1. 1 Stock Valuation Topic #3

2. 2 Context Financial Decision Making Debt Valuation Equity Valuation Derivatives Real Estate

3. 3 Return and Volatility Measures Total return Average return Standard deviation of returns

4. 4 Expected Future Risk and Return What is the expected future return on a stock?  Use historical expected returns Expected returns likely change We don’t really know even the historical expected returns Need a better way to estimate expected returns…

5. 5 Returns of Large Portfolios

6. 6 How about individual stocks?

7. 7 Common Vs. Independent Risks Diversification remedies independent risks Firm-specific risk  Idiosyncratic, unique, diversifiable risk Systematic risk  Undiversifiable, market risk

8. 8 What is the expected return for each type?

9. 9 Risk premium and diversification The risk premium for diversifiable risk is zero The risk premium depends only on the systematic risk  Thus, volatility is not a good measure of risk

10. 10 Estimating Expected Return Expected return is driven only by systematic risk Algorithm:  Measure systematic risk  Determine the risk premium for that systematic risk

11. 11 Measure systematic risk Measure the average change in the return for each 1% change in the return of a portfolio that fluctuates solely due to systematic risk Efficient portfolio  Cannot be diversified further, it only changes with the economy  Perhaps the market portfolio Or a major index (SP500) Beta measures the sensitivity to the market portfolio  Beta measures the amplification of risk

12. 12 Estimate the Risk Premium Market risk premium = E(R market ) – r f. Risk premium is proportional to Beta

13. 13 Cost of Capital The cost of capital for a project is the same as the return on a stock with the same risk: Is the market portfolio efficient?

14. 14 Portfolio Expected Return Weighted average of individual returns: Weight of each stock in the portfolio

15. 15 Covariance and Correlation Covariance: Correlation:

16. 16 Variance of a Portfolio Variance of a 2-stock portfolio: Variance of a large portfolio:

17. 17 Variance of a portfolio

18. 18 Risk and Return

19. 19 Correlation and Diversification

20. 20 Short-selling

21. 21 Three stocks

22. 22 Many stocks

23. 23 Risk-free borrowing and lending

24. 24 Tangent Portfolio

25. 25 Cost of Capital Tangent portfolio is efficient Therefore,