CHAPTER

11
2003 South-Western/Thomson Learning

Stock Valuation And Risk

Chapter Objectives
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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

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 doesnt 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

Stock Valuation Methods

Price-Earnings (PE) Method
Apply the mean PE ratio of publicly traded competitors Use expected earnings rather than historical Equation:
Firms Stock = Expected EPS Mean industry PE ratio Price

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

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

Price

t 1

Dt t (1 k)

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

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

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 firms EPS in the year they plan to sell, then multiply by the industry PE ratio

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)

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.

Determining the Required Rate of Return to Value Stocks Rj = Rf + j(Rm Rf)

Estimating the firms beta
Beta measures systematic risk Reflects how sensitive individual stocks returns are relative to the overall market Example: beta of 1.2 indicates that the stocks 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 stocks returns on returns of the market, usually represented by the S&P 500 index or other market proxy

Determining the Required Rate of Return to Value Stocks

Arbitrage Pricing Model
Differs from CAPM in that it suggests a stocks 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

Factors that Affect Stock Prices

Economic factors
Interest rates
Most of the significant stock market declines occurred when interest rates increased substantially Markets 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

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

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

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

Exhibit 11.3
International Economic Conditions U.S. Fiscal Policy U.S. Monetary Policy U.S. Economic Conditions Industry Conditions Firm-Specific Conditions

Stock Market Conditions

Firms Systematic Risk (Beta)

Market Risk Premium

Risk-Free Interest Rate

Firms Risk Premium

Expected Cash Flows to Be Generated by the Firm

Required Return by Investors Who Invest in the Firm

Price of the Firms Stock

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

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 Investors Business Daily

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

Measures of Stock Risk

Beta of a stock
Measures sensitivity of stocks returns to markets returns

Beta of a stock portfolio

Weighted average of the betas of the stocks that comprise the portfolio

p = wi i

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

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

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

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 portfolios beta

Forecast changes in individual stock betas

Stock Performance Measurement

Sharpe Index
Assumes total variability is the appropriate measure of risk

A measure of reward relative to risk

R - Rf Sharpe Index

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

R - Rf Treynor Index

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

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

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

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

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