BE331 The Pricing of Securities in

Financial Markets

Dr Nick Rowe
nick.rowe@essex.ac.uk

Lecture 4
 Share Valuation Models
The Earnings Model

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 Where does growth come from?
• Recall from last class:

• Let
– <- firm period 1 earnings
– <- firm “plowback” ratio
• Then

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 Where does growth come from?
• To see why:

• When b = 0, earnings don’t grow – and, by

extension, neither do dividends

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 Where does growth come from?
• Given the foregoing, it must be that:

implying

One may wonder then how the P/E ratio

changes as the firm plowback rate changes

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Where does growth come from?

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Plowback ratios and P/E behaviour

• ROE>k: firm investment returns are better

than shareholder OCC -> P/E up
– Better returns get capitalized as higher P
• ROE<k: firm investment returns are worse
return than shareholder OCC -> P/E down
– Shareholders could do better if earnings were
distributed as dividends, so price falls

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 The Earnings Model
When we assume company invests a fixed % of a
company’s earnings, the earnings model shows that the
firm’s value is determined by the dividend distributed to
shareholders

 Why focus on future earnings?

– Core business determinants of value
• Dividend policy is not such a core determinant
– Dividends may not be representative of the firm's financial
status
– Takeover investors are not concerned with the pattern of future
dividends because they can choose any pattern they wish
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 Share Valuation Models
Modigliani & Miller’s Cash Flow Model

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 Modigliani and Miller’s Cash Flow Model

A share’s value (or a company’s value) is equal to the present

value of the future cash flows generated by the company

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 Modigliani and Miller’s Cash Flow Model

To our interest, Modigliani and Miller hypothesized that:

 the market value of a firm is determined by its cash flow-

generating power and by the risk of its underlying assets

• Its value is independent of the way it chooses to distribute

dividends

• Its value is not based on “earnings” (which is an

accounting term that can be manipulated to some extent)
but on free cash flows the firm can generate though its
investment decisions
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 Concluding Remarks
The earnings model and the dividend model should be used carefully in calculating share
prices through an understanding of their limitations:

 Dividends represent arbitrary distribution decisions

 Earnings are influenced by the broad leeway of accounting board guidelines

However, these models still hold an important place in business practice and in the
economic press today while the cash flow model is used only by financial professionals

 Why ?
1. To present historical developments in financial theory thought
2. For practical purposes as they are still valuable indicators of share market
trends

Free cash flow is subject to less manipulation and it is more relevant in calculating a
company’s value
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Thank you for your attention!
Cash flows can’t be perfectly predicted
• In order to relax this assumption, we’ll need to
introduce the idea of “randomness”
– Randomness: unpredictability
– There can be patterns in the way certain things are random
• We’ll start treating financial assets like random
variables
– Random variable: a variable that can take a number of
different possible values
– “different possible values” here  return/payoff on
financial asset

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 One-period Finite State Economy
Suppose we hold a security that has payoffs:

 The economy will have 2 states next period: up or down

 The security will have a value of $1 or 0 in the up and down states,
respectively

Similarly, if we extend to three states next period, we have:

 With 3 possible payoffs corresponding to the 3 states: good, normal or bad

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Cash flows can’t be perfectly predicted
• In order to relax this assumption, we’ll need to
introduce the idea of “randomness”
– Randomness: unpredictability
– There can be patterns in the way certain things are random
• We’ll start treating financial assets like random
variables
– Random variable: a variable that can take a number of
different possible values
– “different possible values” here  return/payoff on
financial asset

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 One-period Finite State Economy
In general, we can consider an economy with an
arbitrary number of s states and N securities

 In this economy, each security’s payoff is:

 Where the v’s are the payoffs in the s states

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 One-period Finite State Economy
 Suppose now that there are a total of N securities, in an
economy of s states
 The payoffs next period of all the N securities can be summarized
in the following matrix:

Where each of the N columns represents the value of the security

and each of the s rows represents a given state in the economy

Matrix X summarizes all possible payoffs of all securities and

determines their future values completely
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 One-period Finite State Economy
The asset pricing question is how to determine
the price for each of the securities
Mathematically, the pricing mechanism can be viewed
as a mapping from (vector of all possible payoffs
obtained from owning security ) to a price that an
investor is willing to pay today:

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 Portfolio of Securities
 In evaluating securities, a key principle is to evaluate them as a
whole, and not in isolation

 We consider a portfolio of N securities:

Where:
• are portfolio weights representing the units of the purchased
securities (negative weights indicate a short position on a given
security)
• is the vector of payoffs to the portfolio, that simply adds up the
individual values
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 Portfolio of Securities
If we express the portfolio in terms of returns, rather than payoffs, the portfolio
return is:

Where the gross return on security j is:

The relation between the and the is:

 The numerator is the amount of money we spent on security j and the

denominator is the total amount of money invested in the securities
Therefore the weights in terms of units or % of money are easily related as shown
above

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 Portfolio of Securities
Consider the following 2 securities in a 2-state economy:

 Suppose their prices today are $1

 With an investment of $1 that buys 0.5 units of each security, we
obtain:

 With payoffs:
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 Portfolio of Securities
With your initial $1, you can also buy 2 units of the first security and short 1 unit of the
second security

 In this case the resulting portfolio would be:

 With payoffs:

Note: the payoff is negative in the down state

• This means that, when the economy is down, you have to buy back the second security
at a price of $1 (value in the down state) to cover the short position
• Thus, this portfolio with short sales has a higher payoff of $2 in the up state, which
compensates for the loss in the down state

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 Redundant Asset
A portfolio is uniquely determined by its portfolio weights:

The portfolio’s payoffs are uniquely determined by the vector:

A portfolio is said to be replicable if we can find another

portfolio with different weights, , such that their payoffs are
equal:
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 Redundant Asset
 If one of the can be replicated by a portfolio of
others, it is referred to as redundant asset or
redundant security

 In an economy, redundant assets can be eliminated

without affecting the properties of all the possible
portfolios of the remaining assets

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 Redundant Asset
Consider the following 2-state economy:

Price for both securities today = $1

 The portfolio with weights

 Is expressed as:

 The portfolio is replicable because it is also equal to:

The asset is redundant because its payoff is simply double the payoff of the
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 Market Completeness
The market is complete if for any possible payoff, there is a portfolio
of securities to replicate it

That is, for any desired payoff , we can find portfolio weights such that:

A complete market allows investors to obtain any desired payoff in

any state and permits unique security pricing

Note: our previous example represents an incomplete market because

for any possible portfolio, it will be impossible to create a payoff of $1
in the down state

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 The Law of One Price & Linear Pricing
The law of one price (LOP) states that:

“Two assets with identical payoffs must have the same price”

 Mathematically, under LOP, if 2 portfolios have the same

payoffs, , then their prices today must be the same:

Where is the mapping that maps the payoff of a portfolio into its
price
• The price mapping is uniquely determined by the payoffs, so prices are identical
if the payoffs are

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 The Law of One Price & Linear Pricing
The LOP is valid if and only if the linear pricing rule holds

That is, the price of a portfolio must be equal to a portfolio of the component prices

 The LOP prevents an asset from having multiple prices, which gives rise to its name
 The linear pricing rule implies the LOP
 A necessary and sufficient condition for the LOP to hold is that every portfolio with zero
payoff must have a price of zero

 Only when the LOP is true it is possible to have rational pricing with a unique price

 If the LOP is violated, our first suspicion would be that:

• Something interferes with the normal operation of the competitive market (arbitrage)
• There was some (perhaps undetected) economic difference between the two assets

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 Arbitrage
 Asset pricing theories rely on assuming the absence of
systematic arbitrage opportunities
 Arbitrage: buy low, sell high (long); sell high, buy low (short

 A violation of the LOP would give rise to arbitrage

opportunities
• Assets prices are not well related to each other and investors
are likely to be able to exploit such arbitrage opportunities

• Eventually, these opportunities will disappear and the prices will

reflect the equilibrium values with which asset pricing theory is
concerned
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 Arbitrage
There are two types of arbitrage:

 Type A: exists if there is a portfolio strategy that requires

no investment today (i.e. zero-investment strategy) and
yet yields non-negative payoffs in the future, and
positive (or not identical to zero) at least in one of the
states of nature

 Type B: exists if there is a portfolio strategy that earns

money today and yet has no future obligations
• You obtain money immediately and never have to pay anything
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 Arbitrage
 Mathematically, arbitrage of type A can be expressed
as:

With

 Mathematically, arbitrage of type B can be expressed

as:

With
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 Arbitrage of Type A
Consider the following 2 securities in a 2-state economy with payoffs:

With prices $1 and $2, respectively

If we short 2 units of the 1st security and buy 1 unit of the 2nd, then our net
investment will be:

but the payoff will be:

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 Arbitrage of Type B
Consider the following 2 securities in a 2-state economy:

With prices $2 and $3.9, respectively

If we short 2 units of the 1st security and buy 1 unit of the 2nd, then our net
investment will be:

but the payoff will be:

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 Arbitrage & LOP
• Previous examples showed how deviations
from linear pricing created arbitrage
opportunities
– Arbitrage B: X2 was essentially 2 units of X1, but
cost slightly less  Linear pricing violation
– Arbitrage A: X2 was better than having 2 units of
X1, but cost the same  Linear pricing violation
• We can think of LOP as “no arbitrage” and
arbitrage as “no LOP”
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The Fundamental Theorem of Asset Pricing

The Fundamental Theorem of Asset Pricing states that the

following are equivalent:

 Absence of arbitrage opportunities

 Existence of a positive linear pricing rule
 Existence of an investor with monotonic preference whose
utility is maximised

The Fundamental Theorem of Asset Pricing ties altogether

the no arbitrage, positive linear pricing rule, and the utility
maximisation problem
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The Fundamental Theorem of Asset Pricing
Assume an investor prefers more to less
• His utility function is a monotonic increasing function of both and

Given initial wealth , and given trading opportunities, the investor’s

future consumption will be:

= consumption today
= return on a optimal portfolio of assets, optimally chosen by the
investor and maximising his utility
= investor's income in period 1, such as labour income
= initial wealth in period 0
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The Fundamental Theorem of Asset Pricing

 Provides important insight into what we need for

models of asset pricing
• Several theoretical equilibrium asset pricing models assume all
investors behave rationally and have identical information sets

 According to the theorem, to rationally price assets or

to ensure market pricing efficiency, there is no need to
assume that all investors are smart
• What is needed is a few smart investors or traders who can capitalise
on any arbitrage opportunities
• Eventually, equilibrium prices should reflect no arbitrage
opportunities

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 Efficient Markets Hypothesis
Market efficiency is associated with the underlying information about financial assets

 However, in real world information is not distributed evenly among market participants
(information asymmetries)
 Unevenly-distributed information leads to strong, semi-strong, or weak forms of
market efficiency

The Weak Form of Efficiency

Prices fully reflect the information contained in past prices (i.e. technical analysis, patterns
in securities' prices/returns etc.)

The Semi-strong Form of Efficiency

Prices fully reflect past prices and all other publicly available information (i.e. dividend
distribution, M&A etc.)

The Strong Form of Efficiency

Prices fully reflect all information, public and private (i.e. insider information)
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Thank you for your attention!