Questions
1. Price-Earnings Model. Explain the use of the price-earnings (PE) ratio for valuing a stock. Why
might investors derive different valuations for a stock when using the price-earnings method? Why
might investors derive an inaccurate valuation of a firm when using the price-earnings method?
ANSWER: Investors can value a stock by applying the industry PE ratio to the firm’s expected
This method has several variations, which can result in different valuations. For example, investors
A second reason for different valuations when using the PE method is that investors disagree on the
proper measure of earnings. Some investors prefer to us operating earnings, or exclude some
2. Dividend Discount Model. Describe the dividend discount valuation model. What are some
limitations of the dividend discount model?
ANSWER: The dividend discount valuation model measures the value of a firm as the present value
of future expected dividends to be received by the investor. The model can account for uncertainty by
The dividend discount model may result in an inaccurate valuation of a firm because of potential
errors in determining the dividend to be paid over the next year, or the growth rate, or the required
3. Impact of Economic Growth. Explain how economic growth affects the valuation of a stock.
ANSWER: The firm’s value should reflect the present value of its future cash flows. Because
4. Impact of Interest Rates. How are the interest rate, the required rate of return on a stock, and the
valuation of a stock related?
ANSWER: Given a choice of risk-free Treasury securities or stocks, stocks should be purchased only
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Chapter 11: Stock Valuation and Risk 2
The relation between interest rates and stock prices is not constant over time. However, most of the
5. Impact of Inflation. Assume that the expected inflation rate has just been revised upward by the
market. Would the required return by investors who invest in the stocks be affected? Explain.
ANSWER: An increase in expected inflation can increase the risk-free interest rate, which is a key
6. Impact of Exchange Rates. Explain how the value of the dollar affects stock valuations.
ANSWER: The value of the dollar can affect U.S. stock prices for a variety of reasons. First, foreign
investors tend to purchase U.S. stocks when the dollar is weak and sell them when it is near its peak.
Thus, the foreign demand for any given U.S. stock may be higher when the dollar is expected to
strengthen, other things being equal. Also, stock prices are affected by the impact of the dollar’s
The changing value of the dollar can also affect stock prices by affecting expectations of economic
factors that influence the firm’s performance. For example, if a weak dollar stimulates the U.S.
7. Investor Sentiment. Explain why investor sentiment can affect stock prices.
ANSWER: Investor sentiment represents the general mood of investors in the stock market. Since the
8. January Effect. Describe the January effect.
ANSWER: Because many portfolio managers are evaluated over the calendar year, they tend to invest
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Chapter 11: Stock Valuation and Risk 3
9. Earnings Surprises. How do earnings surprises affect valuations of stocks?
10. Impact of Takeover Rumors. Why can expectations of an acquisition affect the value of the target’s
stock?
ANSWER: The expected acquisition of a firm typically results in an increased demand for the target’s
11. Emerging Markets. What are the risks of investing in stocks in emerging markets?
ANSWER: Stocks in emerging markets are more exposed to major government turnover and other
12. Stock Volatility During the Credit Crisis. Explain how stock volatility changed during the
credit crisis.
13. Stock Portfolio Volatility. Identify the factors that affect a stock portfolio’s volatility and explain
their effects.
ANSWER: A stock portfolio has more volatility when its individual stock volatilities are high, other
factors held constant. In addition, a stock portfolio has more volatility when its individual stock
14. Beta. Explain how to estimate the beta of a stock. Explain why beta serves as a measure of the stock’s
risk.
ANSWER: The beta of a stock can be estimated by obtaining returns of the firm and the stock market
over the last 12 quarters and applying regression analysis to derive the slope coefficient as in this
model:
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Chapter 11: Stock Valuation and Risk 4
Some investors or analysts prefer to use monthly returns rather than quarterly returns to estimate the
15. Wall Street. In the movie Wall Street, Bud Fox is a broker who conducts trades for Gordon Gekko’s
firm. Gekko purchases shares of firms he believes are undervalued. Various scenes in the movie offer
excellent examples of concepts discussed in this chapter.
a. Bud Fox makes the comment to Gordon Gekko that a firm’s breakup value is twice its market
price. What is Bud suggesting in this statement? How would employees of the firm respond to
Bud’s statement?
ANSWER: Bud is suggesting that the firm could be acquired and separated into divisions and sold to
various firms. The combined value of the individual divisions (when sold) would be worth more than
b. When Bud informs Gekko that another investor, Mr. Wildman, is secretly planning to acquire a
target firm in Pennsylvania, Gekko tells Bud to buy a large amount of this stock. Why?
ANSWER: Gekko wants to accumulate much of the stock before Mr. Wildman attempts to acquire
c. Gekko says “Wonder why fund managers can’t beat the S&P 500? Because they are sheep.” What
is Gekko’s point? How does it relate to market efficiency?
ANSWER: Gekko is implying that all fund managers use the same type of information, which is
16. Market Efficiency. Explain the difference between weak-form, semistrong-form, and strong-form
efficiency. Which of these forms of efficiency is most difficult to test? Which is most likely to be
refuted? Explain how to test weak-form efficiency in the stock market.
ANSWER: The weak form suggests that security prices reflect recent price movements and trading
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Chapter 11: Stock Valuation and Risk 5
17. Market Efficiency. A consulting firm was hired to determine whether a particular trading strategy
could generate abnormal returns. The strategy involved taking positions based on recent historical
movements in stock prices. The strategy did not achieve abnormal returns. Consequently, the
consulting firm concluded that the stock market is weak-form efficient. Do you agree? Explain.
Advanced Questions
18. Value at Risk. Describe the value-at-risk method for measuring risk.
ANSWER: Value at risk is a risk measurement that estimates the largest expected loss to a particular
The value at risk is also commonly used to measure the risk of a portfolio. Some stocks may be
19. Implied Volatility. Explain the meaning and use of implied volatility.
ANSWER: Investors can derive the stock’s implied standard deviation (ISD) from the stock option
pricing model. The premium on a call option for a stock is dependent on factors such as the
relationship between the current stock price and the exercise (strike) price of the option, the number
20. Leveraged Buyout. At the time a management group of RJR Nabisco initially considered engaging
in a leveraged buyout, RJR’s stock price was less than $70 per share. Ultimately, RJR was acquired
by the firm Kohlberg, Kravis, and Roberts (KKR) for about $108 per share. Does the large
discrepancy between the stock price before an acquisition was considered versus after the acquisition
mean that RJR’s price was initially undervalued? If so, does this imply that the market was
inefficient?
ANSWER: The stock price may have been appropriate under the conditions of unchanged
management. However, when management is changed in a manner that will reduce the waste and
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Chapter 11: Stock Valuation and Risk 6
21. How Stock Prices May Respond to Prevailing Conditions. Consider the prevailing conditions that
could affect the demand for stocks, including inflation, the economy, the budget deficit, and the Fed’s
monetary policy, political conditions, and the general mood of investors. Based on prevailing
conditions, do you think stock prices will increase or decrease during this semester? Offer some logic
to support your answer. Which factor do you think will have the biggest impact on stock prices?
ANSWER: This question is open-ended. It requires students to apply the concepts that were presented
22. Application of CAPM to Stock Pricing. Explain (using intuition instead of math) why stock prices
may decrease in response to a higher risk-free rate according to the CAPM. In some periods, the
risk-free rate rises in response to higher economic growth. Explain (using intuition instead of math)
why stock prices may increase in this situation even though the risk-free rate increases.
ANSWER: When the risk-free rate rises, the required rate of return rises, and therefore expected cash
23. Impact of SOX on Stock Valuations. Use a stock valuation framework to explain why the
Sarbanes-Oxley Act (SOX) could improve the valuation of a stock. Why might SOX cause a
reduction in the valuation of a stock?
ANSWER: The Sarbanes-Oxley Act of 2002 was intended to improve the reporting of financial
24. Interpretation of the VIX Index. Explain why participants in the stock market monitor the
VIX index. What does a decline in the VIX index imply about a change in expected volatility by
market participants?
ANSWER At a given point in time, the VIX index measures investor’s expectation of the
stock market volatility over the next 30 days. Some investors refer to VIX as an indicator of
Interpreting Financial News
Interpret the following comments made by Wall Street analysts and portfolio managers.
a. “The stock market’s recent climb has been driven by falling interest rates.”
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Chapter 11: Stock Valuation and Risk 7
The value of a stock may be measured as the present value of future cash flows provided to
b. “Future stock prices are dependent on the Fed’s policy meeting next week.”
The Fed’s monetary policy affects the values of stocks in various ways. First, it can affect
c. “Given a recent climb in stocks that cannot be explained by fundamentals, a correction is
inevitable.”
The recent climb in stocks occurred without any fundamental change in the performance of firms.
Managing in Financial Markets
As an investment manager, you frequently make decisions about investing in stocks versus other types of
investments, and about types of stocks to purchase.
a. You have noticed that investors tend to invest more heavily in stocks after interest rates have
declined. You are considering this strategy as well. Is it rational to invest more heavily in stocks
once interest rates have declined?
One argument is that investors are unwilling to accept a very low interest rate on debt securities,
and are more willing to invest in stocks simply because their opportunity cost (what they forgo)
on debt securities is low. The value of stocks may rise in response to lower interest rates, simply
b. Assume that you are about to select a specific stock that will perform well in response to an
expected runup in the stock market. You are very confident that the stock market will perform
well in the near future. Recently, a friend recommended that you consider purchasing stock of a
specific firm because it had decent earnings over the last few years, it has a low beta (reflecting a
low degree of systematic risk), and its beta is expected to remain low. You normally rely on beta
as a measurement of a firm’s systematic risk. Should you seriously consider buying that stock?
Explain.
No. Given that you expect the stock market to perform well, you would not be so interested in a
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Chapter 11: Stock Valuation and Risk 8
c. You are considering an investment in an initial public offering by Marx Co., which has performed
very well recently, according to its financial statements. The firm will use some of the proceeds
from selling stock to pay off some of its bank loans. How can you apply stock valuation models
to estimate this firm’s value, when its stock is not yet publicly traded? Once you estimate the
value of the firm, how can you use this information to determine whether to invest in it? What are
some limitations involved in estimating the value of this firm?
There are numerous possible solutions, but most solutions would involve the estimation of the
firm’s future cash flows, and deriving a present value of those cash flows. You can apply the
dividend discount model by assessing past earnings to generate forecasts of future earnings.
d. In the past, your boss assessed your performance based on the actual return on the portfolio of
U.S. stocks that you manage. For each quarter in which your portfolio generated an annualized
return of at least 20 percent, you received a bonus. Now your boss wants you to develop a method
for measuring your performance from managing the portfolio. Offer a method that accurately
measures your performance.
There are many possible solutions. The method should include some control for the stock market
movements over the period of concern. For example, your performance may be measured as an
excess return beyond the return of some stock index representing U.S. stocks. If your portfolio is
e. Assume that you were also asked to manage a portfolio of European stocks. How would your
method for measuring your performance in managing this portfolio differ from the U.S. stock
portfolio in the previous question?
The European portfolio return should be compared to a European stock index. The reason is that
you have no control over the general stock market conditions in Europe. You only have control
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Chapter 11: Stock Valuation and Risk 9
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.