Chap. 11: Stock Valuation and Risk

adjusted div. discount model

-DDM 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 div. plus the present value of the forecasted

valuation of foreign stocks

-Price-earnings method -div. discount model

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

volatility of a stock

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

change in div. policy

-an increase in div. may reflect the firm's expectation that it can more easily afford to pay div.

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

value at risk application using historical returns

-an investor may determine that out of the last trading 100 trading days, a stock experienced a decline of greater than 7% on 5 different days -the investor could infer a maximum daily loss or no more than 7% for that stock based on a 95% confidence level

PE Method (Price-Earnings)

-applies the mean 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 -assume that the growth in earnings in future years will be similar to that of the industry

test of strong form efficiency

-are difficult because the inside information used is not publicly available and cannot be properly tested

expectations

-attempting to anticipate new polices so that they can make their move in the market before other investors

Valuation of Foreign Stocks: div. discount model

-can be applied by discounting the stream of expected div. while adjusting to account for expected exchange rate movements

beta of a stock portfolio

-can be measured as the weighted average of the betas of stocks that make up the portfolio -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

firm specific factors

-change in div. policy -earnings surprises -acquisitions and divestitures -expectations

using implied volatility to forecast stock price volatility

-derive 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 -div vs non-div paying

free cash flow model limitation

-difficulty of obtaining an accurate estimate of free cash flow per period

limitations of the div. discount model

-errors can be made in determining the div to be paid, the growth rate, and 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

free cash flow model

-for firms that do not pay div: -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

impact of the dollar's exchange rate value

-foreign investors prefer to purchase US 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 US companies may also be affected by exchange rates if the 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

impact of interest rates

-given a choice of risk-free Treasury securities or stocks, investors should purchase stocks only if they are appropriately prices to reflecct a sufficiency high expected return above the risk-free rate -interest rates commonly rise in response to an increase in economic growth

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 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

value at risk adjusting the length of the historical period

-if conditions have changed such that only the most recent days reflect the general state of market conditions, then those days should be used...

market-related factors

-investor sentiment -January effect

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

limitations of the adjusted div. discount model

-may be inaccurate if errors are made in: -deriving the present value of div. 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

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

value at risk application using the standard deviaiton

-measure the standard deviation of daily returns over the previous period -then apply it to derive boundaries for a specific confidence level

Treynor Index

-measures risk-adjusted returns when beta is the most appropriate measure of risk

beta of a stock

-measures the sensitivity of its returns to market

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' expectations of the stock market volatility over the next 30 days

value at risk limitations of the value-at-risk method

-portfolio managers may be using a relatively calm historical period when assessing possible future risk

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

investor sentiment

-represents the general mood of investors in the stock market

performance from global diversification

-research has demonstrated that investors in stocks can benefit by diversifying internationally

international market efficiency

-some foreign markets are likely to be inefficient because a small number of analysts and portfolio managers may monitor the stocks

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 stock is influenced by the prevailing risk-free rate, the market return, and the beta

strong form efficiency

-suggests that security prices fully reflect all information, including private or insider information

semi strong form efficiency

-suggests that security prices fully reflect all public information, such as firm announcements, economic news, or political news

weak form efficiency

-suggests that security prices reflect all market-related information, such as historical security price movements and volume of securities trades

tests of the efficient market hypothesis

-test of week form efficiency -test of semi strong form efficiency -test of strong form efficiency

test of semi strong form efficiency

-tested by assessing how security returns adjust to particular announcements

test of weak form efficiency

-tested by searching for a nonrandom pattern in security prices

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

diversification among emerging stock amarkets

-the correlation between stocks of different countries is low, so investors can reduce risk by including some stocks from these markets in their portfolios

acquisitions and divestiitures

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

Valuation of Foreign Stocks: price-earnings method

-the expected earnings per share are multiplied by the PE ratio (based on the firm's risk and local industry) to determine the price of the stock -the PE ratio for an industry may change, especially when the industry consists of few firms -the value derived by this method is denominated in the local foreign currency

volatility of a stock portfolio

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

stock risk

-the return from investing in stock over a particular period -the risk of a stock can be measured by using its price volatility, its beta, and the value-at-risk method

measuring performance from investing in foreign stocks

-the returns from investing in foreign stocks is most properly measured in terms of the investor's objectives

sharpe index

-the reward-to-variability ratio, or Sharpe Index, measures risk-adjusted returns when total variability is the most appropriate measure of risk -this index measures the excess return above the risk-free rate per unit of risk

value at risk adjusting the investment horizon desired

-the same methods can be applied over a week or a month

value at risk application using a stock portfolio

-the three methods can be used to derive the maximum expected loss of a stock portfolio for a given confidence level

estimating the market risk premium

-the yield on newly issued Treasury bonds is commonly used as a proxy for the risk-free rate -historical data for 30 or more years can be used to determine the average market risk premium over time

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

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 as the forecast over the future

forms of efficiency

-weak -semi strong -strong

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

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

Valuation

=Expected earnings per share X Mean industry PE ratio

Div. Discount Model Equation

P0=Div/r-g