1. STOCK VALUATION METHODS AND EFFICIENT MARKET HYPOTHESIS
CHAPTER 3
STOCK VALUATION METHODS AND EFFICIENT MARKET HYPOTHESIS

2. Learning Objectives
Explain the different approaches in the valuation of stocks.
Analyze the different techniques in measuring stock performances.
Describe the important features of the efficient market hypothesis.

3. Chapter Outline Why Valuations of Shares are Needed
Stock Valuation Methods
Asset-based Valuation
Income or Earnings-based Valuation
Dividend Valuation Model (zero growth, constant growth & differential growth)
Factors Affecting Share Prices
Stock Risk

4. Chapter Outline Sources of Investment Risk Systematic Risk
Unsystematic Risk
Beta
Stock Performance Measurements
Treynor Index
Sharpe Index
Jensen Index
Efficient Market Hypothesis (EMH)

5. Why Valuations of Shares are Needed
To fix an issue price for an unquoted company to be listed.
Takeover bid and the offer price for the purpose of merger and acquisition activities.
For the purposes of taxation and as collateral for a loan made by a company.
When a group holding company is negotiating the sale of its subsidiary to a management buyout team or to an external buyer.

6. Why Valuations of Shares are Needed (continuation)
When a shareholder wishes to dispose of his holding especially if a large or controlling interest is being sold..
When a company is being broken up in a liquidation situation or the company needs to obtain additional finance or refinance current debt.

7. Stock Valuation Methods
Three main methods
The asset-based valuation method
The income-based valuation method
The dividend valuation method

8. Asset-based Valuation
Determines a company’s ordinary share value by analyzing the value of the company’s assets.
The difficulty in an asset valuation method is establishing the asset values to use.
Asset valuation can be based on; Historic cost basis/book value, replacement basis,or realizable basis/break-up value.

9. Asset-based Valuation (continuation)
Weaknesses
Assumes that investors normally buy a company for its balance sheet assets.
Ignores non-balance sheet intangible assets which may include a strong and experienced management team and highly skilled workers.

10. Asset-based Valuation (continuation)
Method is useful
As a measure of the “security” in the share value for comparison with other valuation approaches.
As a measure of comparison in a scheme of merger – asset backing valuation.
As a “floor value” for a business that is up for sale or to set a minimum price in a takeover bid.

11. Asset-based Valuation (continuation)
The value of an ordinary share can be computed by taking the net tangible assets and divide this by the number of ordinary shares outstanding.
Intangible assets (including goodwill) should be excluded, unless they have a market value (for example, patents and copyrights, which could be sold).
Study the illustration in the text- page 59.

12. Income or Earnings-based Valuation
One of the most common methods for valuing share price.
Apply the price-to-earnings ratio (P/E)
P/E ratio = Market price per share/Earnings per share.
By selecting a suitable P/E ratio and multiplying this by the EPS, the market price per share or the the total value of a company can be computed.
The market price per share = EPS x P/E ratio.

13. Income or Earnings-based Valuation (continuation)
Example
The latest financial statements of food retail company Kesang Berhad, show earnings per share of RM0.20 and the average P/E for the companies in the same industry is quoted at a ratio of 15 at the time of valuation.
A possible value could be computed as follows:
The market price per ordinary share is RM3 (RM0.20 x 15).

14. Dividend Valuation Model
The equilibrium price for any security depends on the future expected stream of income from the security discounted using an appropriate cost of capital or a required rate of return.
Williams (1938) stated that the price of a stock should reflect the present value of the share’s future dividends. In equation form, this is the statement of the DVM:
Where Dt is the dividend paid in time t and ke is the required rate of return by investors at the time of valuation t.

15. Dividend Valuation Model (continuation)
The general model can be formulated if the company’s dividends are expected to follow these basic patterns:
Zero growth.
Constant growth.
Differential growth.

16. Dividend Valuation Model (continuation)
Case 1 (Zero growth model)
where
D = Constant annual dividend
ke = Shareholders’ required rate of return
P0 = Market value excluding any dividend currently payable

17. Dividend Valuation Model (continuation)
Example
Mara Berhad is expected to pay a dividend of RM1.10 per share every year in the foreseeable future. Investors require a return of 15% on investment in the company’s shares. Applying the DVM, what is a fair price for the company’s share?

18. Dividend Valuation Model (continuation)
Case 2 (Constant growth model)
where
D0 = Current year’s dividend
g ; ROE *RR = Growth rate in earnings and dividends (ROE * retention Ratio
D0(1 + g) = Expected dividend in one year’s time (D1)
ke = Shareholders’ required rate of return
P0 = Market value excluding any dividend currently payable

19. Current Dividend (D0)
Dividend in year T-t * (1+ growth rate)T-t
D0 = D T-t x (1+g)T-t
Example Problem 6 page 53.

20. A company is just about to pay a dividend of RM0. 50 a share this year
A company is just about to pay a dividend of RM0.50 a share this year. Four years ago, its dividend was RM0.25 a share. What was the average annual growth rate of dividends over the four years?
Dividend 4 years ago x (1 + g) 4 = Dividend this year
(1 + g) 4 = Dividend this year/Div.four years ago
= RM 0.50/RM 0.25 = 2
(1 + g) = 2 ¼ = 1.189
Therefore g = – 1 = = 18.9%.

21. Dividend Valuation Model (continuation)
Example
Suria Berhad is expected to pay a dividend of RM0.90 per share in one year. In every subsequent year, the dividend is expected to grow by 4% annually. Investors require a return of 10% on the firm’s stock. Applying the DVM, what is a fair price for the company’s shares?

22. APRIL 2010 Q1
D0 = 70% * RM0.60 = RM0.42
Div 2 years ago x (1 + g )2 = Proposed div.
0.40 (1+g)2 = 0.42
1+g = (0.42/0.4)1/2 = 1.051/2
g = – 1 = 2.47%
R = Rf + beta (Rm - Rf) = (8-4) = 10%
IV = 0.42 ( )/( ) = RM5.72

23. Dividend Valuation Model
Case 3 (Differential growth model)
Two growth period;
Variable growth
Constant till perpetuity
The intrinsic value of the ordinary share can be computed as follows:
PV period 1 ( variation) P1 + PV period 2 (constant) P2

24. Dividend Valuation Model (continuation)
Example
Parabola Berhad paid RM1.50 dividend per ordinary share last year. The company's policy is to allow its dividend to grow at 5% for the first four years and then the rate of growth changes to 3% per year from year 5 and so on. What is the value of the ordinary share if the required rate of return is 8%?

25. Dividend Valuation Model (continuation)
P1 = PV up to year 4. (Variation) t Dt
PVIF8%, t
PresentValue PV 1
RM1.575
D0 (1+g)
0.926
RM1.46 2
RM1.653
D1(1+g)
0.857
RM1.42 3
RM1.737
D2(1+g)
0.794
RM1.38 4
RM1.824
D3(1+g)
0.735
RM1.34
PV PERIOD 1 (P1) = RM5.60

26. Price beginning of year 5 or end of year 4
P2 = PV from beg of year 5 or end of yr 4 to perpetuity. (Constant)
Dividend in year 5, D5 = ( ) = RM1.88
PV PERIOD 2 (P2) = 1.88/( ) x 0.735
= RM37.60 x 0.735
= RM27.64
Intrinsic Value of share = P1 + P2
= RM RM27.64
= RM33.24
Price beginning of year 5 or end of year 4

27. EXERCISE
Hairee Bhd’s stock is selling at RM20 per share. Its current EPS and dividend payout ratio are RM2.50 and 30% respectively. Given the slow economy, the firm expects that the growth rate of EPS and dividend to decline by 5% for the next two years but then grow at a more gradual rate indefinitely. If the required rate of return for similar investment is 15%, what is the projected price of the company at the end of year 2?

28. Year
Dividend
PVIF15% PV 1
0.75 (1-5%) = √√√
D0 = 0.3 x 2.50 = 0.75
0.8696√ 2
0.6769√√
0.7561√
0.5118
1.1314
V0 = PV1 + PV2
RM20 = Price end 2 * PVIF 15%, 2
V0 = V2 (PVIF15% , 2)
V2 = (20 – )/ = RM24.96m

29. Factors Affecting Share Prices
Earnings announcements
Industry performance
Dividend
Stock splits
Share buy-back
Product innovation
Takeover or merger
Major contracts
Insider trading
Analyst upgrade/downgrade
New technology
War
Natural disasters
Economic meltdowns
Etc.

30. Stock Risk
Risk can be defined as the uncertainty that actual returns will not match expected returns.
Standard deviation is a statistical measure of the degree to which actual returns are spread (disperse) around the mean actual return.
A higher standard deviation means higher risk. Expressed as a percentage, standard deviation is usually considered the best measure of risk.

31. Stock Risk (continuation)
Investors normally find it useful to hold more than one risky asset, that is, holding a portfolio of several risky assets and risk-free assets.
Investors therefore, are concerned primarily with the risk and return of their portfolio, and individual assets are considered risky only to the extent that they add to the portfolio.
The diversification of risk occurs when the variabilities of returns of the individual assets in the portfolio offset one another and as more securities are added, the risk of the portfolio is further reduced accordingly.

32. Stock Risk (continuation)
The expected return on a portfolio is the weighted average of expected returns of the assets in the portfolio and for a portfolio containing two assets (Stock A and Stock B), the formula can be presented as follows:
E(Rp) = XAE(RA) + XBE(RB)
Where
Rp = Expected return of the portfolio
XA = Percentage of fund invested in Stock A
XB = Percentage of fund invested in Stock B
RA = Expected return of Stock A
RB = Expected return of Stock B

33. Stock Risk (continuation)
The formula for the standard deviation of a portfolio composed of two stocks, A and B is as follows:
From this equation, we can see that the volatility of a stock portfolio (σp) depends on three things:
The proportion of total funds invested in each stock, represented by the letters XA and XB;
The volatility (standard deviation) of the individual stocks in the portfolio, represented by the symbols σA and σB;
The correlation between returns of the stocks in the portfolio, represented by CORRAB.

34. Sources of Investment Risk
The first is called systematic risk, or risk attributed to relatively uncontrollable external factors.
The second is called unsystematic risk, or risk attributed to the underlying investment.
Total risk is equal to the sum of systematic and unsystematic risk.

35. Systematic Risk The four principal types of systematic risk are:
Exchange rate risk: The risk that an investment’s value will be impacted by changes in the foreign currency market.
Interest rate risk: The risk attributed to the loss in market value due to an increase in the general level of interest rates.
Market risk: The risk attributed to the loss in market value due to declining movement of the entire market portfolio.
Purchasing power risk: The risk attributed to inflation and how it erodes the real value of an investment over time.

36. Unsystematic Risk
The principal types of unsystematic risk include the following:
Business risk: The risk attributed to a company’s operations, particularly those involving sales and income.
Financial risk: The risk attributed to a company’s financial stability and structure, namely the company’s use of debt to leverage earnings.
Industry risk: The risk attributed to a group of companies within a particular industry. Investments of companies tend to rise and fall based on what their peers in the industry are doing.

37. Unsystematic Risk (continuation)
The principal types of unsystematic risk include the following:
Liquidity risk: The risk that an investment cannot be purchased or sold at a price at or near market prices.
Call risk: The risk attributed to an event where an investment may be called prior to maturity.
Regulation risk: The risk that new laws and regulations will negatively impact the market value of an investment.

38. Beta
The risk of a single stock can be defined in terms of the contribution it makes to the risk (standard deviation) of the market portfolio. This risk measure is called beta.
Beta is the ratio of the standard deviation of the stock to the standard deviation of the market portfolio, multiplied by the correlation coefficient between the stock and the market portfolio.

39. Beta (continuation) BetaA =
The formula of beta of a stock A can be presented as follows:
Beta (βA) = Relative risk of Stock A
= (Total risk of Stock A)/(Total risk of market portfolio)
BetaA =
The beta of a stock therefore measures the sensitivity of its returns to market returns.

40. Beta (continuation)
The beta coefficient is a key parameter in the capital asset pricing model (CAPM).
Beta estimates are derived by regressing a stock’s historical returns against the returns on a reasonable market portfolio proxy by using the following equation:
The slope of this equation which is B1 is the measure of beta for a stock A.

41. Beta (continuation)
The beta of a portfolio 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.
The formula can be presented as follows:
Where βp is the beta of the portfolio, wi is the relative weight and βi is the beta of individual securities.

42. Stock Performance Measurements
There are three techniques that have been developed to measure portfolio performance. These measures are sometimes known as composite performance measures.
Treynor Index
Sharpe Index
Jensen Index
All the three measures combine risk and return performance into a single value. This makes it easier to compare the performance of competing portfolios.

43. Treynor Index
This index therefore relates excess return over the risk-free rate to the additional risk taken.
The focus of risk is on systematic risk instead of total risk.
This performance measure should really only be used by investors who hold diversified portfolios.

44. Treynor Index (continuation)
The higher the Treynor Index, the higher the return relative to the risk-free rate, per unit of risk.
The formula is as follows:
Where
Rp = Portfolio return
Rf = Risk free rate of return
βp = Beta of portfolio

45. Treynor Index (continuation)
Example
Assume that the five-year average annual return for the KLCI (proxy market portfolio) is 10%, while the average annual return on Malaysian Government Securities is 5%. You, as the finance director are evaluating three distinct portfolio managers with the following data:
Manager
Average Annual Return
Portfolio Beta A
10%
0.90 B
14%
1.03 C
15%
1.20

46. Treynor Index (continuation)
Computing the Treynor Index (TI) for each manager yields the following risk-adjusted results:
TI (Market) = (.10 –.05)/1 = .05 TI (Manager A) = (.10 – .05)/0.90 = .056 TI (Manager B) = (.14 – .05)/1.03 = .087 TI (Manager C) = (.15 – .05)/1.20 = .083
If we are to evaluate base on performance alone, we will select Manager C as the best performer.However, when considering the risks that each manager took to attain their respective returns, Manager B demonstrated the better outcome. In this case, all three managers performed better than the aggregate market.

47. Sharpe Index
The Sharpe ratio is almost similar to the Treynor measure, except that the risk measure used is the standard deviation of the portfolio instead of considering only the systematic risk, as represented by beta.
The higher the portfolio’s mean return relative to the mean risk-free rate and the lower the standard deviation σp, the higher the Sharpe Index will be.
The formula can be expressed as follows:

48. Sharpe Index (continuation)
Example
Examine the following example and assuming that the KLCI had a standard deviation of 18% over a five-year period, let us determine the Sharpe ratios for the following portfolio managers:
Manager
Average Annual Return
Portfolio Standard Deviation D
14%
11% E
17%
20% F
19%
27%

49. Sharpe Index (continuation)
The Sharpe Index (SI) computations are as follows:
SI (Market) = (.10 –.05)/.18 = .278 SI (Manager D) = (.14 – .05)/.11 = .818 SI (Manager E) = (.17 – .05)/.20 = .600 SI (Manager F) = (.19 – .05)/.27 = .519
Once again, we find that the best portfolio is not necessarily the one with the highest return. Instead, it is the one with the most superior risk-adjusted return, or in this case the fund headed by manager D.

50. Jensen Index This measure is also known as alpha.
The Jensen Index measures how much of the portfolio's rate of return is attributable to the manager's ability to deliver above-average returns, adjusted for market risk.
A portfolio with a consistently positive excess return will have a positive alpha, while a portfolio with a consistently negative excess return will have a negative alpha.
The higher the ratio, the better are the risk-adjusted returns

51. Jensen Index (continuation)
The formula is as follows:
Jensen Index =
Portfolio return – [Risk-free return + (Market return – Risk-free return) * Beta]

52. Jensen Index (continuation)
Example
Assume a risk-free rate of 5% and a market return of 10%, what is the alpha for the following funds? 
Manager
Average Annual Return
Portfolio Beta D
11%
0.90 E
15%
1.10 F
1.20

53. Jensen Index (continuation)
First, we calculate the portfolio's expected return (ER). ER (D) = (.10 – .05) = or 9.5% ER (E) = (.10 – .05) = or 10.50% ER (F) = (.10 – .05) = or 11%
Then, we calculate the portfolio's alpha by subtracting the expected return of the portfolio from the actual return:
Alpha D = 11% – 9.5% = 1.5% Alpha E = 15% – 10.5% = 4.5% Alpha F = 15% – 11% = 4.0%
Conclusion: Manager E produced the highest alpha and therefore the best performance.

55. The rate of return and risk for three growth-oriented unit trust funds were calculated over the most recent 5 years and are listed below: Fund Return Risk (σ) A 15% 16% B C Rank each fund by applying the Sharpe Index of portfolio performance if the risk-free rate is 7%. SI(A) = (15 – 7)/16 = 0.50 (First) SI(B) = (13 -7)/18 = 0.33 (Third) SI(C) = (12 – 7)/11 = 0.45 (Second)

56. Efficient Market Hypothesis (EMH)
The efficient market hypothesis is a theory that tries to explain the movement of share prices.
It hypothesizes that at any given time, share prices fully reflect all available information and the stock market reacts immediately to all the information that is available.
Therefore, a long-term investor cannot obtain higher than average returns from a well-diversified share portfolio.

57. Efficient Market Hypothesis (continuation)
Fama (1965) defines an “efficient” market as a market where there are large numbers of rational, profit-maximizers actively competing with each other, trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.
In an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.
It is argued that if the stock market is efficient, share prices should vary in a rational manner.

58. Forms of Efficient Market Hypothesis
The "weak" form efficiency asserts that all past market prices and data are fully reflected in share prices. Since new information arrives unexpectedly, changes in share prices should occur in a random fashion.
The "semi-strong" form efficiency asserts that all publicly available information as well as information about past price movements are fully reflected in securities prices. If semi-strong form efficiency holds, weak form efficiency holds as well.
The "strong" form efficiency asserts that all information, whether publicly available or private or insider information, is fully reflected in securities prices.

59. Test of Weak Form Efficiency
Weak form efficiency tests examine whether past data can be used to predict future returns.
Tests are conducted to determine whether an autocorrelation exists between a return at a given point in time and its return in a subsequent time period.
Earlier studies have generally found that historical price changes are independent over time, that is, security returns are generally unrelated to prior returns.

60. Test of Weak Form Efficiency (continuation)
Recent studies, however, have found evidence of systematic patterns in stock returns. The patterns are generally known as the following:
The January effect
The monthly effect
The weekly effect
The daily effect
If the weak form efficiency is true, then technical analysis is of no use.

61. Test of Semi-strong Form Efficiency
Semi-strong form tests examine how rapidly securities prices adjust to new information.
This implies that any investor cannot outperform the market by acquiring publicly available information since the information contained in these sources is already reflected in the share prices.
Most of the tests conducted used the event studies methodology to assess how security returns adjust to particular announcements.
Generally, studies on events concerning the announcements of stock splits, earnings, earnings forecast and growth in money supply find that no abnormal returns are available.
If semi-strong efficiency holds, then it undermines the works of fundamental analysts.

62. Test of Strong Form Efficiency
Strong form tests determine whether investors with inside information are able to earn abnormal returns.
Tests for the value of private information have focused on trades by corporate insiders, security analysts and portfolio managers.
Results indicate that, in general, corporate insiders do earn abnormal returns.
No market is strong form efficient.

63. What are the Roles of Portfolio Managers?
If markets are efficient, the primary role of a portfolio manager consists of analyzing and investing appropriately based on an investor's tax considerations and risk profile.
Optimal portfolios will vary according to factors such as age, tax bracket, risk aversion and employment.
The role of the portfolio manager in an efficient market is to tailor a portfolio to those needs, rather than to beat the market.
Investors will be best served by constructing broadly-diversified portfolios that correspond to the level of systematic risk they are willing to bear, and adopting a buy-and-hold strategy.