(4) EQUITY VALUATIONS & CAPM

Core Reading

• ME, Ch 13 or M Ch 7
• BD Ch10-11
• Fama, E. and French, K. R. (2004). The capital asset pricing model: theory and evidence, Journal of
Economic Perspectives, 18 (3), pp25 - 46.

Pricing Common Stock

• Stockholders own a part of the corporation equal to the percentage of outstanding shares they
own
• Gives them rights:
o Right to vote
o Residual Claimant of all cash flows remaining after all claims against the firm have been
satisfied
§ Get paid after debt payments
o Dividend payments from the profit left over (usually every quarter)
o Right to sell stock
Valuing of stock is equal to the present value of all future cash flows that the stock will generate
(dividend payments + value of stock at future time of sale)

Generalised Dividend Valuation Model

Purchasing a stock:
• Claim part ownership
• Riskier than bonds (less guarantee you will get your investment back)
• The investment will last for infinity (assuming the company does not shut down)
• Equity investments pay out dividends from the profit the company makes
o Not fixed like coupon payments

Consider the price of common stock:

• PN: the sale price of the stock at future period N

• Dt: dividend paid at the end of year t
• ke: the required return on equity

Consider when N is infinite:

• Holding the stock forever means the denominator becomes infinitely large and so the value of the
fraction becomes zero, so it is just the sum of all dividend payments
o Need to discount the future dividends by the required rate of return

o
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Gordon Growth Model

Firms aim to increase dividend payments in the long run, hence we can assume that dividends grow
with a constant rate (g < ke):
• D0: the most recent dividend paid
• g: expected constant dividend growth rate
• ke: required rate of return

Assumptions/Challenges of the Valuation

1. Assuming dividends continue growing at a constant rate and forever
a. Errors in discounting, in the long run, become smaller with increasing dividend growth
b. Difficult to foresee the future, as there are deviations and dividend payments can differ
c. Growth rates are not always constant or increasing
2. Growth rate is assumed to be less than the required return
a. Because if growth rates were higher than the rate demanded by stockholders, firms would
grow impossibly large

Example
Suppose one uses Gordon Model to evaluate stock price with dividends growing at a rate of 10.95%.
The last dividend paid was $1, and the required rate of return is 13%.

Answer = 1(1+0.1095)/(0.13-0.1095) = £54.12

Capital Asset Pricing Model (CAPM)

• E(ri): expected return on the asset i
• rf: risk-free return
• E(rm): expected return on the market m
• 𝜷i: sensitivity of asset i’s return to the market return
E(𝑟! ) = 𝑟" + 𝛽! [E(𝑟# ) − 𝑟" ]
• The expected return is equal to the risk-free rate + the risk premium
o The risk-free rate is the expected return for the value of time
o The risk premium = Loading * Market Risk Premium

Example
Suppose the market return is expected to be 14%, stock ABC has a beta of 1.2, and the risk-free (e.g.
Treasury bill) rate is 6%. The CAPM would predict the expected return to be:

E(rABC) = 6% + 1.2*(14%-6%) = 15.6%

Beta and Security Market Line

𝛽: the sensitivity of asset returns to the overall market returns
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• E.g. if 𝛽 = 1.5
o For every 1% increase in market returns, the stock’s
return is expected to increase by 1.5%
• Security market line: the expected return of the stocks is a
linear function of their beta with the market

CAPM Valuation: Systematic Risk & Diversification

E(𝑟! ) = 𝑟" + 𝛽! ,E(𝑟# ) − 𝑟" - + 𝑢!

• CAPM rewards systematical risk components only

Portfolio Choice & Mean-Variance Analysis

• Mean-variance analysis on portfolio selection problem assumes that the expected return and risk
of a portfolio are measured respectively by the mean and variance of the portfolio’s return.
• E.g. Portfolio ‘P’ consisting of assets A & B
o Weights of Shares: Wa + Wb = 1
o Expected return:
§ E(rp) = WAE(rA) + WBE(rB)
o Risk/Volatility:
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Mean-Variance Analysis: Efficient Frontier

• The risk of the portfolio can be reduced by adding more assets.
• Efficient Frontier: portfolios with the highest expected returns and lowest volatility
o Sharpe Ratio =

Mean-Variance Analysis & CAPM: Capital Market Line

• By introducing a risk-free asset, investors choose their optimal portfolio to combine the risk-free
asset with an efficient risky portfolio.
• Capital Market Line: under CAPM, all investors optimally would hold some combination of risk-
free security and the market (efficient) portfolio.

CAPM Assumptions & Extensions

Comes with restrictive assumptions:
• Investors choose a portfolio based on the mean and variance of returns
• Investors are rational and risk-averse
• Investors all invest for the same period
• Investors have homogenous expectations
• Investors can have unlimited short-sale positions on the risk-free assets
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• Markets are competitive and frictionless

One can check the systematic existence of the abnormal return:
• On average:

• From regression:

Multi-Factor Models
• In multifactor models (Arbitrage Pricing Theory), CAPM and hence the market risk can be thought
as one of the risk factors for the required return.