Fin 334 Test 3 Concepts Chapter 8 and 9
What is a stock chart? What kind of information can be put on charts, and what is the purpose of charting?
A stock chart is simply a historical record of the behavior of a stock, the market, or some technical measure. Chartists believe that price patterns evolve into chart formations, which provide signals about the future course of the market or a particular stock. These formations are said to result because of certain supply and demand forces in the marketplace. Some investors argue that history repeats itself, and so chart formations indicate the course of events to come. of course, the formations are often not very clear, so identification and interpretation may require as much imagination as skill.
How can behavioral finance have any bearing or investor returns? Do supporters of behavioral finance believe in efficient markets? Explain.
Beyond firm fundamentals, behavioral finance advocates believe that decisions are affected by a number of biases. These biases cause investors to overreact to some types of information and underreact to others, and the resulting behavior of investors pushes stock prices away from their equilibrium values. Because these biases are widespread in the investor population, the market is not efficient.
Can the growth prospects of a company affect its P/E multiple? Explain. How about the amount of debt a firm uses? Are there any other variables that affect the level of a firm's P/E ratio?
Both growth prospects and the amount of debt affects the P/E ratio. As growth rates increase, a higher P/E ratio can be expected. Likewise, as the debt level decreases, the financial risk inherent in the firm decreases, and the P/E ratio can be expected to increase. Other factors that affect the P/E ratio are market expectations and level of dividends.
How would you go about finding the expected return on a stock? Note how such information would be used in the stock selection process.
Expected return on a stock can be found using the IRR. The expected rate of return on a stock would be the discount rate that equates the future stream of benefits from the stock to its current market value. In order to accept a stock as an investment, its IRR must at least equal its required rate of return (using CAPM). If the expected return is higher than its required return, then it's a good investment.
Are the expected future earnings of the firm important in determining a stock's investment suitability? Discuss how these and other future estimates fit into the stock valuation framework.
In making an investment decision, the investor must decide if a stock is undervalued or overvalued by comparing the current market price to its intrinsic value. The intrinsic value depends on an investor's expectations about its future cash flows and its risk. To estimate future cash flows, one has to forecast the future earnings of that company.
In the stock valuation framework, how can you tell whether a particular security is a worthwhile investment candidate? What role does the required rate of return play in this process? Would you invest in a stock if all you could earn was a rate of return that just equaled? Explain.
Investors should be willing to purchase a stock if the rate of return equals or exceeds the return the the investor feels is warranted or if the justified price is equal to or greater than the current market price. The required return provides a standard that is compared to the expected return. The rate of return is positively related to risk.
What are market anomalies and how do they come about? Do they support or refute the EMH? Briefly describe the January effect, the size effect, and the value effect.
Market anomalies are deviations from what is expected in an efficient market, and, hence, refute the efficient market hypothesis. Most of these anomalies are empirical anomalies, suggesting that over a specified period, certain info could have been used to earn abnormal, risk-adjusted returns. The January effect is the term applied to the tendency for small stocks to earn higher returns than are stocks during the month of January. The size effect is the term applied to the tendency for investments in the common stock of small firms to outperform investment in large firms. The value effect is the term applied to the tendency for so-called value stocks to outperform growth stocks.
Briefly describe the price-to-sales ratio and explain how it is used to value stocks. Why not just use the P/E multiple? How does the P/S ratio differ from the P/BV measure?
P/S and P/BV are alternatives. They are useful for valuing firms that are new or have volatile earnings streams, where the P/E multiple approach has little value. Unprofitable firms still have sales. Both are used in a similar fashion to estimate future values, by multiplying estimated sales or book value by the relevant ratio. Investors prefer low P/S and P/BV ratios, with desired P/S ratios of less than 2.0 and P/BV ratios of less than 7.0. However, if a company has a high profit margin, it is likely to have a high P/S and P/BV. An important difference lies in the fact that sales arise in the current period, while book value is based on the issuance of stock and retention of earnings since the firm went public and therefore can be distorted by inflation.
Can the market really have a measurable effect on the price behavior of individual securities? Explain.
Studies have indicated that 20% to 50% of stock price behavior can be traced to market forces. When the market is bullish, stock prices rise. When the market is bearish, most prices fall. This is because stock prices are simply the result of supply and demand forces in the market. Since the demand for and supply of securities depend on the general condition of the market, stock prices are affected by the general behavior of the marketplace.
Briefly describe the P/E approach to stock valuation and note how this approach differs from the variable-growth DVM. Describe the P/CF approach and note how it is used in the stock valuation process. Compare the P/E and P/CF, noting the relative strengths and weaknesses of each.
The P/E approach is a simpler, more intuitive approach to valuing a stock. Given an EPS, decided on a P/E ratio that is appropriate for the stock, multiply the EPS by the P/E to determine the stock price, and then compare this price to the stock's current price. The P/E approach differs from the variable growth DVM in that the P/E approach estimates EPS and develops an appropriate P/E for the firm. The DVM only uses future dividends and estimated growth rates to determine the stock price. The P/CF measure has been popular because cash flow is felt to provide a more accurate picture of a company's earning power. Cash flow is multiplied by a P/CF ratio. In addition to ease of use, the relatively low level of the P/CF ratio is viewed as a strength. The obstacle is the varying cash flow measures.
Describe the confidence index, and note the feature that makes it unique.
The confidence index is the ratio of the average yield on high-grade corporate bonds to the average yield on low-grade corporate bonds. Low-rated bonds always provide a higher yield than high-grade bonds. If investors are pessimistic about the future, they will require a much higher yield on low-rated bonds, resulting in a decline in the confidence index. The unique feature of this index is that it uses bond yields to judge stock market performance.
What is the difference between the variable-growth dividend valuation model and the free cash flow to equity approach to stock valuation? Which procedure would work better if you were trying to value a growth stock that pays little or no dividends? Explain.
The difference between the two is in the determination of the future selling price of stock. The VG dividend model uses the future dividends to derive the price of the stock while the free cash flow to equity model uses the PV of free cash flows to equity. Free cash flow to to equity would be more useful for valuing growth stocks that are not likely to pay dividends in the near future because the model requires only an estimate of future cash flows and a required rate of return.
What is the market multiple and how can it help in evaluating a stock's P/E ratio? Is a stock's relative P/E the same thing as the market multiple? Explain.
The market multiple is the average P/E ratio of stocks in the marketplace. It provides insight into the general state of the market, and it gives the investor information on how aggressively the market is pricing stocks. Using the market multiple as a benchmark, a stock's P/E performance can be evaluated relative to the market. The relative P/E of a stock is not the same as the multiple; the relative P/E is found by dividing a stock's P/E by the market's P/E.
What is the purpose of stock valuation? What role does intrinsic value play in the stock valuation process?
The purpose of stock valuation is to obtain a standard of performance that can be used to judge the investment merits of a share of stock. A stock's intrinsic value is such a standard; it provides an indication of the future risk and return performance of a security.
Briefly describe the dividend valuation model and three versions of this model. Explain how CAPM fits into the DVM.
The value of any asset is the PV of all future cash flow. For common stock, cash flow is dividends received plus future sales price of the stock. If any future price can be described in terms of subsequent dividends, then the current price can be viewed as the PV of dividends received over an infinite time horizon. -The constant growth dividend valuation model reduces the need to estimate all future dividends individually by saying that the value of a share of stock is a function of dividends that are growing at a specified rate over time. -The zero growth assumes that dividends will not grow over time. -Variable growth predicts that the growth rate will vary. The CAPM fits into the DVM through its effect on the required return. The greater the systematic risk (beta) of an investment, the greater the return.
What is the random walk hypothesis, and how does it apply to stocks? What is an efficient market? How can a market be efficient if its prices behave in a random fashion?
This hypothesis claims that stock prices follow a random pattern. An efficient market is one in which the market price of the security always fully reflects all available information. Stock prices respond to new information when it becomes available. But new information is not available today and cannot be predicted based on other historical information. This is why prices move randomly in an efficient market. In an efficient market, random price movements simply reflect a highly competitive market where investors quickly use and digest any new information. This competition holds security prices close to their correct level; as new information becomes available, adjustments in price are random and quick to follow.
What is the purpose of technical analysis? Explain how and why it is used by technicians; note how it can be helpful in timing investment decisions.
This involves the study of historical stock prices, returns, and trading volume to identify repeating patterns that investors may exploit to earn higher returns. Technical analysts argue that internal market factors, such as trading volume and price movements, often reveal the market's future direction, before the cause is evident in financial statistics. Thus, by revealing the market's future direction, technical analysis provides insight that is supposed to be helpful to investors in timing their decisions. If technical analysis indicates the market is about to move up, it signals a good time to buy.
Explain why it is difficult, if not impossible, to consistently outperform an efficient market. Does this mean that high rates of return are not available in the stock market? How can an investor earn a high rate of return in an efficient market?
To outperform the market consistently, one must be able to consistently find stocks selling below their justified prices. By purchasing those stocks and holding them until they adjust, investors could outperform the market. Of course, that is predicated on being able to identify the undervalued stocks in the first place. In an efficient market, current prices reflect all information; therefore, current prices equal justified prices, and investors can expect to earn only the "normal" rate of return. In an efficient market, there's a tradeoff between risk and return. If markets are efficient, it is not possible to earn higher returns without additional risk by identifying undervalued securities. Investors can earn a high rate of returns consistently through stocks with higher risks. They can also minimize transaction costs and tax expenses.
Briefly describe each of the following and note how it is computed and how it is used by technicians: a. Advance-decline lines b. Arms Index c. On-balance volume d. Relative strength index e. Moving averages
a. The difference between the number of shares going up in price and the number going down in price. Different exchanges publish stats on how many of their stocks closed higher or lower than the previous day. b. The ratio of advancing issues to declining issues is divided by the volume of rising issues to declining issues to create a trading index. The higher the TRIN, the worse the market condition is. c. a momentum indicator that relates volume to price change. When the security closes higher than the previous day, all the day's volume is considered up volume and added to the running total. Higher OBV indicates bull market. d. a measure of the average price change on up days to the average price change on down days. If the average price change is the same on up and down days, the RSI value will be 50. If the average price change is twice as high on up days as down days, the RSI value will be 67 e. Moving averages compare current share prices to the average share price over a specified period. Every new day is added to the average and the oldest day is dropped
Briefly describe each of the following and explain how it is used in technical analysis: a. Breadth of the market b. short interest c. Odd-lot trading
a. contrasts the number of firms with share price advancing to the number of firms with share price declining. When investors are optimistic, the number of advances will generally outnumber the frequency of declining share prices. b. This is a measure of the number of shares in the stock market that have been sold short. Because shares sold short will have to be purchased by the short sellers in order to cover their positions, the short sale measure is a indicator of future demand for the shares. Provides insight to the current expectations regarding share prices and future demand. c. Based on the cynical assumption that small investors will be the last to invest in a bull market and the last to sell in a bear market. Hence, as the number of odd-lot purchases increases, there is an increasing chance of a market decline.The supply of additional shares will reduce price to sellers but increase the likelihood that subsequent prices will be higher.
Briefly explain how behavioral finance can affect: a. the trading activity of investors b. the tendency of value stocks to outperform growth stocks c. the tendency of stock prices to drift after unusual earning news
a. observes that overconfidence is a common trait. Investors may trade too often, thinking they are skilled at identifying undervalued securities. If they aren't skilled in that regard, they will simply trade too much, generating excessive transaction costs b. Behavioral finance suggests that investors are too inclined to believe historical trends will continue. They believe that growth stocks will continue to perform well, so investors are too aggressive in buying these stocks. This makes the value of growth stocks saturated, and thus, perform poorly as markets correct this mistake. Value stocks are then avoided, but the prices of value stocks remain too low. However, markets correct this mistake. c. Representativeness can sometimes cause investors to under react to new info, particular new information that is extreme. Investors seem to put insufficient weight on surprisingly good or bad earnings news. When a firm announces earnings, it is reasonable to think that earnings will also be higher(lower) than expected in the next quarter, and indeed there is evidence that analysts' earnings forecasts adjust after a firm reports the quarter.