FINC 3345 Chapter 11

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 at 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.

Describe the January effect

The dividend discount valuation model measures the value of a firm as the present value of future expected dividends to be received by the investor.

Describe the dividend discount valuation model.

Change in dividend policy, earnings surprises, and acquisitions.

Firm-specific factors

have less effect on the valuation of dividend-paying stocks than on stocks with high growth prospects.

Holding other factors constant, an increase in the capital gains tax rate will

Stock prices may rise if most investors expect that the economy will improve in the near future and stock prices may fall if most investors expect that the economy will weaken in the near future.

How can investor sentiment affect stock prices?

Favorable earnings surprises increase the values of stocks. Negative earnings surprises decrease the values of stocks.

How do earnings surprises affect valuations of stocks?

The Sarbanes-Oxley Act of 2002 may allow firms to detect problems that they would not have recognized otherwise, so that they can increase their cash inflows. However, the costs of complying with SOX result in higher cash outflows

Use a stock valuation framework to explain why the Sarbanes-Oxley Act (SOX) could improve the valuation of a stock. Why might SOX cause a reduction in the valuation of a stock?

The dividend discount model may result in an inaccurate valuation of a firm when valuing firms that retain most of their earnings rather than distribute them as dividends. The dividend discount model may result in an inaccurate valuation of a firm because of potential errors in determining the dividend to be paid over the next year, or the growth rate, or the required rate of return by investors.

What are some limitations of the dividend discount model?

Stocks in emerging markets are more exposed to political risk and a high degree of exchange rate risk

What are the risks of investing in stocks in emerging markets?

Strong-form

Which of these forms of efficiency is most difficult to test?

There is a constant positive relationship between interest rates and stock prices. It means that lower interest rates commonly occur in response to weak economic conditions, which tend to reduce expected cash flows of firms and their stock prices

how are the interest rate, the required rate of return on a stock, and the valuation of a stock related?

Price-earnings ratio

market price per share/earnings per share

$33.30

A firm is expected to generate earnings of $2.22 per share next year. The mean ratio of share price to expected earnings of competitors in the same industry is 15. Based on this information, the valuation of the firm's shares based on the price-earnings (PE) method is

10.2%

A stock's beta is estimated to be 1.3. The risk-free rate is 5 percent, and the market return is expected to be 9 percent. What is the expected return on the stock based on the CAPM?

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.

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.

The stock price may have been appropriate under the conditions of unchanged management. However, when management is changed in a manner that will reduce the waste and improve cash flows, the firm's value increases, and investors revalue the stock higher. Thus, the market could still be efficient.

At the time a management group of RJR Nabisco initially considered engaging in a leveraged buyout, RJR's stock price was less than $70 per share. Ultimately, RJR was acquired by the firm Kohlberg, Kravis, and Roberts (KKR) for about $108 per share. Does the large discrepancy between the stock price before an acquisition was considered versus after the acquisition mean that RJR's price was initially undervalued? If so, does this imply that the market was inefficient?

Value at risk is a risk measurement that estimates the largest expected loss to a particular investment position for a specified confidence level. It is intended to warn investors about the potential maximum loss that could occur.

Describe the value-at-risk method for measuring risk.

very limited potential for high return

Emerging market stocks tend to exhibit all of the following except

When the risk-free rate rises, the required rate of return rises, and therefore expected cash flows generated by the stock are discounted at a higher discount rate, which results in a lower value.

Explain (using intuition instead of math) why stock prices may decrease in response to a higher risk-free rate according to the CAPM.

If the economic growth increases, there may be an increase in expected cash flows. This effect can overwhelm the effect of a rise in the discount rate used to discount cash flows.

Explain (using intuition instead of math) why stock prices may increase in this situation even though the risk-free rate increases.

A stock portfolio has more volatility when its individual stock volatilities are high, other factors held constant. In addition, a stock portfolio has more volatility when its individual stock returns are highly correlated, other factors held constant. A stock portfolio containing some stocks with low or negative correlation will exhibit less volatility because the stocks will not experience peaks and troughs simultaneously.

Explain how different factors affect a stock portfolio's volatility.

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 stock valuation.

Explain how economic growth affects the valuation of a stock

Stock prices became much more volatile during the credit crisis. The prices of some stocks were frequently changing by more than 5 percent on a single day.

Explain how stock volatility changed during the credit crisis

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.

Explain how to estimate the beta of a stock.

Weak-form efficiency can be tested by searching for a nonrandom pattern in stock prices.

Explain how to test weak-form efficiency in the stock market.

The weak-form suggests that security prices reflect recent price movements and trading information. The semistrong suggests that security prices reflect all publicly traded information. The strong-form suggests that security prices reflect public and private information.

Explain the difference between weak-form, semistrong-form, and strong-form efficiency.

Investors can value a stock by applying the industry PE ratio to the firm's expected earnings for the next year

Explain the use of the price-earnings (PE) ratio for valuing a stock.

Beta serves as a measure of the stock's risk because it measures sensitivity to the market.

Explain why beta serves as a measure of the stock's risk.

168.83

LeBlanc Inc. currently has earnings of $10 per share, and investors expect that the earnings per share will grow by 3 percent per year. Furthermore, the mean PE ratio of all other firms in the same industry as LeBlanc Inc. is 15. LeBlanc is expected to pay a dividend of $3 per share over the next four years, and an investor in LeBlanc requires a return of 12 percent. What is the forecasted stock price of LeBlanc in four years, using the adjusted dividend discount model?

Investor sentiment and january effect

Market related factors

Sharpe Index

Measure of risk-adjusted return; defined as the asset's excess mean return beyond the mean risk-free rate, divided by the standard deviation of returns of the asset of concern.

Technical Analysis

Method of forecasting future stock prices based on historical stock price patterns.

Fundamental Analysis

Method of valuing stocks that relies on fundamental financial characteristics (such as earnings) about the firm and its corresponding industry.

25.18

Protsky Inc. paid a dividend of $2.20 per share this year. The dividend growth rate for Protsky's dividends is 3 percent per year. If the required rate of return on Protsky stock is 12 percent, the stock should be valued at $____ per share according to the dividend discount model.

Systematic risk

Risk that is attributable to market movements and cannot be diversified away.

Strong-form efficiency

Security prices fully reflect all information, including private (insider) information.

Semistrong-form efficiency

Security prices reflect all public information, including announcements by firms, economic news or events, and political news or events.

less dispersed than that of Stock Y

Stock X has a lower beta than Stock Y. The market return for next month is expected to be -1 percent, +1 percent, or +2 percent with an equal probability of each scenario. The probability distribution of Stock X returns for next month is

1) Economic factors, 2) Market-related factors, 3) Firm-specific factors

Stock prices re drive n by three types of factors

Sharpe

The ____ index can be used to measure risk-adjusted performance of a stock while controlling or the stock's volatility.

Capital Gain

The difference between the prices at which a stock is sold versus the price at which it was purchased.

risk-free rate

The formula for a stock portfolio's volatility does not contain the

Short-term capital gain

The gain on a stock position that was held for less than one year.

Long-term capital gain

The gain on a stock position that was held for one year or longer.

Weak-form efficiency

Theory that suggests that security prices reflect all market-related data, such as historical security price movements and volume of securities traded.

Weak-form

Which is most likely to be refuted?

potential errors in the forecast of the firm's beta

Which of the following is not a reason the PE ratio method may result in an inaccurate valuation for a firm?

The expected acquisition of a firm typically results in an increased demand for the target's stock and therefore raises the stock price. Investors recognize that the target's stock price will be bid up once the acquiring firm attempts to acquire the target's stock.

Why can expectations of an acquisition affect the value of the target's stock?