48 views

Uploaded by daongocphap

- A - Basic Concepts in Portfolio Analysis
- Corporate Finance
- Project Report Ashish
- 1 Bed Semi Detached with £16,750 Equity and Cashflowing by £192 - KA11
- FM10e_ch08
- ipm ch01
- Performance Mutual Funds
- Chapter 08 Risk & Return
- Daily Commodity Report 3 April
- Proper Event Study Analysis 2009
- 128-Equity Valuation - Models From Leading Investment Banks (the Wiley Finance Series)-Jan Viebig
- M08_GITM4380_13E_IM_C08.pdf
- EQUITY-MARKET-LATEST-NEWS-BY-THEEQUICOM-FOR-TODAY-11-MAR-2014
- Copy de Enclosure 8.xls
- joshua final stock track report
- Mary Buffett, David Clark - Buffettology 39
- Matching Type
- exam Sec 2
- Capital Market & Portfolio Management
- CAPM BETA

You are on page 1of 5

Chapter 14 : Stock Valuation and the EMH

Q1

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?

A1

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

years time is :

[1]

P=

D3

P3

D1

D2

+

+

+

2

3

(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 :

[2]

P3 =

D5

D4

+

+ ....

(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.

Q2

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

A2

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

portfolio:

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

Q3

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

rational way?

A3

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

by :

P=

D1

Rg

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.

Q4

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 ?

A4

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).

Q5

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?

A5

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.

Q6

Cents

EPS (Earnings per share)

Dividends per share

2008

10

4

2009

12

4.8

2010

15

6

2012 of 26 cents. Earnings growth thereafter is expected to be 10%.

(a)

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

3

(b.)

(c.)

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

BubbleStock.

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)?

A6

(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)

Var(RBubble)

(RBubble)

= (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.

Q7

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

4

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?

A7

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.

Q8

A8

(a.)

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) ?

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)

(b.)

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.

(c.)

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

5

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.

- A - Basic Concepts in Portfolio AnalysisUploaded bymanishbyte
- Corporate FinanceUploaded byjblackred
- Project Report AshishUploaded byDeepak Agarwal
- 1 Bed Semi Detached with £16,750 Equity and Cashflowing by £192 - KA11Uploaded byMark I'Anson
- FM10e_ch08Uploaded byjawadzaheer
- ipm ch01Uploaded byAbdullah Al Rabi Taron
- Performance Mutual FundsUploaded byChristopher Paul
- Chapter 08 Risk & ReturnUploaded byyawar86
- Proper Event Study Analysis 2009Uploaded bykeladimanis
- Daily Commodity Report 3 AprilUploaded byEpicresearch
- 128-Equity Valuation - Models From Leading Investment Banks (the Wiley Finance Series)-Jan ViebigUploaded byveryhman
- M08_GITM4380_13E_IM_C08.pdfUploaded byGolamSarwar
- EQUITY-MARKET-LATEST-NEWS-BY-THEEQUICOM-FOR-TODAY-11-MAR-2014Uploaded byDewayne Puckett
- Copy de Enclosure 8.xlsUploaded byDarpan Goel
- joshua final stock track reportUploaded byapi-315319707
- Mary Buffett, David Clark - Buffettology 39Uploaded byAsok Kumar
- Matching TypeUploaded byDrei Toledana
- exam Sec 2Uploaded bytomjerrybeck
- Capital Market & Portfolio ManagementUploaded byRupal Rohan Dalal
- CAPM BETAUploaded byVimalanathan Vimal
- CAPM y Efficient MarketsUploaded bypxlaga
- cfpacket1Uploaded byCharles Chen
- Axis Mf ProjectUploaded bySyed Munni
- AlphaStock: A Buying-Winners-and-Selling-Losers Investment Strategy using Interpretable Deep Reinforcement Attention NetworksUploaded byGaston GB
- Dcf ChecklistUploaded byKP
- sipUploaded byAnish Tiwary
- Analysis of FsUploaded byimroz_alam
- Investments+Quiz+3-Key-1.docxUploaded byHashaam Javed
- DecentralizationUploaded byDeopito Barrett
- mol 525e course analysis summaryUploaded byapi-306760073

- Financial Performance of Banking Sector in Pakistan (A Study of Listed Banks on Karachi Stock Exchange)Uploaded byTI Journals Publishing
- pvUploaded byPratheep Gs
- ADL-03-Ver1+Uploaded bySanjeev Kumar
- Class12 Accountancy1 Unit03Uploaded byArunima Rai
- Hotel Asset Management 2Uploaded byNguyễn Thế Phong
- Where's the Bar - Introducing Market-Expected Return on InvestmentUploaded bypjs15
- CFIN_09 Capital BudgetingUploaded bymohitkapoor
- Financial MathematicsUploaded byKr Prajapat
- ajit newUploaded byanon_925306181
- BIMB PresentationUploaded byAhmadNajmi
- Ration Analysis of M&S.xlsxUploaded byRashid Jalal
- Financial Statement and Ratio AnalysisUploaded byAsad Ali
- Reference Form 2015Uploaded byMillsRI
- Bain & Co. Writing Style Compilation (Updated)Uploaded byvinod
- Vino Maestro LtdUploaded byvalentinlenium2094
- Financial Management MaterialUploaded byNoorunnisha
- The Surprising Alpha From Malkiel’s Monkey and Upside-Down Strategies Arnott JoPM 2013Uploaded byGuido 125 Lavespa
- ROW15-proceedings.pdfUploaded bymikaelcollan
- riskfinUploaded bypostscript
- Exam June 2009 SolutionsUploaded byesa
- Calculating Geometric MeansUploaded byThuy Ngoc Tran ◔̯◔
- Building Minds for Building Wealth v2.2Uploaded bytrignal
- Analysisonfinancialperformanceofrsrm 150110115528 Conversion Gate01Uploaded byadithv
- Cute Exam Paper Set 4Uploaded byBudak Baru Belajar
- 8624-1 Spring 2018Uploaded byMinahail Shuja
- StudyGuide_Chapter3Uploaded byAdil Anwar
- Investment Function Jannatul FerdusUploaded byInvincible Raisul
- testbank.docxUploaded byChrence Go
- FM FINALUploaded bykarthika kounder
- The Capital Asset Pricing ModelUploaded byYoujune Hou