FIN 435

Stock valuation
Stock valuation methods
 Dividend discount model
 Price-earnings (PE) method
 Adjusted dividend discount model
 Capital asset pricing model (CAPM)
Discounted Cash Flow (DCF) models
 Intrinsic value of a security is

Cash Flowsn
Value of sec urity  
t 1 ( 1  k)
t

where k = discount rate

Dividend Discount Model (DDM)
 Current value of a share of stock is the discounted value of all
future dividends

D1 D2 D
P    ...  
(1  k) 1
(1  k) 2
(1  k)
 Dt

t 1 ( 1  k)
t

where k = discount rate

Zero-growth rate model
 The price of a stock should reflect the present value of the
stock’s future dividends (John Williams, 1931).
 For a constant dividend:

D
Price 
k
Constant growth-rate model
 The price of a stock should reflect the present value of the stock’s
future dividends (John Williams, 1931).

 For a constantly growing dividend:

D1
Price 
kg

where g = dividend growth rate

Dividend discount model
 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?
Dividend discount model
D
Price 
k

$2.10

15%

 $14
Dividend discount model
 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?
Dividend discount model
D
Price 
kg

$2.10

15%  3%

 $17.50
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 year
 Valuation per share
= Expected earnings of firm/share X Mean industry PE ratio
Price-earnings (PE) method
 A 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?
Price-earnings (PE) method
 Valuation per share
= Expected earnings of firm/share X Mean industry PE ratio
= $2/share X 14
= $28
Adjusted dividend discount model
 Forecasted earnings in n years
= E (1 + G)n

 Price per share in n years

= Expected earnings of firm/share X Mean industry PE ratio

 The value of the stock is:

 The PV of the future dividends over the investment horizon
 The PV of the forecasted price at which the stock will be sold
Adjusted dividend discount model
 Kimye 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.
 Other firms in Kimye’s industry have a mean PE ratio of
7.
 Kimye is expected to pay a dividend of $2 per share over
the next four years. Investors require a return of 13% on
their investment.
What is a fair value of the stock according to the adjusted
dividend discount model?
Adjusted dividend discount model
 Forecasted earnings in 4 years
= E (1 + G)n
= $10 (1 + 0.03)4
= $11.26
 Stock price in 4 years
= Earnings in 4 years X Mean industry PE ratio
= $11.26 X 7
= $78.82

 Fair value of the stock

$2 $2 $2 $2 $78.82
    
(1.13) (1.13) (1.13) (1.13) (1.13) 4
1 2 3 4

 $54.29
Capital asset pricing model (CAPM)
 Suggests that the return on an asset is influenced by the
prevailing risk-free rate, the market return and beta

R j  Rf  B j ( R m  Rf )
Capital asset pricing model (CAPM)
 The yield on newly issued T-bonds is commonly used as
a proxy for the risk-free rate
 The market risk premium can be determined using
historical data over 30 or more years
 Beta reflects the sensitivity of the stock’s return to the
market’s overall return
 Beta is typically measured with monthly or quarterly
data over the last four years or so

R j  Rf  B j ( R m  R f )
Capital asset pricing model (CAPM)
 Tyrion 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 Tyrion Corp.

according to the CAPM?
Capital asset pricing model (CAPM)

R j  Rf  B j ( R m  R f )
 5%  1.7(10%  5%)
 13.5%
Stock performance measurement
 Sharpe ratio
 Is the reward-risk ratio
 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
index

R  Rf
Sharpe index 

Stock performance measurement
 Sharpe ratio
 Tywin Co’s 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 Tywin’s stock?

R  Rf
Sharpe index 

Stock performance measurement
 Sharpe ratio
 Tywin Co’s 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 Tywin’s stock?

R  Rf
Sharpe index 

15%  8%
  0.54
13%
Stock performance measurement
 Treynor ratio
 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 risk

R  Rf
Treynor index 
B
Stock performance measurement
 Treynor ratio
 Eddard Inc’s stock has an average return of 15% and a beta of 1.8.
 The average risk-free rate is 8%.

 What is the Treynor index for Eddard Inc’s stock?

R  Rf
Treynor index 
B
Stock performance measurement
 Treynor ratio
 Eddard Inc’s stock has an average return of 15% and a beta of 1.8.
 The average risk-free rate is 8%.

 What is the Treynor index for Eddard Inc’s stock?

R  Rf
Treynor index 
B
15%  8%
  0.04
1.8
Common stocks: Analysis and strategy
Impact of the market
– Pervasive and dominant
– The single most important risk affecting the price movement of
common stocks
– Particularly true for a diversified portfolio of stocks
–Accounts for 90% of the variability in a diversified portfolio’s return
– Investors buying foreign stocks face the same situation
Required rate of return
– Minimum expected rate of return needed to induce investment
– Given risk, a security must offer some minimum expected
return to persuade purchase
– Required RoR = RF + Risk premium
– Investors expect the risk free rate as well as a risk premium to
compensate for the additional risk assumed
Security market line (SML)
– Beta = 1.0 implies as risky as market
– Securities A and B are more risky than the market
Beta >1.0
– Security C is less risky than the market
Beta <1.0 SML
E(R)

A
kM B
C
kRF

0 0.5 1.0 1.5 2.0

BetaM
Understanding the required rate of return
– Risk-free rate
– RF =Real RoR +Inflation premium
– Real rate of return is basic exchange rate in the economy
– Nominal RF must contain premium for expected inflation
–The risk premium
– Reflects all uncertainty in the asset
Passive stock strategies
– Natural outcome of a belief in efficient markets
– No active strategy should be able to beat the market on a risk adjusted basis
– Emphasis is on minimizing transaction costs and time spent in
managing the portfolio
– Expected benefits from active trading or analysis less than the costs
Passive stock strategies
– Buy-and-hold strategy
– Belief that active management will incur transaction costs and involve
inevitable mistakes
– Important initial selection needs to be made
– Functions to perform: reinvesting income and adjusting to changes in risk
tolerance
Passive stock strategies
– Index funds
– Mutual funds designed to duplicate the performance of some market index
– No attempt made to forecast market movements and act accordingly
– No attempt to select under- or overvalued securities
– Low costs to operate, low turnover
Active stock strategies
– Assumes the investor possesses some advantage relative to
other market participants
– Most investors favor this approach despite evidence about efficient markets
– Identification of individual stocks as offering superior return-
risk tradeoff
– Selections part of a diversified portfolio
Active stock strategies
– Majority of investment advice geared to selection of stocks
– Value Line Investment Survey
– Security analyst’s job is to forecast stock returns
– Estimates provided by analysts
expected change in earnings per share, expected return on equity,
and industry outlook
– Recommendations: Buy, Hold, or Sell
Sector rotation
– Similar to stock selection, involves shifting sector weights in
the portfolio
– Benefit from sectors expected to perform relatively well and de-emphasize
sectors expected to perform poorly
– Four broad sectors:
– Interest-sensitive stocks, consumer durable stocks, capital goods stocks, and
defensive stocks
Market timing
– Market timers attempt to earn excess returns by varying the
percentage of portfolio assets in equity securities
– Increase portfolio beta when the market is expected to rise
– Success depends on the amount of brokerage commissions and
taxes paid
– Can investors regularly time the market to provide positive risk-adjusted
returns?
Efficient markets and active strategies
– If EMH true:
– Active strategies are unlikely to be successful over time after all costs
–If markets efficient, prices reflect fair economic value
– EMH proponents argue that little time should be devoted to
security analysis
– Time spent on reducing taxes, costs and maintaining chosen portfolio risk
Efficient market hypothesis (EMH)
Efficient markets
– How well do markets respond to new information?
– Should it be possible to decide between a profitable and
unprofitable investment given current information? How should
investors select the best risky portfolio?
– Efficient Markets
The prices of all securities quickly and fully reflect all available information
Conditions for an efficient market
– Large number of rational, profit-maximizing investors
– Actively participate in the market
– Individuals cannot affect market prices
– Information is costless, widely available, generated in a
random fashion
– Investors react quickly and fully to new information
Consequences of efficient market
– Quick price adjustment in response to the arrival of random
information makes the reward for analysis low
– Prices reflect all available information
– Price changes are independent of one another and move in a
random fashion
– New information is independent of past
Forms of market efficiency
– Efficient market hypothesis
– To what extent do securities markets quickly and fully reflect different
available information?
– Three levels of Market Efficiency
– Weak form - market level data
– Semistrong form - public information
– Strong form - all (nonpublic) information
Weak form
– Prices reflect all past price and volume data
– Technical analysis, which relies on the past history of prices, is
of little or no value in assessing future changes in price
– Market adjusts or incorporates this information quickly and
fully
Semistrong form
– Prices reflect all publicly available information
– Investors cannot act on new public information after its
announcement and expect to earn above-average, risk-adjusted
returns
– Encompasses weak form as a subset
Strong form
– Prices reflect all information, public and private
– No group of investors should be able to earn abnormal rates of
return by using publicly and privately available information
– Encompasses weak and semistrong forms as subsets
Evidence on market efficiency
– Keys:
– Consistency of returns in excess of risk
– Length of time over which returns are earned
– Economically efficient markets
– Assets are priced so that investors cannot exploit any discrepancies and
earn unusual returns
– Transaction costs matter
Weak form evidence
– Test for independence (randomness) of stock price changes
– If independent, trends in price changes do not exist
– Overreaction hypothesis and evidence
– Test for profitability of trading rules after brokerage costs
– Simple buy-and-hold better
Semistrong form evidence
– Empirical analysis of stock price behavior surrounding a
particular event
– Examine company unique returns
 The residual error between the security’s actual return and that given by
the index model
 Abnormal return (Arit) =Rit - E(Rit)
 Cumulative when a sum of Arit
Semistrong form evidence
– Stock splits
 Implications of split reflected in price immediately following the
announcement
– Accounting changes
 Quick reaction to real change in value
– Initial public offerings
 Only issues purchased at offer price yield abnormal returns
– Announcements and news
 Little impact on price after release
Strong form evidence
– Test performance of groups which have access to nonpublic
information
 Corporate insiders have valuable private information
 Evidence that many have consistently earned abnormal returns on their
stock transactions
– Insider transactions must be publicly reported
Implications of efficient market hypothesis
– What should investors do if markets efficient?
– Technical analysis
 Not valuable if weak form holds
– Fundamental analysis of intrinsic value
 Not valuable if semistrong form holds
 Experience average results
Implications of efficient market hypothesis
For professional money managers

– Less time spent on individual securities

 Passive investing favored
 Otherwise must believe in superior insight
– Tasks if markets informationally efficient
 Maintain correct diversification
 Achieve and maintain desired portfolio risk
 Manage tax burden
 Control transaction costs
Market anomalies
– Exceptions that appear to be contrary to market efficiency
– Earnings announcements affect stock prices
 Adjustment occurs before announcement but significant amount after
 Contrary to efficient market because the lag should not exist
Market anomalies
– Low P/E ratio stocks tend to outperform high P/E ratio stocks
 Low P/E stocks generally have higher risk-adjusted returns
 But P/E ratio is public information
– Should portfolio be based on P/E ratios?
 Could result in an undiversified portfolio
Market anomalies
– Size effect
 Tendency for small firms to have higher risk-adjusted returns than large
firms
– January effect
 Tendency for small firm stock returns to be higher in January
 Of 30.5% size premium, half of the effect occurs in January
Behavioral finance
– Rationality as a principle of behavior
– Are there systematic deviations from the norms of rationality?
– How do human beings make decisions?
 Distortion throughout the process of decision-making
 Marriage of psychology and finance
Conclusions about market efficiency
– Support for market efficiency is persuasive
 Much research using different methods
 Also many anomalies that cannot be explained satisfactorily
– Markets very efficient but not totally
 To outperform the market, fundamental analysis beyond the norm must
be done
Conclusions about market efficiency
– If markets operationally efficient, some investors with the skill
to detect a divergence between price and semistrong value earn
profits
 Excludes the majority of investors
 Anomalies offer opportunities
– Controversy about the degree of market efficiency still remains
Bond valuation
Interest rates
Rates and basis points

1% = 100 basis points (b.p.)

Interest rates
Assume the 10-year Treasury bond yield is 4.54 percent,
compared to 4.39 percent a week earlier. Calculate the
change in yield of the Treasury bond in terms of basis
points.

Increase in yield
= 4.54% – 4.39%
= 0.15%

1% = 100b.p.
0.15% = 15 b.p.

The yield has increased 15 basis points in a week.

Interest rates
Assume the 10-year Treasury bond yield is 5.94 percent,
compared to 6.23 percent a week earlier. Calculate the
change in yield of the Treasury bond in terms of basis
points.

Increase in yield
= 5.94% – 6.23%
= – 0.29%

1% = 100b.p.
– 0.29% = – 29 b.p.

The yield has decreased 29 basis points in a week.

Interest rates
Nominal interest rate  real interest rate + expected inflation
Interest rates
If the annual real rate of interest is 5% and the expected
inflation rate is 4%, what would be the nominal rate of
interest?

Nominal interest rate

 real interest rate + expected inflation
= 5% + 4%
= 9%
Interest rates
A year ago, you invested $1,000 in a savings account that
pays an annual interest rate of 7%. What is your
approximate annual real rate of return if the rate of
inflation was 3% over the year?

Real interest rate

 nominal interest rate – expected inflation
= 7% – 3%
= 4%
Current yield

CP
CY 
P
Current yield
A coupon bond which is selling for $1,052.42 pays annual
coupon payments worth $100. Calculate its current yield.

$100
CY   9.5%
$1,052.42
Current yield
Texaco Oil’s 10 percent coupon bonds are selling at 109
3/8. Exactly 14 years remain to maturity. Determine the
current yield.

3/8 = 0.375
Price = 109.375% of par = $1,093.75
Coupon payments = $100

$100
CY   9.14%
$1,093.75
Yield to maturity

( FV  P)
C .
YTM  n
(FV  P)
2
Yield to maturity
The price of a bond is $920 with a face value of $1000.
Assume that the annual coupons are $100, and that there
are 10 years remaining until maturity. Calculate the yield
to maturity of the bond.

YTM
($1,000  $920)
$100  .
 10
( $1,000  $920 )
2
 11.25%
Yield to maturity
The price of a bond is $950 with a face value of $1000.
Assume that the annual coupons are $70, and that there are
10 years remaining until maturity. Calculate the yield to
maturity of the bond.

YTM
($1,000  $950)
$70  .
 10
( $1,000  $950 )
2
 7.69%
Yield to maturity for zero-coupon bond

YTM  2  {[FV/P] 1/2n

 1}
Yield to maturity for zero-coupon bond
A zero-coupon bond with a face value of $1,000 has 12
years to maturity and is selling for $300. Calculate its yield
to maturity.

YTM
1
$1000 ( )
 2  {( ) 2 * 12  1}
$300
 5.14%
Bond valuation

2n
FV Ct / 2
V 
(1  YTM/ 2 ) 2n
t 1 ( 1  YTM/ 2 )
t
Bond valuation
A bond with a three-year maturity, sold at par with a 10
percent coupon rate. Assuming semiannual interest
payments of $50 for each of the next six periods, calculate
the value of the bond.

Bond.value , V
2n
FV Ct / 2
 
(1  YTM/ 2 ) 2n
t 1 ( 1  YTM/ 2 ) t

6
1,000 50
 6
 t
(1.05) t 1 ( 1 .05 )
 $746.22  $253.78
 $1,000.00
Bond valuation
A coupon bond that pays interest semi-annually has a par
value of $1,000, matures in 5 years, and has a yield to
maturity of 10%. What will be the value of the bond today
if the coupon rate is 8%?

Bond.value , V
2n
FV Ct / 2
 
(1  YTM/ 2 ) 2n
t 1 ( 1  YTM/ 2 ) t

6
1,000 40
 10
 t
(1.05 ) t 1 ( 1.05 )
 $613.91  $308.87
 $922.78
Duration
Duration is a present-value weighted average of the number of
years over which investors receive cash flows from a bond.

Duration allows comparison of effective lives of bonds that differ

in maturity and coupon rates.

It measures bond price sensitivity to interest rate movements,

which is very important in any bond analysis.

n
PV(CFt )
D t
t 1 Market Price
Duration
Calculate the duration of a bond with a 5 percent coupon,
five-year maturity, currently priced at $974.17 for a YTM
of 5.6 percent.

Answer: 4.477 years

Modified duration

DUR
DUR* 
(1  YTM)
Modified duration
A bond has a duration of 4.054 years and a YTM of 10
percent. What is the modified duration of the bond?

D*
= 4.054 / (1 + 0.05)
= 3.861
Change in price using modified duration

-D
% Δ in bond price  Δ r
(1  r)
Change in price using modified duration
A bond with a modified duration of 3.861 experienced a
yield change of 20 basis points (0.2%) from 10 percent to
10.20 percent. What would be the approximate change in
price of the bond?

Percentage change in bond price

= – 3.861 X (0.002 X 100)
= – 0.772%