PPM Next week

Chapter Outline
o Stock valuation methods
o Determining the required rate of return to value stocks
o Factors that affect stock prices
o Role of analysts in valuing stocks
o Stock risk
o Applying value at risk
o Forecasting stock price volatility and beta
o Stock performance measurement
o Stock market efficiency
o Foreign stock valuation, performance, and efficiency
3. Stock Valuation Methods
o The price-earnings (PE) method assigns the mean PE ratio based on
expected earnings of all traded competitors to the firms expected
earnings for the next year
Assumes future earnings are an important determinant of a firms
value
Assumes that the growth in earnings in future years will be similar
to that of the industry
4. Stock Valuation Methods (contd)
o Price-earnings (PE) method (contd)
Reasons for different valuations
Investors may use different forecasts for the firms earnings
or the mean industry earnings
Investors disagree on the proper measure of earnings
Limitations of the PE method
May result in inaccurate valuation for a firm if errors are
made in forecasting future earnings or in choosing the
industry composite
Some question whether an investor should trust a PE ratio
5. Valuing A Stock Using the PE Method
o A firm is expected to generate earnings of $2 per share next year. The
mean ratio of share price to expected earnings of competitors in the same
industry is 14. What is the valuation of the firms shares according to the
PE method?
6. Stock Valuation Methods (contd)
o Dividend discount model
John Williams (1931) stated that the price of a stock should reflect
the present value of the stocks future dividends:
D can be revised in response to uncertainty about the firms
cash flows
k can be revised in response to changes in the required rate
of return by investors
7. Stock Valuation Methods (contd)
o Dividend discount model (contd)
For a constant dividend, the cash flow is a perpetuity:

For a constantly growing dividend, the cash flow is a growing

perpetuity:
8. Valuing A Stock Using the Dividend Discount Model
o Example 1 : A firm is expected to pay a dividend of $2.10 per share every
year in the foreseeable future. Investors require a return of 15% on the
firms stock. According to the dividend discount model, what is a fair price
for the firms stock?
9. Valuing A Stock Using the Dividend Discount Model
o Example 2 : A firm is expected to pay a dividend of $2.10 per share in one
year. In every subsequent year, the dividend is expected to grow by 3
percent annually. Investors require a return of 15% on the firms stock.
According to the dividend discount model, what is a fair price for the firms
stock?
10. Stock Valuation Methods (contd)
o Dividend discount model (contd)
Relationship between dividend discount model and PE ratio
The PE multiple is influenced by the required rate of return
and the expected growth rate of competitors
The inverse relationship between required rate of return and
value exists in both models
The positive relationship between a firms growth rate and
its value exists in both models
11. Stock Valuation Methods (contd)
o Dividend discount model (contd)
Limitations of the dividend discount model
Errors can be made in determining the:
Dividend to be paid
Growth rate
Required rate of return
Errors are more pronounced for firms that retain most of
their earnings
12. Stock Valuation Methods (contd)
o Adjusting the dividend discount model
The value of the stock is:
The PV of the future dividends over the investment horizon
The PV of the forecasted price at which the stock will be sold
Must estimate the firms EPS in the year they plan to
sell the stock by applying an annual growth rate to
the prevailing EPS
13. Using the Adjusted Dividend Discount Model
o Parker Corp. currently has earnings of $10 per share. Investors expect that
the EPS will growth by 3 percent per year and expect to sell the stock in
four years. What is the EPS in four years?
14. Using the Adjusted Dividend Discount Model (contd)
o Other firms in Parkers industry have a mean PE ratio of 7. What is the
estimated stock price in four years?
15. Using the Adjusted Dividend Discount Model (contd)
o Parker is expected to pay a dividend of $2 per share over the next four
years. Investors require a return of 13% on their investment. Based on this

information, what is a fair value of the stock according to the adjusted

dividend discount model?
16. Stock Valuation Methods (contd)
o Adjusting the dividend discount model (contd)
Limitations of the adjusted dividend discount model
Errors can be made in deriving the PV of dividends over the
investment horizon or the forecasted price at which the
stock can be sold
Errors can be made if an improper required rate of return is
used
17. Determining the Required Rate of Return to Value Stocks
o The capital asset pricing model:
Assumes that the only important risk is systematic risk
Is not concerned with unsystematic risk
Suggests that the return on an asset is influenced by the prevailing
risk-free rate, the market return, and the covariance between a
stocks return and the markets return:
18. Determining the Required Rate of Return to Value Stocks (contd)
o The capital asset pricing model (contd)
Estimating the risk-free rate and the market risk premium
The yield on newly issued T-bonds is commonly used as a
proxy for the risk-free rate
The terms within the parentheses measure the market risk
premium
Historical data over 30 or more years can be used to
determine the average market risk premium over time
Estimating the firms beta
Beta reflects the sensitivity of the stocks return to the
markets overall return
Beta is typically measured with monthly or quarterly data
over the last four years or so
19. Using the CAPM
o Fantasia Corp. has a beta of 1.7. The prevailing risk-free rate is 5% and the
market risk premium is 5%. What is the required rate of return of Fantasia
Corp. according to the CAPM?
20. Determining the Required Rate of Return to Value Stocks (contd)
o The capital asset pricing model (contd)
Limitations of the CAPM
A study by Fama and French found that beta is unrelated to
the return on stock over the 1963 1990 period
Chan and Lakonishok:
Found that the relation between stock returns and
beta varied with the time period used
Concluded that it is appropriate to question whether
beta is the driving force behind stock returns
Found that firms with the highest betas performed
much worse than firms with low betas
Found that high-beta firms outperformed low-beta
firms during market upswings

21. Determining the Required Rate of Return to Value Stocks (contd)

o Arbitrage pricing model
Suggests that a stocks price can be influenced by a set of factors
in addition to the market
e.g., economic growth, inflation
In equilibrium, expected returns on assets are linearly related to the
covariance between assets returns and the factors:
22. Factors That Affect Stock Prices
o Economic factors
Impact of economic growth
An increase in economic growth increases expected cash
flows and value
Indicators such as employment, GDP, retail sales, and
personal income are monitored by market participants
Impact of interest rates
Given a choice of risk-free Treasury securities or stocks,
stocks should only be purchased if they offer a sufficiently
high expected return
23. Factors That Affect Stock Prices (contd)
o Economic factors (contd)
Impact of the dollars exchange rate value
The value of the dollar affects U.S. stocks because:
Foreign investors purchase U.S. stocks when the
dollar is weak
Stock prices are affected by the impact of the dollars
changing value on cash flows
Some U.S. firms are involved in exporting
U.S.-based MNCs have some earnings in foreign
currencies
Exchange rates may affect expectations of other
economic factors
24. Factors That Affect Stock Prices (contd)
o Market-related factors
Investor sentiment
In some periods, stock market performance is not highly
correlated with existing economic conditions
Stocks can exhibit excessive volatility because their prices
are partially driven by fads and fashions
A study by Roll found that only one-third of the variation in
stocks returns can be explained by systematic economic
forces
January effect
Many portfolio managers invest in riskier small stocks at the
beginning of the year and shift to larger companies near the
end of the year
Places upward pressure on small stocks in January
25. Factors That Affect Stock Prices (contd)
o Firm-specific factors

Some firms are more exposed to conditions within their own

industry than to general economic conditions, so participants
monitor:
Industry sales forecasts
Entry into the industry by new competitors
Price movements of the industrys products
Market participants focus on announcements that signal
information about a firms sales growth, earnings, or characteristics
that cause a revision in the expected cash flows
26. Factors That Affect Stock Prices (contd)
o Firm-specific factors (contd)
Dividend policy changes
An increase in dividends may reflect the firms expectation
that it can more easily afford to pay dividends
Earnings surprises
When a firms announced earnings are higher than expected,
investors may raise their estimates of the firms future cash
flows
Acquisitions and divestitures
Expected acquisitions typically result in an increased
demand for the targets stock and raise the stock price
The effect on the acquiring firm is less clear
Expectations
Investors attempt to anticipate new policies so they can
make their move before other investors
27. Factors That Affect Stock Prices (contd)
o Integration of factors affecting stock prices
Whenever economic indicators signal the expectation of higher
interest rates, there is upward pressure on the required rate of
return
Firms expected future cash flows are influenced by economic
conditions, industry conditions, and firm-specific conditions
28. Role of Analysts in Valuing Stocks
o Many investors rely on opinions of stock analysts employed by securities
firms or other financial firms
o Many analysts are assigned to specific stocks and issue ratings that can
indicate whether investors should buy or sell the stock
o A 2001 study by Thomson Financial determined that analysts at the
largest brokerage firms typically recommended sell for less than 1
percent of all the stocks for which they provided ratings
29. Role of Analysts in Valuing Stocks (contd)
o Conflicts of interest
Many analysts are employed by securities firms that have other
investment banking relationships with rated firms
Some analysts may own the stock of some of the firms they rate
o Impact of disclosure regulations
In October 2000, the SEC enacted Regulation FD, which requires
firms to disclose any significant information simultaneously to all
market participants
o Unbiased analyst rating services

Popular rating services include Morningstar, Value Line , and

Investors Business Daily
Analyst rating services typically charge subscribers between $100
and $600 per year

30. Stock Risk

o Risk reflects the uncertainty about future returns such that the actual
return may be less than expected
o The holding period return is measured as:
The main source of uncertainty is the price at which the stock can
be sold
Dividends tend to be much more stable than stock price
31. Stock Risk (contd)
o Measures of risk
The volatility of a stock:
May indicate the degree of uncertainty surrounding the
stocks future returns
Reflects total risk because it reflects movements in stock
prices for any reason
32. Stock Risk (contd)
o Measures of risk (contd)
The volatility of a stock portfolio depends on:
The volatility of the individual stocks in the portfolio
The correlations between returns of the stocks in the
portfolio
The proportion of total funds invested in each stock
A portfolio containing some stocks with low or negative
correlation will exhibit less volatility
33. Stock Risk (contd)
o Measures of risk (contd)
The beta of a stock:
Measures the sensitivity of its returns to market returns
Is used by many investors who have a diversified portfolio of
stocks
Can be estimated by obtaining returns of the firm and the
stock market and applying regression analysis to derive the
slope coefficient:
34. Stock Risk (contd)
o Measures of risk (contd)
The beta of a stock portfolio:
Is useful for investors holding more than one stock
Can be measured as a weighted average of the betas of
stocks in the portfolio, with the weights reflecting the
proportion of funds invested in each stock:
The risk of a high-beta portfolio can be reduced by
replacing some of the high-beta stocks with low-beta
stocks
35. Stock Risk (contd)
o Measures of risk (contd)
Value at risk:

Is a risk measurement the estimates the largest expected

loss to a particular investment position for a specified
confidence level
Became very popular in the late 1990s after some mutual
funds and pension funds experienced abrupt large losses
Is intended to warn investors about the potential maximum
loss that could occur
Focuses on the pessimistic portion of the probability
distribution of returns
Is commonly used to measure the risk of a portfolio
36. Applying Value at Risk
o Methods of determining the maximum expected loss
Use of historical returns to derive the maximum expected loss
e.g., an investor may determine that out of the last 100
trading days, a stock experienced a decline of greater than 7
percent on 5 different days
The investor could infer a maximum daily loss of no more
than 7 percent for that stock based on a 95 percent
confidence level
37. Applying Value at Risk (contd)
o Methods of determining the maximum expected loss (contd)
Use of standard deviation to derive the maximum expected loss
The standard deviation of daily returns over the previous
period can be used and applied to derive boundaries for a
specific confidence level
Use of beta to derive the maximum expected loss
38. Using the Standard Deviation to Derive the Maximum Expected Loss
o The standard deviation of daily returns for a stock in a recent period is 1%.
The 95% confidence level is desired for the maximum loss. The stock has
an expected daily return of .1%. What is the lower boundary of expected
returns?
39. Using Beta to Derive the Maximum Expected Loss
o A stocks beta over the last 100 days is 1.3. The stock market is expected
to perform no worse than 2.1% on a daily basis based on a 95%
confidence level. What is the maximum loss to the stock over a given day
based on this information?
40. Applying Value at Risk (contd)
o Deriving the maximum dollar loss
The maximum percentage loss for a given confidence level can be
applied to derive the maximum dollar loss of a particular
investment
Value at risk is commonly applied to assess the maximum possible
loss for an entire portfolio
o Common adjustments to value at risk applications
Investment horizon desired
Length of historical period used
Time-varying risk
Restructuring the investment portfolio
41. Forecasting Stock Price Volatility and Beta

Methods of forecasting stock price volatility

The historical method uses a historical period to derive a stocks
standard deviation of returns and uses that estimate as the forecast
for the future
The time-series method uses volatility patterns in previous periods
Places more weight on the most recent data
Normally uses the weights and number of periods that were
the most accurate in previous periods
The implied standard deviation derives the estimate from the stock
option pricing model
Represents the anticipated volatility of the stock over a
future period by investors trading the stock
42. Forecasting Stock Price Volatility and Beta (contd)
o Forecasting a stock portfolios volatility
Portfolio volatility can be forecast by first deriving forecasts of
individual volatility levels
Next, the correlation coefficient for each pair of stock in the
portfolio is forecast by estimating the correlation in recent periods
o Forecasting a stock portfolios beta
First forecast the betas of the individual stocks and then take a
weighted average
43. Stock Performance Measurement
o The Sharpe index is appropriate when total variability is thought to be the
appropriate measure of risk:
The higher the stocks mean return relative to the mean risk-free
rate and the lower the standard deviation, the higher the Sharpe
index
Measures the excess return above the risk-free rate per period
44. Using the Sharpe Index
o Patrick stock has an average return of 15% and an average standard
deviation of 13%. The average risk-free rate is 8%. What is the Sharpe
index for Patrick stock?
45. Stock Performance Measurement (contd)
o The Treynor index is appropriate when beta is thought to be the most
appropriate type of risk:
The higher the Treynor index, the higher the return relative to the
risk-free rate, per unit of risk
46. Using the Treynor Index
o Patrick stock has an average return of 15% and a beta of 1.8. The average
risk-free rate is 8%. What is the Sharpe index for Patrick stock?
47. Stock Market Efficiency
o Forms of efficiency
Weak-form efficiency suggests that security prices reflect all traderelated information
Semistrong-form efficiency suggests that security prices fully reflect
all public information
Includes announcements by firms, economic news or events,
and political news or events
If semistrong-form efficiency holds, weak-form efficiency
holds as well
o

Strong-form efficiency suggests that security prices fully reflect all

information, including private or insider information
48. Stock Market Efficiency (contd)
o Tests of the efficient market hypothesis
Test of weak-form efficiency
Tested by searching for a nonrandom pattern in security
prices
Studies have generally found that historical price changes
are independent over time
There is some evidence that stocks:
Have performed better in January (January effect)
Have performed better on Fridays than on Mondays
(weekend effect)
Have performed well on the trading days just before
holidays (holiday effect)
49. Stock Market Efficiency (contd)
o Tests of the efficient market hypothesis
Test of semistrong-form efficiency
Tested by assessing how security returns adjust to particular
announcements
Generally, security prices immediately reflect the
information from announcements
There is evidence of unusual profits from investing in IPOs
Test of strong-form efficiency
Difficult to test
There is evidence that share prices of target firms rise
substantially when the acquisition is announced
Insiders are discouraged from using inside information
because it is illegal
50. Foreign Stock Valuation, Performance, and Efficiency
o Valuation of foreign stocks
PE method
The expected EPS of the foreign firm are multiplied by the
appropriate PE ratio based on the firms risk and local
industry
The PE ratio for a given industry may change continuously in
some foreign markets
The PE ratio for a particular industry may need to be
adjusted for the firms country
Dividend discount model
An adjustment for expected exchange rate movements is
required
The value of foreign stocks from a U.S. perspective is subject
to more uncertainty than the value of the stock from a local
investors perspective
51. Foreign Stock Valuation, Performance, and Efficiency (contd)
o Measuring performance from investing in foreign stocks
The performance measurement should control for general market
movements and exchange rate movements in the region where the
portfolio managers has been assigned to invest funds

52. Foreign Stock Valuation, Performance, and Efficiency (contd)

o Performance from global diversification
Stock investors can benefit by diversifying internationally
Economies do not move in tandem
Stock markets across countries may respond to some of the
same expectations
In general, correlations between stock indexes have been
higher in recent years than they were several years ago
53. Foreign Stock Valuation, Performance, and Efficiency (contd)
o Performance from global diversification (contd)
Integration of markets during the 1987 crash
There was a high correlation among country stock markets
during the crash
This suggests that the underlying cause of the crash
systematically affected all markets
Integration of markets during mini-crashes
On August 27, 1998 (Bloody Thursday) most stock markets
around the world experienced losses
Illustrates that even a well-diversified international portfolio
is not insulated from some events
Diversification among emerging stock markets
These markets have lower correlations with developed
countries, but also higher risk
54. Foreign Stock Valuation, Performance, and Efficiency (contd)
o International market efficiency
Some foreign markets are inefficient because of the small number
of analysts and portfolio managers
Market inefficiencies are more common in small foreign stock
markets
Insider trading is more prevalent in many foreign markets
Political and exchange rate risk may be high in some foreign
markets