PowerPoint Slides for:
Financial Markets
and Institutions
6th Edition
By Jeff Madura
Prepared by
David R. Durst
The University of Akron
CHAPTER
10
Stock Valuation
And Risk
Chapter Objectives
Explain the general steps necessary to value
stocks and the commonly used valuation
models
 Learn the factors that affect stock prices
 Explain methods of determining the required
rate of return on stocks
 Learn how to measure the risk of stocks
 Learn how to measure performance of stock
 Explain the concept of stock market efficiency

Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Valuation Methods


The price of a share of stock is the total value of the
company divided by the number of shares outstanding
Stock price by itself doesn’t represent firm value




Number of shares outstanding
Stock price is determined by the demand and supply for
the shares
Investors try to value stocks and purchase those that are
perceived to be undervalued by the market
New information creates re-evaluation
Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Valuation Methods
Price-Earnings (PE) Method
Apply the mean PE ratio of publicly traded
competitors
 Use expected earnings rather than historical
 Equation:

Firm’s
Stock
Price
= Expected EPS x Mean industry PE ratio
Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Valuation Methods
Price-Earnings (PE) Method

Reasons for different valuations
Different earnings forecasts
 Different PE multipliers

Different

comparison or benchmark firms
Limitations of the PE method
Errors in forecast or industry composite
 Based on PE, which some analysts question

Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Valuation Methods
Dividend Discount Method

The price of a stock reflects the present value of
the stock's future dividends
t
= period
Dt = dividend in period t
k = discount rate

Dt
Price  
t
t 1 (1  k)
Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Valuation Methods
Dividend Discount Method

Relationship between DDM and PE Ratio for
valuing firms
PE multiple is influenced by required rate of
return of competitors and their expected growth
rate
 When using PE multiple method, the investor
implicitly assumes that k and g will be similar to
competitors

Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Valuation Methods
Dividend Discount Method

Limitations of the Dividend Discount Model
Potential errors in estimating dividends
 Potential errors in estimating growth rate
 Potential errors in estimating required return
 Not all firms pay dividends

Technology
firms
Biomedical firms
Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Valuation Methods
Dividend Discount Method

Adjusting the Dividend Discount Model

Value of stock is determined by
Present
value of dividends over investment horizon
Present value of selling price at the end

To forecast the selling price, the investor can
estimate the firm’s EPS in the year they plan to
sell, then multiply by the industry PE ratio
Copyright© 2002 Thomson Publishing. All rights reserved.
Determining the Required Rate of Return
to Value Stocks

Capital Asset Pricing Model (CAPM)
Used to estimate the required return on publicly
traded stock
 Assumes that the only relevant risk is systematic
(market) risk

Uses
beta to measure risk rather than standard deviation
of returns
Rj = Rf + j(Rm – Rf)
Copyright© 2002 Thomson Publishing. All rights reserved.
Determining the Required Rate of Return
to Value Stocks
Rj = Rf + j(Rm – Rf)

Capital Asset Pricing Model (CAPM)

Estimating the risk-free rate and the market risk
premium
Proxy
for risk-free rate is the yield on newly issued
Treasury bonds
The market risk premium, or (Rm-Rf), can be estimated
using a long-term average of historical data.
Copyright© 2002 Thomson Publishing. All rights reserved.
Determining the Required Rate of Return
to Value Stocks
Rj = Rf + j(Rm – Rf)

Estimating the firm’s beta
Beta
measures systematic risk
Reflects how sensitive individual stock’s returns are relative to
the overall market
Example: beta of 1.2 indicates that the stock’s return is 20%
more volatile than the overall market
Investor can look up beta in a variety of sources such as Value
Line or Yahoo! Finance (Profile)
Computed by regressing stock’s returns on returns of the
market, usually represented by the S&P 500 index or other
market proxy
Copyright© 2002 Thomson Publishing. All rights reserved.
Determining the Required Rate of Return
to Value Stocks

Arbitrage Pricing Model
Differs from CAPM in that it suggests a stock’s
price is influenced by a set of factors rather than
just the return on the market
 Factors may include things like:

Economic
growth
Inflation
Industry

effects
Problem with APT: factors are unspecified and
must be defined
Copyright© 2002 Thomson Publishing. All rights reserved.
Factors that Affect Stock Prices

Economic factors

Interest rates
Most
of the significant stock market declines occurred
when interest rates increased substantially
Market’s rise in 1990s: low interest rates; low required
rates of return

Exchange rates
Foreign
investors purchase U.S. stocks when dollar is weak
or expected to appreciate
Stock prices of U.S. companies also affected by exchange
rates
Copyright© 2002 Thomson Publishing. All rights reserved.
Factors that Affect Stock Prices

Market-related factors
January effect
 Noise trading

Trading
by uninformed investors pushes stock price
away from fundamental value
Market maker spreads

Trends
Technical
analysis
Repetitive patterns of price movements
Copyright© 2002 Thomson Publishing. All rights reserved.
Factors that Affect Stock Prices

Firm-specific factors
Expected +NPV investments
 Dividend policy changes
 Significant debt level changes
 Stock offerings and repurchases
 Earnings surprises
 Acquisitions and divestitures

Copyright© 2002 Thomson Publishing. All rights reserved.
Factors that Affect Stock Prices
Integration of factors affecting stock prices
 Evidence on factors affecting stock prices


Fundamental factors influence stock prices, but they do
not fully account for price movements
 Smart-money
investors
 Noise
traders
 Excess volatility

Indicators of future stock prices


Things that affects cash flows and required returns
Variance in opinions about indicators
Copyright© 2002 Thomson Publishing. All rights reserved.
Exhibit 11.3
International
Economic
Conditions
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
U.S.
Economic
Conditions
Stock Market
Conditions
Industry
Conditions
Firm-Specific
Conditions
Firm’s
Systematic
Risk
(Beta)
Market
Risk
Premium
Risk-Free
Interest
Rate
Expected
Cash Flows
to Be
Generated
by the
Firm
Firm’s
Risk
Premium
Required Return
by Investors
Who Invest in
the Firm
Price of the
Firm’s
Stock
Copyright© 2002 Thomson Publishing. All rights reserved.
Analysts and Stock Valuation
Stock analysts interpret “valuation effect” of
new information for investors
 Analysts’ opinions impact stock buying/selling
 Analysts’ ratings seldom recommend sell

Income of analyst may come from investment
banking side of business selling company shares
 Companies shun analysts who recommend “sell”
 Analyst may personally own shares of company

Copyright© 2002 Thomson Publishing. All rights reserved.
Analysts and Stock Valuation, cont.

Analyst may obtain “new” information with
company executives in conference call
Other investors are not privy to information
 Regulation FD (Fair Disclosure) from SEC
requires “release” of new significant information
at the same time as teleconference calls with
analysts.


Other analyst recommendations
Value Line
 Investor’s Business Daily

Copyright© 2002 Thomson Publishing. All rights reserved.
Measures of Stock Risk

Market price volatility of stock
Indicates a range of possible returns
 Positive and negative
 Standard deviation measure of variability


Volatility of a stock portfolio depends upon:
Volatility of individual stocks in the portfolio
 Correlation coefficients between stock returns
 Proportion of total funds invested in each stock

Copyright© 2002 Thomson Publishing. All rights reserved.
Measures of Stock Risk

Beta of a stock


Measures sensitivity of stock’s returns to
market’s returns
Beta of a stock portfolio

Weighted average of the betas of the stocks that
comprise the portfolio
 p =  wi  i
Copyright© 2002 Thomson Publishing. All rights reserved.
Measures of Stock Risk

Value at Risk
Estimates the largest expected loss to a particular
investment position for a specified confidence
level
 Warns investors about the potential maximum loss
that they may incur with their investment portfolio
 Focuses on the “loss” side of possible returns
 Used to analyze risk of a portfolio

Copyright© 2002 Thomson Publishing. All rights reserved.
Applying Value at Risk

Methods of determining the maximum expected
loss

Use of historical returns
Example:
count the percent of total days that a stock drops a
certain level

Use of standard deviation
Used

to derive boundaries for a specific confidence level
Use of beta
Used
in conjunction with a forecast of a maximum market
drop
Beta serves as a multiplier of the expected market loss
Copyright© 2002 Thomson Publishing. All rights reserved.
Applying Value at Risk

Deriving the maximum dollar loss


Apply the maximum percentage loss to the value
of the investment
Common adjustments to the value-at-risk
applications
Investment horizon desired
 Length of historical period used
 Time-varying risk
 Restructuring the investment portfolio

Copyright© 2002 Thomson Publishing. All rights reserved.
Forecasting Stock Price Volatility and
Beta

Methods of forecasting stock price volatility



Historical method
Time-series method
Implied standard deviation
 Derived

Forecasting a stock portfolio's volatility


from the stock option pricing model
One method involves forecasts of individual volatility
levels and using correlation coefficients
Forecasting a stock portfolio’s beta

Forecast changes in individual stock betas
Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Performance Measurement

Sharpe Index


Assumes total variability is the appropriate
measure of risk
A measure of reward relative to risk
Sharpe Index =
R - Rf

Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Performance Measurement

Treynor Index
Assumes
that beta is the appropriate type of risk
Measure of risk-adjusted return
Higher the value; the higher the return relative to the
risk-free rate
Treynor Index =
R - Rf

Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Market Forms of Efficiency

Weak-form efficiency
Security
prices reflect all historical price and volume
information
Implication: investors cannot earn abnormal returns based on
past price movements

Semistrong-form efficiency
Security

prices reflect all public information
Strong-form efficiency
Security
prices reflect all information
Copyright© 2002 Thomson Publishing. All rights reserved.
Stock Market Efficiency

Tests of the Efficient Market Hypothesis (EMH)

Test of weak-form
 Searches
for non-random patterns in prices
 Cannot find dependencies that can overcome transaction costs

Test of semistrong-form
 Event
studies
 General support for semi-strong efficiency

Test of strong-form
 Insiders
can earn excess returns
 Strong-form efficiency does not appear to hold
Copyright© 2002 Thomson Publishing. All rights reserved.
Globalization of Stock Markets

U.S. investors desire foreign stocks
Diversification effects
 High real rates in parts of world


Corporations desire to finance in all markets
Diversified sources of funds
 Stock traded where operating
 Enhance global image

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Investing In Foreign Stocks
Deregulation increases access to foreign
markets
 New stock markets in emerging economies
 Investors seek underpriced stocks in less
efficient markets
 Investors seek diversification
 Higher average returns and variability

Copyright© 2002 Thomson Publishing. All rights reserved.
Foreign Stock Valuation, Performance,
and Efficiency

Valuation of foreign stocks


Price-earnings (PE) method
Dividend discount model
 Adjusted
for expected exchange rate movements
Measuring performance from investing in foreign
stocks
 International market efficiency



Some countries appear to be inefficient
Beware of the associated volatility and exchange rate
risks
Copyright© 2002 Thomson Publishing. All rights reserved.