be used to determine the average market risk premium over time.  Estimating the Firm’s Beta - typically measured by applying regression analysis to determine the sensitivity of the stock return to the market return based on monthly or quarterly data. 11

12. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Application of CAPM ■The beta of the stock is estimated as 1.2. The prevailing risk-free rate is 6%, and the market risk premium is estimated to be 7%. The required rate of return is 12

13. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Factors that Affect Stock Prices Economic Factors  Impact of Economic Growth (Exhibit 11.1)  An increase in economic growth is expected to increase the demand for products and services produced by firms and thereby increase a firm’s cash flows and valuation.  Impact of Interest Rates  Interest rates commonly rise in response to an increase in economic growth. 13

14. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 11.1 Stock Market Trend Based on the S&P 500 Index 14 Source: Federal Reserve.

15. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Factors that Affect Stock Prices Economic Factors (Cont.)  Impact of the Dollar’s Exchange Rate Value  Foreign investors prefer to purchase U.S. stocks when the dollar is weak and to sell them when the dollar is near its peak.  Stock prices are also affected by the impact of the dollar’s changing value on cash flows.  Stock prices of U.S. companies may also be affected by exchange rates if stock market participants measure performance by reported earnings. 15

16. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Factors that Affect Stock Prices Market-Related Factors  Investor Sentiment  Represents the general mood of investors in the stock market.  January Effect  Portfolio managers prefer investing in riskier, small stocks at the beginning of the year and then shifting to larger, more stable companies near the end of the year in order to lock in their gains.  This tendency places upward pressure on small stocks in January each year. 16

17. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Factors that Affect Stock Prices Firm-Specific Factors  Change in Dividend Policy  An increase in dividends may reflect the firm’s expectation that it can more easily afford to pay dividends.  Earnings Surprises  When a firm’s announced earnings are higher than expected, some investors raise their estimates of the firm’s future cash flows and hence revalue its stock upward.  Acquisitions and Divestitures  The expected acquisition of a firm typically results in an increased demand for the target’s stock, which raises its price. 17

18. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Factors that Affect Stock Prices Tax Effects  Differences in tax laws for short-term vs. long-term capital gains affect the after tax cash flows investors receive from selling stocks.  Tax laws cause some stocks to be more desirable than others. ie. dividend vs. non-dividend paying  In 2013, tax rates on dividends increased from 15% to 20% for investors in high personal income tax brackets. 18

19. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Return and Risk The return from investing in stock over a particular period is measured as The risk of a stock can be measured by using its price volatility and its beta. 19

20. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Risk Volatility of a Stock or total risk serves as a measure of risk because it may indicate the degree of uncertainty surrounding the stock’s future returns.  Using Standard Deviation to forecast Stock Price Volatility  Using the historical method: a historical period is used to derive a stock’s standard deviation of returns, and that estimate is then used as the forecast over the future. 20

21. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Volatility of a two-stock Portfolio  Volatility of a Two-Stock Portfolio - The portfolio’s volatility can be measured by the standard deviation: 21

22. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Risk Beta of a Stock - measures the sensitivity of its returns to market  Beta of a Stock Portfolio can be measured as the weighted average of the betas of stocks that make up the portfolio  High-beta stocks are expected to be relatively volatile because they are more sensitive to market returns over time. Likewise, low-beta stocks are expected to be less volatile because they are less responsive to market returns. 22

23. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Risk-Adjusted Stock Performance Sharpe Index (Sharpe Ratio) The reward-to-variability ratio, or Sharpe Index, measures risk- adjusted returns when total variability is the most appropriate measure of risk. This index measures the excess return above the risk-free rate per unit of risk. 23

24. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sharpe Index example ■If investors hold only one stock, stock B performs better. 24

25. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Risk-Adjusted Stock Performance Treynor Index The Treynor Index measures risk-adjusted returns when beta is the most appropriate measure of risk. 25

26. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Treynor Index example ■If investors hold a diversified portfolio, stock A performs better. 26

27. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Market Efficiency Forms of Efficiency  Weak-Form Efficiency - suggests that security prices reflect all market-related information, such as historical security price movements and volume of securities trades.  Semistrong-Form Efficiency - suggests that security prices fully reflect all public information, such as firm announcements, economic news, or political news.  Strong-Form Efficiency - suggests that security prices fully reflect all information, including private or insider information. 27

28. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Foreign Stock Valuation and Performance Performance from Global Diversification  Research has demonstrated that investors in stocks can benefit by diversifying internationally.  Diversification among Emerging Stock Markets:  The correlation between stocks of different countries is low, so investors can reduce risk by including some stocks from these markets in their portfolios. 28

29. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Homework Assignment 10 Chapter 11 Questions and Applications: 3,4,5,7,8,14 Problems: 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12 29