Chapter 11: Stock Valuation and Risks

Limitations of the Adjusted Dividend Discount Model

-deriving the present value of dividends over the investment horizon or -the present value of the forecasted price at which the stock can be sold at the end of the investment horizon

Volatility of a Stock: Using Volatility Patterns to Forecast Stock Price Volatility

A time series trend is applied to the standard deviations to account for changes in economic trends during the previous periods.

Change in Dividend Policy

An increase in dividends may reflect the firm's expectation that it can more easily afford to pay dividends.

Economic Factors: Impact of Economic Growth

An increase in economic growth is expected to increase the demand for products and services produced by firms and thereby increase a firm's cash flows and valuation.

The Price-Earnings (PE) Method

Applies the mean price-earnings (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.

Expectations

Attempting to anticipate new policies so that they can make their move in the market before other investors

Beta of a Stock Portfolio

Can be measured as the weighted average of the betas of stocks that make up the portfolio -§-beta stocks are expected to be relatively volatile because they are more sensitive to market returns over time. Likewise, low-beta stocks are expected to be less volatile because they are less responsive to market returns.

Required Rate of Return on Stocks

Capital Asset Pricing Model

Firm-Specific Factors

Change in Dividend Policy Earnings Surprises Acquisitions and Divestitures Expectations

Volatility of a Stock: Using Implied Volatility to Forecast Stock Price Volatility

Derive a stock's implied standard deviation from a stock option pricing model.

Tax Effects

Differences in tax laws for short-term vs. long-term capital gains affect the after tax cash flows investors receive from selling stocks. Tax laws cause some stocks to be more desirable than others (i.e. dividend vs. non-dividend paying).

Free Cash Flow Model: Limitations

Difficulty of obtaining an accurate estimate of free cash flow per period.

Value at Risk: Application Using Historical Returns

E.g. an investor may determine that out of the last trading 100 trading days, a stock experienced a decline of greater than 7% on five different days. The investor could infer a maximum daily loss of no more than 7% for that stock based on a 95% confidence level.

Dividend Discount Model: Limitations of the Dividend Discount Model

Errors can be made in determining the dividend to be paid, the growth rate, and the required rate of return. Errors are more pronounced for firms that retain most of their earnings.

Value at Risk

Estimates the largest expected loss to a particular investment position for a specified confidence level. Is intended to warn investors about the potential maximum loss that could occur. Is commonly used to estimate the risk of a portfolio.

Valuation =

Expected earnings per share x Mean industry PE ratio

Free Cash Flow Model

For firms that do not pay dividends: -Estimate the free cash flows that will result from operations. -Subtract existing liabilities to determine the value of the firm. -Divide the value of the firm by the number of shares to derive a value per share.

Economic Factors: Impact of the Dollar's Exchange Rate Value

Foreign investors prefer to purchase U.S. stocks when the dollar is weak and to sell them when the dollar is near its peak. Stock prices are also affected by the impact of the dollar's changing value on cash flows. Stock prices of U.S. companies may also be affected by exchange rates if stock market participants measure performance by reported earnings. The changing value of the dollar can also affect stock prices by affecting expectations of economic factors that influence the firm's performance.

Economic Factors: Impact of Interest Rates

Given a choice of risk-free Treasury securities or stocks, investors should purchase stocks only if they are appropriately priced to reflect a sufficiently high expected return above the risk-free rate. Interest rates commonly rise in response to an increase in economic growth.

Capital Asset Pricing Model: Application of the CAPM

Given the risk-free rate as well as estimates of the firm's beta and the market risk premium, it is possible to estimate the required rate of return from investing in the firm's stock. At any given time, the required rates of return estimated by the CAPM will vary across stocks because of differences in their risk premiums, which are due to differences in their systematic risk (as measured by beta). Historical data for 30 or more years can be used to determine the average market risk premium over time.

Having an Edge in the Valuation Process

Information Leakages Reliance on Expert Networks

Market-Related Factors:

Investor Sentiment January Effect

Price-Earnings Method: Reasons for Different Valuations

Investors may use different forecasts for the firm's earnings or the mean industry earnings over the next year. Investors disagree on the proper measure of earnings.

Price-Earnings Method: Limitations of the PE Method

May result in an inaccurate valuation of a firm if errors are made in forecasting the firm's future earnings or in choosing the industry composite used to derive the PE ratio.

Beta of a Stock

Measures the sensitivity of its returns to market

Volatility of a Stock: Forecasting Stock Price Volatility of the Stock Market

Monitor the volatility index (VIX) derived from stock options on the S&P 500 stock at a given point in time. The VIX measures investors' expectation of the stock market volatility over the next 30 days. (Exhibit 11.3)

January Effect

Portfolio managers prefer investing in riskier, small stocks at the beginning of the year and then shifting to larger, more stable companies near the end of the year in order to lock in their gains. This tendency places upward pressure on small stocks in January each year.

Reliance on Expert Networks

Private information can also be obtained by hiring experts in the field as consultants. Experts are not supposed to provide inside information.

Investor Sentiment

Represents the general mood of investors in the stock market.

Capital Asset Pricing Model

Sometimes used to estimate the required rate of return for any firm with publicly traded stock. The only important risk of a firm is systematic risk. Suggests that the return of a stock (Rj) is influenced by the prevailing risk-free rate (Rf), the market return (Rm), and the beta (Bj): Rj = Rf + Bj(Rm - Rf) -where Bj is measured as the covariance between Rj and Rm, which reflects the asset's sensitivity to general stock market movements.

Dividend Discount Model: Relationship with PE Ratio for Valuing

The PE multiple is influenced by the required rate of return and the expected growth rate of competitors. The inverse relationship between rate of return and value exists in both models. The positive relationship between required rate of return and value exists in both models.

Stock Valuation Methods

The Price-Earnings (PE) Method Dividend Discount Model Free Cash Flow Model

Adjusted Dividend Discount Model

The dividend discount model can be adapted to assess the value of any firm, even those that retain most or all of their earnings. -The value of the stock is equal to the present value of the future dividends plus the present value of the forecasted.

Acquisitions and Divestitures

The expected acquisition of a firm typically results in an increased demand for the target's stock, which raises its price.

Volatility of a Stock: Volatility of a Stock Portfolio

The portfolio's volatility can be measured by the standard deviation

The return from investing in stock over a particular period is measured as

The risk of a stock can be measured by using its price volatility, its beta, and the value-at-risk method.

Capital Asset Pricing Model: Estimating the Market Risk Premium

The yield on newly issued Treasury bonds is commonly used as a proxy for the risk-free rate. The term, (Rm - Rf), is the market risk premium: the return of the market in excess of the risk-free rate. Historical data for 30 or more years can be used to determine the average market risk premium over time.

Capital Asset Pricing Model: Estimating the Firm's Beta

Typically measured by applying regression analysis to determine the sensitivity of the asset's return to the market return based on monthly or quarterly data.

Information Leakages

Under Regulation FD, when firms disclose material information, they must do it publicly. Analysts no longer have an information advantage

Using Standard Deviation to forecast Stock Price Volatility

Using the historical method — A historical period is used to derive a stock's standard deviation of returns, and that estimate is then used as the forecast over the future

Earning Surprises

When a firm's announced earnings are higher than expected, some investors raise their estimates of the firm's future cash flows and hence revalue its stock upward

Integration of Factors Affecting Stock Prices

Whenever indicators signal the expectation of higher interest rates, there is upward pressure on the required return by investors and downward pressure on a firm's value.

Volatility of a Stock

or total risk serves as a measure of risk because it may indicate the degree of uncertainty surrounding the stock's future returns.

Dividend Discount Model

where t = period D t = dividend in period t k = discount rate