# Power Point Slides for Financial Markets and Institutions

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Power. Point Slides for: Financial Markets and Institutions 6 th Edition By Jeff Madura Prepared by David R. Durst The University of Akron

CHAPTER 10 Stock Valuation And Risk

Chapter Objectives Explain the general steps necessary to value stocks and the commonly used valuation models n Learn the factors that affect stock prices n Explain methods of determining the required rate of return on stocks n Learn how to measure the risk of stocks n Learn how to measure performance of stock n Explain the concept of stock market efficiency n Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Valuation Methods n n 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 l n n n Number of shares outstanding Stock price is determined by the demand 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 Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Valuation Methods Price-Earnings (PE) Method Apply the mean PE ratio of publicly traded competitors l Use expected earnings rather than historical l Equation: l Firm’s Stock Price = Expected EPS x Mean industry PE ratio Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Valuation Methods Price-Earnings (PE) Method n Reasons for different valuations Different earnings forecasts l Different PE multipliers l u. Different n comparison or benchmark firms Limitations of the PE method Errors in forecast or industry composite l Based on PE, which some analysts question l Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Valuation Methods Dividend Discount Method l The price of a stock reflects the present value of the stock's future dividends ut = period u. Dt = dividend in period t uk = discount rate Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Valuation Methods Dividend Discount Method n 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 l When using PE multiple method, the investor implicitly assumes that k and g will be similar to competitors l Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Valuation Methods Dividend Discount Method n Limitations of the Dividend Discount Model Potential errors in estimating dividends l Potential errors in estimating growth rate l Potential errors in estimating required return l Not all firms pay dividends l u. Technology firms u. Biomedical firms Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Valuation Methods Dividend Discount Method n Adjusting the Dividend Discount Model l Value of stock is determined by u. Present value of dividends over investment horizon u. Present value of selling price at the end l 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 Copyright© 2002 Thomson Publishing. All rights reserved.

Determining the Required Rate of Return to Value Stocks n Capital Asset Pricing Model (CAPM) Used to estimate the required return on publicly traded stock l Assumes that the only relevant risk is systematic (market) risk l u. Uses beta to measure risk rather than standard deviation of returns Rj = Rf + j(Rm – Rf) Copyright© 2002 Thomson Publishing. All rights reserved.

Determining the Required Rate of Return to Value Stocks Rj = Rf + j(Rm – Rf) n Capital Asset Pricing Model (CAPM) l Estimating the risk-free rate and the market risk premium u. Proxy for risk-free rate is the yield on newly issued Treasury bonds u. The market risk premium, or (Rm-Rf), can be estimated using a long-term average of historical data. Copyright© 2002 Thomson Publishing. All rights reserved.

Determining the Required Rate of Return to Value Stocks Rj = Rf + j(Rm – Rf) l Estimating the firm’s beta u. Beta measures systematic risk u. Reflects how sensitive individual stock’s returns are relative to the overall market u. Example: beta of 1. 2 indicates that the stock’s return is 20% more volatile than the overall market u. Investor can look up beta in a variety of sources such as Value Line or Yahoo! Finance (Profile) u. Computed by regressing stock’s returns on returns of the market, usually represented by the S&P 500 index or other market proxy Copyright© 2002 Thomson Publishing. All rights reserved.

Determining the Required Rate of Return to Value Stocks n 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 l Factors may include things like: l u. Economic growth u. Inflation u. Industry l effects Problem with APT: factors are unspecified and must be defined Copyright© 2002 Thomson Publishing. All rights reserved.

Factors that Affect Stock Prices n Economic factors l Interest rates u. Most of the significant stock market declines occurred when interest rates increased substantially u. Market’s rise in 1990 s: low interest rates; low required rates of return l Exchange rates u. Foreign investors purchase U. S. stocks when dollar is weak or expected to appreciate u. Stock prices of U. S. companies also affected by exchange rates Copyright© 2002 Thomson Publishing. All rights reserved.

Factors that Affect Stock Prices n Market-related factors January effect l Noise trading l u. Trading by uninformed investors pushes stock price away from fundamental value u. Market maker spreads l Trends u. Technical analysis u. Repetitive patterns of price movements Copyright© 2002 Thomson Publishing. All rights reserved.

Factors that Affect Stock Prices n Firm-specific factors Expected +NPV investments l Dividend policy changes l Significant debt level changes l Stock offerings and repurchases l Earnings surprises l Acquisitions and divestitures l Copyright© 2002 Thomson Publishing. All rights reserved.

Factors that Affect Stock Prices Integration of factors affecting stock prices n Evidence on factors affecting stock prices n l Fundamental factors influence stock prices, but they do not fully account for price movements u Smart-money investors u Noise traders u Excess volatility n Indicators of future stock prices Things that affects cash flows and required returns l Variance in opinions about indicators l Copyright© 2002 Thomson Publishing. All rights reserved.

Exhibit 11. 3 International Economic Conditions U. S. Fiscal Policy U. S. Monetary Policy U. S. Economic Conditions Stock Market Conditions Industry Conditions Firm-Specific Conditions Firm’s Systematic Risk (Beta) Market Risk Premium Risk-Free Interest Rate Expected Cash Flows to Be Generated by the Firm’s Risk Premium Required Return by Investors Who Invest in the Firm Price of the Firm’s Stock Copyright© 2002 Thomson Publishing. All rights reserved.

Analysts and Stock Valuation Stock analysts interpret “valuation effect” of new information for investors n Analysts’ opinions impact stock buying/selling n Analysts’ ratings seldom recommend sell n Income of analyst may come from investment banking side of business selling company shares l Companies shun analysts who recommend “sell” l Analyst may personally own shares of company l Copyright© 2002 Thomson Publishing. All rights reserved.

Analysts and Stock Valuation, cont. n Analyst may obtain “new” information with company executives in conference call Other investors are not privy to information l Regulation FD (Fair Disclosure) from SEC requires “release” of new significant information at the same time as teleconference calls with analysts. l n Other analyst recommendations Value Line l Investor’s Business Daily l Copyright© 2002 Thomson Publishing. All rights reserved.

Measures of Stock Risk n Market price volatility of stock Indicates a range of possible returns l Positive and negative l Standard deviation measure of variability l n Volatility of a stock portfolio depends upon: Volatility of individual stocks in the portfolio l Correlation coefficients between stock returns l Proportion of total funds invested in each stock l Copyright© 2002 Thomson Publishing. All rights reserved.

Measures of Stock Risk n Beta of a stock l n Measures sensitivity of stock’s returns to market’s returns Beta of a stock portfolio l Weighted average of the betas of the stocks that comprise the portfolio p = wi i Copyright© 2002 Thomson Publishing. All rights reserved.

Measures of Stock Risk n Value at Risk Estimates the largest expected loss to a particular investment position for a specified confidence level l Warns investors about the potential maximum loss that they may incur with their investment portfolio l Focuses on the “loss” side of possible returns l Used to analyze risk of a portfolio l Copyright© 2002 Thomson Publishing. All rights reserved.

Applying Value at Risk n Methods of determining the maximum expected loss l Use of historical returns u. Example: count the percent of total days that a stock drops a certain level l Use of standard deviation u. Used l to derive boundaries for a specific confidence level Use of beta u. Used in conjunction with a forecast of a maximum market drop u. Beta serves as a multiplier of the expected market loss Copyright© 2002 Thomson Publishing. All rights reserved.

Applying Value at Risk n Deriving the maximum dollar loss l n Apply the maximum percentage loss to the value of the investment Common adjustments to the value-at-risk applications Investment horizon desired l Length of historical period used l Time-varying risk l Restructuring the investment portfolio l Copyright© 2002 Thomson Publishing. All rights reserved.

Forecasting Stock Price Volatility and Beta n Methods of forecasting stock price volatility Historical method l Time-series method l Implied standard deviation l u Derived n Forecasting a stock portfolio's volatility l n from the stock option pricing model One method involves forecasts of individual volatility levels and using correlation coefficients Forecasting a stock portfolio’s beta l Forecast changes in individual stock betas Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Performance Measurement n Sharpe Index l n Assumes total variability is the appropriate measure of risk A measure of reward relative to risk Sharpe Index = R - Rf Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Performance Measurement l Treynor Index u. Assumes that beta is the appropriate type of risk u. Measure of risk-adjusted return u. Higher the value; the higher the return relative to the risk-free rate Treynor Index = R - Rf Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Market Forms of Efficiency l Weak-form efficiency u. Security prices reflect all historical price and volume information u. Implication: investors cannot earn abnormal returns based on past price movements l Semistrong-form efficiency u. Security l prices reflect all public information Strong-form efficiency u. Security prices reflect all information Copyright© 2002 Thomson Publishing. All rights reserved.

Stock Market Efficiency n Tests of the Efficient Market Hypothesis (EMH) l Test of weak-form u Searches for non-random patterns in prices u Cannot find dependencies that can overcome transaction costs l Test of semistrong-form u Event studies u General support for semi-strong efficiency l Test of strong-form u Insiders can earn excess returns u Strong-form efficiency does not appear to hold Copyright© 2002 Thomson Publishing. All rights reserved.

Globalization of Stock Markets n U. S. investors desire foreign stocks Diversification effects l High real rates in parts of world l n Corporations desire to finance in all markets Diversified sources of funds l Stock traded where operating l Enhance global image l Copyright© 2002 Thomson Publishing. All rights reserved.

Investing In Foreign Stocks Deregulation increases access to foreign markets n New stock markets in emerging economies n Investors seek underpriced stocks in less efficient markets n Investors seek diversification n Higher average returns and variability n Copyright© 2002 Thomson Publishing. All rights reserved.

Foreign Stock Valuation, Performance, and Efficiency n Valuation of foreign stocks Price-earnings (PE) method l Dividend discount model l u Adjusted for expected exchange rate movements Measuring performance from investing in foreign stocks n International market efficiency n Some countries appear to be inefficient l Beware of the associated volatility and exchange rate risks l Copyright© 2002 Thomson Publishing. All rights reserved.