All Rights ReservedDr David P Echevarria1 STOCK VALUATION AND RISK CHAPTER 11

Benjamin Graham The essence of Graham's value investing is that any investment should be worth substantially more than an investor has to pay for it. He believed in thorough analysis, which we would call fundamental analysis. He sought out companies with strong Balance sheets, or those with little debt, above-average profit margins, and ample cash flow. (Securities Analysis, 1934, written with David Dodd) Investopedia2

Benjamin Graham He coined the phrase "margin of safety" to explain his common- sense formula that seeks out undervalued companies whose stock prices are temporarily down, but whose fundamentals, for the long run, are sound. The margin of safety on any investment is the difference between its purchase price and its intrinsic value. The larger this difference is (purchase price below intrinsic), the more attractive the investment - both from a safety and return perspective. The investment community commonly refers to these circumstances as low multiple stocks; Price/Earnings, Price/Book, Price/Sales All Rights ReservedDr David P Echevarria3

John Burr Williams One of the first economists to view stock prices as determined by “intrinsic value”, is recognized as a founder and developer of fundamental analysis. He is best known for his 1938 text "The Theory of Investment Value", based on his Ph.D. thesis, which was amongst the first to articulate the theory of Discounted Cash Flow (DCF) based valuation, and in particular, dividend based valuation. Wikipedia4

Nassim N. Taleb “The Black Swan” The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. 1.The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology 2.The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities) 3.The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs Wikipedia5

All Rights ReservedDr David P Echevarria6 STOCK VALUATION MODELS A.Importance of Efficient Stock Valuation Models 1.Identify over- or under-valued stocks 2.Assist in investment efficiency

Value: Three Models Basic: Value = Future Cash Flows / k k = discount rate A.Modigliani & Miller: V = NOI / k* B.Sharpe, et alia: Price = FCF / k e Where: k e = R f +  (R m – R f ) C.Gordon: Price = Div 1 / (k – g) Subject to: k > g ≥ 0 All Rights ReservedDr David P Echevarria7

All Rights ReservedDr David P Echevarria8 STOCK VALUATION MODELS C.Price-Earnings Multiplier (P/E ratio) 1.Measure of investment attractiveness 2.Earnings-Price Yield D.Factors Affecting Stock Price Movements 1.Anticipated future earnings 2.General economic conditions 3.Interest Rates 4.Inflationary expectations

All Rights ReservedDr David P Echevarria9 MODERN PORTFOLIO THEORY Harry Markowitz A.Two sources of risk 1.Variance 2.Covariance B.The Efficient Frontier 1.Locus of efficiently price securities or portfolios 2.Securities not on the EF are inefficiently priced

All Rights ReservedDr David P Echevarria10 CAPITAL ASSET PRICING MODEL William Sharpe, et alia A.Pricing risky assets in market equilibrium 1.Are Investment A's cash flows correlated with the market [portfolio] M? 2.The relative volatility (riskiness) of a security is captured by its Beta (B) 3.The coefficient of correlation, r (rho); degree of co- movement of A and M B.Total risk is separated into two components 1.Diversifiable: individual firm riskiness 2.Non-Diversifiable risk: the tendency to move with the market (relative risk)

All Rights ReservedDr David P Echevarria11 STOCK MARKET EFFICIENCY A.Forms of Efficiency 1.Weak Form (historical data) 2.Semi-Strong Form (current news) 3.Strong Form (insider information) B.Empirical Test Results: Is the market a random walk? Can you consistently beat the market? 1.Weak Form: unexplained volatility suggests market not weak form efficient. 2.Semi-Strong Form: a number of anomalies have been discerned 3.Strong Form: insiders can and do successfully beat the market

All Rights ReservedDr David P Echevarria12 GLOBALIZATION OF STOCK MARKETS A.International placement of stocks; multi- national market for placement B.Integration among international stock markets; magnitude of co-movement varies C.International diversification as method of reducing portfolio risk

All Rights ReservedDr David P Echevarria13 HOMEWORK QUESTIONS A.What is the difference between the MPT and CAPM in terms of risk measurement? B.What are the principal determinants of stock price movements? C.What particular problems do under-valued stocks encounter? D.Why we would include foreign stocks in our investment portfolio