Chapter 11- Stock Valuation and Risk
Estimating the Firm's Beta
- typically measured by applying regression analysis to determine the sensitivity of the stock return to the market return based on monthly or quarterly data.
Factors that affect stock prices 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. ie. dividend vs. non-dividend paying -In 2013, tax rates on dividends increased from 15% to 20% for investors in high personal income tax brackets.
Factors that affect stock prices 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.
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), an the beta(Bj) Rj= Rf+Bj(Rm-Rf) Where Bj is measured as the covariance between Rj and Rm which reflects the assets sensitivity to general stock market movements
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 selling price.
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.
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
Consider a stock that is expected to pay a dividend of $7 next year, and dividend will grow by 4% per year. Assume that the required rate of return k is 14%, the value of the stock is
=7/(0.14-0.04)=$70
Consider a stock that is expected to pay a dividend of $7 per share annually forever. Assume that the required rate of return k is 14%, the value of the stock is
=7/0.14 =$50
Consider a firm that is expected to generate earnings of $3/share next year. If the mean PE ratio of competitors in the same industry is 15, then the value of the firm's share is
=expected earnings of the firm x mean PE =3 x 15 =$45
Assume that the expected inflation rate has just been revised upward by the market. Would the required return by investors who invest in the stocks be affected? Explain.
ANSWER: An increase in expected inflation can increase the risk-free interest rate, which is a key component of the required rate of return on stocks. Therefore, it should cause an increase in the required rate of return on stocks.
Impact of Economic Growth. Explain how economic growth affects the valuation of a stock.
ANSWER: The firm's value should reflect the present value of its future cash flows. Because earnings are a primary component of corporate cash flows, many investors use forecasted earnings to determine whether a firm's stock is over- or undervalued.
Factors that Affect Stock Prices: Change in dividend policy
An increase in dividends may reflect the firm's expectation that it can more easily afford to pay dividends
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.
Describe the January effect.
Because many portfolio managers are evaluated over the calendar year, they tend to invest in riskier small stocks at the beginning of the year and shift to larger (more stable) companies near the end of the year to lock in their gains. This tendency places upward pressure on small stocks in January of every year, causing the so-called January effect.
Deriving the Required Rate of Return. A share of common stock currently sells for $110. Current dividends are $8 per share, and are expected to grow at 6 percent per year indefinitely. What is the rate of return required by investors in the stock?
D 1 = D 0 (1 + g) D 1 = $8.00(1 + 0.06) = $8.48 k = (D 1 /PV of stock ) + g k = (8.48/110) + 0.06 = 0.137 = 13.7%
Suppose you know that a company just paid an annual dividend of $1.75 per share on its stock and that the dividend will continue to grow at a rate of 8% per year. If the required return on this stock is 10%, what is the current share price?
D 1 = D0 (1 + g) D 1 = 1.75(1 + 0.08) = 1.89 PV of stock = D 1 /(k - g) PV of stock = 1.89/(0.10 - 0.08) = $94.5 per share
PV of stock= (with no dividend growth)
D/k
PV of stock= (with constant dividend growth)
D1/(k-g) D1 is the expected dividend per share over the next year, g is the dividend growth rate
Assume that a firm currently has earnings of $12 per share and the earnings will grow by 2% annually. The firm is expected to pay $4 dividend per share over the next three years. If the mean PE ratio of all other firms in the same industry is 6, what is the stock price in three years? If an investor's required rate of return is 14% and he wants to hold the stock for only three years, what is the maximum price he would like to pay now?
E3= 12X(1=.02)^3= 12.73 P3= E3X PE of industry= 12.73X6= 76.38
Valuation
Expected earnings per share X Mean industry PE ratio
Impact of Interest Rates. How are the interest rate, the required rate of return on a stock, and the valuation of a stock related?
Given a choice of risk-free Treasury securities or stocks, stocks should be purchased only if they are appropriately priced to reflect a sufficiently high expected return above the risk-free rate. The relation between interest rates and stock prices is not constant over time. However, most of the largest stock market declines have occurred in periods when interest rates increased substantially. Furthermore, the stock market's rise in the late 1990s is partially attributed to the low interest rates during that period, which encouraged investors to shift from debt securities (with low rates) to equity securities.
What does beta say about volatility
High-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.
Impact of Interest Rates
Interest rates commonly rise in response to an increase in economic growth.
Explain why investor sentiment can affect stock prices.
Investor sentiment represents the general mood of investors in the stock market. Since the stock valuations reflect expectations, there are some periods in which the stock market performance is not highly correlated with existing economic conditions. For example, stock prices may rise when the economy is weak if most investors expect that the economy will improve in the near future.
Rm-Rf
Market risk premium
Dividend Discount Model
P= Sum (Dt/(1+k)^t Where t= period Dt= dividend in period t k= discount rate
Deriving the Required Rate of Return. The next expected dividend for Sun, Inc., will be $1.20 per share and analysts expect the dividend to grow at a rate of 7 percent indefinitely. If Sun stock currently sells for $22 per share, what is the required rate of return?
PV of stock = D 1 /(k - g) k = (D 1 /PV of stock) + g k = (1.20/22) + 0.07 = 0.1245 = 12.45%
Micro, Inc will pay a dividend of $2.30 per share next year. If the company plans to increase its dividend by 9% per year indefinitely, and you require a 12% return on your investment, what should you pay for the company stock?
PV of stock= D/(k-g) 2.30/(12%-9%)= 76.667
Suppose that you are interested in buying the stock of a company that has a policy of paying a $6 per share dividend each year. assuming no changes in the firms policies, what is the value of a share of stock if the required rate of return is 11%
PV of stock= Dividend/required rate of return $6/11%= $54.5455
Measuring the Portfolio Beta. Assume the following information: Beta of IBM = 1.31 Beta of LUV = 0.85 Beta of ODP = 0.94 If you invest 40 percent of your money in IBM, 30 percent in LUV and 30 percent in ODP, what is your portfolio's beta?
Portfolio beta = 0.4(1.31) + 0.3(0.85) + 0.3(0.94) = 0.524 + 0.255 + 0.282 = 1.061
Deriving the Stock's Beta. You are considering investing in a stock that has an expected return of 13 percent. If the risk-free rate is 5 percent and the market risk premium is 7 percent, what must the beta of this stock be?
R j = R f + B j (R m - R f ) 0.13 = 0.05 + B j (0.07) B j = 1.142
Deriving the Required Rate of Return. A stock has a beta of 2.2, the risk-free rate is 6 percent, and the expected return on the market is 12 percent. Using the CAPM, what would you expect the required rate of return on this stock to be? What is the market risk premium?
R j = R f + B j (R m - R f ) R j = 6% + 2.2(12% - 6%) R j = 19.2% The market risk premium is 6 percent.
Stock return and Risk- the return from investing in stock over a particular period is measured as
R= (SP-INV)+ D/ INV Where INV= Initial investment D= dividend SP= selling price of the stock The risk of a stock can be measured by using its price volatility and its beta
Measuring Stock Returns. Suppose you bought a stock at the beginning of the year for $76.50. During the year, the stock paid a dividend of $0.70 per share and had an ending share price of $99.25. What is the total percentage return from investing in that stock over the year?
R=(SP-INV)+D/INV =(99.25- 76.5)+.70/76.25 =30.65%
Market-related Factors Investor Sentiment
Represents the general mood of the investors in the stock market
Performance from Global Diversification
Research has demonstrated that investors in stocks can benefit by diversifying internationally
The beta of the stock is estimated as 1.2. The prevailing risk-free rate is 6%, and the market risk premium is estimated to be 7%. The required rate of return is
Rs= 6%+ 1.2X7%= 14.4%
Treynor Index
The Treynor Index measures risk-adjusted returns when beta is the most appropriate measure of risk. FORMULA slide 26
Explain how to estimate the beta of a stock. Explain why beta serves as a measure of the stock's risk.
The beta of a stock can be estimated by obtaining returns of the firm and the stock market over the last 12 quarters and applying regression analysis to derive the slope coefficient. The regression analysis estimates the intercept (B 0 ) and the slope coefficient (B 1 ), which serves as the estimate of beta. Beta serves as a measure of the stock's risk because it measures sensitivity to the market. The higher the sensitivity, the more likely that the stock will perform poorly under adverse market conditions.
Diversification among Emerging Stock Markets
The correlation between stocks of different countries is low, so investors can reduce risk by including some stocks from these markets in their portfolios.
Factors that Affect Stock Prices: 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 Portfolio
The portfolio's volatility can be measured by the standard deviation: FORMULA slide 22
Sharpe Index (Sharpe Ratio)
The reward-to-variability ratio, or Sharpe Index, measures risk-adjusted returns when total variability is the most appropriate measure of risk. FORMULA slide 24 This index measures the excess return above the risk-free rate per unit of risk.
Using the PE Model you found that Verto stock expected to generate earnings of 4.38 per share this year and that the mean PE ratio for its industry is 27.195. Use the PE valuation method to determine the value of Verto shares.
Valuation per share= expected earnings of firm per share X mean industry PE ratio $4.38X27.195= $119.1141
Forms of Efficiency
Weak-Form Efficiency - suggests that security prices reflect all market-related information, such as historical security price movements and volume of securities trades. Semistrong-Form Efficiency - suggests that security prices fully reflect all public information, such as firm announcements, economic news, or political news. Strong-Form Efficiency - suggests that security prices fully reflect all information, including private or insider information.
Factors that Affect Stock Prices: Earnings 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.
Beta of a Stock
measures the sensitivity of its returns to market can be measured as the weighted average of the betas of stocks that make up the portfolio FORMULA slide 23
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.
The Price-earnings(PE) Method
uses the mean price-earnings ratio on the expected earnings of all traded competitors in the same industry as the firm's expected earnings for the next year