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Chapter 14 : Stock Valuation and the EMH


Does the dividend discount model ignore the mass of investors who have bought their
shares with the intention of selling them in, say, 3 years time?

The dividend discount model implies that the fair price today of a share you intend to sell in 3
years time is :


(1 + R) (1 + R)
(1 + R)
(1 + R) 3

where we have assumed the discount rate is constant. But you need to forecast what you
think P3 will be. The logical way to do this is to note that :

P3 =

+ ....
(1 + R) (1 + R) 2

But when we substitute equation [2] into equation [1] we obtain the result that the fair price
depends on all future dividends, that is, the dividend discount model. Therefore the dividend
discount model implicitly includes the behaviour of those (rational) investors who want to sell
the stock in 3 years time.


What practical use is there in knowing the beta of your stock portfolio?

Portfolio beta p is a weighted average of the individual betas of the stocks in your portfolio :
p = w i i
where wi = proportion of the total dollar value of your portfolio held in asset-i. The portfolio
beta is a measure of the responsiveness of your portfolio return to changes in the market
ERp r = p (ERm r)
Hence, if you feel you are overexposed to changes in the market return, you can alter the
composition of your stock portfolio to achieve a lower desired value of p

Why might stock prices be highly volatile even though all investors act in a perfectly
rational way?

The Gordon growth model is useful here. In an efficient market the price of a stock is given
by :

K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition



where D1 = expected dividends in year-1, R = required (risk adjusted) return on this stock, g =
growth rate of dividends.
Suppose D1 = 10, R = 0.10 and g = 0.05 then P = 200.
Now suppose there is an upturn in the economy so investors alter their view of future dividend
growth by a mere 1% p.a. so that g now equals 0.06. The new stock price is P = 10/0.04 =
250. The change in the stock price is a relatively large rise of 25%. Similarly, changes in
investors views about inflation or the risk premium (i.e. the stocks beta) can lead to a change
in R and a change in the stock price. Hence large changes in stock prices are likely to occur
when investors are rational and forward looking.


Why is it better to short sell an overvalued stock and simultaneously buy a different
undervalued stock, rather than simply just buying the undervalued stock ?

You buy an undervalued stock when its quoted price PA is below the fair value VA (e.g.
calculated using the dividend discount model), expecting the market price to rise towards its
fair value. However, if economy wide bad news about dividends arrives, this will lead to a
reappraisal of fair value which may now be below PA and hence you are now holding an
overpriced stock.
Suppose however that there had been another stock-B available which was initially
overpriced, that is PB > VB then you would short-sell this stock in the hope its price falls. The
arrival of economy wide bad news will further depress VB, so you would make even more
money when PB falls to the new lower value for VB. Hence the extra gains on stock-B partly
compensate for possible losses on stock-A, after the arrival of the economy wide bad news
(e.g. slower growth in output).


The dividends of company-X are expected to grow at the constant rate of 5% p.a.
The last dividend pay-out was $1.80 per share. The risk adjusted (required) rate of
return is ER = 11% p.a. The current market price of the share is $ 35. Should you
purchase the share?

Gordon Growth Model:
Fair (Correct) Value of share V = D0(1+g) / (R-g) = 1.80 (1.05) / (0.11-0.05) = $31.50
The current quoted market price is $35 (i.e. its overvalued). Since you expect the actual
price to fall towards the fair value, you would not buy the share. If anything you would short
sell the share.


The past performance of BubbleStock is:

EPS (Earnings per share)
Dividends per share




BubbleStock is expected to produce earnings per share in 2011 of 20 cents and in

2012 of 26 cents. Earnings growth thereafter is expected to be 10%.
What is the pay-out ratio? If the rate of return on BubbleStock required by
investors is 14%, what is the fair price for the share at the end of 2010?
K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition



In the past 5 years BubbleStock shares have provided a 10%, 12%, 3%, 6%
and 8% return. Estimate the expected return and standard deviation of
The expected return on the market portfolio is 7%, the standard deviation of
the market portfolio is 6%, correlation of BubbleStock with the market return
is 0.7 and the risk-free rate is 5%. If the current market price of
BubbleStock is P = 235, is it a "good buy" (or should we just say goodbye
to the stock)?

(a.) 40% of earnings is being paid out as dividends (e.g. 4/10, 4.8/12, 6/15).
Hence we can expect
D(2011) = 0.4(20 cents) = 8 cents.
D(2012) = 0.4(26 cents) = 10.4 cents
PV of first two dividend payments V2 = 8 / 1.14 + 10.4 / 1.142 = $15.02
Value at the end 2012 of dividends from 2013 onwards
V(2012) = 10.4 (1.1) / (0.14-0.10) = 286
Discounting back to end 2010
V * = 286 / (1.14)2 = $220.07
Hence fair value V = $15.02 + $220.07 = $235.10
The fair price for BubbleStock stock (consistent with a required return of 14%) is $ 235.10
(b.) Mean (RBubble)

= (1/5) (10 + 12 + 3 + 6 + 8) = 7.8

= (1/5) ((10-7.8)2 + (12-7.8)2 + (3-7.8)2 + (6-7.8)2 + (8-7.8)2)
= (1/5) (4.84 + 17.64 + 23.04 + 3.24 + 0.04) = 9.76
= 3.1241

(c.) r = 5%
E(Rm) = 7%
m = SD(Rm) = 6%
(RBubble) = 3.12141%
(from b.)
= Corr(RBubble , Rm) = 0.7
Cov(RBubble , Rm) = m ( RBubble )t = (0.7) (6) (3.1241) = 13.1212
Bubble Cov (RBubble , Rm) / m 2 = 13.1212 / 62 = 0.3645
Knowing Bubbles beta, we can use the SML to calculate it required return:
E(RBubblet) = r + (ERm - r) Bubblet = 5% + (7% 5%) 0.3645 = 5.73%
With a discount rate of 14% Internet has a fair price of $235.10 - see (a). Using the
correct risk adjusted discount rate of 5.73 % given by the SML would give a fair value
much greater than $235.10. Hence the quoted price of $235 is below the fair value and
you should buy the stock. Alternatively, you can note that at a price of $235.10 the IRR
on the stock is 14% - see (a). However, the required (risk adjusted) rate of return is only
5.73%, hence invest in the stock because its current risk adjusted IRR > required rate of
return, of 5.73% given by the SML.


A firm is expected to pay dividends of 20p at the end of the year t=1. Dividends are
then expected to grow at 5%. The (risk adjusted) required rate of return for this firm is

K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition

11%. What would you expect its current market price to be? If the dividend payout
ratio is 60% what would you expect the price earnings ratio to be?
Using the Gordon growth model:
P = D1/(R-g) = 20/(0.11-0.05) = 333.3p
D1 = pE1 = 0.6E1
Hence : E1 = D/0.6 = 33.3
Thus P/E1 = 333.3/33.3 = 10.


The dividends of company-X are expected to grow at the constant rate of 5% p.a.
from now on. The last dividend has just been paid and was $1.80 per share.
(a.) Given the business risk of company-X investors require an average rate of return
on the stock of ER = 11% p.a. Show that the fair value of this share is $31.50.
The current market price of the share is $28. As a speculator should you buy or
sell this share? What are the risks involved in your strategy?
(b.) What would you have done if the market price had been $36 (rather than $28)?
(c.) Suppose share-A has a market price of $28 and another share-B (of a firm in the
same industry sector) has a market price of $36 and both have the same fair
value calculated in (a). They are both mispriced because other traders have not
yet correctly recognised the true profit potential of each of these firms. How can
you speculate on these two shares while largely insulating your strategy from any
general fall in all shares (i.e. the whole market or market risk)?
(d.) To simplify the calculations, assume that general economic conditions deteriorate
(because of a rise in interest rates by the Central Bank) and both the market price
of A and B fall by $1, which simply reflects the fall in fair value (by $1) of both
shares (i.e. the rise in interest rates has raised the discount factor for both firms
and hence the fair value falls by $1). What happens if you have to close out
your positions in A and B immediately after this general fall in prices (and hence
cannot wait for any miss-pricing to be corrected) ?

Gordon Growth Model:

Fair (Correct) Value of share V = D0 (1+g) / (R-g) = 1.80 (1.05) / (0.11-0.05) = $31.50
If P = $28 and V = $31.50 then the share is undervalued by $3.5 (about 11%). You
should buy the share today at P = $28. If V remains unchanged over say the next
week, then as more traders notice the share is undervalued, they too will purchase the
share. This will push the share price up towards its fair value of $31.5 and if you got in
fast you might then close out your position by selling at a price close to $31.5 by the
end of the week. The danger is that the company announces some bad news over
the next week (e.g. profits this year will be lower than previously forecast because we
have not had our option accepted by MGM on our new film Harry Potter and the Money
Making Machine and the pilot cost a lot to make). This is known as idiosyncratic or
specific risk as it affects only this firm (or at most a small group of film/movie
companies). This would immediately lower forecasts of future dividends for this firm
and hence V might fall to $26 and now you are left currently holding an overvalued
share. (For an example of market risk see below)


If the current quoted market price is P = $36 and V = $31.50 then the share is
overvalued. You expect the actual price to fall towards the fair value. Hence, you
would short sell the share, in the hope that if your calculation is correct, you will be able
to buy it back at a lower price in the future and return the original share to your broker.


To minimise risk you should (short) sell a share which is overvalued (i.e. P > V) and buy
another which is undervalued (i.e. P < V). Then, if there is a change in the overall

K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition

market (i.e. all shares prices fall or rise by 10%) your position long+short is less risky
than either position taken individually.
Consider a general price fall. You are long share-A (PA = 28, VA = $31.5) which is initially
miss-priced by $3.5. After the general price fall PA = 27, VA = $30.5 and if you have to
immediately close out, you will lose $1. This is the danger in just holding the under priced
share its price could fall. Note that after the general price fall, the miss-pricing is still $3.5
its just that here you cannot hang on long enough to profit from this miss-pricing.
Suppose you had also initially short sold share-B. Then when there is a general market fall,
its price also falls by $1 (as does its fair value, V). But if you are forced to immediately close
out, you can buy back share-B at $1 below the price you initially sold it for and make $1 profit.
So if you are long+short you have removed much of the risk compared with holding just
(either) one of the mis-priced shares. This is a simple long-short hedge fund strategy.
If the two assets are perfect substitutes as we finance people say at dinner parties (and then
dont get invited back again), then this means that they always fall or rise by the same amount
no matter what - and the long-short arbitrage is then totally riskless. However, the latter
condition is rarely met in practice while you can find shares which move together when the
whole market moves, it is much more difficult to find 2 shares whose prices move together in
all states of the world (e.g. consider shares in 2 premier football clubs and one of the players
on only one of the teams breaks his leg the two share prices would move differently this is
specific risk again).
The above scenario holds if we had assumed a general market rise in prices.
Futures contracts can also be used to offset any general market risk in a portfolio of stocks
formed by stock picking - this is not dealt with here.

K. Cuthbertson and D. Nitzsche (2008) Investments, J. Wiley, 2nd edition