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Fundamental Analysis

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You are on page 1of 33

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.

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