Lecture4 2017-18 Upload

Lecture 4: Stock valuation and stock portfolios
BEAM047A Fundamentals of Financial

Management
Panagiotis Couzo↵
Autumn Term, 2017/18

Putting things into perspective
I In Lecture 3, we discussed fixed-income securities.

I In the next few lectures, we will study stocks:
I Lecture 4 introduces stock valuation and some basic facts on stock
returns;
I Lecture 5 discusses how to choose a stock portfolio;
I Lecture 6 focuses on determining a stock’s expected return.
Outline
Equity securities
Stock Valuation
Measures of risk and return
Risk and return of portfolios
E↵ects of diversification
Equity securities
Outline
Equity securities
Stock Valuation
Equity securities
Equity
I Companies finance their operations by issuing either debt or equity

securities.
I Although debt is a liability of the issuing company, equity is not.
I In fact, the company is not contractually obligated either to repay
the amount received by shareholders nor to make periodic payments
to them.
I Instead, shareholders hold securities that indicate ownership in a
corporation and represent a (residual) claim on the corporation’s
assets and earnings.
I These securities are shares of a company’s equity or stock.
Equity securities
Equity securities
I Main features of equity securities:

I Voting rights
I Right to dividends
I Limited liability
I Dividends are cash flows that are generated by stocks. They are:
I Discretionary (contrary to debt payments)
I Not tax-deductible (not considered expenses; contrary to debt
payments)
I Generally paid in regular intervals (quarterly in the US; semiannually
in the UK)
Stock Valuation
Outline
Equity securities
Stock Valuation
Stock Valuation
Stock returns
I For simplicity, assume a stock that pays a single dividend between

dates 0 and 1, at date 1.
I Denoting by Pt the stock price at time t and by Dt the dividend
payment at time t, the return of the stock satisfies
D1 P1 P0
P0 (1 + r ) = D1 + P1 () r = + (1)
P0 P0
I Hence,
⇣ ⌘ the one-period stock return ⌘ of the dividend yield
⇣ is a sum
D1 P1 P0
P0 and the capital gain/loss P0 .
Stock Valuation
Stock returns (generalised)
I Generally, in order to calculate the return between times 0 and T :

I Denote by X0 the amount invested in the stock at date 0;
I If there are any dividend payments between the two dates, assume
they are reinvested in the stock (extra shares are purchased).
I Denoting by XT the value of the investment at date T , the
cumulative return (RT ) for the period is equal to
XT X0
X0 (1 + RT ) = XT () RT =
X0
Stock Valuation
Stock valuation
I Going back to the one-period return equation (1), it is more

accurate to express it as
E0 [D1 ] + (E0 [P1 ] P0 )

E0 [r ] =
P0
where E0 [i] represents the expectation of i at t = 0.

I Rearranging the equation with a focus on the share price today (P0 )
yields
E [D1 ] + E [P1 ]
P0 =
1 + E[r ]
I This formulation points out that the stock price represents the
Present Value of next year’s expected cash flows, where the discount
rate is the stock’s “expected return”.
Stock Valuation
Stock valuation (two periods)
I Notice that the stock price today, P0 , depends on its expected price
one period from now, P1 .
I For exposition purposes, let’s drop the expectation factors E (but
keep in mind they are still there!).
I Assuming that the expected return remains constant, we can use the
same formula to determine the stock price one period from now:
D2 + P 2
P1 =
1+r
I Plugging back into the previous formula yields
D1 D2 P2
P0 = + 2 + 2
1+r (1 + r ) (1 + r )
Stock Valuation
Stock valuation (multiple periods)

I We can keep substituting future (expected) prices with the present
value of subsequent (expected) dividends and future prices.
PT
I Under the “no-bubbles” assumption, i.e. lim = 0,
T !1 (1 + r )T
T
X Dt
D1 D2 Dt
P0 = + 2 + ... + t + ... = t
1+r (1 + r ) (1 + r ) t=1
(1 + r )
I In (other) words: The price of a stock is the Present Value of

expected dividends discounted at the stock’s expected return.
I Like all Present Values, stock prices also depend heavily on the
discount rate.
I Most of the next two lectures is devoted to the understanding and
determination of any asset’s “expected return”.
Stock Valuation
Constant growth model
I Assume that dividends are expected to grow at a constant rate g ,
D t = Dt 1 (1 + g )
I The valuation formula becomes a growing perpetuity of dividends

and
D1
P0 =
r g
I Note that this implies that the stock price also grows at the same
constant rate
D2 D1 (1 + g )
P1 = = = P0 (1 + g )
r g r g
I This is known as the constant growth valuation formula.
Stock Valuation
Constant growth model (parameters)
I Where can we find values for these parameters?

I Expectations of next year’s dividend D1 can be found in financial
sources, and r will be discussed in future lectures.
I How can we estimate g ?
I Apart from the obvious historical and forecasted growth of dividends,
g can be estimated using information on a company’s operations,
and especially the reinvestment of earnings in the business.
Stock Valuation
Dividend growth rate

I If a firm has no new investment opportunity and pays out its full
earnings to shareholders, the dividend growth rate can only be zero
and the firm does not grow in value.
I However, if a firm can pursuit new projects, it might decide to retain
some of its earnings for reinvestment, and pay out the remainder to
shareholders.
I If the project’s return on equity and the firm’s retention ratio (the
complement of the payout ratio, p) remain constant, dividends are
expected to grow at a rate equal to the product of the two:
g = (1 p) ⇤ ROE
I A word of notice: this formula does not imply that a firm can
increase its growth by simply decreasing the payout ratio, as this
could a↵ect the ROE at the same time (it is fair to assume that
there is a finite number of high return projects that wait to be
financed at any point in time).
Stock Valuation
Present Value of Growth Opportunities: An example
I Suppose the expected return of Food Inc. is 10% and earnings per
share are expected to be $3.
I The company pays out 40% of its earnings each year in dividends,
while the rest is invested in projects generating 15% annual return.
What is the current value of Food Inc.?
D1 = $3 ⇤ 0.4 = $1.20
g = (1 0.4) ⇤ 0.15 = 0.09
$1.20
P0 = = $120
0.10 0.09
I What would your answer be if Food Inc. was paying out all earnings
as dividends?
Stock Valuation
Present Value of Growth Opportunities: An example

(cont’d)
I If Food Inc. paid all earnings out as dividends, its share price would
be
$3
Pno growth = = $30
0.10
I The latter price represents the value of assets in place, and the
di↵erence between the two prices ($120 $30 = $90) represents the
value of Food Inc.’s growth opportunities:
Earnings1
P0 = + PVGO
r
Outline
Equity securities
Stock Valuation
Risk in finance
I Risk is defined as the

uncertainty over the amount
and/or the timing of future
cash flows from an
investment.
I Some investments can be
viewed as virtually risk-free
(e.g. an investment in a
short-term Treasury bill).
I However, most investments
are risky. . .
Value of $100 invested at the end of 1925
Source: Berk, J. and P. DeMarzo, 2014. Corporate Finance, 3rd (global) edition
Risk and return data
I Using historical returns for the period 1926-2011:

Investment Sample average Sample st. dev.
Small stocks 18.7% 39.2%
S&P 500 11.7% 20.3%
Corporate bonds 6.6% 7.0%
Treasury bills 3.6% 3.1%
I Basic fact: Riskier investments have higher returns on average.
A refresher in statistics
I Consider a data series X1 , X2 , . . . , XN .
I A measure of the average value of the series is the sample average:
X1 + X2 + . . . + XN
X =
N
I Two measures of the dispersion of the series around the average
value are the sample variance:
2 2 2
X1 X + X2 X + . . . + XN X
sX2 =
N 1
and the sample standard deviation:
q
sX = sX2
I The standard deviation is expressed in the same units as the data

series. It measures the “typical” distance of the series elements from
the average value.
A refresher in probabilities
I We can also define the expectation, variance, and standard deviation
in a probability sense, for a random variable Z .
I Suppose that Z takes values Z1 , Z2 , . . . , ZN with respective
probabilities p1 , p2 , . . . , pN .
I The expectation of Z is:
E[Z ] = p1 Z1 + p2 Z2 + . . . + pN ZN
I The variance of Z is:

2 2 2 2
X = p1 (Z1 E[Z ]) + p2 (Z2 E[Z ]) + . . . + pN (ZN E[Z ])
and its standard deviation:

q
= 2
X X
Statistics vs Probability definitions
I The sample statistics and probability definitions are related.

I Suppose that we roll a dice for a number of times and record the
data series of the outcomes.
I We can use the data series to compute the sample average, the
sample variance, and the sample standard deviation.
I Those will generally be di↵erent than the expectation (3.5), variance
(2.9167), and standard deviation (1.7078) of a dice roll using
probabilities.
I However, if the dice is rolled many many times, they will get very
close. If the dice is rolled “infinite” times, they will become equal.
I Law of large numbers: Sample statistics converge to their
probability counterparts as the sample grows.
Using statistics in finance
I Next year’s return can be viewed as a random variable. We can

estimate its
I expectation by the sample average;
I variance by the sample variance;
I standard deviation by the sample standard deviation.
I For the variance and the standard deviation, we can obtain quite
precise estimates using a sample of even one year (the most recent),
provided we use daily or weekly data.
I For expected return, we need to use as large a sample as possible, as
the estimates are quite imprecise.
An important clarification: realised vs expected returns
I Using past data, one can find that the average return of S&P 500
firms is 11.7%.
I Hence, an estimate of the expected return of S&P 500 firms is
11.7%.
I This does not mean that S&P 500 firms will have a return of 11.7%
next year.
I The return of S&P 500 firms next year will be the realised return.
Outline
Equity securities
Stock Valuation
Individual stocks vs indices
I Using historical returns for the period 1967-2009:

Sample average Sample st. dev.
Coca-Cola 14.7% 22.1%
Kodak 3.7% 30.0%
IBM 12.6% 29.8%
Disney 21.8% 40.1%
Xerox 8.3% 35.3%
S&P 500 11.7% 20.3%
I Although the sample standard deviation of the S&P 500 is smaller
than those of individual stocks, the sample average of its returns is
comparable.
Historical returns of stocks and indices
Source: Berk, J. and P. DeMarzo, 2014. Corporate Finance, 3rd (global) edition
Portfolios
I Let’s have a closer look at what happens when individual stocks (or
more generally assets) are combined in a portfolio.
I Consider n individual assets with a fraction wi of your wealth
invested in each asset i.
I This is an investment in a portfolio of n assets, where the fractions
wi are the portfolio weights.
Portfolio weights
I The sum of portfolio weights is by definition equal to one:

n
X
wi = 1
i=1
I Note that the above condition does not exclude negative weights nor
weights higher than one!
I A positive weight implies a positive quantity of the asset in the
portfolio (also called a long position).
I A negative weight implies a “negative” quantity of the asset in the
portfolio (also called a short position).
I Short positions are achieved through short sales, i.e. the sale of a
stock that we do not own.
A primer in short sales
I Timeline of short sale:

I Date 0: Borrow the stock from a broker
I Date 0: Sell the stock in the market
I Between dates 0 and 1: Compensate the broker for any dividends the
stock pays
I Date 1: Buy the stock in the market
I Date 1: Return the stock to the broker
I A short sale is profitable if the stock price goes down.
Portfolio returns
I The realised return of a portfolio is the weighted average of the

realised returns of the individual assets
N
X
RP = wi R i
i=1
I Similarly, the expected return of a portfolio is the weighted average

of the expected returns of the individual assets
N
X
E[rP ] = wi E[ri ]
i=1
Covariance and correlation

I Before expressing the variance of portfolios, a quick reminder on
covariances might be useful.
I The covariance is a measure of association between two variables.
I The sample covariance between two data series X and Y is
calculated as follows:
PN
Xi X Yi Y
Cov (X , Y ) = i=1
N 1
I A related measure of association is correlation:
Cov (X , Y )
Corr (X , Y ) =
sX sY
I Covariance ( XY ) and correlation (⇢XY ) can be defined for random

variables. Sample covariance and correlation are their estimates.
What do they reflect?
I The covariance and the correlation of two variables have the same
sign. They are
I positive, if X and Y tend to move to the same direction;
I zero, if X and Y are un(cor)related; or
I negative, if X and Y tend to move in opposite directions.
I The correlation is a number taking values between 1 and 1.
I A correlation
I equal to 1 indicates an exact linear relation with positive slope
between X and Y (perfectly positively correlated);
I equal to 1 indicates an exact linear relation with negative slope
between X and Y (perfectly negatively correlated).
Portfolio variance
I The variance of a portfolio can be viewed as the weighted average of

covariances between individual assets
N X
X N
2
P = wi wj ij
i=1 j=1
N
X N X
X N
= wi2 2
i + wi wj ij
i=1 i=1 j=1
j6=i
or equivalently
N X
X N
2
P = wi wj ⇢ij i j
i=1 j=1
An example
I You are considering investing $300 in Disney and $100 in IBM.
I The weights of each stock in the portfolio are
300 3
wD = =
400 4
and
100 1
wI = =
400 4
I Assuming average past returns of 21.8% and 12.6% respectively, the
expected return of the portfolio is
⇥ ⇤ ⇥ ⇤ ⇥ ⇤
E r P = wD E r D + w I E r I
3 1
= ⇤ 0.218 + ⇤ 0.126 = 19.5%
4 4
An example (cont’d)
I The past standard deviations of the two stocks are 40.1% (Disney)
and 29.8% (IBM), and that the historical correlation between the
returns of the two if 0.17.
I The variance of the portfolio is
2
P = wD2 D
2
+ wI2 I2 + 2wD wI ⇢DI D I
✓ ◆2 ✓ ◆2
3 2 1 3 1
= 0.401 + 0.2982 + 2 ⇤ ⇤ ⇤ 0.17 ⇤ 0.401 ⇤ 0.298
4 4 4 4
= 0.10362
I The standard deviation is simply

q p
= 2
P P = 0.10362 = 32.2%
Outline
Equity securities
Stock Valuation
Diversification
I Let’s now start changing the composition of the portfolio.

I Keeping the total amount invested constant, let the weight put on
Disney vary:
wD 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
⇥ ⇤
E rP 12.6% 13.5% 14.4% 15.4% 16.3% 17.2% 18.1% 19.0% 20.0% 20.9% 21.8%
P 29.8% 27.8% 26.4% 25.8% 26.0% 26.9% 28.6% 30.9% 33.6% 36.7% 40.1%
I Can you spot anything interesting?

Graphically
I Plotting portfolios in the standard deviation/expected return space:
Allowing for short sales

I Plotting portfolios in the standard deviation/expected return space:
E↵ect of diversification
I The key observation from the table and the graph is that
diversification can substantially reduce risk.
I Notice that a lot of portfolios have a lower standard deviation than
pure Disney or IBM investments.
I A diversified portfolio can have lower risk because the individual
stocks do not always move together.
I A second observation is that diversification does not necessarily
reduce expected return
I By including Disney in a pure IBM investment raises the expected
return (but not always the standard deviation)
I Basic fact: There may be benefits to diversification. By holding
a diversified portfolio, we can reduce risk without sacrificing
expected return.
Stand-alone stocks
I Let’s have a look at the two stand-alone stocks:
Does diversification always decrease risk?

I Set of feasible portfolios with perfect (positive) correlation:
When does diversification decrease risk?

I Set of feasible portfolios with imperfect correlation:
Can diversification eliminate risk?

I How does the feasible set look like if correlation is 1?
Understanding the mechanism
I It is easier to grasp the mechanics of diversification by taking the

simple case of a portfolio consisting of two assets.
I The expected return of such a portfolio is equal to
⇥ ⇤ ⇥ ⇤ ⇥ ⇤
E rP = w E r1 + (1 w ) E r2
where w is the weight invested in asset 1.

I It is easy to see that the expected return of a portfolio is linear in
w . A simple manipulation yields
⇥ ⇤ ⇥ ⇤ ⇥ ⇤ ⇥ ⇤
E rP = E r2 + w E r1 E r2
Understanding the mechanism (cont’d)
I However, this is not the case for variance (nor for standard
deviation).
I The variance of this portfolio is not the weighted average of the
variances of the individual assets:
2 2
P = w2 2
1 + (1 w) 2
2 + 2 w (1 w ) ⇢12 1 2
2
= [w 1 + (1 w) 2] 2 w (1 w) 1 ⇢12 1 2
2
< [w 1 + (1 w) 2]
for any ⇢ < 1.

I Hence diversification is due to the imperfect correlation between
assets’ returns.
So, what now?
I The big question now is:

I Which portfolio should one invest in?
I This is the topic of the next lecture.

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Lecture 4: Stock valuation and stock portfolios

BEAM047A Fundamentals of Financial

Autumn Term, 2017/18

Putting things into perspective

I In Lecture 3, we discussed fixed-income securities.

Measures of risk and return

Risk and return of portfolios

Measures of risk and return

Risk and return of portfolios

I Companies finance their operations by issuing either debt or equity

I Main features of equity securities:

Measures of risk and return

Risk and return of portfolios

I For simplicity, assume a stock that pays a single dividend between

Stock returns (generalised)

I Generally, in order to calculate the return between times 0 and T :

I Going back to the one-period return equation (1), it is more

E0 [D1 ] + (E0 [P1 ] P0 )

where E0 [i] represents the expectation of i at t = 0.

Stock valuation (two periods)

Stock valuation (multiple periods)

I In (other) words: The price of a stock is the Present Value of

Constant growth model

I Assume that dividends are expected to grow at a constant rate g ,

I The valuation formula becomes a growing perpetuity of dividends

Constant growth model (parameters)

I Where can we find values for these parameters?

Dividend growth rate

Present Value of Growth Opportunities: An example

Present Value of Growth Opportunities: An example

Measures of risk and return

Risk and return of portfolios

I Risk is defined as the

Value of $100 invested at the end of 1925

Risk and return data

I Using historical returns for the period 1926-2011:

I The standard deviation is expressed in the same units as the data

I The variance of Z is:

and its standard deviation:

Statistics vs Probability definitions

I The sample statistics and probability definitions are related.

Using statistics in finance

I Next year’s return can be viewed as a random variable. We can

An important clarification: realised vs expected returns

Measures of risk and return

Risk and return of portfolios

Individual stocks vs indices

I Using historical returns for the period 1967-2009:

Historical returns of stocks and indices

I The sum of portfolio weights is by definition equal to one:

A primer in short sales

I Timeline of short sale:

I The realised return of a portfolio is the weighted average of the

I Similarly, the expected return of a portfolio is the weighted average

Covariance and correlation

I Covariance ( XY ) and correlation (⇢XY ) can be defined for random

What do they reflect?

I The variance of a portfolio can be viewed as the weighted average of

I The standard deviation is simply

Measures of risk and return

Risk and return of portfolios

I Let’s now start changing the composition of the portfolio.