11Stock Valuation

And Risk

© 2003 South-Western/Thomson Learning

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

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

Stock Valuation Methods

Apply the mean PE ratio of publicly traded competitors Use expected earnings rather than historical Equation:

Price-Earnings (PE) Method

Firm’sStock = Expected EPS Mean industry PE ratioPrice

Stock Valuation Methods

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

Price-Earnings (PE) Method

Stock Valuation Methods

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

Dividend Discount Method

1tt

t

k)(1

DPrice

Stock Valuation Methods

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

Dividend Discount Method

Stock Valuation Methods

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

Dividend Discount Method

Stock Valuation Methods

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

Dividend Discount Method

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 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

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

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

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 11.3InternationalEconomicConditions

U.S.FiscalPolicy

IndustryConditions

Firm’sSystematic

Risk(Beta)

ExpectedCash Flows

to BeGenerated

by theFirm

Required Returnby InvestorsWho Invest in

the Firm

Firm-SpecificConditions

U.S.Monetary

Policy

U.S.EconomicConditions

Stock MarketConditions

MarketRisk

Premium

Firm’sRisk

Premium

Risk-FreeInterestRate

Price of theFirm’sStock

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 Investor’s 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 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

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 portfolio’s 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

fR-R

Index Sharpe

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

fR-R

Index Treynor

Stock Market Forms of EfficiencyWeak-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

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

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