Exam 3 CH 11 Stock Valuation and Risk Questions and Answers

Exam 3 CH 11 Stock Valuation and Risk Questions and Answers Fundamental analysis relies on fundamental financial characteristics (like earnings) of the firm and its corresponding industry that are expected to influence stock values Technical analysis relies on stock price trends to determine stock values Price-earnings method applies the mean price-earnings (PE) ratio (based on expected earnings rather than recent earnings) of all publicly traded competitors in the respective industry to the firm's expected earnings for the next year *assumes: --future earnings are an important determinant of a firm's value --growth in earnings in future years will be similar to that of the industry Reasons for different valuations with the PE method the PE method has several variations, which can result in 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 Limitation of the PE method *may result in an inaccurate valuation of a firm if errors are made in forecasting the firms future earnings or in choosing the industry composite used to derive the PE ratio *some firms may use creative accounting methods to exxagerate their earnings in a particular period, but be unable to sustain that earnings level in the future *investors disagreeing on the proper measure of earnings can be a limitation as well (some investors may prefer to use operating earnings or excluded some unusually high expenses that result from one-time events) *investors may disagree on which firms represent the industry norm that should be used when applying PE ratio to a firms earnings (narrow industry composite V broad industry composite) *stock buybacks by firms can distort a firms earnings, in turn, distort a valuation derived form those earnings -- complicate the stock valuation process bc they reduce the number of shares outstanding but increase EPS even when the company's total earnings have not increased Dividend Discount Model (DDM) the model can account for uncertainty by allowing Dt to be revised in response to revised expectations about a firms CFs or by allowing k to be revised in response to changes in the required rate of return by investors *highly dependent of the required rate of return and growth rate DDM relationship with PE ratio for valuing firms *PE multiple is influenced by the required rate of return on stocks of competitors and expected growth rate of competitor firms *the inverse relationship between rate of return and value exists in BOTH models *the positive relationship between growth rate and value exists in both models Limitations of Dividend Discount Model *errors can be made in determining the dividend to be paid, the growth rate, and the RRR *errors are more pronounced for firms that retain most of their earnings, rather than distributing them as dividends, bc the model relies on the dividend as the base for applying the growth rate *can only be used for firms that pay dividends -- not very accurate for firms that do not Adjusted dividend model dividend discount model can be adapted to asses the value of any firm, even those firms that retain most of / all of their earnings From an investors perspective the value of the stock is =: 1. the PV of the future dividends to be received plus 2. the PV of the forecasted price at which the stock will be sold at the end of the investment horizon Limitations of the adjusted DDM may be inaccurate if errors are made in: *deriving the pV of dividends over the investment horizon *the PV of the forecasted price at which the stock can be sold at the end of the investment horizon (FV) ^^bc RRR affects both of these factors, using the wrong RRR will lead to inaccurate valuations Free Cash Flow Model This model is based on the PV of future cash flows and involves 3 steps For firms that do not pay dividends: 1. Estimate the free cash flow that will result from operations 2. Subtract existing liabilities to determine the value of the firm 3. Divide the value of the firm by the number of shares to derive a value per share Limitations of the FCF model *difficulty of obtaining an accurate estimate of free cash flow per period (bc there is no garuntee of what it will actually be) *some possibilities to determine this may be: --start w forecasted earnings and then add a forecast of the firms non cash expenses and capital investment and working capital investment required to support the growth in future earnings -- but obtaining that accurate earnings forecast is still a challenge Capital Asset Pricing Model (CAPM) Required rate of return on stocks *based on the premise that the only important risk for a firm is systematic risk, risk that results from exposure to general stock market movements. *not concerned with unsystematic risk (risk specific to an individual firm) b/c investors can avoid that type of risk by holding diversified portfolios CAPM suggests that the return of a stock Rj is influenced by: *prevailing risk free rate (Rf) *market return (Rm) *stocks beta (Bj) -- covariance between Rj and Rm Estimating market risk premium The yield on newly issued Treasury bonds is commonly used as a proxy for the risk-free rate. *The term, (Rm - Rf), is the market risk premium: the return of the market in excess of the risk-free rate. *Historical data for 30 or more years can be used to determine the average market risk premium over time. Estimating firms 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. Application of the CAPM *given the Rf rate as well as estimates of the firms beta and the market risk premium, it is possible to estimate the required rate of return from investing in the firms stock *at any given time, the required rates of return estimated by the CAPM will vary across stocks because of differences in their risk premiums, which are due to differences in their systematic risk (as measured by beta). *historical data for 30 or more years can be used to determine the avg market risk premium over time Stock prices are driven by 3 factors 1. economic factors **economic growth **interest rates **dollar exchange rates 2. market related factors **investor sentiment **January affect 3. firm specific factors **change in dividend policy **earnings surprise **acquisitions Impact of economic growth on stock prices (economic factors) *increase in economic growth is expected to increase the demand for products and services produced by firms and thereby increase firms CFs and valuations *Economic indicators --employment --GDP --retail sales --personal income (CPI) *(international impacts) --economic crisis in other countries tend to reduce foreign demand for US products, which reduces the expected CFs to US firms -- ultimately reducing their valuation Impact of interest rates (economic factors) the risk free rate is one of the most prominent economic forces driving stock market prices *given a choice of Rf treasury securities or stocks, investors should purchase stocks only if they are appropriately priced to reflect a sufficiently high expected return ABOVE the risk free rate *high interest rates should (in theory) raise the RRR of investors and therefor reduce the PV of FCFs generated by stock *interest rates commonly rise in response to economic growth, so stock prices may rise in response to an increase in expected cash flows even if investors RRR increases *^^ & vice versa with slowed economic growth **Effects of interest rates should be considered along with economic growth and other factors when seeking a more complete explanation of stock price movements Impact of the dollar's exchange rate value (economic factors) Foreign investors prefer to purchase U.S. stocks when the dollar is weak and to sell them when the dollar is near its peak. **foreign demand for US stocks may be higher when the $ is expected to strengthen (want to buy in before its peak) Stock prices are also affected by the impact of the dollar's changing value on cash flows. *US firms primarily involved in exporting could be favorably affected by the weak dollar, and adversely by the strong dollar -- US firms involved in importing could be affected in opposite manner Stock prices of U.S. companies may also be affected by exchange rates if stock market participants measure performance by reported earnings. *weaker dollar tends to inflate the reported earnings of a US based companies foreign subsidiaries The changing value of the dollar can also affect stock prices by affecting expectations of economic factors that influence the firm's performance. *weak dollar stimulates the US economy -- that trend may increase the value of a US firm who's sales depends on the US economy - strong dollar in contrast, could adversely affect this firm if it dampens US economic growth Investor sentiment (market related factors) represents the general mood of investors in the stock market *positive sentiment could emerge because of optimistic expectations, even during weak economic conditions -- investors expect the economy will improve *can be predictive of recession January effect (market related factors) (portfolio managers are evaluated over the calendar year) -- thus, they prefer investing in riskier small stocks in the beginning of the year and then shift to larger more stable companies near the end of the year. *this tendency places upward pressure on small stocks in January -- resulting in January effects *most annual stock market gains occur in January *investors trying to take advantage of this gain, and invest in smaller stocks near the end of December end up placing upward pressure on these prices in decemeber Change in dividend policy (firm specific factors) *increase in dividends may reflect the firms expectation that it can more easily afford to pay dividends (increasing valuation) *in contrast, decrease in dividends may reflect the firm expectation that it will not have sufficient cash flow to pay dividends (decreasing valuation) **its important to keep in mind tho, that companies can take out loans to pay dividends to keep investor goodwill high -- but this pisses off creditors Earnings surprise (firm specific factors) *when firms announced earnings are higher that expected, some investors raise their estimates of FCFs and revalue its stock upward (+) earnings surprise *conversly an announcement of lower-than-expected earnings can cause investors to reduce their valuation of a firms FCFs -- (-) earnings surprise Acquisitions (firm specific factors) *if a firm is expected to be the target of an acquisition by another company, increased demand usually results for the target stock (raising its price) Tax effects differences in tax laws for short term V 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 (dividend V non dividend paying) -- dividends are not tax deductible *LT capital gains -- taxed at MAX rate of 20% *ST capital gains -- taxed at regular income 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. Gaining an edge in valuation process private information (info advantage over other investors) Analsyts within securities firms who have an edge can offer valuable insights to their favored institutional investors clients, which will likely create stronger relationships with those investors -- sec firms will then be rewarded by receiving more requests from institutional investors to execute stock trades -- which generates larger commission revenue *Information leakages *Reliance on expert networks Information Leakages prior to 2000, firms would disclose info about changes in their expected Q earnings to analyst days before they announced it to the public -- analyst use to be able to use this information advantage to their benefit Post 2000, SEC issued Regulation Fair Disclosure (FD) to prevent such leakages **when firms disclose material information to any person they must disclose it to the general public at the same time *Analyst no longer have an information advantage Reliance on Expert Networks *Private information can also be obtained by hiring experts in the fields as consultants *these networks can be very valuable when investors are conducting valuations of tech firms because there is a high degree of asymmetric information between these firms and the investment community *Experts are NOT suppose to disclose this type of private information with clients -- YET, institutional investors are unlikely to hire experts for general insight that is avaliable from public information *Experts opinions are also often influenced by their knowledge of material inside information Stock risk reflects uncertainty about future returns *main source of uncertainty is the price at which the stock will be sold Risk associated with a stock can be measured by using its price volatility its beta value-at-risk (VAR) method Volatility (or total risk ) of a stock -- using standard deviation serves as a measure of risk because it may indicate the degree of uncertainty surrounding the stock's future returns *often referred to as total risk because it reflects movements in stock prices for any reason, NOT just movements attributatable to stock market movements *measured by the standard deviation **can be derived from use of a historical period of standard deviation periodic (ann, monthly, quarterly) returns and then using that estimate as the forecast overtime Assuming stocks returns are normally distributed 68% prob that the stocks return will be within 1 std of expected return (r hat) 95% probability that they will be 2 stds from expected outcome *HIGHER standard deviation reflects wider dispersion of the stocks returns -- MORE risk Using volatility patterns to forecast stock price volatility a time series trend is applied to the standard deviation to account for changes in economic trends during the previous periods *typically the weights & numbers of previous periods (lags) that were most accurate (had lowest forecast error) in previous period is used Using Implied Volatility to Forecast Stock Price Volatility Derive the stocks implied standard deviation from a stock option pricing model premium on a call option for a stock depends on many things, including the stocks volatility **by considering the actual call option premium paid by investors for a specific stock along with the values of all other factors that affect the premium, it is possible to derive the anticipated volatility Forecasting stock price volatility of the stock market *monitor the volatility index (VIX) derived from stock options on the SP 500 stock at a given point in time *the VIX measures investors expectations of the stock markets volatility over the next 30 days Beta of a stock portfolio measures the sensitivity of its returns to market **typical risk adverse investor would prefer stock with the narrowest variation between returns -- typically lowest beta PORTFOLIO *can be measured as the weighted avg of the betas of the stock that make up a 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 **ideally you want a mix of low beta and high beta stocks in a diversified portfolio Value at Risk (VAR) a measurement that estimates the largest expected loss in a particular investment position for a specified confidence level *it is intended to warn investors about potential maximum losses they could incur *commonly used to estimate the risk of a portfolio *confidence intervals reflect the confidence that a loss greater than the max calculated will NOT occur VAR application using standard deviation *measure std of daily returns over previous period *then apply it to derive boundaries for specific confidence level application using beta apply the firms beta instead of its std deriving the max dollar loss once the max percentage loss (lower bound) for a given confidence level is determined, it can be applied to derive the max dollar loss of a particular investment (multiply it by the amt invested) ^^ application to a stock portfolio *apply in same manner as you would for a single stock -- use portfolio std adjusting the investment horizon desired same method is applied over a week or a month (nothing needs to be changed except for the term of the returns & stds being used) adjusting the length of historical period if conditions have changed such that only the most recent days reflect the general state of market conditions, then only those days should be used Limitations to VAR *portfolio manager may be using a relatively calm historical period when assessing possible future risk **could imply that the actual loss of a portfolio in the future may be more pronounced than the expected Max loss that is estimated for historical data