Recap of Lecture 5: - When You Buy A Stock, There Is A Chance of Getting A Return Different From Expected

Recap of Lecture 5
When you buy a stock, there is a chance of getting

a return different from expected
Standard deviation of stock returns measures the likelihood
of getting a return different from the expected return a
measure of total risk/stand-alone risk
Coefficient variation (s.d/) measures total risk per unit of
return
Variability in stock returns is caused by firm-specific

events and market-wide events
Total risk/stand-alone risk can be decomposed into
diversifiable risk and market risk
1
Forms of Risk
Diversifiable risk: Variability in return caused by
specific events to company
Can be eliminated through diversification
Market risk: Variability in return caused by market-
wide events
Often cannot be eliminated through diversification since
every stock would be affected. But some stocks are
affected more than others
Beta can be used as a measure of a stocks return sensitivity
in relation to general economic conditions
2
In Practice: Calculation of Beta
_ Historical returns
ri
.
.
20 Year rM ri
1 15% 18%
15
2 -5 -10
10 3 12 16
5
-5 0 5 10 15 20
rM
Regression line:
.
-5 ^ ^
ri = -2.59 + 1.44 rM
-10 Estimated Beta
of Stock i
Go back 3
Recap of Lecture 5
Most investors are risk averse dislike risk
and require higher rates of return to hold
riskier securities.
Higher risk higher required returns
CAPM says that higher market risk higher
required returns: ri = rRF + (rM rRF)bi
Not compensated for being exposed to diversifiable risk
4
Stocks and their valuation > Constant growth stock approach> Calculating yield for constant growth stocks > What is the expected
future growth rate? > LL1 > Non-constant growth stock approach > Calculating yield for non-constant growth stocks > Multiples of
comparable firms approach > Preferred stock > What is market equilibrium? > LL2 > Stock market efficiency > LL3 > Conclusion
Stocks and Their Valuation,

and
Stock Market Efficiency
Watch Video 2: Introduction (animation) on Online Lesson
5
Lecture 6: Stocks and Their Valuation, and Stock Market Efficiency
Learning Objectives
Understand the difference between stock price and intrinsic
value
Identify and explain the two models that can be used to
estimate a stocks intrinsic value: the discounted dividend
model and multiples of comparable firms method
Calculate the intrinsic value of a stock with constant growth
and non-constant growth
Calculate the stocks expected return, expected dividend
yield and expected capital gains yield
Understand the key features of preferred stock and calculate
the estimated value of preferred stock or its expected return
Discuss the importance of market efficiency, and explain why
some markets are more efficient than others
6
AB1201:
Financial Management
Lecture 6: Stocks and Their Valuation,

and Stock Market Efficiency
By: Chanika Charoenwong

Stocks and Their Valuation

Determining common stock values
Discounted dividend model
Stocks with constant growth
Stocks with non-constant growth
Using multiples of comparable firms
Preferred Stock
8
Returns from Investing in Stocks

Returns: Shareholders share in the profits
through dividends and stock price
appreciation (capital gains)
Sometimes shareholders also suffer losses when
the stock price falls (capital loss)
Question: You bought a stock at $20. At the
end of the year, you received $1 as
dividends and you sold the stock for $22.
What is the annual return you receive on the
stock?
9
Intrinsic Value and Stock Price

Outside investors, corporate insiders, and
analysts use a variety of approaches to
estimate a stocks intrinsic value (P0).
In equilibrium, we assume that a stocks
price equals its intrinsic value.
Outsiders estimate intrinsic value to help
determine which stocks are attractive to buy
and/or sell.
Stocks priced below (above) its intrinsic value are
undervalued (overvalued).
10
Different Approaches for Estimating

the Stocks Intrinsic Value
Discounted Discounted
dividend dividend
model model Multiples of
comparable
Stocks with - Stocks with firms
constant non-constant
growth growth
11
Discounted Dividend Model

Value of a stock is the present value of the
future dividends expected to be generated
by the stock.
0 1 2 3
rs %
D1 D2 D3
^ D1 D2 D3 D
P0 ...
(1 rs ) (1 rs )
1 2
(1 rs ) 3
(1 rs )
12
Constant Growth Stock

A stock whose dividends are expected
to grow forever at a constant rate, g.
D1 = D0 (1+g)1
D2 = D1 (1+g) = D0 (1+g)2
Dt = Dt-1 (1+g) = D0 (1+g)t
If g is constant, the discounted dividend

formula converges to:
P = D0 (1+ g) = D1
0
rs g rs g
13
What Happens if g > rs?

If g > rs, the constant growth formula leads
to a negative stock price, which does not
make sense.
The constant growth model can only be
used if:
rs > g
g is expected to be constant forever.
14
Example: Calculating the intrinsic value

of a stock with constant growth.
A stock has just announced a dividend of $2
(i.e. D0 = 2). The dividend is expected to
grow at a constant rate of 6% forever.
Given rRF = 7%, rM = 12%, and b = 1.2, what is
the intrinsic value of the stock?
15

of a stock with constant growth.
Step 1: Calculate the required rate of return
(rs) using SML
rs = rRF + (rM rRF)b
= 7% + (12% 7%)1.2
= 13%
Step 2: Find the expected D1

D1=2*1.06 = $2.12
16

of a stock with constant growth
Step 3: Using the constant growth model:
D1 $2.12
P0
rs g 0.13 0.06
$2.12

0.07
$30.29
17
Extension: What is the expected market

price of the stock one year from now?
0 1 2 3
2.00 2.12 2.247
1. $28.57
2. $30.29
3. $32.10
4. Not sure
18
Extension: What is the expected market

price of the stock one year from now?
D1 will have been paid out already. So, P1 is
the present value (as of Year 1) of D2, D3,
D4, etc.
2
D2 2(1.06) $2.247
Expected P1
intrinsic value of rs g 0.13 0.06 0.13 0.06
stock at t = 1
$32.10
Or, find expected P1 as:

P1 P0 (1.06) $32.10
19
Find the expected dividend yield, capital gains

yield, and expected total return during the first
year if you paid $30.29 for the stock.
Expected dividend yield
= D1 / P0 = $2.12/$30.29 = 7.0%
Expected capital gains yield

= ( P1 P0 ) / P0
= ($32.10 $30.29)/$30.29 = 6.0%
Expected total return r

= Dividend yield + Capital gains yield
= 7.0% + 6.0% = 13.0%
20
If the stock is trading at $28, what is the

expected total return during the first year?
Stock is undervalued!
Stock price ($28) < Intrinsic value ($30.29)
Expected dividend yield = 2.12/28 = 7.57%
Expected capital gains yield
= (32.10-28)/28 = 14.64%
Expected total return = 7.57+14.64
= 22.21% > Required rate of return (13%)
Is the stock a good buy?
How good are your assumptions?
21
What is the expected future growth rate, g?

Payout ratio ROE = Return on Equity
= Dividends/Net Income = Net Income/Total
Common Equity
g = ( 1 Payout ) (ROE)
g = ( Retention ratio ) (ROE)
A firm has been earning 15% on equity (ROE =
15%) and retaining 35% of its earnings
(dividend payout = 65%). This situation is
expected to continue.
g = (0.35) (15%)
= 5.25%
22
Lessons Learnt 1
General formula: ^ D1 D2 D3 D
P0 ...
(1 rs )1 (1 rs )2 (1 rs )3 (1 rs )
Constant growth stocks: dividends are expected to grow

forever at a constant rate, g.
D (1+ g) D
P0 = 0 = 1
rs g rs g
Expected total return at time t

= Expected dividend yield + Expected capital gains yield
P )/ P
= (D t / Pt 1 ) + ( Pt t 1 t 1
Expected future growth rate, g = ( 1 Payout ) (ROE)

23

dividend dividend
comparable
- Stocks with - Stocks with firms
growth growth
24
Supernormal Growth
A stock has just announced a dividend of $2,
(i.e. D0 = 2). The dividend is expected to
grow (g) at 30% for three years before
achieving a constant growth of 6%? Given
rRF = 7%, rM = 12%, and b = 1.2, What is its
estimated intrinsic value?
This means we can no longer use just the
constant growth model to find stock value.
However, the growth does become constant
after three years.
25
Valuing Common Stock with Non-constant

Growth
0 r = 13% 1 2 3
3 4
s
...
g1 = 30% g1 = 30% g1 = 30% g2 = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
4.658
P$ 3 $66.54
0.13 0.06
^ 2.600 3.380 4.394 66.54
P0
(1 rs )1 (1 rs ) 2 (1 rs ) 3
54.107
26
Valuing Common Stock with Non-constant

Growth
0 r = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P$ 3 $66.54
^ 0.13 0.06
54.107 = P0
27
Find the expected dividend and capital gains

yields during the first and fourth years if we paid
$54.11 for the stock.
Expected dividend yield (first year)
= $2.60/$54.11 = 4.81%
Expected capital gains yield (first year)
= 13.00% 4.81% = 8.19%
During non-constant growth, expected dividend
yield and capital gains yield are not constant, and
capital gains yield g.
After t = 3, dividend
Expected the stockyield
has constant growth and
(fourth year)
expected dividend=yield
= $4.658/$66.54 7.0% = 7%, while expected
capital
Expected gains yieldgains
capital = 6%.yield (fourth year)
= 13.00% 7.0% = 6.0%
28

dividend dividend
comparable
- Stocks with - Stocks with firms
growth growth
29
future growth rate? > LL1 > Non-constant growth stock approach > Calculating yield for non-constant growth stocks > Multiple of
Multiples of Comparable Firms Method

Analysts often use the following multiples to
value stocks.
P/E Stock price divided by earnings per share
P/CF
P/Sales
Example: Based on comparable firms,

estimate the appropriate P/E. Multiply this by
expected earnings to back out an estimate
of the stock price.
30
Preferred Stock
Hybrid security.
Like bonds, preferred stockholders receive a
fixed dividend that must be paid before
dividends are paid to common
stockholders.
However, companies can omit preferred
dividend payments without fear of pushing
the firm into bankruptcy.
31
Preferred Stock
If a preferred stock with an annual dividend
of $5 sells for $50, what is the preferred
stocks expected return?
D
Vp =
rp
$5
$50 =
rp
rp = $5
$50
= 0.10 =10%
32
What is Market Equilibrium?

In equilibrium, stock prices are stable and there is no
general tendency for people to buy versus to sell.
In equilibrium, two conditions hold:
The current market stock price equals its intrinsic value (P0 =
P0).
Expected returns must equal required returns.
D1
rs g rs rRF (rM rRF )b
P0
33
How is Market Equilibrium Established?
If price is below intrinsic value

The current price is too low and offers a
bargain.
Buy orders will be greater than sell orders.
The price will be bid up until expected return
equals required return.
34
How are the Equilibrium Values

Determined?
Are the equilibrium intrinsic value and
expected return estimated by managers or
are they determined by something else?
Equilibrium levels are based on the markets
estimate of intrinsic value and the markets
required rate of return, which are both
dependent on the attitudes of the marginal
investor.
35
Lessons Learnt 2
Non-constant growth stockassume the growth does become
constant after a certain period
During non-constant growth, expected dividend yield and capital
gains yield are not constant
During constant growth, expected dividend yield and capital
gains yield are constant and expected gains yield = g.
Multiples of comparable firms approach is used to
estimate the stock price such as P/E, P/CF, and P/Sales
The preferred stocks expected return = D/Vp
The market is in equilibrium when two conditions occur:
The current market stock price equals its intrinsic value
Expected returns must equal required returns.
36
Financial Markets and Institutions

Stock Market Efficiency
Section 2-7 in the textbook
37
What is an Efficient Market?

A market in which prices are close to intrinsic
value and stocks seem to be in equilibrium.
Market efficiency does not require the
market price to be equal to the intrinsic
value at every point in time
It just requires that the deviations between the
market price and intrinsic value are random.
Implication: Investors cannot beat the
market except through good luck or better
information.
38
Yahoos Close Market efficiency

Price
35
1 Feb 2008
30 Microsoft
announced
25
takeover
20
15
10
0
16-Jan-08
17-Jan-08
18-Jan-08
19-Jan-08
20-Jan-08
21-Jan-08
22-Jan-08
23-Jan-08
24-Jan-08
25-Jan-08
26-Jan-08
27-Jan-08
28-Jan-08
29-Jan-08
30-Jan-08
31-Jan-08
1-Feb-08
2-Feb-08
3-Feb-08
4-Feb-08
5-Feb-08
6-Feb-08
7-Feb-08
8-Feb-08
9-Feb-08
10-Feb-08
11-Feb-08
12-Feb-08
13-Feb-08
14-Feb-08
15-Feb-08
39
Market Efficiency
Concepts of market efficiency are related to
the assumptions about what information is available to
investors and reflected in the price.
It is also possible that some markets are efficient while
others are not. The key factors are the size of the
company, and the communication between the
company and the analysts/investors.
Highly Highly
Inefficient Efficient
Small companies are usually Large companies are usually

not followed by many analysts. followed by many analysts.
Not much contact with Good communication with
investors. investors.
40
Lessons Learnt 3
An efficient market refers to a market in
which prices are close to intrinsic value and
stocks seem to be in equilibrium.
If the stock prices already reflect all publicly
available information, they will be fairly
priced.
If the stock market is efficient, a person
cannot consistently earn abnormal returns or
beat the market except with luck or inside
information.
41
Where do We Stand?
Dividend growth model:
Value of a stock = PV of expected future
dividends, rs determined using SML
^ D1
Constant growth P0
rs - g
Non-constant growth
Using the multiples of comparable firms

Market equilibrium: Expected return =
required return
When markets are efficient, investors cannot
consistently earn abnormal returns
42

Recap of Lecture 5: - When You Buy A Stock, There Is A Chance of Getting A Return Different From Expected

Загружено:

Сведения о документе

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Recap of Lecture 5: - When You Buy A Stock, There Is A Chance of Getting A Return Different From Expected

Загружено:

Авторское право:

Доступные форматы

Recap of Lecture 5

When you buy a stock, there is a chance of getting

Variability in stock returns is caused by firm-specific

Stocks and Their Valuation,

Watch Video 2: Introduction (animation) on Online Lesson

Lecture 6: Stocks and Their Valuation,

By: Chanika Charoenwong

Stocks and Their Valuation

Returns from Investing in Stocks

Intrinsic Value and Stock Price

Different Approaches for Estimating

Discounted Dividend Model

Constant Growth Stock

If g is constant, the discounted dividend

What Happens if g > rs?

Example: Calculating the intrinsic value

Example: Calculating the intrinsic value

Step 2: Find the expected D1

Example: Calculating the intrinsic value

Extension: What is the expected market

2.00 2.12 2.247

Extension: What is the expected market

Or, find expected P1 as:

Find the expected dividend yield, capital gains

Expected capital gains yield

Expected total return r

If the stock is trading at $28, what is the

What is the expected future growth rate, g?

Constant growth stocks: dividends are expected to grow

Expected total return at time t

Expected future growth rate, g = ( 1 Payout ) (ROE)

Different Approaches for Estimating

Valuing Common Stock with Non-constant

Valuing Common Stock with Non-constant

Find the expected dividend and capital gains

Different Approaches for Estimating

Multiples of Comparable Firms Method

Example: Based on comparable firms,

What is Market Equilibrium?

How is Market Equilibrium Established?

If price is below intrinsic value

How are the Equilibrium Values

Financial Markets and Institutions

What is an Efficient Market?

Yahoos Close Market efficiency

Small companies are usually Large companies are usually

Using the multiples of comparable firms

Вам также может понравиться