1. 1 Chapter 11 Stock Valuation and Risk Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2. 2 Chapter Outline Stock valuation methods Determining the required rate of return to value stocks Factors that affect stock prices Role of analysts in valuing stocks Stock risk Applying value at risk Forecasting stock price volatility and beta Stock performance measurement Stock market efficiency Foreign stock valuation, performance, and efficiency

3. 3 Stock Valuation Methods The price-earnings (PE) method assigns the mean PE ratio based on expected earnings of all traded competitors to the firm’s expected earnings for the next year  Assumes future earnings are an important determinant of a firm’s value  Assumes that the growth in earnings in future years will be similar to that of the industry

4. 4 Stock Valuation Methods (cont’d) Price-earnings (PE) method (cont’d)  Reasons for different valuations Investors may use different forecasts for the firm’s 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. 5 Valuing A Stock Using the PE Method 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 firm’s shares according to the PE method?

6. 6 Stock Valuation Methods (cont’d) Dividend discount model  John Williams (1931) stated that the price of a stock should reflect the present value of the stock’s future dividends: D can be revised in response to uncertainty about the firm’s cash flows k can be revised in response to changes in the required rate of return by investors

7. 7 Stock Valuation Methods (cont’d) Dividend discount model (cont’d)  For a constant dividend, the cash flow is a perpetuity:  For a constantly growing dividend, the cash flow is a growing perpetuity:

8. 8 Valuing A Stock Using the Dividend Discount Model 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 firm’s stock. According to the dividend discount model, what is a fair price for the firm’s stock?

9. 9 Valuing A Stock Using the Dividend Discount Model 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 firm’s stock. According to the dividend discount model, what is a fair price for the firm’s stock?

10. 10 Stock Valuation Methods (cont’d) Dividend discount model (cont’d)  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 firm’s growth rate and its value exists in both models

11. 11 Using the Adjusted Dividend Discount Model (cont’d) 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?

12. 12 Determining the Required Rate of Return to Value Stocks 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 stock’s return and the market’s return:

13. 13 Determining the Required Rate of Return to Value Stocks (cont’d) The capital asset pricing model (cont’d)  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 firm’s beta Beta reflects the sensitivity of the stock’s return to the market’s overall return Beta is typically measured with monthly or quarterly data over the last four years or so

14. 14 Using the CAPM 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?

15. 15 Factors That Affect Stock Prices 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

16. 16 Factors That Affect Stock Prices (cont’d) Economic factors (cont’d)  Impact of the dollar’s 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 dollar’s 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

17. 17 Factors That Affect Stock Prices (cont’d) 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

18. 18 Factors That Affect Stock Prices (cont’d) 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 industry’s products  Market participants focus on announcements that signal information about a firm’s sales growth, earnings, or characteristics that cause a revision in the expected cash flows

19. 19 Factors That Affect Stock Prices (cont’d) Firm-specific factors (cont’d)  Dividend policy changes An increase in dividends may reflect the firm’s expectation that it can more easily afford to pay dividends  Earnings surprises When a firm’s announced earnings are higher than expected, investors may raise their estimates of the firm’s future cash flows  Acquisitions and divestitures Expected acquisitions typically result in an increased demand for the target’s 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

20. 20 Factors That Affect Stock Prices (cont’d) 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

21. 21 Role of Analysts in Valuing Stocks Many investors rely on opinions of stock analysts employed by securities firms or other financial firms Many analysts are assigned to specific stocks and issue ratings that can indicate whether investors should buy or sell the stock 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

22. 22 Role of Analysts in Valuing Stocks (cont’d) 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 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 Unbiased analyst rating services  Popular rating services include Morningstar, Value Line, and Investor’s Business Daily  Analyst rating services typically charge subscribers between $100 and $600 per year

23. 23 Stock Risk Risk reflects the uncertainty about future returns such that the actual return may be less than expected 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

24. 24 Stock Risk (cont’d) Measures of risk  The volatility of a stock: May indicate the degree of uncertainty surrounding the stock’s future returns Reflects total risk because it reflects movements in stock prices for any reason

25. 25 Stock Risk (cont’d) Measures of risk (cont’d)  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

26. 26 Stock Risk (cont’d) Measures of risk (cont’d)  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

27. 27 Forecasting Stock Price Volatility and Beta (cont’d) Forecasting a stock portfolio’s 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 Forecasting a stock portfolio’s beta  First forecast the betas of the individual stocks and then take a weighted average

28. 28 Stock Market Efficiency Forms of efficiency  Weak-form efficiency suggests that security prices reflect all trade-related 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  Strong-form efficiency suggests that security prices fully reflect all information, including private or insider information

29. 29 Stock Market Efficiency (cont’d) 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)

30. 30 Foreign Stock Valuation, Performance, and Efficiency (cont’d) 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

31. 31 Foreign Stock Valuation, Performance, and Efficiency (cont’d) 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

32. 32 Foreign Stock Valuation, Performance, and Efficiency (cont’d) Performance from global diversification (cont’d)  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

33. 33 Foreign Stock Valuation, Performance, and Efficiency (cont’d) 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