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CAPM II and

Fundamental Analysis
Possible or Not Possible?
• Assume CAPM is correct and prices are in equilibrium

1) If given the beta, risk-free rate, and expected market
return, then verify that expected return for stock equals
r
f
+|
i
(E[r
m
]-r
f
)

2) Relation between the expected returns of two stocks
▫ If given betas, stock with higher beta should have higher expected
return
▫ If not given the betas, any rank-ordering is possible

Possible or Not Possible?
3) If given enough information to compute Sharpe
ratio of market and stock, verify that market has
the highest Sharpe ratio.

4) If Sharpe ratio is negative for a given stock,
then E[r] must be less than the risk-free rate.
Example #1
• Possible or not possible according to CAPM if all
assets are in equilibrium?
▫ Stock A
 E[r] = -4%
 o=.20
▫ Stock B
 E[r]=10%
 o=.05


Example #1
• The above scenario is possible according to the
CAPM, since we are not given betas.
▫ The beta of stock A could be negative for all we
know.
Example #2
• Possible or not possible according to CAPM if all
assets are in equilibrium?
▫ Stock A
 E[r] = -4%
 |=1.2
▫ Market
 E[r]=10%
▫ Risk-free rate=4%


Example #2
• Not possible according to the CAPM
• If prices are in equilibrium then expected return
for stock A should be

▫ .04+1.2*(.10-.04)=11.2%
Example #3
• Possible or not possible according to CAPM if all
assets are in equilibrium?
▫ Market Portfolio
 E[r]=10%
 o=.10
▫ Vastera Stock
 E[r]=12%
 o=.13
▫ Risk-free rate=5% (borrowing and lending)

Example #3
• Sharpe ratios
▫ Market : (.10-.05)/.10=0.5
▫ Vastera: (.12-.05)/.13=0.53

• The Sharpe ratio of Vastera is greater than that
for the value-weighted portfolio.

• Not Possible according to CAPM.
Example #4
• Possible or not possible according to CAPM if all
assets are in equilibrium?
▫ IBM stock
 E[r]=10%
 o=.10
▫ Vastera Stock
 E[r]=12%
 o=.13
▫ Risk-free rate=5% (borrowing and lending)

Example #4
• We are not given betas.
• Any rank ordering between expected returns is
possible.
• Hence, this is possible according to the CAPM.
Example #5
• E[r] for a stock is 5%
• Sharpe ratio for this stock is negative
• Risk-free rate is 3%
• Possible or not possible?
Example #5
• Not possible. If the stock’s expected return is
above the risk-free rate, it has a positive Sharpe
ratio.
Equilibrium
• Our definition of equilibrium:



• An alternative definition of Equilibrium:
▫ Prices = sum of discounted cash flows where discount rate
is given by CAPM

• Why do we need 2 definitions? Are they the same?
▫ If prices are the sum of discounted future cash flows, what
is E[r]?
) ] [ ( ] [
f m i f i
r r E r r E ÷ + = |
E[r]=Discount rate

• When prices are set equal to the sum of
discounted cash flows, where the discount rate is
k, then
E[r]=k the discount rate.
▫ If we believe the CAPM, then the discount rate
should be




) ] [ (
f m i f i
r r E r k ÷ + = |
Expected Return
• Assume
▫ A firm will last for three years and then pay an
expected dividend E[D].
▫ Price of stock = PV of cash flows

• If you buy the stock now and sell it in one year,
what is your E[r]?
Expected Return
( )
( )
( )
( )
k
D E
k
k
D E
P
P E
r E
k
D E
P E
k
D E
P
= ÷
+
×
+
= ÷ =
+
=
+
=
1
] [
1
1
] [
1
] [
] [
1
] [
] [
1
] [
3
2
0
1
2 1
3 0
Out of Equilibrium
) ( ] [ then ), ( if
) ( ] [ then ), ( if
: implies This
) ( if ] [
0
0
0
alpha k r E Flows Cash PV P
alpha k r E Flows Cash PV P
Flows Cash PV P k r E
+ > <
÷ < >
= =
Fundamental Analysis
• Forecast dividends paid for a stock

• Estimate beta, and the required rate of return

• Discount forecasted dividends back to the present

• Compare the PV of cash flows with the actual price
the stock is trading in the market.


Gordon Growth
• Assume:
▫ Discount rate of k
▫ Dividends are paid annually.
▫ Next dividend will arrive in one year
▫ Expected dividend at year-end is D
▫ Dividends expected to grow at rate g forever


g k
D
PV
÷
=
Not Paying Dividends
• Many firms right now are not paying dividends.

• Companies follow life-cycles.
▫ Firms in new industries have many profitable
opportunities to invest (e.g. tech companies).
 Pay zero dividends.

▫ Firms in mature industries do not have profitable
opportunities (e.g. utilities)
 Pay high dividends
Not Paying Dividends
• For the stock to have value, investors must
expect the firm to pay dividends at some point in
the future.

• What is PV of cash flows?


Not Paying Dividends
• Assume
▫ A firm will begin paying dividends in n years.
▫ The initial expected dividend is D
n
▫ Dividends will grow from that point onward at
rate g forever.
▫ The discount rate is k.
• Then
1
) 1 )( (
÷
+ ÷
=
n
n
k g k
D
PV
Intuition
(
¸
(

¸

÷ g k
D
n
1
) 1 /(
÷
+
(
¸
(

¸

÷
n n
k
g k
D
Not Paying Dividends
• Example:
• It’s the end of 2011
• The R-investor expects stock ABC
▫ to begin paying dividends at the end of 2021
▫ the initial dividend to be $1.50 per share.
▫ annual dividends to grow by 3% thereafter forever.
▫ k= 12% (determined by CAPM)

• At what price is stock ABC in equilibrium?
▫ When price=PV of cash flows from the view of the R-
investor.
Not Paying Dividends
• Given expectations, it’s easy to find the PV of
cash flows as of the end of 2020. Just use
Gordon Growth:
▫ PV=1.50/(0.12-0.03)=16.67

• To find PV as of the end of 2011, just discount
back 9 years:
▫ 16.67/(1.12^9)=6.01
Not Paying Dividends
• Let a superscript “R” denote the view of the R-
investor.
• If price =6.01, what is ?


• Assume the R-investor expects prices to be in
equilibrium at the end of the year.




R
r E ] [
1 / 1 / ] [ ] [
0 1
÷ = ÷ = P P Pay Get E r E
R R
Not paying dividends
• If prices are in EQ at year end, then the R-
investor’s best forecast for the price at year end
is the PV of cash flows as of 2012
▫ Discount 16.67 back 8 years










k r E
P
R
= = ÷ =
= =
% 12 1 01 . 6 / 73 . 6 ] [
73 . 6 12 . 1 / 67 . 16
8
0 , 1
You disagree
• Suppose you disagree with the R-investor.
▫ You believe growth rates of dividends will be 3.1%
rather than 3%.
▫ You believe the R-investor will agree with you at
year end.
• Note the R-investor is the one who sets prices
through shifts in his demand curve.
• You’re just a price taker.
R-investor
• Given expectations, it’s easy to find the PV of
cash flows as of the end of 2020. Just use
Gordon Growth:
▫ PV=1.50/(0.12-0.031)=16.85

• To find PV as of the end of 2012, just discount
back 8 years:
▫ 16.85/(1.12^8)=6.81

You Disagree
• But the price right now is 6.01, because prices
are set by R-investor (and currently, he believes
g=3.0)
• Let the “Y” superscript denote the expected
return from your view.


• You have found a positive alpha stock.

% 3 . 13 1 01 . 6 / 81 . 6 ] [ = ÷ =
Y
r E
Fundamental Analysis
• If the PV of cash flows is above the actual price
▫ You have found a stock with positive alpha (assuming your
information is correct)
▫ When the actual price moves to reflect your information,
the return will be higher than k.

• If the PV of cash flows is below the actual price
▫ You have found a stock with negative alpha (assuming your
information is correct)
▫ When the actual price moves to reflect your information,
the return will be less than k.

Fundamental Analysis
• Pros: Grounded in finance theory
• Cons:
▫ Forecasting dividends and dividend growth rates
is no trivial matter.
▫ Small changes in dividend growth rates lead to
BIG changes in your view of the expected return.