Financial Instruments and Their Markets

Note # 6

Narat Charupat
Winter 2021

Outline of This Note

 In this note, we will talk about (i) the common
approaches used to value common stocks and (ii) stock
indices.

‒ Valuations by comparables

‒ Dividend Discount Models

‒ Price-weighted stock index

‒ Value-weighted stock index

1. Fundamental Analysis (Valuation)

 Fundamental analysis (or fundamental valuation) is an

approach used by fundamental analysts to estimate
stocks' fair market values.

‒ They use info on the economy/market to forecast the

earnings/profitability of companies.

‒ Then, based on the earnings/profitability, they use models to

come up with stocks' values.

 We will talk about these various models.

1.1. Valuation by Comparables

 This approach uses current and predicted values of

various items in a company's financial statements.

‒ These values are then compared against benchmarks for

"similar" companies.

‒ The idea is that "similar" companies (e.g., same industry,

same size, same growth potential, etc.) should be valued the
same.

‒ This approach is simple, and should be used as a

secondary/confirmation tool, rather than a primary tool.
 There are various measures used in the comparison,
commonly:

‒ Price/Earnings (P/E) ratio (forward or trailing)

‒ Price/Book Value (P/B) ratio

‒ Price/Sales (P/S) ratio

‒ Price/Earnings to Growth (PEG) ratio

 P/E ratio (aka price multiple or earnings multiple):

P Market Price per Share

=
E Earnings per Share

‒ It can be interpreted as the amount of time the company has

to generate the same earnings in order to pay back the price.

‒ Two common types of PE ratio:

 Trailing P/E
 Forward P/E
‒ For trailing P/E, we use EPS from the most recent 4 quarters
or most recent 12 months (i.e., TTM).

‒ For forward P/E, we use estimated EPS for the next 4

quarters or next 12 months.

 Estimated EPS usually comes from the company's earnings guidance.

 Companies may have incentives to provide incorrect guidance.

‒ The two methods can produce significantly different results

(e.g., for fast-growing companies)

‒ For companies with no or negative earnings, most

practitioners say that P/E ratio is not defined.

‒ A stock's P/E ratio varies according the stage of its life (e.g.,
Microsoft).

‒ A high P/E can mean the stock is overvalued or has a high

expected growth rate, compared to other stocks.
S&P 500 Historical P/E Ratio (as of March 2021)
‒ Another method for calculating P/E i's Cyclically Adjusted P/E
(CAPE).

 Also known as Shiller's P/E.

 The denominator is the average earnings over the past 10 years,
adjusted for inflation.
 This method smooths out the effects of business cycles and unique
events.
 So it provides a better picture of the company's earning ability.
Lululemon P/E Ratio in 2016
 P/B ratio:

P Market Price per Share

=
B Book Value per Share

Total Assets − Total Liabilities

BVS =
No. of Shares Outstanding

‒ Normally, companies have P/B ratios >1.

‒ However, companies that are in financial distress or

bankruptcy can have P/B ratio <1.

‒ For firms with negative earnings (i.e., undefined P/E), P/B

ratio can be used instead (if book values are positive).

‒ The nature of balance sheets vary across industries.

‒ Companies with lots of intellectual property will have low book

values (e.g., technology, pharmaceutical).

‒ Studies show that P/B ratios can explain stocks' returns (e.g.,
FF 3-factor model).
 P/S ratio is calculated by dividing the stock's market
price by its revenue per share.

‒ The revenue can be for the most recent 12 months (trailing)

or the next 12 months (forward).

‒ P/S can be misleading because firms with positive revenues

may be unprofitable.

‒ So it is useful for (i) comparing early-stage firms (that have

some revenues but no profits); or (ii) firms in the same
industry.
 PEG ratio is calculated by dividing its P/E ratio by the
annual growth rate of its EPS.

‒ The P/E ratio used in the calculation can be forward or

trailing.

‒ The annual growth rate of EPS is typically the expected real

growth rate for the next year or next 5 years.

Ex. Firm A's market price is $50 per share. Its trailing EPS is $2, and
previous year's EPS is $1.80. Firm B's market price is $80 per share.
Its trailing EPS is $2.50, and previous year's EPS is $2.10.
 The P/E ratio of any
company that's fairly
priced will equal its growth
rate...
1.2. Dividend Discount Models

 Dividend Discount Models are one of the common

approaches practitioners use to value stocks.

‒ When an individual buys a stock, he/she receives dividends

and then the sale price at the end of the holding period.

‒ This leads to the basic dividend discount model.

𝑑 𝑑 𝑑
𝑃 = + +⋯= .
1+𝑟 1+𝑟 1+𝑟

 So in this basic model,

‒ Stock price is the PV of an infinite stream of expected

dividends.

‒ To obtain expected dividends, once can make assumptions

about expected growth rate in earnings and payout ratio.

‒ The discount rate is the stock's required rate of return, which

reflects the risk of the stock (CAPM or factor models).

‒ We can also allow for the discount rate to vary with time to
reflect changes in interest rates or risk premium.
 It is difficult to predict an infinite stream of dividends.

‒ Several versions of the model have been developed based on

different assumptions about how dividends evolve.

 Constant-growth model

 Two-stage model

 Three-stage model

1.2.1. The Constant-Growth Model

 The constant-growth (Gordon growth) model:

‒ Dividends are assumed to grow at a constant rate forever.

𝑑 1+𝑔 𝑑 1+𝑔 𝑑 1+𝑔 𝑑

𝑃 = + +⋯= = .
1+𝑟 1+𝑟 𝑟−𝑔 𝑟−𝑔

Ex. ABC Company has just paid its annual dividend of $2 per
share. The dividend is expected to grow at a constant rate of 4%
per year indefinitely. The stock's expected return is 10% p.a.
What should be the price of the stock?
 The model is appropriate for firms that are growing at a
stable rate.

‒ The firm's earnings are expected to grow at the same rate.

‒ The assumed growth rate cannot be greater than the growth

rate of the economy.

 The assumption of constant-growth dividends is difficult

to meet in practice.

‒ The firm's earnings can fluctuate over time.

‒ The model can be used as long as the average growth rate is

close to the constant rate. Why?

 The mathematical effects of using the average growth

rate rather than a constant growth rate are small.

 Firms tend not to make abrupt changes in dividends.

 The model is very sensitive to the growth rate

assumption.
 The model will underestimate the value of firms with low
dividend payout ratio.

‒ These firms have to be handled in a different way.

1.2.2. The Two-Stage Model

 The two-stage model allows for two stages of growth,

each with a different rate.

‒ Typically, growth is high in the first stage before stabilizing at

a lower rate in the second stage.

‒ But the model also works with the reverse case.

𝑃 = PV(1st-stage dividends) + PV(2nd-stage dividends)

= PV + PV
 𝑑 1+𝑔 𝑑 1+𝑔 𝑑 1+𝑔
PV = + + ⋯+ .
1+𝑟 1+𝑟 1+𝑟

𝑑 1+𝑔 1+𝑔 𝑑 1+𝑔 1+𝑔

PV = + + ⋯.
1+𝑟 1+𝑟

𝑑 1+𝑔 1+𝑔 𝑔 −𝑔
𝑃 = PV + PV = 1− .
𝑟−𝑔 1+𝑟 𝑟−𝑔

Ex. Suppose the growth rates of ABC's dividends (in the

previous example) are 6% p.a. for the first 10 years, and then
settle down to 3% p.a.

 Practical issues:

‒ It is not easy to define the length of the first stage.

‒ It would be more realistic to assume that the growth rate

changes gradually through time.

‒ The required rates of return can be different between the two

stages.
2. Stock Indices

 A stock index is a measure of changes in a stock market.

‒ It consists of a hypothetical portfolio of stocks representing

the whole market or a segment thereof.

‒ Each index has its own calculation methodology.

‒ Changes in it are more important than its numeric value.

‒ Indices are not tradeable. But there are funds that track
them.

Major Stock Indices

Name Market No. of Stocks Weighting Method

Dow Jones Industrial
US 30 Price-weighted
Average
S&P 500 US 500 Market cap-weighted

Nasdaq Composite US 2,500 Market cap-weighted

FTSE 100 UK 100 Market cap-weighted

Euro Stoxx 50 Europe 50 Market cap-weighted

Nikkei 225 Japan 225 Price-weighted

Hang Seng Hong Kong 50 Market cap-weighted

Shanghai Composite China > 1,500 Market cap-weighted

21 developed markets
MSCI EAFE excluding US and > 900 Market cap-weighted
Canada
Russell 2000 US 2,000 Market cap-weighted
2.1. Index Constructing Methodologies

 We will talk about three different methodologies used in

constructing an index:

‒ Price-weighted index

‒ Value-weighted index

‒ Equally weighted index

2.1.1. Price-Weighted Index

 A price-weighted index is constructed based on the

prices of the constituent stocks as follows:

‒ Step 1: Determine which stocks (how many) to include in the

index.

‒ Step 2: Sum up the current prices of those stocks, and then

divide the result by a number known as the divisor.

On the day on which the index is calculated for the first time,
the divisor can be set to any arbitrary value (typically set
equal to the number of stocks in the index).

Ex. Suppose we are at the end of day 𝑡. The closing price of

stock 𝑖 is 𝑃 , . The index level is:

𝑃,
𝐼 =
𝐷𝑖𝑣

where 𝐷𝑖𝑣 is the divisor on day 𝑡, and 𝑁 is the number of stocks

in the index.
Ex. Suppose we want to start an index consisting of the following
5 stocks:

Stock Price ($)

3M 80

American Express 55

Coca-Cola 45

IBM 80

Merck 35

Ex. Suppose on the following day, the prices become:

Stock Price ($)

3M 85

American Express 60

Coca-Cola 48

IBM 85

Merck 40
 The divisor has to be adjusted if one or more of the
following actions occur:

‒ A stock split or reverse split in one or more of the constituent

stocks

‒ A stock dividend on one or more of the stocks

‒ A change of composition

Ex. Suppose that at the end of the start date, Coca-Cola has a 3-
for-1 stock split.

 In a price-weighted index, higher-priced stocks tend to

have a greater impact on the index than lower-priced
stocks.

Ex. Consider our 5-stock index on a particular day. Suppose that

the divisor is 5.0.

Stock Price ($) Current Weight

3M 85 27.42%

American Express 60 19.35%

Coca-Cola 45 14.52%

IBM 90 29.03%

Merck 30 9.68%
 Suppose the next day, IBM goes up by 20% (Case A). What if
Merck goes up by 20% (Case B)?

Stock Case A - Price ($) Case B - Price ($)

3M 85 85

American Express 60 60

Coca-Cola 45 45

IBM 108 90

Merck 30 36

 A price-weighted index is like a portfolio that invests in

one share of each company.

 Examples of price-weighted indices:

‒ Dow Jones Industrial Average (DJIA)

‒ Nikkei 225

 Price-weighted indices is easier to manipulate then other

types.
2.1.2. Market Cap-Weighted Index

 A market-capitalization-weighted (or value-weighted)

index is a stock index whose constituents are weighted
by their market capitalization.

‒ Stocks with higher market cap have a larger impact on the

index.

‒ Examples are S&P500, Nasdaq Composite, FTSE 100, Hang

Seng, MSCI EAFE, SSE Composite.

 A value-weighted index is constructed based on the

market cap of the constituent stocks as follows:

‒ Step 1: Determine which stocks (how many) to include in the

index.

‒ Step 2: On the start date (or base date), assign an arbitrary

value for the index (typically 100).

‒ Step 3: From that point on, the index value on any other day
is calculated based on the change in the total market cap of
the constituent stocks
 1 ∑ 𝑃, 𝑄 ,
𝐼 = ,
𝐷𝑖𝑣 ∑ 𝑃, 𝑄 ,

where 𝑃 , = market price of stock 𝑖 on day 𝑡

𝑃 , = market price of stock 𝑖 on day 𝑏 (base date)

𝑄 , = number of shares of stock 𝑖 outstanding on day 𝑡

𝑄 , = number of shares of stock 𝑖 outstanding on day 𝑏

𝐷𝑖𝑣 = value of the divisor on day 𝑡

Ex. Consider the same 5 stocks on the base date.

Stock Price ($) No. of shares Market Cap Weight

(million) ($ million)

3M 85 780 66,300 14.19%

American Express 60 1,250 75,000 16.06%

Coca-Cola 45 2,425 109,125 23.36%

IBM 85 1,635 138,975 29.75%

Merck 35 2,220 77,700 16.63%

 Suppose on the following day, the prices and number of shares are:

Stock Price ($) No. of shares Market Cap Weight

(million) ($ million)

3M 90 780 70,200 13.80%

American Express 65 1,250 81,250 15.97%

Coca-Cola 50 2,425 121,250 23.84%

IBM 90 1,635 147,150 28.93%

Merck 40 2,220 88,800 17.46%

 There is no need to adjust the divisor in case of stock

splits.

 The divisor has to be adjusted if there is a change in the

constituents.

Ex. Suppose that Merck is replaced with GE, which has a price of
$50 and 10,500,000,000 shares outstanding.
 Suppose on the following day, the prices and number of shares are:

Stock Price ($) No. of shares Market Cap Weight

(million) ($ million)

3M 90 780 70,200 7.43%

American Express 65 1,250 81,250 8.60%

Coca-Cola 50 2,425 121,250 12.83%

IBM 90 1,635 147,150 15.57%

GE 50 10,500 525,000 55.56%

 A market cap-weighted index is like a portfolio that

invests in each company according to its relative market
cap.
2.3. Equally Weighted Index

 An equally weighted index gives the same weight (or

importance) to each stock in the index.

 Several popular indices have an equally weighted

version; e.g.,

‒ S&P500 Equal Weight

‒ Nasdaq 100 Equal Weighted

 A equally weighted index is constructed based on the

prices of the constituent stocks as follows:

‒ Step 1: Determine which stocks (how many) to include in the

index.

‒ Step 2: On the start date (or base date), assign an arbitrary

value for the index (typically 100).

‒ Step 3: From that point on, the index value on any other day
is calculated based on the returns of the constituent stocks.
 1 𝑃,
𝐼 =𝐼 .
𝑁 𝑃,

Ex. Consider the same 5 stocks on the base date.

Stock Price ($)

3M 85

American Express 60

Coca-Cola 45

IBM 85

Merck 35
 Suppose on the following day, the prices are:

Stock Price ($) 1 + One-Day

Return

3M 90 1.0588235

American Express 65 1.0833333

Coca-Cola 50 1.1111111

IBM 90 1.0588235

Merck 40 1.1428571

2.2. Price Return Index vs. Total Return Index

 There are primarily two versions of any stock index.

‒ Price return

‒ Total return

 A price return index:

‒ only considers price movements (capital gains or losses)

‒ and so does not truly reflect the returns from holding the
index.
 A total return index:

‒ includes both price movements and cash distributions (e.g.,

dividends)

‒ assumes that all cash distributions are reinvested into the

index

‒ provides a more accurate measure of performance

 Most stock indices calculate both versions.

‒ But the version commonly reported is the price return version

(e.g., DJIA, S&P 500)

‒ Once major exception is DAX (Germany).

Ex. Consider the 5 stocks. Suppose that the price return index on
this day is 100, and the total return index is 150.

Stock Price ($) No. of shares Market Cap (S)

3M 85 780,000,000 66,300,000,000
American Express 60 1,250,000,000 75,000,000,000
Coca-Cola 45 2,425,000,000 109,125,000,000
IBM 85 1,635,000,000 138,975,000,000
Merck 35 2,220,000,000 77,700,000,000

Suppose on the following day, the prices and number of shares are:

Stock Price ($) Div. No. of shares Market Cap (S)

3M 90 2 780,000,000 70,200,000,000
American Express 65 - 1,250,000,000 81,250,000,000
Coca-Cola 50 - 2,425,000,000 121,250,000,000
IBM 90 1 1,635,000,000 147,150,000,000
Merck 40 - 2,220,000,000 88,800,000,000