Tài chính doanh nghiệp - Chapter 11: Stock valuation and risk

Chapter 11Stock Valuation and RiskFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineStock valuation methodsDetermining the required rate of return to value stocksFactors that affect stock pricesRole of analysts in valuing stocksStock riskApplying value at riskForecasting stock price volatility and betaStock performance measurementStock market efficiencyForeign stock valuation, performance, and efficiency2Stock Valuation MethodsThe price-earnings (PE) method assigns the mean PE ratio based on expected earnings of all traded competitors to the firm’s expected earnings for the next yearAssumes future earnings are an important determinant of a firm’s valueAssumes that the growth in earnings in future years will be similar to that of the industry3Stock Valuation Methods (cont’d)Price-earnings (PE) method (cont’d)Reasons for different valuationsInvestors may use different forecasts for the firm’s earnings or the mean industry earningsInvestors disagree on the proper measure of earningsLimitations of the PE methodMay result in inaccurate valuation for a firm if errors are made in forecasting future earnings or in choosing the industry compositeSome question whether an investor should trust a PE ratio 4Valuing A Stock Using the PE MethodA firm is expected to generate earnings of $2 per share next year. The mean ratio of share price to expected earnings of competitors in the same industry is 14. What is the valuation of the firm’s shares according to the PE method?5Stock Valuation Methods (cont’d)Dividend discount modelJohn Williams (1931) stated that the price of a stock should reflect the present value of the stock’s future dividends:D can be revised in response to uncertainty about the firm’s cash flowsk can be revised in response to changes in the required rate of return by investors6Stock Valuation Methods (cont’d)Dividend discount model (cont’d)For a constant dividend, the cash flow is a perpetuity:For a constantly growing dividend, the cash flow is a growing perpetuity:7Valuing A Stock Using the Dividend Discount ModelExample 1: A firm is expected to pay a dividend of $2.10 per share every year in the foreseeable future. Investors require a return of 15% on the firm’s stock. According to the dividend discount model, what is a fair price for the firm’s stock?8Valuing A Stock Using the Dividend Discount ModelExample 2: A firm is expected to pay a dividend of $2.10 per share in one year. In every subsequent year, the dividend is expected to grow by 3 percent annually. Investors require a return of 15% on the firm’s stock. According to the dividend discount model, what is a fair price for the firm’s stock?9Stock Valuation Methods (cont’d)Dividend discount model (cont’d)Relationship between dividend discount model and PE ratioThe PE multiple is influenced by the required rate of return and the expected growth rate of competitorsThe inverse relationship between required rate of return and value exists in both modelsThe positive relationship between a firm’s growth rate and its value exists in both models10Stock Valuation Methods (cont’d)Dividend discount model (cont’d)Limitations of the dividend discount modelErrors can be made in determining the:Dividend to be paidGrowth rateRequired rate of returnErrors are more pronounced for firms that retain most of their earnings11Stock Valuation Methods (cont’d)Adjusting the dividend discount modelThe value of the stock is:The PV of the future dividends over the investment horizonThe PV of the forecasted price at which the stock will be soldMust estimate the firm’s EPS in the year they plan to sell the stock by applying an annual growth rate to the prevailing EPS12Using the Adjusted Dividend Discount ModelParker Corp. currently has earnings of $10 per share. Investors expect that the EPS will growth by 3 percent per year and expect to sell the stock in four years. What is the EPS in four years?13Using the Adjusted Dividend Discount Model (cont’d)Other firms in Parker’s industry have a mean PE ratio of 7. What is the estimated stock price in four years?14Using the Adjusted Dividend Discount Model (cont’d)Parker is expected to pay a dividend of $2 per share over the next four years. Investors require a return of 13% on their investment. Based on this information, what is a fair value of the stock according to the adjusted dividend discount model?15Stock Valuation Methods (cont’d)Adjusting the dividend discount model (cont’d)Limitations of the adjusted dividend discount modelErrors can be made in deriving the PV of dividends over the investment horizon or the forecasted price at which the stock can be soldErrors can be made if an improper required rate of return is used16Determining the Required Rate of Return to Value StocksThe capital asset pricing model:Assumes that the only important risk is systematic riskIs not concerned with unsystematic riskSuggests that the return on an asset is influenced by the prevailing risk-free rate, the market return, and the covariance between a stock’s return and the market’s return:17Determining the Required Rate of Return to Value Stocks (cont’d)The capital asset pricing model (cont’d)Estimating the risk-free rate and the market risk premiumThe yield on newly issued T-bonds is commonly used as a proxy for the risk-free rateThe terms within the parentheses measure the market risk premiumHistorical data over 30 or more years can be used to determine the average market risk premium over timeEstimating the firm’s betaBeta reflects the sensitivity of the stock’s return to the market’s overall returnBeta is typically measured with monthly or quarterly data over the last four years or so18Using the CAPMFantasia Corp. has a beta of 1.7. The prevailing risk-free rate is 5% and the market risk premium is 5%. What is the required rate of return of Fantasia Corp. according to the CAPM?19Determining the Required Rate of Return to Value Stocks (cont’d)The capital asset pricing model (cont’d)Limitations of the CAPMA study by Fama and French found that beta is unrelated to the return on stock over the 1963–1990 periodChan and Lakonishok:Found that the relation between stock returns and beta varied with the time period usedConcluded that it is appropriate to question whether beta is the driving force behind stock returnsFound that firms with the highest betas performed much worse than firms with low betasFound that high-beta firms outperformed low-beta firms during market upswings20Determining the Required Rate of Return to Value Stocks (cont’d)Arbitrage pricing modelSuggests that a stock’s price can be influenced by a set of factors in addition to the markete.g., economic growth, inflationIn equilibrium, expected returns on assets are linearly related to the covariance between assets returns and the factors:21Factors That Affect Stock PricesEconomic factorsImpact of economic growthAn increase in economic growth increases expected cash flows and valueIndicators such as employment, GDP, retail sales, and personal income are monitored by market participantsImpact of interest ratesGiven a choice of risk-free Treasury securities or stocks, stocks should only be purchased if they offer a sufficiently high expected return22Factors That Affect Stock Prices (cont’d)Economic factors (cont’d)Impact of the dollar’s exchange rate valueThe value of the dollar affects U.S. stocks because:Foreign investors purchase U.S. stocks when the dollar is weakStock prices are affected by the impact of the dollar’s changing value on cash flowsSome U.S. firms are involved in exportingU.S.-based MNCs have some earnings in foreign currenciesExchange rates may affect expectations of other economic factors 23Factors That Affect Stock Prices (cont’d)Market-related factorsInvestor sentimentIn some periods, stock market performance is not highly correlated with existing economic conditionsStocks can exhibit excessive volatility because their prices are partially driven by fads and fashionsA study by Roll found that only one-third of the variation in stocks returns can be explained by systematic economic forcesJanuary effectMany portfolio managers invest in riskier small stocks at the beginning of the year and shift to larger companies near the end of the yearPlaces upward pressure on small stocks in January24Factors That Affect Stock Prices (cont’d)Firm-specific factorsSome firms are more exposed to conditions within their own industry than to general economic conditions, so participants monitor:Industry sales forecastsEntry into the industry by new competitorsPrice movements of the industry’s productsMarket participants focus on announcements that signal information about a firm’s sales growth, earnings, or characteristics that cause a revision in the expected cash flows25Factors That Affect Stock Prices (cont’d)Firm-specific factors (cont’d)Dividend policy changesAn increase in dividends may reflect the firm’s expectation that it can more easily afford to pay dividendsEarnings surprisesWhen a firm’s announced earnings are higher than expected, investors may raise their estimates of the firm’s future cash flowsAcquisitions and divestituresExpected acquisitions typically result in an increased demand for the target’s stock and raise the stock priceThe effect on the acquiring firm is less clearExpectationsInvestors attempt to anticipate new policies so they can make their move before other investors26Factors That Affect Stock Prices (cont’d)Integration of factors affecting stock pricesWhenever economic indicators signal the expectation of higher interest rates, there is upward pressure on the required rate of returnFirms’ expected future cash flows are influenced by economic conditions, industry conditions, and firm-specific conditions27Role of Analysts in Valuing StocksMany investors rely on opinions of stock analysts employed by securities firms or other financial firmsMany analysts are assigned to specific stocks and issue ratings that can indicate whether investors should buy or sell the stockA 2001 study by Thomson Financial determined that analysts at the largest brokerage firms typically recommended “sell” for less than 1 percent of all the stocks for which they provided ratings28Role of Analysts in Valuing Stocks (cont’d)Conflicts of interestMany analysts are employed by securities firms that have other investment banking relationships with rated firmsSome analysts may own the stock of some of the firms they rateImpact of disclosure regulationsIn October 2000, the SEC enacted Regulation FD, which requires firms to disclose any significant information simultaneously to all market participantsUnbiased analyst rating servicesPopular rating services include Morningstar, Value Line, and Investor’s Business DailyAnalyst rating services typically charge subscribers between $100 and $600 per year29Stock RiskRisk reflects the uncertainty about future returns such that the actual return may be less than expectedThe holding period return is measured as:The main source of uncertainty is the price at which the stock can be soldDividends tend to be much more stable than stock price30Stock Risk (cont’d)Measures of riskThe volatility of a stock:May indicate the degree of uncertainty surrounding the stock’s future returnsReflects total risk because it reflects movements in stock prices for any reason31Stock Risk (cont’d)Measures of risk (cont’d)The volatility of a stock portfolio depends on:The volatility of the individual stocks in the portfolioThe correlations between returns of the stocks in the portfolioThe proportion of total funds invested in each stockA portfolio containing some stocks with low or negative correlation will exhibit less volatility32Stock Risk (cont’d)Measures of risk (cont’d)The beta of a stock:Measures the sensitivity of its returns to market returnsIs used by many investors who have a diversified portfolio of stocksCan be estimated by obtaining returns of the firm and the stock market and applying regression analysis to derive the slope coefficient:33Stock Risk (cont’d)Measures of risk (cont’d)The beta of a stock portfolio:Is useful for investors holding more than one stockCan be measured as a weighted average of the betas of stocks in the portfolio, with the weights reflecting the proportion of funds invested in each stock:The risk of a high-beta portfolio can be reduced by replacing some of the high-beta stocks with low-beta stocks34Stock Risk (cont’d)Measures of risk (cont’d)Value at risk:Is a risk measurement the estimates the largest expected loss to a particular investment position for a specified confidence levelBecame very popular in the late 1990s after some mutual funds and pension funds experienced abrupt large lossesIs intended to warn investors about the potential maximum loss that could occurFocuses on the pessimistic portion of the probability distribution of returnsIs commonly used to measure the risk of a portfolio35Applying Value at RiskMethods of determining the maximum expected lossUse of historical returns to derive the maximum expected losse.g., an investor may determine that out of the last 100 trading days, a stock experienced a decline of greater than 7 percent on 5 different daysThe investor could infer a maximum daily loss of no more than 7 percent for that stock based on a 95 percent confidence level36Applying Value at Risk (cont’d)Methods of determining the maximum expected loss (cont’d)Use of standard deviation to derive the maximum expected lossThe standard deviation of daily returns over the previous period can be used and applied to derive boundaries for a specific confidence levelUse of beta to derive the maximum expected loss37Using the Standard Deviation to Derive the Maximum Expected LossThe standard deviation of daily returns for a stock in a recent period is 1%. The 95% confidence level is desired for the maximum loss. The stock has an expected daily return of .1%. What is the lower boundary of expected returns?38Using Beta to Derive the Maximum Expected LossA stock’s beta over the last 100 days is 1.3. The stock market is expected to perform no worse than –2.1% on a daily basis based on a 95% confidence level. What is the maximum loss to the stock over a given day based on this information?39Applying Value at Risk (cont’d)Deriving the maximum dollar lossThe maximum percentage loss for a given confidence level can be applied to derive the maximum dollar loss of a particular investmentValue at risk is commonly applied to assess the maximum possible loss for an entire portfolioCommon adjustments to value at risk applicationsInvestment horizon desiredLength of historical period usedTime-varying riskRestructuring the investment portfolio40Forecasting Stock Price Volatility and BetaMethods of forecasting stock price volatilityThe historical method uses a historical period to derive a stock’s standard deviation of returns and uses that estimate as the forecast for the futureThe time-series method uses volatility patterns in previous periodsPlaces more weight on the most recent dataNormally uses the weights and number of periods that were the most accurate in previous periodsThe implied standard deviation derives the estimate from the stock option pricing modelRepresents the anticipated volatility of the stock over a future period by investors trading the stock41Forecasting Stock Price Volatility and Beta (cont’d)Forecasting a stock portfolio’s volatilityPortfolio volatility can be forecast by first deriving forecasts of individual volatility levelsNext, the correlation coefficient for each pair of stock in the portfolio is forecast by estimating the correlation in recent periodsForecasting a stock portfolio’s betaFirst forecast the betas of the individual stocks and then take a weighted average42Stock Performance MeasurementThe Sharpe index is appropriate when total variability is thought to be the appropriate measure of risk:The higher the stocks’ mean return relative to the mean risk-free rate and the lower the standard deviation, the higher the Sharpe indexMeasures the excess return above the risk-free rate per period43Using the Sharpe IndexPatrick stock has an average return of 15% and an average standard deviation of 13%. The average risk-free rate is 8%. What is the Sharpe index for Patrick stock?44Stock Performance Measurement (cont’d)The Treynor index is appropriate when beta is thought to be the most appropriate type of risk:The higher the Treynor index, the higher the return relative to the risk-free rate, per unit of risk45Using the Treynor IndexPatrick stock has an average return of 15% and a beta of 1.8. The average risk-free rate is 8%. What is the Sharpe index for Patrick stock?46Stock Market EfficiencyForms of efficiencyWeak-form efficiency suggests that security prices reflect all trade-related informationSemistrong-form efficiency suggests that security prices fully reflect all public informationIncludes announcements by firms, economic news or events, and political news or eventsIf semistrong-form efficiency holds, weak-form efficiency holds as wellStrong-form efficiency suggests that security prices fully reflect all information, including private or insider information47Stock Market Efficiency (cont’d)Tests of the efficient market hypothesisTest of weak-form efficiencyTested by searching for a nonrandom pattern in security pricesStudies have generally found that historical price changes are independent over timeThere is some evidence that stocks:Have performed better in January (January effect)Have performed better on Fridays than on Mondays (weekend effect)Have performed well on the trading days just before holidays (holiday effect)48Stock Market Efficiency (cont’d)Tests of the efficient market hypothesisTest of semistrong-form efficiencyTested by assessing how security returns adjust to particular announcementsGenerally, security prices immediately reflect the information from announcementsThere is evidence of unusual profits from investing in IPOsTest of strong-form efficiencyDifficult to testThere is evidence that share prices of target firms rise substantially when the acquisition is announcedInsiders are discouraged from using inside information because it is illegal49Foreign Stock Valuation, Performance, and EfficiencyValuation of foreign stocksPE methodThe expected EPS of the foreign firm are multiplied by the appropriate PE ratio based on the firm’s risk and local industryThe PE ratio for a given industry may change continuously in some foreign marketsThe PE ratio for a particular industry may need to be adjusted for the firm’s countryDividend discount modelAn adjustment for expected exchange rate movements is requiredThe value of foreign stocks from a U.S. perspective is subject to more uncertainty than the value of the stock from a local investor’s perspective50Foreign Stock Valuation, Performance, and Efficiency (cont’d)Measuring performance from investing in foreign stocksThe performance measurement should control for general market movements and exchange rate movements in the region where the portfolio managers has been assigned to invest funds51Foreign Stock Valuation, Performance, and Efficiency (cont’d)Performance from global diversificationStock investors can benefit by diversifying internationallyEconomies do not move in tandemStock markets across countries may respond to some of the same expectationsIn general, correlations between stock indexes have been higher in recent years than they were several years ago52Foreign Stock Valuation, Performance, and Efficiency (cont’d)Performance from global diversification (cont’d)Integration of markets during the 1987 crashThere was a high correlation among country stock markets during the crashThis suggests that the underlying cause of the crash systematically affected all marketsIntegration of markets during mini-crashesOn August 27, 1998 (“Bloody Thursday”) most stock markets around the world experienced lossesIllustrates that even a well-diversified international portfolio is not insulated from some eventsDiversification among emerging stock marketsThese markets have lower correlations with developed countries, but also higher risk53Foreign Stock Valuation, Performance, and Efficiency (cont’d)International market efficiencySome foreign markets are inefficient because of the small number of analysts and portfolio managersMarket inefficiencies are more common in small foreign stock marketsInsider trading is more prevalent in many foreign marketsPolitical and exchange rate risk may be high in some foreign markets54