Chapter 11
Stock Valuation and Risk
Outline
Stock Valuation Methods
Price-Earnings (PE) Method
Dividend Discount Model
Adjusted Dividend Discount Model
Free Cash Flow Model
Required Rate of Return on Stocks
Capital Asset Pricing Model
Factors That Affect Stock Prices
Economic Factors
Market-Related Factors
Firm-Specific Factors
Tax Effects
Integration of Factors Affecting Stock Prices
Having an Edge in the Valuation Process
Stock Risk
Volatility of a Stock
Beta of a Stock
Value at Risk
Risk-Adjusted Stock Performance
Sharpe Index
Treynor Index
Stock Market Efficiency
Forms of Stock Market Efficiency
Tests of the Efficient Market Hypothesis
Foreign Stock Valuation and Performance
Valuation of Foreign Stocks
International Market Efficiency
Measuring Performance from Investing in Foreign Stocks
Performance from Global Diversification
Chapter 11: Stock Valuation and Risk ❖ 2
Key Concepts
1. Explain stock valuation models.
2. Explain how to assess the risk of stocks and stock portfolios.
POINT/COUNTER-POINT:
Is The Stock Market Efficient?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
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
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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.
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
3. Impact of Economic Growth. Explain how economic growth affects the valuation of a stock.
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?
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.
6. Impact of Exchange Rates. Explain how the value of the dollar affects stock valuations.
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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.
7. Investor Sentiment. Explain why investor sentiment can affect stock prices.
8. January Effect. Describe the January effect.
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?
11. Emerging Markets. What are the risks of investing in stocks in emerging markets?
12. Stock Volatility During the Credit Crisis. Explain how stock volatility changed during the
credit crisis.
Chapter 11: Stock Valuation and Risk ❖ 6
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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.
the firm’s prevailing market value. Employees of a firm are concerned about comments like this
because it means that they may subject to reorganization (although some employees might benefit
from this).
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?
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?
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.
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.
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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
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?
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?
22. Application of the 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.
Chapter 11: Stock Valuation and Risk ❖ 9
b. “Future stock prices are dependent on the Fed’s policy meeting next week.”
c. “Given a recent climb in stocks that cannot be explained by fundamentals, a correction is
inevitable.”
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?
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.
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?
Chapter 11: Stock Valuation and Risk ❖ 10
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.
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?
Problems
1. Risk-Adjusted Return Measurements. Assume the following information over a five-year period.
Average risk-free rate = 6%
Average return for Crane stock = 11%
Average return for Load stock = 14%
Standard deviation of Crane stock returns = 2%
Standard deviation of Load stock returns = 4%
Beta of Crane stock = 0.8
Beta of Load stock = 1.1
Chapter 11: Stock Valuation and Risk ❖ 11
Determine which stock has higher risk-adjusted returns according to the Sharpe Index. Which stock
has higher risk-adjusted returns according to the Treynor Index? Show your work.
ANSWER:
Sharpe Index of Crane stock:
f
RR −
=index Sharpe
5.2=
Sharpe Index of Load stock:
f
RR −
=index Sharpe
8.0
%6%11 −
=
0625.=
Treynor Index of Crane stock:
0625.=
2. Measuring Expected Return. Assume Mess stock has a beta of 1.2. If the risk-free rate is 7 percent,
and the market return is 10 percent, what is the expected return on Mess stock?
%2
%6%11 −
=
Chapter 11: Stock Valuation and Risk ❖ 12
ANSWER:
3. Using the PE Method. You found that Verto Stock is expected to generate earnings of $4.38 per
share this year, and that the mean PE ratio for its industry is 27.195. Use the PE valuation method to
determine the value of Verto shares.
ANSWER:
4. Using the Dividend Discount Model. Suppose that you are interested in buying the stock of a
company that has a policy of paying a $6 per share dividend every year. Assuming no changes in the
firm’s policies, what is the value of a share of stock if the required rate of return is 11 percent?
ANSWER:
5. Using the Dividend Discount Model. Micro, Inc. will pay a dividend of $2.30 per share next year. If
the company plans to increase its dividend by 9 percent per year indefinitely, and you require a 12
percent return on your investment, what should you pay for the company’s stock?
ANSWER:
6. Using the Dividend Discount Model. Suppose you know that a company just paid a dividend of
$1.75 per share on its stock and that the dividend will continue to grow at a rate of 8 percent per year.
If the required return on this stock is 10 percent, what is the current share price?
ANSWER:
Chapter 11: Stock Valuation and Risk ❖ 14
ANSWER:
12. Measuring the Portfolio Beta. Assume the following information:
Beta of IBM = 1.31
Beta of LUV = 0.85
Beta of ODP = 0.94
If you invest 40 percent of your money in IBM, 30 percent in LUV and 30 percent in ODP, what is
your portfolio’s beta?
ANSWER:
13. Measuring the Portfolio Beta. Using the information from Problem 12, suppose that you instead
decide to invest $20,000 in IBM, $30,000 in LUV and $50,000 in ODP. What is the beta of your
portfolio now?
ANSWER:
14. Value at Risk. Assume that Quitar Co. has a beta of 1.31.
a. If you assume that the stock market has a maximum expected loss of –3.2 percent on a daily basis
(based on a 95 percent confidence level), what is the maximum daily loss for the Quitar Co.
stock?
ANSWER:
1.31(–3.2%) = –4.192%
b. If you have $19,000 invested in Quitar Co. stock, what is your maximum daily dollar loss?
ANSWER:
Chapter 11: Stock Valuation and Risk ❖ 16
Flow of Funds Exercise
Valuing Stocks
Recall that if the economy continues to be strong, Carson Company may need to increase its production
capacity by about 50 percent over the next few years to satisfy demand. It would need financing to
expand and accommodate the increase in production. Recall that the yield curve is currently upward
sloping. Also recall that Carson is concerned about a possible slowing of the economy because of
potential Fed actions to reduce inflation. It is also considering issuing stock or bonds to raise funds in the
next year. If Carson goes public, it might even consider using its stock as a means of acquiring some
target firms. It would also consider engaging in a secondary offering at a future point in time if the IPO is
successful and if its growth continues over time. It would also change its compensation system to
compensate most of its managers with shares of its stock that would represent about 30 percent of their
compensation and would pay the remainder of the compensation as salary.
a. At the present time, the price-earnings (PE) ratio (stock price per share divided by earnings per
share) of other firms in Carson’s industry is relatively low but should rise in the future. Why
might this information affect the time at which Carson issues its stock?
Carson would like to attempt to issue the shares when the valuation of its stock is favorable.
b. Assume that Carson Company believes that issuing of stock is an efficient means of
circumventing the potential for high interest rates. Even if long-term interest rates have increased
by the time it issues stock, Carson thinks that it would be insulated by issuing stock instead of
bonds. Is this view correct?
No. If interest rates increase, the risk-free interest rate that can be earned by investors has
c. Carson Company recognizes the importance of a high stock price at the time it engages in an IPO
(if it goes public). But why would its stock price be important to Carson Company even after the
IPO?
d. If Carson Company goes public, it may be able to motivate its managers by granting them stock
as part of their compensation. Explain why the stock may motivate them to perform well. Then
explain why the use of stock as compensation may motivate them to use a very focus on short-
term goals, even though they are supposed to focus on maximizing shareholder wealth over the
Chapter 11: Stock Valuation and Risk ❖ 17
long run. How can a firm provide stock as motivation but prevent its managers from using a very
short-term focus?
Stock compensation can motivate managers to make decisions that maximize the stock price,
number of years.
Answers to Appendix Discussion Questions
1. Should an accounting firm be prohibited from offering both auditing services and consulting services
to the same client? Explain your answer. If an accounting firm offered only one service, could there
still be conflicts of interest due to referrals (and finder’s fees)?
2. Should members of Congress be allowed to enact laws on accounting and financial matters while
receiving donations from related lobbying groups?
3. What alternative sources of information about a firm should investors rely on if they cannot rely on
financial statements?
4. Should investors have confidence in ratings by analysts who are affiliated with securities firms that
provide consulting services to firms? Explain.
5. Does an analyst employed by a securities firm to rate firms face a conflict of interest? If so, can the
conflict be resolved?
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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.
6. How might a firm’s board of directors discourage its managers from attempting to manipulate
financial statements to create a temporarily high stock price?
7. How can the compensation of a firm’s board of directors be structured so that the board will not be
tempted to allow accounting or other managerial decisions that could cause a superficially high price
over a short period?