Chapter 11 Stock Valuation and Risk Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning All rights reserved Chapter Outline           Stock valuation methods Determining the required rate of return to value stocks Factors that affect stock prices Role of analysts in valuing stocks Stock risk Applying value at risk Forecasting stock price volatility and beta Stock performance measurement Stock market efficiency Foreign stock valuation, performance, and efficiency Stock Valuation Methods  The price-earnings (PE) method assigns the mean PE ratio based on expected earnings of all traded competitors to the firm’s expected earnings for the next year  Assumes future earnings are an important determinant of a firm’s value  Assumes that the growth in earnings in future years will be similar to that of the industry Stock Valuation Methods (cont’d)  Price-earnings (PE) method (cont’d)  Reasons   for different valuations Investors may use different forecasts for the firm’s earnings or the mean industry earnings Investors disagree on the proper measure of earnings  Limitations   of the PE method May result in inaccurate valuation for a firm if errors are made in forecasting future earnings or in choosing the industry composite Some question whether an investor should trust a PE ratio Valuing A Stock Using the PE Method A firm is expected to generate earnings of $2 per share next year The mean ratio of share price to expected earnings of competitors in the same industry is 14 What is the valuation of ?the firm’s shares according to the PE method Valuation per share (Expected earnings of firm per share) (Mean industry PE ratio) $2 14 $28 Stock Valuation Methods (cont’d)  Dividend discount model  John Williams (1931) stated that the price of a stock should reflect the present value of the stock’s future dividends: k  Dt Price  t (  k ) t 1   D can be revised in response to uncertainty about the firm’s cash flows k can be revised in response to changes in the required rate of return by investors Stock Valuation Methods (cont’d)  Dividend discount model (cont’d)  For a constant dividend, the cash flow is a perpetuity: Dt D  t k (  k ) t 1  Price    For a constantly growing dividend, the cash flow is a growing perpetuity: Dt D1  t k g (  k ) t 1  Price   Valuing A Stock Using the Dividend Discount Model Example 1: A firm is expected to pay a dividend of $2.10 per share every year in the foreseeable future Investors require a return of 15% on the firm’s stock According to the dividend discount model, what is a fair price ?for the firm’s stock Dt D $2.10   $14 t k 15% t 1 (1  k )  Price   Valuing A Stock Using the Dividend Discount Model Example 2: A firm is expected to pay a dividend of $2.10 per share in one year In every subsequent year, the dividend is expected to grow by percent annually Investors require a return of 15% on the firm’s stock According to the dividend discount model, ?what is a fair price for the firm’s stock Dt D1 $2.10 Price    $17.50 t k  g 15%  3% t 1 (1  k )   Stock Valuation Methods (cont’d)  Dividend discount model (cont’d)  Relationship between dividend discount model and PE ratio    The PE multiple is influenced by the required rate of return and the expected growth rate of competitors The inverse relationship between required rate of return and value exists in both models The positive relationship between a firm’s growth rate and its value exists in both models 10 .. .Chapter Outline           Stock valuation methods Determining the required rate of return... Required rate of return Errors are more pronounced for firms that retain most of their earnings 11 Stock Valuation Methods (cont’d)  Adjusting the dividend discount model  The   value of the... years What is the EPS ?in four years Forecasted earnings in n years E (1  G )n $10 (1.03 )4  $11. 26 13 Using the Adjusted Dividend Discount Model (cont’d) Other firms in Parker’s industry have