Chapter 11: Stock Valuation
and Risk
Since the values of stocks change continuously, so do stock
prices. Institutional and individual investors constantly value
stocks so that they can capitalize on expected changes in
stock prices.
The specific objectives of this chapter
are to:
■ explain methods of valuing stocks and determining the
required rate of return on stocks,
■ identify the factors that affect stock prices,
■ explain how analysts affect stock prices,
■ explain how to measure the risk of stocks, and
■ explain the concept of stock market efficiency.
Stock Valuation Methods
Investors conduct valuations of stocks when making their investment decisions. They
consider investing in undervalued stocks and selling their holdings of stocks that
they consider to be overvalued. There are many different methods of valuing stocks.
Fundamental analysis relies on fundamental fi nancial characteristics (such as earnings)
about the fi rm and its corresponding industry that are expected to influence stock values. Technical analysis relies on stock price trends to determine stock values. Our focus is on fundamental analysis. Investors who rely on fundamental analysis commonly
use the price-earnings method, the dividend discount model, or the free cash flow
model to value stocks. Each of these methods is described in turn.
http://
http://finance.yahoo.com
Insert ticker symbol for
financial data, including
earnings forecasts.
Price-Earnings (PE) Method
A relatively simple method of valuing a stock is to apply the mean price-earnings (PE)
ratio (based on expected rather than recent earnings) of all publicly traded competitors in the respective industry to the firm’s expected earnings for the next year.
Consider a firm that is expected to generate earnings of $3 per share
next year. If the mean ratio of share price to expected earnings of competitors in the same industry is 15, then the valuation of the firm’s shares is
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Valuation
5 1 Expected earnings of firm per share 2 3 1 Mean industry PE ratio 2
per share
5 $3 3 15
5 $45 ■
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Part 4: Equity Markets
The logic of this method is that future earnings are an important determinant of
a firm’s value. Although earnings beyond the next year are also relevant, this method
implicitly assumes that the growth in earnings in future years will be similar to that
of the industry.
Reasons for Different Valuations This method has several variations,
which can result in different valuations. For example, investors may use different forecasts for the firm’s earnings or the mean industry earnings over the next year. The
previous year’s earnings are often used as a base for forecasting future earnings, but
the recent year’s earnings do not always provide an accurate forecast of the future.
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 use operating earnings or exclude some unusually high expenses that result from onetime
events. A third reason is that investors may disagree on which firms represent the
industry norm. Some investors use a narrow industry composite composed of firms
that are very similar (in terms of size, lines of business, etc.) to the firm being valued; other investors prefer a broad industry composite. Consequently, even if investors agree on a firm’s forecasted earnings, they may still derive different values for that
firm as a result of applying different PE ratios. Furthermore, even if investors agree on
the firms to include in the industry composite, they may disagree on how to weight
each firm.
Limitations of the PE Method The PE method may result in an inaccurate valuation for a firm if errors are made in forecasting the firm’s future earnings
or in choosing the industry composite used to derive the PE ratio. In addition, some
question whether an investor should trust a PE ratio, regardless of how it is derived.
In 1994, the mean PE ratio for a composite of 500 large firms was 14. By 1998, the
mean PE ratio for this same group of firms was 28, which implies that the valuation
for a given level of earnings had doubled. Some investors may interpret such increases
in PE ratios as a sign of irrational optimism in the stock market.
Dividend Discount Model
One of the first models used for pricing stocks was developed by John B. Williams
in 1931. This model is still applicable today. Williams stated that the price of a stock
should reflect the present value of the stock’s future dividends, or
`
Dt
Price 5 a
t
1
t 51 1 1 k 2
where
t 5 period
Dt 5 dividend in period t
k 5 discount rate
The model can account for uncertainty by allowing Dt to be revised in response to revised expectations about a firm’s cash flows, or by allowing k to be revised in response
to changes in the required rate of return by investors.
To illustrate how the dividend discount model can be used to value a
stock, consider a stock that is expected to pay a dividend of $7 per share
per year forever. This constant dividend represents a perpetuity, or an annuity that lasts
forever. The present value of the cash flows (dividend payments) to investors in this example is the present value of a perpetuity. Assuming that the required rate of return (k)
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Chapter 11: Stock Valuation and Risk
265
on the stock of concern is 14 percent, the present value (PV) of the future dividends is
PV of stock 5 D/k
5 $7/.14
5 $50 per share ■
http://
http://www.investingator
.com/PEND-stockinvesting.html Information
on how practitioners value
stock.
Unfortunately, the valuation of most stocks is not this simple because their dividends
are not expected to remain constant forever. If the dividend is expected to grow at a
constant rate, however, the stock can be valued by applying the constant-growth dividend discount model:
PV of stock 5 D1/ 1 k 2 g 2
where D1 is the expected dividend per share to be paid over the next year, k is the required rate of return by investors, and g is the rate at which dividends are expected to
grow. For example, if a stock is expected to provide a dividend of $7 per share next
year, the dividend is expected to increase by 4 percent per year, and the required rate
of return is 14 percent, the stock can be valued as
PV of stock 5 $7/ 1 .14 2 .04 2
5 $70 per share
Relationship between Dividend Discount Model and PE
Ratio for Valuing Firms The dividend discount model and the PE ratio may
seem to be unrelated, since the dividend discount model is highly dependent on the required rate of return and the growth rate, whereas the PE ratio is driven by the mean
multiple of competitors’ stock prices relative to their earnings expectations, along with
the earnings expectations of the firm being valued. Nevertheless, the PE multiple is
influenced by the required rate of return on stocks of competitors and the expected
growth rate of competitor firms. When using the PE ratio for valuation, the investor
implicitly assumes that the required rate of return and the growth rate for the firm being valued are similar to those of its competitors. When the required rate of return on
competitor firms is relatively high, the PE multiple will be relatively low, which results
in a relatively low valuation of the firm for its level of expected earnings. When the competitors’ growth rate is relatively high, the PE multiple will be relatively high, which results in a relatively high valuation of the firm for its level of expected earnings. Thus,
the inverse relationship between required rate of return and value exists when applying
either the PE ratio or the dividend discount model. In addition, there is a positive relationship between a firm’s growth rate and its value when applying either method.
Limitations of the Dividend Discount Model The dividend discount model may result in an inaccurate valuation of a firm if errors are made in determining the dividend to be paid over the next year, or the growth rate, or the required rate of return by investors. The limitations of this model are more pronounced
when valuing firms that retain most of their earnings, rather than distributing them
as dividends, because the model relies on the dividend as the base for applying the
growth rate. For example, many Internet-related stocks retain any earnings to support
growth and thus are not expected to pay any dividends.
Adjusting the Dividend Discount Model
The dividend discount model can be adapted to assess the value of any firm, even
those that retain most or all of their earnings. From the investor’s perspective, the
value of the stock is (1) the present value of the future dividends to be received over
the investment horizon, plus (2) the present value of the forecasted price at which the
stock will be sold at the end of the investment horizon. To forecast the price at which
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Part 4: Equity Markets
the stock can be sold, investors must estimate the firm’s earnings per share (after removing any nonrecurring effects) in the year that they plan to sell the stock. This estimate is derived by applying an annual growth rate to the prevailing annual earnings
per share. Then, the estimate can be used to derive the expected price per share at
which the stock can be sold.
Assume that a firm currently has earnings of $12 per share. Future
earnings can be forecasted by applying the expected annual growth
rate to the firm’s existing earnings (E):
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Forecasted earnings in n years 5 E 1 1 1 G 2 n
where G is the expected growth rate of earnings and n is the number of years until
the stock is to be sold.
If investors expect that the earnings per share will grow by 2 percent per year and
expect to sell the firm’s stock in three years, the earnings per share in three years are
forecasted to be
Earnings in three years 5 $12 3 1 1 1 .02 2 3
5 $12 3 1.0612
5 $12.73
The forecasted earnings per share can be multiplied by the PE ratio of the firm’s industry to forecast the future stock price. If the mean PE ratio of all other firms in the
same industry is 6, the stock price in three years can be forecasted as follows
Stock price in three years 5 1 Earnings in three years 2 3 1 PE ratio of industry 2
5 $12.73 3 6
5 $76.38
This forecasted stock price can be used along with expected dividends and the investor’s required rate of return to value the stock today. If the firm is expected to pay a
dividend of $4 per share over the next three years, and if the investor’s required rate
of return is 14 percent, the present value of expected cash flows to be received by the
investor is
PV 5 $4/ 1 1.14 2 1 1 $4/ 1 1.14 2 2 1 $4/ 1 1.14 2 3 1 $76.38/ 1 1.14 2 3
5 $3.51 1 $3.08 1 $2.70 1 $51.55
5 $60.84 ■
In this example, the present value of the cash flows is based on (1) the present
value of dividends to be received over the three-year investment horizon, which is
$9.29 per share ($3.51 ⫹ $3.08 ⫹ $2.70), and (2) the present value of the forecasted
price at which the stock can be sold at the end of the three-year investment horizon,
which is $51.55 per share.
Limitations of the Adjusted Dividend Discount Model This
model may result in an inaccurate valuation if errors are made in deriving the present
value of dividends over the investment horizon or the present value of the forecasted
price at which the stock can be sold at the end of the investment horizon. Since the
required rate of return affects both of these factors, the use of an improper required
rate of return will lead to inaccurate valuations. Possible methods for determining the
required rate of return are discussed next.
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Chapter 11: Stock Valuation and Risk
267
Free Cash Flow Model
For fi rms that do not pay dividends, a more suitable valuation may be the free cash
flow model, which is based on the present value of future cash flows. The fi rst step is
to estimate the free cash flows that will result from operations. Second, subtract existing liabilities to determine the value of the fi rm. Third, divide the value of the fi rm by
the number of shares to derive a value per share.
Limitations The limitation of this model is the difficulty of obtaining an accurate estimate of free cash flow per period. One possibility is to start with forecasted
earnings and then add a forecast of the fi rm’s noncash expenses and capital investment and working capital investment required to support the growth in the forecasted earnings. Obtaining accurate earnings forecasts can be difficult, however. Even
if earnings can be forecasted accurately, the flexibility of accounting rules can cause
major errors in estimating free cash flow based on earnings.
Determining the Required Rate
of Return to Value Stocks
When investors attempt to value a firm based on discounted cash flows, they must determine the required rate of return by investors who invest in that stock. Investors require a return that reflects the risk-free interest rate plus a risk premium. Although investors generally require a higher return on firms that exhibit more risk, there is not
complete agreement on the ideal measure of risk or the way risk should be used to derive the required rate of return. Two commonly used models for deriving the required
rate of return are the capital asset pricing model and the arbitrage pricing model.
Capital Asset Pricing Model
The capital asset pricing model (CAPM) is sometimes used to estimate the required rate
of return for any firm with publicly traded stock. The CAPM is based on the premise
that the only important risk of a firm is systematic risk, or the risk that results from
exposure to general stock market movements. The CAPM is not concerned with socalled unsystematic risk, which is specific to an individual firm, because investors can
avoid that type of risk by holding diversified portfolios. That is, any particular adverse
condition (such as a labor strike) affecting one particular firm in an investor’s stock
portfolio should be offset in a given period by some favorable condition affecting another firm in the portfolio. In contrast, the systematic impact of general stock market
movements on stocks in the portfolio cannot be diversified away because most of the
stocks would be adversely affected by a general market decline.
The CAPM suggests that the return of an asset (Rj) is influenced by the prevailing risk-free rate (Rf), the market return (Rm), and the covariance between the Rj and
Rm as follows:
Rj 5 Rf 1 Bj 1 Rm 2 Rf 2
where Bj represents the beta and is measured as COV(Rj, Rm)/VAR(Rm). This model
implies that given a specific Rf and Rm , investors will require a higher return on an asset that has a higher beta. A higher beta reflects a higher covariance between the asset’s returns and market returns, which contributes more risk to the portfolio of assets
held by the investor.
Estimating the Risk-Free Rate and the Market Risk
Premium The yield on newly issued Treasury bonds is commonly used as a proxy
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268
Part 4: Equity Markets
for the risk-free rate. The terms within the parentheses measure the market risk premium, or the excess return of the market above the risk-free rate. Historical data over
30 or more years can be used to determine the average market risk premium over
time, which serves as an estimate of the market risk premium that will exist in the
future.
Estimating the Firm’s Beta A firm’s
beta is a measure of its systematic
risk, as it reflects the sensitivity of the stock’s return to the market’s overall return.
For example, a stock with a beta of 1.2 means that for every 1 percent change in the
market overall, the stock tends to change by 1.2 percent in the same direction. The
beta is typically measured with monthly or quarterly data over the last four years or
so. It is reported in investment services such as Value Line, or it can be computed by
the individual investor who understands how to apply regression analysis. A stock’s
sensitivity to market conditions may change over time in response to changes in the
firm’s operating characteristics. Thus, the beta may adjust as time passes, and the
stock’s value should also adjust in response.
Investors can measure their exposure to systematic risk by determining how the
value of their present stock portfolio has been affected by market movements. They
can apply regression analysis by specifying the stock portfolio’s periodic (monthly or
quarterly) return over the last 20 or so periods as the dependent variable and the
market’s return (as measured by the S&P 500 index or some other suitable proxy) as
the independent variable over those same periods. After inputting these data, a computer spreadsheet package such as Excel can be used to run the regression analysis.
Specifically, the focus is on the estimation of the slope coefficient by the regression
analysis, which represents the estimate of each stock’s beta (for more details, see the
discussion under “Beta of a Stock” later in the chapter). Additional results of the analysis can also be assessed, such as the strength of the relationship between the fi rm’s
returns and market returns. (See Appendix B for more information on using regression analysis.)
To illustrate how the CAPM can be used to estimate the required rate
of return on a firm’s stock, consider a firm that has a beta of 1.2 (based
on the application of regression analysis to determine the sensitivity of the firm’s return to the market return). Also, assume that the prevailing risk-free rate is 6 percent
and that the market risk premium is 7 percent (based on historical data that show that
the annual market return has exhibited a premium of 7 percent above the annual riskfree rate). Using this information, the risk premium (above the risk-free rate) is
8.4 percent (computed as the market risk premium of 7 percent times the beta of
1.2). Thus, the required rate of return on the firm is
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Rj 5 6% 1 1.2 1 7% 2
5 14.4%
The firm’s required rate of return is 14.4 percent, so its estimated future cash flows
would be discounted using a discount rate of 14.4 percent to derive the firm’s present
value. At this same point in time, the required rates of return for other firms could
also be determined. Although the risk-free rate and the market risk premium are the
same regardless of the firm being assessed, the beta varies across firms. Therefore, at
a given point in time, the required rates of return estimated by the CAPM will vary
across firms because of differences in their risk premiums, which are attributed to differences in their systematic risk (as measured by beta). ■
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Chapter 11: Stock Valuation and Risk
269
Limitations of the CAPM The CAPM suggests that the return of a particular stock is positively related to its beta. However, a study by Fama and French1
found that beta was unrelated to the return on stocks over the period 1963–1990.
Subsequently, Chan and Lakonishok 2 reassessed the relation between stock returns and beta. They found that the relation varied with the time period used, which
implies that it is difficult to make projections about the future based on the findings
in any specific period. Thus, they concluded that although it is appropriate to question whether beta is the driving force behind stock returns, it may be premature to
pronounce beta dead.
Furthermore, if beta is a stable measure of the firm’s sensitivity to market movements, it would still be useful for determining which stocks are more feasible investments when the stock market is expected to perform well. Thus, investors should still
monitor a firm’s beta.
Chan and Lakonishok assessed the 10 worst months for the U.S. stock market in
order to compare the returns of firms with relatively high betas versus firms with relatively low betas. They found that firms with the highest betas performed much worse
than firms with low betas in those periods. They also found that high-beta firms
outperformed low-beta firms during market upswings. These results support the
measurement of beta as an indicator of the firm’s response to market upswings or
downswings.
Arbitrage Pricing Model
An alternative pricing model is based on the arbitrage pricing theory (APT). The APT
differs from the CAPM in that it suggests that a stock’s price can be influenced by
a set of factors in addition to the market. The factors may possibly reflect economic
growth, inflation, and other variables that could systematically influence asset prices.
The following model is based on the APT:
E 1 R 2 5 B0 1 a BiFi
m
E 1 R 2 5 expected return of asset
i51
where
B0 5 a constant
Fi cFm 5 values of factors 1 to m
Bi 5 sensitivity of the asset return to particular force
The model suggests that in equilibrium, expected returns on assets are linearly related to the covariance between asset returns and the factors. This is distinctly different from the CAPM, where expected returns are linearly related to the covariance between asset returns and the market. The appeal of the APT is that it allows for factors
(such as industry effects) other than the market to influence the expected returns of
assets. Thus, the required rate of return may be based not only on the firm’s sensitivity to market conditions but also on its sensitivity to industry conditions. A possible
disadvantage of the APT is that it is not as well defined as the CAPM. This characteristic could be perceived as an advantage, however, since it allows investors to include
whatever factors they believe are relevant in deriving the required rate of return for a
particular firm.
1
Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance
(June 1992): 427–465.
2
Louis K. C. Chan and Josef Lakonishok, “Are the Reports of Beta’s Death Premature?” Journal of Portfolio
Management (Summer 1993): 51–62.
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Part 4: Equity Markets
Factors That Affect Stock Prices
Stock prices are driven by three types of factors: (1) economic factors, (2) marketrelated factors, and (3) firm-specific factors.
Economic Factors
A firm’s value should reflect the present value of its future cash flows. Investors consider various economic factors that affect a firm’s cash flows when valuing a firm to
determine whether its stock is over- or undervalued.
http://
http://biz.yahoo.com/c/
e.html Calendar of upcoming announcements of economic conditions that may
affect stock prices.
http://
http://research.stlouisfed.org
Economic information that
can be used to value securities, including money supply
information, gross domestic
product, interest rates, and
exchange rates.
Impact of Economic Growth An increase in economic growth is expected to increase the demand for products and services produced by firms and therefore increase a firm’s cash flows and valuation. Participants in the stock markets monitor economic indicators such as employment, gross domestic product, retail sales,
and personal income because these indicators may signal information about economic
growth and therefore affect cash flows. In general, unexpected favorable information
about the economy tends to cause a favorable revision of a firm’s expected cash flows
and therefore places upward pressure on the firm’s value. Because the government’s
fiscal and monetary policies affect economic growth, they are also continually monitored by investors.
Exhibit 11.1 shows the U.S. stock market performance, based on the S&P 500
index, an index of 500 large U.S. stocks. The stock market’s strong performance in
the late 1990s was partially due to the strong economic conditions in the United
States at that time. Conversely, the stock market’s weak performance in 2000 and
in 2001 was primarily due to the weak economic conditions at that time. The rise in
stock prices in the 2003–2007 period is partially attributed to the improvement in
the economy.
Impact of Interest Rates One of the most prominent economic forces
driving stock market prices is the risk-free interest rate. Investors should consider purchasing a risky asset only if they expect to be compensated with a risk premium for
the risk incurred. Given a choice of risk-free Treasury securities or stocks, investors
should purchase stocks only if they are appropriately priced to reflect a sufficiently
high expected return above the risk-free rate. Although the relationship between interest rates and stock prices is not constant over time, most of the largest stock market
declines have occurred in periods when interest rates increased substantially. Furthermore, the stock market’s rise in the late 1990s is partially attributed to the low interest rates during that period, which encouraged investors to shift from debt securities
(with low rates) to equity securities.
Impact of the Dollar’s Exchange Rate Value The value of the
dollar can affect U.S. stock prices for a variety of reasons. First, foreign investors
prefer 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 changing value on cash flows. Stock prices of U.S.
firms primarily involved in exporting could be favorably affected by a weak dollar and
adversely affected by a strong dollar. U.S. importing firms could be affected in the
opposite manner.
Stock prices of U.S. companies may also be affected by exchange rates if stock market participants measure performance by reported earnings. A multinational corpora-
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271
Chapter 11: Stock Valuation and Risk
Exhibit 11.1
Stock Market Trend Based on the S&P 500 Index
1500
1400
1300
1200
1100
Index Level
1000
900
800
700
600
500
400
300
200
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
100
Year
tion’s consolidated reported earnings will be affected by exchange rate fluctuations
even if the company’s cash flows are not affected. A weaker dollar tends to inflate the
reported earnings of a U.S.-based company’s foreign subsidiaries. Some analysts argue that any effect of exchange rate movements on financial statements is irrelevant
unless cash flows are also affected.
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. economy, it may enhance the value of a U.S. firm whose
sales are dependent on the U.S. economy. A strong dollar could adversely affect such a
firm if it dampens U.S. economic growth. Because inflation affects some firms, a weak
dollar could indirectly affect a firm’s stock by putting upward pressure on inflation.
A strong dollar would have the opposite indirect impact. Some companies attempt to
insulate their stock price from the changing value of the dollar, but other companies
purposely remain exposed with the intent to benefit from it.
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Part 4: Equity Markets
Market-Related Factors
Market-related factors also drive stock prices. These factors include investor sentiment
and the January effect.
Investor Sentiment A key market-related factor is investor sentiment, which
represents the general mood of investors in the stock market. Since stock valuations
reflect expectations, in some periods the stock market performance is not highly
correlated with existing economic conditions. For example, even though the economy is weak, stock prices may rise if most investors expect that the economy will
improve in the near future. That is, there is a positive sentiment because of optimistic expectations.
Stocks can exhibit excessive volatility because their prices are partially
driven by fads and fashions, which may be unrelated to the present
value of future dividends. During the late 1990s, stock prices increased beyond what
might be attributed to strong economic conditions. At that time, investor sentiment
was unusually optimistic about Internet fi rms. In 2000 and 2001, investor sentiment
shifted, causing a substantial decline in stock prices.
Movements in stock prices may be partially attributed to investors’ reliance on
other investors for stock market valuation. Rather than making their own assessment
of a firm’s value, many investors appear to focus on the general investor sentiment.
This can result in irrational exuberance, whereby stock prices increase without reason.
Given the potential changes in valuation caused by market sentiment, some investors attempt to anticipate future momentum of stock prices by using technical analysis. The rationale behind technical analysis is that if trends in stock prices are repetitive, investors can take positions in stocks when they recognize that a particular
trend is occurring. Technical analysis is most commonly used to anticipate short-term
movements in stock prices. ■
BEHAVIORAL
BEHAVIORAL FINANCE
FINANCE
January Effect Because many portfolio managers are evaluated over the calendar year, they tend to invest in riskier small stocks at the beginning of the year and shift
to larger (more stable) companies near the end of the year to lock in their gains. This
tendency places upward pressure on small stocks in January of every year, causing the
so-called January effect. Some studies have found that most of the annual stock market
gains occur in January. Once investors discovered the January effect, they attempted to
take more positions in stocks in the prior month. This has placed upward pressure on
stocks in mid-December, causing the January effect to begin in December.
Firm-Specific Factors
A fi rm’s stock price is affected not only by macroeconomic and market conditions but
also by firm-specific conditions. Some fi rms are more exposed to conditions within
their own industry than to general economic conditions, so participants monitor industry sales forecasts, entry into the industry by new competitors, and price movements
of the industry’s products. Stock market participants may focus on announcements
by specific fi rms that signal information about a fi rm’s sales growth, earnings, or
other characteristics that may cause a revision in the expected cash flows to be generated by that fi rm.
Dividend Policy Changes An increase in dividends may reflect the firm’s
expectation that it can more easily afford to pay dividends. A decrease in dividends
may reflect the firm’s expectation that it will not have sufficient cash flow.
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USING THE WALL STRE
ET
JO
U and
RRisk
N A 273
L
Chapter
11: Stock
Valuation
Stocks in the News
The Wall Street Journal identifies stocks that
are in the news. For example, the prices of
these stocks may have experienced a pronounced gain recently because of news of a
potential buyout, a large dividend increase,
a large stock repurchase, or a favorable
earnings surprise. This table also identifies
stocks whose prices have experienced a pronounced decline because of negative news
such as fraudulent accounting or a negative
earnings surprise. Market participants commonly review stocks that are in the news because the market’s reaction to the news may
prompt them to buy or sell shares of some
stocks. For example, if they believe the market overreacted to unfavorable news, they
may decide that the stock is now undervalued
and consider investing in the stock.
Source: Reprinted with permission of Dow Jones &
Company, Inc., from The Wall Street Journal, April 6,
2007; permission conveyed through the Copyright
Clearance Center, Inc.
Earnings Surprises Recent earnings are used to forecast future earnings
and therefore to forecast a firm’s future cash flows. When a firm’s announced earnings
are higher than expected, some investors raise their estimates of the firm’s future cash
flows and therefore revalue its stock upward. Conversely, an announcement of lower
than expected earnings can cause investors to reduce their valuation of a firm’s future
cash flows and its stock.
Acquisitions and Divestitures The expected acquisition of a firm typically results in an increased demand for the target’s stock and therefore raises the
stock price. Investors recognize that the target’s stock price will be bid up once the
acquiring firm attempts to acquire the target’s stock. The effect on the acquiring
firm’s stock is less clear, as it depends on the perceived synergies that could result from
the acquisition. Divestitures tend to be regarded as a favorable signal about a firm if
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the divested assets are unrelated to the firm’s core business. The typical interpretation
by the market in this case is that the firm intends to focus on its core business.
Expectations Investors do not necessarily wait for a firm to announce a new
policy before they revalue the firm’s stock. Instead, they attempt to anticipate new
policies so that they can make their move in the market before other investors. In
this way, they may be able to pay a lower price for a specific stock or sell the stock at
a higher price. For example, they may use the firm’s financial reports or recent statements by the firm’s executives to speculate on whether the firm will adjust its dividend
policy. The disadvantage of trading based on incomplete information is that the investors may not properly anticipate the firm’s future policies.
http://
Integration of Factors Affecting Stock Prices
http://screen.yahoo.com/
stocks.html Screens stocks
based on various possible
valuation indicators.
Exhibit 11.2 illustrates the underlying forces that cause a stock’s price to change over
time. As with the pricing of debt securities, the required rate of return is relevant, as
are the economic factors that affect the risk-free interest rate. Stock market participants also monitor indicators that can affect the risk-free interest rate, which affects
Exhibit 11.2 Framework for Explaining Changes in a Firm’s Stock Price over Time
International
Economic
Conditions
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
U.S.
Economic
Conditions
Stock Market
Conditions
Market
Risk
Premium
Risk-Free
Interest
Rate
Expected
Cash Flows
to Be
Generated
by the
Firm
Industry
Conditions
Firm-Specific
Conditions
Firm’s
Systematic
Risk
(Beta)
Firm’s
Risk
Premium
Required Return
by Investors
Who Invest in
the Firm
Price of the
Firm’s
Stock
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the required return by investors who invest in stocks. Indicators of inflation (such as
the consumer price index and producer price index) and of government borrowing
(such as the budget deficit and the volume of funds borrowed at upcoming Treasury
bond auctions) also affect the risk-free rate and therefore affect the required return of
investors. In general, whenever these indicators signal the expectation of higher interest rates, there is upward pressure on the required rate of return by investors and
downward pressure on a firm’s value.
In addition, the firm’s expected future cash flows are commonly estimated to
derive its value, and these cash flows are influenced by economic conditions, industry conditions, and firm-specific conditions. This exhibit provides an overview of what
stock market participants monitor when attempting to anticipate future stock price
movements.
Role of Analysts in Valuing Stocks
http://
http://finance.yahoo.com/
mru?u List of stocks that
were upgraded or downgraded by analysts.
Most investors agree that the factors just identified affect stock prices. However, they
tend to disagree on how any particular stock’s price will be affected by changes in
those factors. Given the difficulty in valuing stocks, many investors rely on opinions
of stock analysts who are employed by investment banks or other financial fi rms. Analysts are assigned by their employer to periodically review and rate specific stocks.
Since analysts command very high salaries, they are usually hired to cover only relatively large publicly traded fi rms. About half of the publicly traded fi rms with a total
market value of less than $250 million do not have any analyst coverage. In contrast,
the most widely traded stocks are followed by many analysts.
Analysts play an important role in the market valuation of stocks. Through their
recommendations, they influence the buying or selling decisions of some investors
and therefore can influence the price of stocks. Many analysts are assigned to specific
stocks and issue ratings that can indicate whether investors should buy the stock or
sell the stock.
The ratings have historically been confusing, however, because they use terminology such as strong buy, buy, accumulate buy, hold, and sell. In 2001, research by
Thomson Financial determined that analysts at the largest brokerage fi rms typically
recommended “sell” for less than 1 percent of all the stocks for which they provided
ratings. Some analysts respond (anonymously) that investors simply are misinterpreting the ratings. Ratings such as “accumulate buy” or “hold” may really mean sell. As
a result of the media attention to this issue, some analysts have changed their ratings
to make them clearer to investors.
Ratings for a particular stock are provided along with stock quotes and other information at http://finance.yahoo.com/?u. This website provides summaries of ratings
by well-known analysts and recent changes in analyst ratings for any stock.
Analyst Conflicts of Interest
Many analysts are employed by investment banks that provide many
services for publicly traded fi rms. A bank’s analyst division and the divisions that sell services to client fi rms are supposed to be separated by a so-called
Chinese wall so that the analysts can rate those fi rms in an unbiased manner. In some
periods, this Chinese wall did not exist at many investment banks. In fact, during the
late 1990s and early 2000s, many analysts were rewarded with large bonuses if they
generated other business (such as merger advice or secondary offerings) for the investment bank that employed them. Thus, these analysts had an incentive to rate fi rms
more favorably than they deserved, because fi rms are more likely to select an investment bank whose analyst rates them highly. ■
BEHAVIORAL
BEHAVIORAL FINANCE
FINANCE
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Glenbard Company wanted to hire an investment bank to help it pursue another company for a merger. It knew that the fees to be paid for
this service would probably be at least $1 million. Glenbard considered two large investment banks, Riverside Investment Bank and Los Angeles Investment Bank. The
analyst at Riverside Investment Bank rated Glenbard’s stock as neutral for investors.
His rating was honest and accurate, as Glenbard’s stock was already priced high given
the fi rm’s fi nancial condition. In contrast, the analyst at Los Angeles Investment Bank
rated Glenbard’s stock a strong buy for investors.
The analyst at Los Angeles Investment Bank was well aware that Glenbard Company was fi nancially weak. Nevertheless, he realized that if he rated the stock highly,
Glenbard would be more likely to do business with his investment bank. Therefore,
he assigned an overly optimistic rating to Glenbard’s stock. Glenbard’s managers believed that an investment bank that thought that Glenbard was fi nancially strong and
would perform well in the future would be likely to negotiate a better merger deal.
Therefore, they selected Los Angeles to handle the merger. Thus, as a result of the analyst’s rating, his investment bank received more business and generated more fees. ■
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Another widely publicized abuse occurs when an analyst at the security fi rm that
underwrites an initial public offering (IPO) for a fi rm continuously issues a buy recommendation for the IPO fi rm, even after there are clear signals that the fi rm is
experiencing fi nancial problems. This behavior was especially obvious during the
2000–2001 period when many analysts maintained their “buy” recommendations on
Internet stocks that their fi rm had underwritten, even after there was substantial evidence that these fi rms had fi nancial problems. Considering the confl ict of interest
that analysts face when their employer serves as their client’s investment bank, such
“buy” ratings are misleading to the investors who rely on the analyst’s opinions.
An SEC investigation in 2001 determined that many research analysts of securities fi rms took positions in stocks contrary to their recommendations. Some analysts
would issue a “buy” recommendation for a fi rm whose IPO had recently been underwritten by their employer but then sell their personal holdings of that stock during
this same period. In one case, an analyst even borrowed the stock and sold it, while
issuing a buy recommendation, which confi rmed that his personal view differed from
the recommendation he gave to satisfy his employer.
In the year 2000, the confl icts of interest should have been very obvious. Many
fi rms were going public, engaging in secondary offerings, or merging, and investment
banks were competing for the advisory business. Some investment banks were paying large bonuses to analysts based on the amount of business that the analysts generated for the banks. Thus, the analysts were encouraged to rate any fi rms that might
need investment banking business optimistically so that these fi rms might hire their
respective investment banking divisions to provide services. The Securities and Exchange Commission (SEC) investigated and found clear evidence of confl icts of interest. For example, some analysts assigned a rating of “strong buy” to stocks that
they described as a “piece of junk” or worse in e-mail within their investment bank.
Some of the e-mail messages confi rmed that the main reason the analysts rated a
stock highly was to attract business from other fi rms and generate fee income.
Stock Exchange Rules In the 2002–2004 period, the U.S. stock exchanges imposed new rules to prevent some obvious confl icts of interest faced by
analysts. First, analysts cannot be supervised by the investment banking division of
their company, and their compensation cannot be driven by the amount of investment banking business that they generate. This rule was intended to encourage analysts to provide more unbiased ratings of stocks. Second, investment banks must dis-
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277
close summaries of their analysts’ ratings, so that investors can determine whether the
ratings are excessively optimistic.
Inside Information
Historically, analysts were able to obtain valuable information by communicating with executives of a firm. In many cases, this gave them an
advantage over other investors because the analysts might be the first to learn that the
firm was revising its revenue or earnings forecast downward. The analysts could use
this information to revise their own estimates of the firm’s quarterly earnings or to revise their rating of the firm. Their actions affected investor demand for the firm’s
shares or the amount of shares that investors wanted to sell and therefore affected the
share price. Thus, the information provided to the analysts was ultimately accounted
for in the market, but the analysts had the information before the other market
participants. ■
BEHAVIORAL
BEHAVIORAL FINANCE
FINANCE
New Disclosure Regulations In the late 1990s, some firms began to
announce significant changes in their expected revenue or earnings through the media, rather than provide the information to the analysts first. In October 2000, the
SEC enacted Regulation FD (“Fair Disclosure”), which requires that firms disclose
any significant information that could affect the share price simultaneously to all market participants. Consequently, analysts no longer have an information advantage over
other market participants.
Unbiased Analyst Rating Services
Some analyst rating services are considered to be unbiased because they are not attempting to provide other services for the firms that they rate. Some of the more
popular analyst rating services include Morningstar, Value Line, and Investor’s Business Daily. Morningstar relies on traditional valuation methods (such as revenue and
cost estimates) to determine whether a firm is undervalued. Value Line rates each
stock from 1 (highest) to 5 (lowest). Investor’s Business Daily rates a stock from 1 to
99, with scores over 80 representing recommended buys and scores under 70 recommended sells. Morningstar rates stocks from 5-star (highest) to 1-star. Investor’s Business Daily covers more than 10,000 stocks, Value Line covers 1,700, and Morningstar covers 500.
Analyst rating services typically charge their subscribers between $100 and $600
per year. There are also some online rating services. For example, the website http://
www.msn.com not only provides stock quotes but also has stock ratings (provided by
StockScouter) for 6,500 stocks.
Stock Risk
A stock’s risk reflects the uncertainty about future returns, such that the actual return
may be less than expected. The return from investing in stock over a particular period
is measured as
R5
where
1 SP 2 INV 2 1 D
INV
INV 5 initial investment
D 5 dividend
SP 5 selling price of the stock
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The main source of uncertainty is the price at which the stock will be sold. Dividends
tend to be much more stable than stock prices. Dividends contribute to the immediate return received by investors, but reduce the amount of earnings reinvested by the
firm, which limits its potential growth.
Measures of Risk
The risk of a stock can be measured by its price volatility, its beta, and by the valueat-risk method.
Volatility of a Stock A stock’s volatility serves as a measure of risk because
it may indicate the degree of uncertainty surrounding the stock’s future returns. The
volatility is often referred to as total risk because it reflects movements in stock prices
for any reason, not just movements attributable to stock market movements. A stock’s
returns over a historical period such as the last 12 quarters may be compiled to estimate future volatility. If the standard deviation of the stock’s returns over the last 12
quarters is 3 percent, and if there is no perceived change in volatility, there is a 68 percent probability that the stock’s returns will be within 3 percentage points (one standard deviation) of the expected outcome and a 95 percent probability that the stock’s
returns will be within 6 percentage points (2 standard deviations) of the expected
outcome.
Volatility of a Stock Portfolio A portfolio’s volatility is dependent on
the volatility of the individual stocks in the portfolio, the correlations between returns of the stocks in the portfolio, and the proportion of total funds invested in each
stock. The portfolio’s volatility can be measured by the standard deviation:
w2i s2i 1 w2j s2j 1 a a wiwj si sj CORRij
Å
n
sp 5
n
i51 j 51
where
si 5 standard deviation of returns of the ith stock
sj 5 standard deviation of returns of the jth stock
CORRij 5 correlation coefficient between the ith and jth stocks
wi 5 proportion of funds invested in the ith stock
wj 5 proportion of funds invested in the jth stock
For portfolios containing more securities, the formula for the standard deviation
would contain the standard deviation of each stock and the correlation coefficients
between all pairs of stocks in the portfolio, weighted by the proportion of funds invested in each stock. The equation for a two-stock portfolio is sufficient to demonstrate that 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 returns are highly correlated, other factors held constant.
As an extreme example, if the returns of the stocks are all perfectly positively correlated (correlation coefficients ⫽ 1.0), the portfolio will have a relatively high degree
of volatility because all stocks will experience peaks or troughs simultaneously. Conversely, a stock portfolio containing some stocks with low or negative correlation will
exhibit less volatility because the stocks will not experience peaks and troughs simultaneously. Some offsetting effects will occur, smoothing the returns of the portfolio
over time.
Beta of a Stock As explained earlier, a stock’s beta measures the sensitivity of
its returns to market returns. This measure of risk is used by many investors who have
a diversified portfolio of stocks and believe that the unsystematic risk of the portfolio
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Chapter 11: Stock Valuation and Risk
279
is diversified away (because favorable firm-specific characteristics will offset unfavorable firm-specific characteristics). 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:
Rjt 5 B0 1 B1Rmt 1 mt
where
Rjt 5 return of stock j during period t
Rmt 5 market return during period t
B0 5 intercept
B1 5 regression coefficient that serves as an estimate of beta
mt 5 error term
Some investors or analysts prefer to use monthly returns rather than quarterly returns to estimate the beta. The choice is dependent on the holding period for which
one wants to assess sensitivity. If the goal is to assess sensitivity to monthly returns,
then monthly data would be more appropriate.
The regression analysis estimates the intercept (B 0) and the slope coefficient (B1),
which serves as the estimate of beta. If the slope coefficient of an individual stock
is estimated to be 1.4, this means that for a given return in the market, the stock’s
expected return is 1.4 times that amount. Such sensitivity is favorable when the
stock market is performing well, but unfavorable when the stock market is performing poorly. This implies that the probability distribution of returns is very dispersed,
reflecting a wide range of possible outcomes for the individual stock.
Beta serves as a measure of risk because it can be used to derive a probability distribution of returns based on a set of market returns. As explained earlier, beta is useful for investors who are primarily concerned with systematic risk because it captures
the movement in a stock’s price that is attributable to movements in the stock market.
It ignores stock price movements attributable to firm-specific conditions because such
unsystematic risk can be avoided by maintaining a diversified portfolio.
Exhibit 11.3 shows how the probability distribution of a stock’s returns is dependent on its beta. At one extreme, Stock A with a very low
beta is less responsive to market movements in either direction, so its possible returns
range only from ⫺4.8 percent under poor market conditions to 6 percent under the
most favorable market conditions. Stock D with a very high beta has possible returns
that range from ⫺11.2 percent under poor market conditions to 14 percent under the
most favorable market conditions. ■
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Beta of a Stock Portfolio Participants in the stock market tend to invest
in a portfolio of stocks rather than a single stock and therefore are more concerned
with the risk of a portfolio than with the risk of an individual stock. The risk of individual stocks is necessary to derive portfolio risk. Portfolio risk is commonly measured by beta or volatility (standard deviation), just as the risk of individual stocks is.
The beta of a stock portfolio can be measured as
Bp 5 a wiBi
That is, the portfolio beta is a weighted average of the betas of stocks that comprise the portfolio, where the weights reflect the proportion of funds invested in
each stock. The equation is intuitive as it simply suggests that a portfolio consisting
of high-beta stocks will have a relatively high beta. This type of portfolio normally
performs poorly relative to other stock portfolios in a period when the market return
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Part 4: Equity Markets
Exhibit 11.3 How Beta Influences Probability Distributions
Probability (%)
Probability (%)
40
40
30
30
20
20
10
10
⫺15
⫺10
⫺5
0
⫹5
⫹10
⫹15
⫺15
⫺10
Probability (%)
⫹5
⫹10
⫹15
Probability (%)
40
40
30
30
20
20
10
10
⫺15
0
⫺5
Expected Return of Stock B (%)
Expected Return of Stock A (%)
⫺10
⫺5
0
⫹5
⫹10
⫺15
⫹15
⫺10
0
⫺5
⫹5
⫹10
⫹15
Expected Return of Stock D (%)
Expected Return of Stock C (%)
Probability
Rm
Stock A’s
Expected
Returns,
E(R), if Bi ⴝ .6
10%
⫺8%
⫺4.8%
⫺7.2%
⫺9.6%
⫺11.2%
20
⫺6
⫺3.6
⫺5.4
⫺7.2
⫺8.4
40
5
6
7
20
8
10
10
3
Stock B’s
Expected
Returns,
E(R), if Bi ⴝ .9
Stock C’s
Expected
Returns,
E(R), if Bi ⴝ 1.2
Stock D’s
Expected
Returns,
E(R), if Bi ⴝ 1.4
4.5
4.8
7.2
6
9
9.6
12
11.2
14
is negative. The risk of such a portfolio could be reduced by replacing some of the
high-beta stocks with low-beta stocks. Of course, the expected return for the portfolio would be lower as a result.
The beta of a stock and its volatility are typically related. High-beta stocks are expected to be very volatile because they are more sensitive to market returns over time.
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281
Conversely, low-beta stocks are expected to be less volatile because they are less responsive to market returns.
Value at Risk Value at risk is a risk measurement that estimates the largest expected loss to a particular investment position for a specified confidence level. This
method became very popular in the late 1990s after some mutual funds and pension
funds experienced abrupt large losses. The value-at-risk method is intended to warn
investors about the potential maximum loss that could occur. If the investors are uncomfortable with the potential loss that could occur in a day or a week, they can revise their investment portfolio to make it less risky.
The value-at-risk measurement focuses on the pessimistic portion of the probability distribution of returns from the investment of concern. For example, a portfolio
manager might use a confidence level of 90 percent, which estimates the maximum
daily expected loss for a stock in 90 percent of the trading days over an upcoming period. The higher the level of confidence desired, the larger the maximum expected
loss that could occur for a given type of investment. That is, one may expect that the
daily loss from holding a particular stock will be no worse than ⫺5 percent when using a 90 percent confidence level, but no worse than ⫺8 percent when using a 99 percent confidence level. In essence, the more confidence investors have that the actual
loss will be no greater than the expected maximum loss, the further they move into
the left tail of the probability distribution.
The value at risk is also commonly used to measure the risk of a portfolio. Some
stocks may be perceived to have high risk when assessed individually, but low risk
when assessed as part of a portfolio. This is because the likelihood of a large loss in
the portfolio is influenced by the probabilities of simultaneous losses in all of the
component stocks for the period of concern.
Applying Value at Risk
Value at risk can be applied to measure the maximum loss for a specific stock based on
a specified confidence level.
Methods of Determining the Maximum
Expected Loss
Numerous methods can be used when applying value at risk. Three basic methods are
discussed next.
Use of Historical Returns to Derive the Maximum Expected Loss An obvious way to use value at risk is to assess historical data. For
example, an investor may determine that out of the last 100 trading days, a stock experienced a decline of greater than 7 percent on 5 different days, or 5 percent of the
days assessed. This information could be used to infer a maximum daily loss of no
more than 7 percent for that stock, based on a 95 percent confidence level for an upcoming period.
Use of Standard Deviation to Derive the Maximum Expected Loss An alternative approach is to measure the standard deviation of
daily returns over the previous period and apply it to derive boundaries for a specific
confidence level.
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Assume that the standard deviation of daily returns for a particular
stock in a recent historical period is 2 percent. Also assume that the
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95 percent confidence level is desired for the maximum loss. If the daily returns are
normally distributed, the lower boundary (the left tail of the probability distribution)
is about 1.65 standard deviations away from the expected outcome. Assuming an expected daily return of .1 percent, the lower boundary is
.1% 2 3 1.65 3 1 2% 2 4 5 23.2%
The expected daily return of .1 percent may have been derived from the use of
subjective information, or it could be the average daily return from the recent historical period assessed. The lower boundary for a given confidence level can be easily derived for any expected daily return. For example, if the expected daily return is .14
percent, the lower boundary is
.14% 2 3 1.65 3 1 2% 2 4 5 23.16% ■
Use of Beta to Derive the Maximum Expected Loss A third
method of estimating the maximum expected loss for a given confidence level is to
apply the stock’s beta.
Assume that the stock’s beta over the last 100 days is 1.2. Also assume
that the stock market is expected to perform no worse than ⫺2.5 percent on a daily basis based on a 95 percent confidence level. Given the stock’s beta of
1.2 and a maximum market loss of ⫺2.5 percent, the maximum loss to the stock over
a given day is estimated to be
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1.2 3 1 22.5% 2 5 23.0%
The maximum expected market loss for the 95 percent confidence level can be derived subjectively or by assessing the last 100 days or so (in the same manner described
for the two previous methods that can be used to derive a maximum expected loss for
an individual stock). ■
Deriving the Maximum Dollar Loss
Once the maximum percentage loss for a given confidence level is determined, it can
be applied to derive the maximum dollar loss of a particular investment.
Assume that an investor has a $20 million investment in a stock. The
maximum dollar loss is determined by applying the maximum percentage loss to the value of the investment. If the investor used beta to measure the maximum expected loss as explained above, the maximum percentage loss over one day
would be ⫺3 percent, so the maximum daily loss in dollars is
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(ⴚ3%) ⴛ $20,000,000 ⴝ $600,000 ■
Since many institutional and individual investors manage stock portfolios, value
at risk is commonly applied to assess the maximum possible loss of the entire portfolio. The same three methods used to derive the maximum expected loss of one
stock can be applied to derive the maximum expected loss of a stock portfolio for a
given confidence level. For instance, the returns of the stock portfolio over the last
100 days or so can be assessed to derive the maximum expected loss. Alternatively,
the standard deviation of the portfolio’s returns can be estimated over the last 100
days to derive a lower boundary at a specified confidence level. As another alternative,
the beta of the portfolio’s returns can be estimated over the last 100 days and then
applied to a maximum expected daily loss in the stock market to derive a maximum
expected loss in the stock portfolio over a given day.
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283
Common Adjustments to the Value-at-Risk
Applications
The basic methods of applying value at risk can be adjusted to improve the assessment
of risk in particular situations, as explained next.
Investment Horizon Desired An investor who wants to assess the maximum loss over a week or a month can apply the same methods, but should use a historical series that matches the investment horizon. For example, to assess the maximum loss over a given week in the near future, a historical series of weekly returns of
that stock (or stock portfolio) can be used.
Length of Historical Period Used The previous examples used a historical series of 100 trading days, but if, for example, conditions have changed such
that only the most recent 70 days reflect the general state of market conditions, then
those 70 days could be used. However, a subperiod of weak market performance
should not be discarded because it could occur again.
Time-Varying Risk The risk of a stock can vary over time for the following
reasons. First, market conditions can change, such that the particular line of business
reflected by the stock is subject to more competition or other industry conditions.
For example, an abrupt increase in competition will increase the probability that the
firm will fail and will normally result in a higher response to poor market conditions
and a higher degree of volatility. Second, the firm’s operations may change, causing a
change in the response of its stock price to market returns and a change in the volatility of the stock’s returns. Consequently, the assessment of a maximum expected loss
based on historical risk characteristics may not be accurate. It is important for investors to recognize how the stock’s risk varies over time so that they can properly assess
its risk in the future.
Restructuring the Investment Portfolio Portfolio managers may
apply value at risk to potential investments. For example, if they are considering the
sale of Stock X and the purchase of Stock Y, they should apply value at risk to their
potential new portfolio. Then, they can compare the risk of this portfolio to their existing portfolio to decide whether they should make these changes. Even if they plan
to increase their investment in some stocks without selling others, they should reapply
value at risk to reflect the new proportions of their stock portfolio allocated to each
security that result from the restructured portfolio.
Forecasting Stock Price
Volatility and Beta
Since the operations of a particular firm and its competitive environment can change
over time, its risk can change as well. Investors are most concerned with the risk of
their investments over the future horizon in which they hold those investments so
that they can anticipate the range of possible returns that may result.
Methods of Forecasting Stock Price Volatility
Some of the more common methods of forecasting stock price volatility are the historical method, the time-series method, and the implied standard deviation method,
which are described next.
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Historical Method With the historical method, a historical period is used to
derive a stock’s standard deviation of returns, and then that estimate is used as the
forecast over the future. Although the stock price volatility level may change over
time, this method can be useful if there is no obvious trend in volatility, so the best
forecast may be the volatility in the most recent period.
Time-Series Method A second method for forecasting stock price volatility
is to use a time series of volatility patterns in previous periods.
The standard deviation of daily stock returns is determined for each of
the last several months. Then, a time-series trend of these standard deviation levels is used to form an estimate for the standard deviation of daily stock returns over the next month. This method differs from the first in that it uses information beyond that contained in the previous month. The forecast may be based on a
weighting scheme such as 50 percent times the standard deviation in the last month
(month 4), plus 25 percent times the standard deviation in the month before that
(month 3), plus 15 percent times the standard deviation in month 2, plus 10 percent
times the standard deviation in month 1. ■
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This scheme places more weight on the most recent data, but allows data from
the last four months to influence the forecast. Normally, the weights and the number
of previous periods (lags) that were most accurate (lowest forecast error) in previous
periods are used. Various economic and political factors can cause stock price volatility to change abruptly, however, so even sophisticated time-series models do not necessarily generate accurate forecasts of stock price volatility.
Implied Standard Deviation A third method for forecasting stock price
volatility is to derive the stock’s implied standard deviation (ISD) from the stock option pricing model (options are discussed in detail in Chapter 14). 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 of days until
the expiration date of the option, and the anticipated volatility of the stock price movements. There is a formula for estimating the call option premium based on various factors. The actual values of these factors are known, except for the anticipated volatility.
However, by plugging in the actual option premium paid by investors for that specific
stock, it is possible to derive the anticipated volatility level. Market participants who
wish to forecast volatility over a 30-day period will consider a call option on the stock
that has 30 days to expiration. This measurement represents the anticipated volatility
of the stock over a 30-day period by investors who are trading stocks. Participants may
use this measurement as their own forecast of that specific stock’s volatility.
Forecasting a Stock Portfolio’s Volatility
Portfolio managers who monitor total risk rather than systematic risk are more concerned about stock volatility than about beta. Recall that a stock portfolio’s volatility is
dependent on the volatility of the individual stocks in the portfolio, as well as their correlations. Since the volatilities and correlations of the individual stocks can change over
time, so can the volatility of the portfolio. One method of forecasting portfolio volatility is to first derive forecasts of individual volatility levels as described earlier. Then, the
correlation coefficient for each pair of stocks in the portfolio is forecasted by estimating the correlation in recent periods and determining whether there was a trend in the
change in correlations. The forecasted volatilities of individual stocks and the correlation coefficients are then used to estimate the future portfolio volatility. This approach
explicitly captures the recent trends in individual volatilities and correlations.
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Forecasting a Stock Portfolio’s Beta
Given that the beta of any stock can change over time and that a stock portfolio’s beta
is dependent on the betas of its individual stocks, the portfolio’s beta is subject to
change. One way to forecast a portfolio’s beta is to first forecast the betas of the individual stocks in the portfolio and then sum the individual forecasted betas, weighted
by the proportion of investment in each stock.
The beta of each individual stock may be forecasted in a subjective manner; for
example, a portfolio manager may forecast a stock’s beta to increase from its existing
level of .8 to .9 because the firm has initiated a more aggressive growth strategy. Alternatively, the manager can assess a set of historical periods to determine whether
there is a trend in the beta over those periods and then apply the trend. For example,
a portfolio manager who is attempting to forecast the beta of stocks based on a daily
horizon may estimate the betas in each of the previous four 100-day periods. Assume that the beta was estimated to be .6 four periods ago, .62 three periods ago, .7
two periods ago, and .8 last period. This firm’s beta appears to have an upward trend,
which may support a forecast of a slightly higher beta in the next period. However,
the stock’s beta will not continually change in one direction.
The same procedure can be used to forecast betas based on a different horizon. For
example, a portfolio manager who wants to forecast the beta based on monthly stock
returns can attempt to determine the trend by assessing recent 12-month periods.
Stock Performance Measurement
The performance of a stock or a stock portfolio over a particular period can be measured by its excess return (return above the risk-free rate) over that period divided by
its risk. Two common methods of measuring performance are the Sharpe index and
the Treynor index.
Sharpe Index
If total variability is thought to be the appropriate measure of risk, a stock’s riskadjusted returns can be determined by the reward-to-variability ratio (also called the
Sharpe index), computed as
Sharpe index 5
where
R 2 Rf
s
R 5 average return on the stock
Rf 5 average risk-free rate
s 5 standard deviation of the stock’s returns
The higher the stock’s mean return relative to the mean risk-free rate and the lower
the standard deviation, the higher the Sharpe index. This index measures the excess
return above the risk-free rate per unit of risk.
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Assume the following information for two stocks:
• Average return for Sooner stock ⫽ 16%
• Average return for Longhorn stock ⫽ 14%
• Average risk-free rate ⫽ 10%
• Standard deviation of Sooner stock returns ⫽ 15%
• Standard deviation of Longhorn stock returns ⫽ 8%
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Sharpe index for Sooner stock 5
16% 2 10%
15%
5 .40
Sharpe index for Longhorn stock 5
14% 2 10%
8%
5 .50
Even though Sooner stock had a higher average percentage return, Longhorn stock
had a higher performance because of its lower risk. If a stock’s average return is less
than the average risk-free rate, the Sharpe index for that stock will be negative. ■
Treynor Index
If beta is thought to be the most appropriate type of risk, a stock’s risk-adjusted returns can be determined by the Treynor index, computed as
Treynor index 5
R 2 Rf
B
where B is the stock’s beta. The Treynor index is similar to the Sharpe index, except
that it uses beta rather than standard deviation to measure the stock’s risk. The higher
the Treynor index, the higher the return relative to the risk-free rate, per unit of risk.
Using the information provided earlier on Sooner and Longhorn stock
and assuming that Sooner’s stock beta is 1.2 and Longhorn’s beta is
1.0, the Treynor index is computed for each stock as follows:
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Treynor index for Sooner stock 5
16% 2 10%
1.2
5 .05
Treynor index for Longhorn stock 5
14% 2 10%
1.0
5 .04
Based on the Treynor index, Sooner stock had the higher performance. ■
A comparison of this and the previous illustration shows that the stock determined to have the higher performance is dependent on the measure of risk and therefore on the index used. In some cases, the indexes will lead to the same results. Like
the Sharpe index, the Treynor index is negative for a stock whose average return is less
than the average risk-free rate.
Stock Market Efficiency
If stock markets are efficient, the prices of stocks at any point in time should fully
reflect all available information. As investors attempt to capitalize on new information that is not already accounted for, stock prices should adjust immediately. Investors commonly over- or underreact to information. This does not mean markets
are inefficient unless the reaction is biased (consistently over- or underreacting). In
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287
this case, investors who recognize the bias will be able to earn abnormally high riskadjusted returns.
Forms of Efficiency
Efficient markets can be classified into three forms: weak, semistrong, and strong.
Weak-Form Efficiency Weak-form efficiency suggests that security prices
reflect all trade-related information, such as historical security price movements and
volume of securities trades. Thus, investors will not be able to earn abnormal returns
on a trading strategy that is based solely on past price movements.
Semistrong-Form Efficiency
Semistrong-form efficiency suggests that
security prices fully reflect all public information. The difference between public information and market-related information is that public information also includes
announcements by firms, economic news or events, and political news or events.
Market-related information is a subset of public information. Thus, if semistrongform efficiency holds, weak-form efficiency must hold as well. It is possible, however,
for weak-form efficiency to hold, while semistrong-form efficiency does not. In this
case, investors could earn abnormal returns by using the relevant information that
was not immediately accounted for by the market.
Strong-Form Efficiency
Strong-form efficiency suggests that security
prices fully reflect all information, including private or insider information. If strongform efficiency holds, semistrong-form efficiency must hold as well. If insider information leads to abnormal returns, however, semistrong-form efficiency could hold,
while strong-form efficiency does not.
Inside information allows insiders (such as some employees or board members) an
unfair advantage over other investors. For example, if employees of a firm are aware
of favorable news about the firm that is not yet disclosed to the public, they may consider purchasing shares or advising their friends to purchase the firm’s shares. Though
such actions are illegal, they still happen and can create market inefficiencies.
Even if insiders do not act on inside information, a particular group of investors
may receive information before others and therefore have an unfair advantage.
Consider the Bank of New York’s announcement that it was experiencing loan defaults on its credit card business. The bank fi rst announced
this information through a conference call to about 90 securities analysts and institutional investors at about 2:00 P.M. on June 19, 1996. After the announcement, its
stock price declined by about 2.6 percent that afternoon. The bank then issued a news
release to the public at about 4:30 P.M. on the same afternoon—30 minutes after the
stock market closed. Small investors were upset that they received the information
later than many institutional investors and therefore could not respond as quickly to
the news. They argued that this allowed institutional investors a head start on selling
the stock in response to negative information. Regulation FD has been enacted to ensure that firms fully disclose their information at the same time to all investors, which
should prevent some market inefficiencies. ■
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Tests of the Efficient Market Hypothesis
Tests of market efficiency are segmented into three categories, as discussed next.
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Part 4: Equity Markets
Test of Weak-Form Efficiency Weak-form efficiency has been tested by
searching for a nonrandom pattern in security prices. If the future change in price is
related to recent changes, historical price movements could be used to earn abnormal
returns. In general, studies have found that historical price changes are independent
over time. Therefore, historical information is already reflected by today’s price and
cannot be used to earn abnormal profits. Even when some dependence was detected,
the transaction costs would offset any excess return earned.
There is some evidence that stocks have performed better in specific time periods.
For example, as mentioned earlier, small stocks have performed unusually well in the
month of January (“January effect”). Second, stocks have historically performed better on Fridays than on Mondays (“weekend effect”). Third, stocks have historically
performed well on the trading days just before holidays (“holiday effect”). To the extent that a given pattern continues and can be used by investors to earn abnormal returns, market inefficiencies exist. In most cases, there is no clear evidence that such
patterns persist once they are recognized by the investment community.
One could argue that the stock market is inefficient based on the number of socalled corrections that occur. During the twentieth century, there were more than
100 specific days when the market (as measured by the Dow Jones Industrial Average)
declined by 10 percent or more. On more than 300 specific days during the century,
the market declined by more than 5 percent. These abrupt declines frequently followed a market runup, which implies that the runup may have been excessive. Thus, a
market correction was necessary to remove the excessive runup.
Test of Semistrong-Form Efficiency Semistrong-form efficiency has
been tested by assessing how security returns adjust to particular announcements.
Some announcements are specific to a firm, such as an announced dividend increase,
an acquisition, or a stock split. Other announcements are economy related, such as an
announced decline in the federal funds rate. In general, security prices immediately
reflected the information from the announcements. That is, the securities were not
consistently over- or undervalued. Consequently, abnormal returns could not consistently be achieved. This is especially true when considering transaction costs.
There is evidence of unusual profits when investing in IPOs. In particular, the return over the first day following the IPO tends to be abnormally high. One reason
for this underpricing is that the investment banking firms underwriting an IPO intentionally underprice to ensure that the entire issue can be placed. In addition, underwriters are required to exercise due diligence in ensuring the accuracy of the information that they provide to investors about the corporation. Thus, underwriters are
encouraged to err on the low side when setting a price for IPOs.
Some analysts might contend that given imperfect information about IPOs,
investors will participate only if prices are low. Thus, the potential return must be
high enough to compensate for the lack of information about these corporations
and the risk incurred. Using this argument, the underpricing does not imply market
inefficiencies but rather reflects the high degree of uncertainty.
Test of Strong-Form Efficiency Tests of strong-form efficiency are
difficult, because the inside information used is not publicly available and cannot be
properly tested. Nevertheless, many forms of insider trading could easily result in abnormally high returns. For example, there is clear evidence that share prices of target
firms rise substantially when the acquisition is announced. If insiders purchased stock
of targets prior to others, they would normally achieve abnormally high returns. Insiders are discouraged from using this information because it is illegal, not because
markets are strong-form efficient.
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289
Foreign Stock Valuation, Performance,
and Efficiency
GL
BALASPECTS Some of the key concepts in this chapter can be adjusted so that they apply on
a global basis, as explained next.
Valuation of Foreign Stocks
Foreign stocks can be valued by using the price-earnings method or the dividend discount model with an adjustment to reflect international conditions.
Price-Earnings (PE) Method The expected earnings per share of the foreign firm are multiplied by the appropriate PE ratio (based on the firm’s risk and local industry) to determine the appropriate price of the firm’s stock. Though easy to
use, this method is subject to some limitations when valuing foreign stocks. The PE
ratio for a given industry may change continuously in some foreign markets, especially when the industry is composed of just a few firms. Thus, it is difficult to determine the proper ratio that should be applied to a specific foreign firm. In addition,
the PE ratio for any particular industry may need to be adjusted for the firm’s country because reported earnings can be influenced by the country’s accounting guidelines and tax laws.
Furthermore, even if U.S. investors are comfortable with their estimate of the
proper PE ratio, the value derived by this method is denominated in the local foreign
currency (since the estimated earnings are denominated in that currency). Therefore,
U.S. investors still need to consider exchange rate effects. Even if the stock is undervalued in the foreign country, it may not necessarily generate a reasonable return for
U.S. investors if the foreign currency depreciates against the dollar.
Dividend Discount Model The dividend discount model can be applied to
value foreign stocks by discounting the stream of expected dividends, but with an adjustment to account for expected exchange rate movements. Foreign stocks pay dividends in the currency in which they are denominated. Thus, the cash flow per period
to U.S. investors is the dividend (denominated in the foreign currency) multiplied
by the value of that foreign currency in dollars. An expected appreciation of the currency denominating the foreign stocks will result in higher expected dollar cash flows
and a higher present value. The dividend can normally be forecasted with more accuracy than the value of the foreign currency. Because of exchange rate uncertainty, the
value of the foreign stock from a U.S. investor’s perspective is subject to more uncertainty than the value of the stock from a local investor’s perspective.
Measuring Performance from
Investing in Foreign Stocks
An investor’s performance from investing in foreign stocks is most properly measured
by considering the objective of the investor. For example, if portfolio managers are assigned to select stocks in Europe, their performance should be compared to the performance of a European index, measured in U.S. dollars. In this way, the performance
measurement controls for general market movements and exchange rate movements
in the region where the portfolio manager has been assigned to invest funds. Thus,
if the entire European market experiences poor performance over a particular quarter, or if the main European currency (the euro) depreciates against the dollar over
the period, the portfolio managers assigned to Europe are not automatically penalized. Conversely, if the entire European market experiences strong performance over a
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US
GMarkets
THE WALL STREET JOURNAL
PartI4:N
Equity
290
International Stock Index Quotations
The Wall Street Journal provides a table of
quotations of various international stock indexes, including several countries in the Americas, Europe, and Asia. For each index, the
table discloses the closing value on the previous trading day. It also provides the net change
and percentage change in the index value from
the day before. In addition, the table reports
the year-to-date (from beginning of the year to
present) return. Market participants can compare the performance of stocks among several
different countries.
Source: Reprinted with permission of Dow Jones &
Company, Inc., from The Wall Street Journal, April 4,
2007; permission conveyed through the Copyright Clearance Center, Inc.
particular quarter, or the euro appreciates against the dollar, the managers are not
automatically rewarded. Instead, the performance of portfolio managers will be
measured relative to the general market conditions of the region to which they are
assigned.
Performance from Global Diversification
A substantial amount of research has demonstrated that investors in stocks can benefit
by diversifying internationally. Most stocks are highly influenced by the country
where their firms are located (although some firms are more vulnerable to economic
conditions than others).
Since a given stock market partially reflects the current and/or forecasted state
of its country’s economy, and economies do not move in tandem, particular stocks
of the various markets are not expected to be highly correlated. This contrasts with
290
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Chapter 11: Stock Valuation and Risk
291
a purely domestic portfolio (such as all U.S. stocks), in which most stocks are often
moving in the same direction and by a somewhat similar magnitude.
Nevertheless, stock price movements among international stock markets are integrated to a degree because some underlying economic factors reflecting the world’s
general financial condition may systematically affect all markets. Since one country’s
economy can influence the economies of other countries, expectations about economies across countries may be somewhat similar. Thus, stock markets across countries
may respond to some of the same expectations. Integration is an important concept
because of its implications about benefits from international diversification. A high degree of integration implies that stock returns of different countries would be affected
by common factors. Therefore, the returns of stocks from various countries would
move in tandem, allowing only modest benefits from international diversification.
In general, correlations between stock indexes have been higher in recent years
than they were several years ago. One reason for the increased correlations is the increased integration of business between countries, which results in more intercountry
trade flows and capital flows, causing each country to have more influence on other
countries. In particular, many European countries have become more integrated because of a movement to standardize regulations throughout Europe and the use of a
single currency (the euro) to facilitate trade between countries.
Integration of Markets during the 1987 Crash Exhibit 11.4
compares the U.S. stock market to three foreign stock markets during October 1987.
Not only did the U.S. market suffer a major decline, but the other three markets
were severely affected as well. The high correlation among country stock markets during the crash suggests that the underlying cause of the crash systematically affected
all markets. Many institutional investors buy and sell stocks on numerous stock exchanges. Because they anticipated a worldwide decline in stock prices, they liquidated
some stocks from all markets, not just from the U.S. market.
Integration of Markets during Mini-Crashes Although there has
not been another world stock market crash since 1987, there have been several minicrashes. For example, on August 27, 1998 (referred to as “Bloody Thursday”), Russian stock and currency values declined abruptly in response to severe financial problems in Russia, and most stock markets around the world experienced losses on that
day. U.S. stocks declined by more than 4 percent. Such mini-crashes that adversely affect most stock markets illustrate that even a well-diversified international stock portfolio is not insulated from some events that have adverse consequences for stocks in
every country. In the case of Bloody Thursday, the adverse effects extended beyond
stocks that would be directly affected by financial problems in Russia, as paranoia
caused investors to sell stocks across all markets due to fears that stocks might be
overvalued.
Diversification among Emerging Stock Markets Emerging markets provide an alternative outlet for investors from the United States and
other countries to invest their funds. The potential economic growth rate is relatively
high. In addition, investors may achieve extra diversification benefits from investing
in emerging markets because their respective economies may not necessarily move in
tandem with those of the more developed countries. Thus, the correlation between
these stocks and those of other countries is low, and investors can reduce risk by including some stocks from these markets within their portfolio. However, emerging
market stocks tend to exhibit a high degree of volatility, which partially offsets the advantage of their low correlations with stocks of other countries.
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Part 4: Equity Markets
Exhibit 11.4
Impact of the Crash on Four Stock Markets
2,700
27,000
Tokyo
N.Y.
2,600
26,000
2,500
2,400
25,000
Index
Index
2,300
24,000
2,200
2,100
23,000
2,000
1,900
22,000
1,800
0
Sept. 28
Oct. 5
12
19
0
Sept. 28
26
1,900
19
26
12
19
26
Frankfurt
1,800
650
1,700
600
1,600
Index
Index
12
700
London
1,500
550
500
1,400
450
1,300
0
Sept. 28
Oct. 5
Oct. 5
12
19
26
0
Sept. 28
Oct. 5
Source: Economic Trends, Federal Reserve Bank of Cleveland (November 1987):17.
International Market Efficiency
Some foreign markets are likely to be inefficient because of the relatively small number of analysts and portfolio managers who monitor stocks in those markets. It is easier to fi nd undervalued stocks when a smaller number of market participants monitor
the market. Research has documented that some foreign markets are inefficient, based
on slow price responses to new information about specific fi rms (such as earnings announcements). The inefficiencies are more common in smaller foreign stock markets.
Some emerging stock markets are relatively new and small and may not be as efficient
as the U.S. stock market. Thus, some stocks may be undervalued, a possibility that
has attracted investors to these markets. Because some of these markets are small,
however, they may be susceptible to manipulation by large traders. Furthermore, insider trading is more prevalent in many foreign markets because rules against it are
not enforced. In general, large institutional investors and insiders based in the foreign
markets may have some advantages.
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Although these markets may appeal to investors seeking abnormal returns, they
also tend to have more volatile price movements than the larger markets. They are
more exposed to major government turnover and other forms of political risk. They
also expose U.S. investors to a high degree of exchange rate risk because their local currencies are typically very volatile. From 1990 to 1996 (before the Asian crisis),
emerging stock markets such as Argentina, Brazil, Indonesia, and the Philippines experienced at least one year when stocks declined in value by at least 40 percent (after accounting for exchange rate effects on U.S. investors). During the Asian crisis
of 1997–1998, these markets and other Asian markets experienced major declines.
Thus, stock market inefficiencies in emerging markets may sometimes result in excessive optimism and overvalued stocks, resulting in periodic corrections.
Summary
■ Stocks are commonly valued using the price-earnings (PE) method, the dividend discount model, or
the free cash flow model. The PE method applies
the industry PE ratio to the firm’s earnings to derive its value. The dividend discount model estimates
the value as the present value of expected future dividends. The free cash flow model is based on the present value of future cash flows.
■ Stock prices are affected by those factors that affect future cash flows or the required rate of return
by investors. Economic conditions, market conditions, and firm-specific conditions can affect a firm’s
cash flows or the required rate of return.
■ Many investors rely on analyst recommendations
when making investment decisions. Analysts can
have a major impact on the value of a stock because
of their influence on the demand for a stock by investors. Recently, analysts have come under scrutiny, as
their recommendations tend to be overly optimistic.
■ The risk of a stock is measured by its volatility, its
beta, or its value-at-risk estimate. Investors are giving more attention to risk measurement in light of
abrupt downturns in the prices of some stocks in recent years.
■ Stock market efficiency implies that stock prices reflect all available information. Weak-form efficiency
suggests that security prices reflect all trade-related
information, such as historical security price movements and volume of securities trades. Semistrongform efficiency suggests that security prices fully
reflect all public information. Strong-form efficiency
suggests that security prices fully reflect all information, including private or insider information. Evidence supports weak-form efficiency to a degree, but
there is less support for semistrong or strong-form
efficiency.
Point Counter-Point
Should the Market Rely on Analysts’ Opinions?
Point Yes. Analysts specialize in recognizing when
a stock is under- or overvalued. They are more skilled
than most investors. They also have better access to information than investors.
Counter-Point No. Even if analysts have better
skills and information, they tend to offer overly opti-
mistic projections. They are subject to major conflicts
of interest and are unwilling to provide negative reports of stocks.
Who Is Correct? Use the Internet to learn
more about this issue. Offer your own opinion on this
issue.
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Questions and Applications
1. Price-Earnings Model Explain the use of the
price-earnings 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?
2. Dividend Discount Model Describe the dividend
discount valuation model. What are some limitations of the dividend discount model?
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 stocks be affected? Explain.
6. Impact of Exchange Rates Explain how the value
of the dollar affects stock valuations.
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. Analyst Recommendations How do analyst recommendations affect stock valuations?
12. Analyst Conflicts of Interest What conflicts
of interest are faced by many analysts who rate
stocks?
13. Stock Portfolio Volatility Identify the factors that
affect a stock portfolio’s volatility and explain their
effects.
14. Beta Explain how to estimate the beta of a stock.
Explain the logic regarding how beta serves as a
measure of the stock’s risk.
15. Wall Street In the movie Wall Street, Bud Fox is
a broker who conducts trades for Gordon Gekko’s
fi rm. Gekko purchases shares of fi rms 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?
b. Once 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 states “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.
19. Implied Volatility Explain the meaning and use of
implied volatility.
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, the
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Chapter 11: Stock Valuation and Risk
Fed’s monetary policy, political conditions, and the
general mood of investors. Based on these 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. Reducing Analyst Conflicts of Interest Explain
why analysts at investment banks sometimes face
confl icts of interest when rating a fi rm. Explain
how stock exchange rules were adjusted to reduce
the confl icts of interest.
Interpreting Financial News
Interpret the following statements made by Wall Street
analysts and portfolio managers:
a. “The stock market’s recent climb has been driven
by falling interest rates.”
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
Stock Portfolio Dilemma 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
295
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 (IPO) by Marx Company, 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
was not 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 in estimating the value of
this firm?
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 method you devised for 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
Determine which stock has higher risk-adjusted returns when using the Sharpe index. Which stock
has higher risk-adjusted returns when using the
Treynor index? Show your work.
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 of Mess stock?
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3. Using the PE Method You found that IBM is expected to generate earnings of $4.38 per share
this year and that the mean PE ratio for its industry is 27.195. Using the PE valuation method, what
should be the value of IBM shares?
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 fi rm’s policies, what is the value of a share of stock if the required rate of return is 11 percent?
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?
6. Using the Dividend Discount Model Suppose
you know that a company just paid an annual 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?
7. Deriving the Required Rate of Return The next
expected annual dividend for Sun, Inc. will be
$1.20 per share, and analysts expect the dividend
to grow at an annual rate of 7 percent indefinitely.
If Sun stock currently sells for $22 per share, what
is the required rate of return?
8. Deriving the Required Rate of Return A share
of common stock currently sells for $110. Current dividends are $8 per share annually and are expected to grow at 6 percent per year indefinitely.
What is the rate of return required by investors in
the stock?
9. Deriving the Required Rate of Return A stock has
a beta of 2.2, the risk-free rate is 6 percent, and the
expected return on the market is 12 percent. Using
the CAPM, what would you expect the required
rate of return on this stock to be? What is the market risk premium?
10. Deriving the Stock’s Beta You are considering investing in a stock that has an expected return of
13 percent. If the risk-free rate is 5 percent and the
market risk premium is 7 percent, what must the
beta of this stock be?
11. Measuring Stock Returns Suppose you bought a
stock at the beginning of the year for $76.50. During the year, the stock paid a dividend of $0.70
per share and had an ending share price of $99.25.
What is the total percentage return from investing
in that stock over the year?
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?
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?
14. Value at Risk IBM 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 IBM
stock?
b. If you have $19,000 invested in IBM stock,
what is your maximum daily dollar loss?
15. Value at Risk If your portfolio beta was calculated to be 0.89 and the stock market has a
maximum expected loss of ⫺2.5 percent on a daily
basis, what is the maximum daily loss to your
portfolio?
16. Dividend Model Relationships
a. When computing the price of a stock with a
dividend discount model, determine how the
price of a stock would be affected if the required rate of return is increased. Explain the
logic of this relationship.
b. When computing the price of a stock using the
constant-growth dividend discount model, determine how the price of a stock would be affected if the growth rate is reduced. Explain the
logic of this relationship.
17. CAPM Relationships
a. When using the CAPM, determine how the
required rate of return on a stock would be
affected if the risk-free rate is lower.
b. When using the CAPM, determine how the required rate of return on a stock would be affected if the market return is lower.
c. When using the CAPM, determine how the
required rate of return on a stock would be
affected if the beta is higher.
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Chapter 11: Stock Valuation and Risk
18. Value at Risk
a. How is the maximum expected loss of a
stock affected by an increase in the volatility (standard deviation), based on a 95 percent
confidence interval?
297
b. Determine how the maximum expected loss of
a stock would be affected by an increase in the
expected return of the stock, based on a 95 percent confidence interval.
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 so
that most of its managers would receive about 30 percent of their compensation in shares of Carson stock
and the remainder 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 in-
formation affect the time at which Carson issues its
stock?
b. Assume that Carson Company believes that issuing 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?
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 short-term focus, even though
they are supposed to focus on maximizing shareholder wealth over the long run. How can a firm
provide stock as motivation but prevent the managers from using a very short-term focus?
Internet/Excel Exercises
1. Go to http://finance.yahoo.com/?u. Compare the
performance of the Dow, Nasdaq, and S&P 500 indexes. Click on each of these indexes and describe
the trend for that index since January. Which index
has had the best performance?
2. Go to http://finance.yahoo.com/, type in the
symbol DELL (for Dell, Inc.) and click on “Get
Quotes.” Then go to the bottom of the stock price
chart and retrieve the end-of-month stock price of
Dell over the last 12 months. Record this information on an Excel spreadsheet and estimate the
standard deviation of the stock’s price movements.
[See Appendix B for guidance on how to estimate
the standard deviation of a stock’s price movements.] Repeat the process for Oracle Corporation
(its symbol is ORCL). Which stock is riskier based
on your analysis?
3. Assume that the expected return on Dell stock and
Oracle stock is 0 percent for the next month. Use
the value-at-risk method to determine the maximum expected loss of Dell and Oracle for the next
month, based on a 95 percent confidence level.
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Part 4: Equity Markets
WSJ Exercise
Reviewing Abrupt Shifts in Stock Valuation
Review Section C of a recent issue of The Wall Street
Journal. Notice that the stocks with the largest one-day
gains and losses are shown. Do an Internet search for
news about the stock with the biggest gain. What is the
reason for the gain? Repeat the exercise for the stock
with the biggest loss.
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APPENDIX 11
The Link between Accounting
and Stock Valuation
In a publicly traded firm, the managers who run the firm are separate from the investors who own it. Managers are hired to serve as agents of the corporation and are expected to serve the interests of the firm’s shareholders by making decisions that maximize the value of the firm. The firm’s management is required to provide substantial
information about the firm’s financial condition and performance. Shareholders and
other investors use this information to monitor management and to value the firm.
For example, if investors use the price-earnings method to derive a valuation, they
rely on the reported earnings. If they use the dividend discount model, they may derive an expected growth rate from recently reported earnings or revenue figures. If
they use the adjusted dividend discount model, they may rely on financial statements
to estimate future cash flows.
If firms provide inaccurate financial information, investors will derive inaccurate
valuations, and money will flow to the wrong sources in the stock markets. In addition, inaccurate financial information creates more risk for stocks because investors
must worry about the uncertainty surrounding the reported financial statement numbers. If financial statement data are questionable, stock values may decline whenever
investors recognize that the earnings or some other proxy used to estimate cash flows
is overstated. Investors will require a higher rate of return to hold stocks subject to
downside risk because of distorted accounting. Thus, deceptive accounting practices
disrupt the stock market and increase the cost of capital raised by issuing of stock.
To ensure that managers serve shareholder interests, firms commonly tie managerial compensation to the stock price. For example, managers may be granted stock options that allow them to buy the firm’s stock at a specified price over a specified time
period (such as the next five years). In this way, the managers benefit directly from a
high stock price just like other shareholders and thus should make decisions that result in a high stock price for the shareholders.
Unfortunately, some managers recognize that it may be easier to increase their
stock’s price by manipulating the financial statements than by improving the firm’s
operations. When the firm’s reported earnings are inflated, investors will likely overestimate the value of its stock, regardless of the method they use to value stocks.
Managers may be tempted to temporarily inflate reported earnings because doing so may temporarily inflate the stock’s price. If no limits are imposed on the stock
options granted, managers may be able to exercise their options (buying the stock at
the price specified in the option contracts) during this period of a temporarily inflated
price and immediately sell the stock in the secondary market. They can capitalize on
the inflated stock price before other investors realize that the earnings and stock price
are inflated.
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Problems with Creative Accounting
Managers would not be able to manipulate a firm’s financial information if accounting rules did not allow them to be creative. The accounting for a firm’s financial statement items is guided by generally accepted accounting principles (GAAP) set by the Financial Accounting Standards Board (FASB).
However, these guidelines allow for substantial flexibility in accounting, which means
that there is no standard formula for converting accounting numbers into cash flows.
The accounting confusion is compounded by the desire of some managers to inflate
their firm’s earnings in particular periods when they wish to sell their holdings of the
firm’s stock. Specifically, the accounting can inflate revenue in a particular period
without inflating expenses or defer the reporting of some expenses until a future
quarter. Investors who do not recognize that some of the accounting numbers are
distorted may overestimate the value of the firm. ■
II L
LL
LU
US
ST
TR
RA
AT
T II O
ON
N
Creative Classification of Expenses
When a fi rm discontinues one of its business projects, it commonly records this as
a writeoff, or a onetime charge against earnings. Investors tend to ignore writeoffs
when estimating future expenses because they do not expect them to occur again.
Some fi rms, however, shift a portion of their normal operating expenses into the
writeoff, even though those expenses will occur again in the future. Investors who do
not recognize this accounting gimmick will underestimate the future expenses.
As a classic example of shifting expenses, WorldCom attempted to write off more
than $7 billion following the acquisition of MCI in 1998. When the Securities and
Exchange Commission (SEC) questioned this accounting, WorldCom changed the
amount to about $3 billion. If it had succeeded in including the extra $4 billion in the
writeoff, it could have reduced its reported operating expenses by $4 billion. Thus, investors who trusted WorldCom’s income statement would have underestimated its future expenses by about $4 billion per year and therefore would have grossly overestimated the value of the stock.
Earnings Restatements:
After the Damage Is Done
When firms go beyond the loose accounting guidelines, the SEC may require them
to restate their earnings and provide a corrected set of financial statements. In recent years, the SEC has forced hundreds of firms to restate their earnings, but the investors who lost money because they trusted a firm’s distorted accounting were not
reimbursed.
Governance Applied to Prevent
Distorted Accounting
Several types of governance can be used to attempt to prevent firms from using
distorted accounting, as explained next.
Auditing
Firms are required to hire auditors to audit their financial statements and verify that
the statements are within the accounting guidelines. The auditors, however, rely
on these firms for their future business. Many large firms pay auditors more than
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Chapter 11: Stock Valuation and Risk
301
APPENDIX 11
$1 million per year for their auditing services and also for nonauditing services. Thus,
the auditors may be tempted to sign off on distorted accounting so that they will be
rehired by their clients in the future. If the auditors uphold proper standards that
force their clients to revise their reported earnings, they may not be hired again. The
temptation to sign off on creative accounting used by client firms is especially strong
given the subjectivity allowed by the accounting rules. Auditors may be more willing
to sign off on financial statements that are somewhat confusing but do not directly
violate accounting rules.
Board of Directors
A fi rm’s board of directors is expected to represent the fi rm’s shareholders. The directors oversee the fi rm’s financial reporting process and should attempt to ensure that
the financial information provided by the fi rm is accurate. However, some boards
have not forced managers to accurately disclose their financial condition. A board can
be ineffective if it is run by insiders who are the same managers that the board is supposed to monitor. Board members who are managers of the firm (insiders) are less
likely to scrutinize the firm’s management. In recent years, many fi rms have increased
the proportion of independent board members (outsiders), who are not subject to
pressure from the fi rm’s executives. Even some independent board members, however,
have strong ties to the fi rm’s employees or receive substantial consulting income beyond their compensation for serving on the board. Thus, they may be willing to overlook distorted accounting or other unethical behavior in order to maintain their existing income stream from the fi rm.
Recently, several proposals have been made to try to increase the independence of
board members. For example, on January 9, 2003, the Commission on Public Trust
and Private Enterprise released its recommendations to improve corporate governance. The Commission is a panel of the Conference Board, and its purpose is to address the widespread abuses that led to corporate scandals and declining public trust
in companies, their leaders, and U.S. capital markets. The Commission issues bestpractices guidelines.
Among its recommendations was that each corporation should consider separating the offices of chair of the board and CEO. Furthermore, the board chair should
be an independent director. The Commission also recommended that a Lead Independent Director position should be established in cases where the chair is not an
independent director. In addition, the Commission recommended that a Presiding
Director position be established in cases where a corporation does not separate the
functions of chair of the board and CEO.
Compensation of Board Members Some boards are ineffective because of the way the board members are compensated. If board members receive stock
options from the fi rm as compensation, the options’ value is tied to the fi rm’s stock
price. Consequently, some board members may be tempted to ignore their oversight
duties, as they may benefit from selling their shares of the stock (received as compensation) while the price is temporarily inflated. Meanwhile, shareholders who hold
their stock for a longer time period will be adversely affected once the market recognizes that the financial statements are distorted.
Board members are more likely to serve the long-term interests of shareholders
if they are compensated in a manner that encourages them to maximize the longterm value of the firm. If they are provided stock that they cannot sell for a longterm period, they are more likely to focus on maximizing the long-term value of
the firm.
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Recent regulations address the issue of potential abuses resulting from granting
stock options to managers and board members. On July 1, 2003, the SEC ruled that
corporations listed on the New York Stock Exchange (NYSE) or the Nasdaq market must have shareholder approval before giving executives company stock or options. The rules were drafted and approved by the NYSE and Nasdaq. In addition,
the FASB recently required that corporations expense their executive stock options
on their income statements. This increases transparency in financial reporting and
might improve corporate governance.
Board’s Independent Audit Committee Some board members may
serve on an independent audit committee, which is responsible for monitoring the
firm’s auditor. The committee is expected to ensure that the audit is completed without conflicts of interest so that the auditors will provide an unbiased audit. Some
boards have not prevented distorted audits, however, either because they did not recognize the conflicts of interest or because they were unwilling to acknowledge them.
Role of Credit Rating Agencies
Investors may also rely on credit rating agencies such as Standard & Poor’s or Moody’s
to assess a fi rm’s risk level. However, these agencies do not always detect a fi rm’s
financial problems in advance. They normally focus on assessing a fi rm’s risk level based
on the financial statements provided, rather than on determining whether the financial
statements are accurate. The agencies may assume that the financial statements are accurate because they were verified by an auditor.
Role of the Market for Corporate Control
In the market for corporate control, firms that perform poorly should be acquired and
reorganized by other more efficient firms (called raiders). The raiders have an incentive
to seek out inefficient firms because they can buy them at a low price (reflecting their
poor performance) and remove their inefficient management. Nevertheless, the market for corporate control does not necessarily prevent faulty accounting. First, raiders
may not be able to identify firms that inflated their earnings. Second, firms that have
inflated their earnings are probably overvalued, and raiders will not want to acquire
them at their inflated price. Third, an acquisition involves substantial costs of integrating businesses, and there is the risk that these costs will offset any potential benefits.
The Enron Scandal
The most famous recent example of the use of creative accounting occurred at Enron Corporation. Enron was formed in 1985 from the merger of two natural gas
pipeline companies. It grew relatively slowly until the 1990s when the deregulation
of the utilities industry presented new opportunities. Enron began to expand in several directions. It acquired power plants in the United States and also expanded internationally, acquiring a power distributor in Brazil, a power plant in India, and a
water company in the United Kingdom, among others. Perhaps most importantly, it
took advantage of the new deregulated environment to pioneer the trading of natural
gas and electricity. Soon it had branched out beyond simple energy trading to trade
such instruments as weather derivatives. In 1999, it introduced Enron Online, an
Internet-based trading platform that gave the company the appeal of an “Internet
stock” at a time when such stocks were highly desired. The company introduced online trading of metals, wood products, and even broadband capacity, as well as energy.
All of this enabled Enron to grow to become the seventh largest firm in the United
States in terms of gross revenues by 2000.
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APPENDIX 11
Most investors were caught by surprise when Enron began to experience financial
problems in October 2001 and then filed for bankruptcy on December 2, 2001. At
the time, it was the largest U.S. firm to go bankrupt. In retrospect, Enron’s stock may
have been overvalued for many years, but some investors and creditors were fooled by
its financial statements. The Enron fiasco received much publicity because it demonstrated how a firm could manipulate its financial statements, and therefore manipulate its valuation, in spite of various controls designed to prevent that type of behavior. This section offers some insight into why investor valuations and risk assessments
of Enron were so poor.
Enron’s Letter to Its Shareholders
If investors trusted the claims made by Enron in its annual report, it is understandable that they would value the stock highly. The letter to shareholders in Enron’s
2000 annual report included the following statements:
• “Enron’s performance in 2000 was a success by any measure, as we continued
to outdistance the competition and solidify our leadership in each of our businesses.
• Enron has built unique and strong businesses that have limitless opportunities
for growth.
• At a minimum, we see our market opportunities company-wide tripling over the
next five years.
• Enron is laser-focused on earnings per share, and we expect to continue strong
performance.
• Enron is increasing earnings per share and continuing our strong return to shareholders.
• The company’s total return to shareholders was 89% in 2000, compared with a
⫺9% returned by the S&P 500.
• The 10-year return to Enron shareholders was 1,415%, compared with 383% for
the S&P 500.
• We plan to . . . create significant shareholder value for our shareholders.”
Enron’s Stock Valuation
Normally, the valuation of a firm is obtained by using the firm’s financial statements
to derive cash flows and to derive a required rate of return that is used to discount
the cash flows. Enron’s valuation was excessive because of various irregularities in its
financial statements.
Estimating Cash Flows Since Enron’s earnings were distorted, the estimates of its cash flows derived from those earnings were also distorted. Moreover,
Enron’s earnings were manipulated to create the perception of consistent earnings
growth, which tempted investors to apply a high growth rate when estimating future
cash flows.
Estimating the Required Rate of Return Investors can derive a required rate of return as the prevailing long-term risk-free interest rate plus the firm’s
risk premium. The risk premium can be measured by the firm’s existing degree of
financial leverage, its ability to cover interest payments with operating earnings, and
its sensitivity to market movements.
Until the accounting distortions were publicized, Enron’s risk was underestimated. The company concealed much of its debt by keeping it off its consolidated
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Part 4: Equity Markets
financial statements, as will be explained shortly. Consequently, investors who estimated Enron’s sensitivity to market movements using historical data were unable
to detect Enron’s potential for failure. As a result, they used a lower risk premium
than was appropriate. Thus, the financial statements caused investors both to overestimate Enron’s future cash flows and to underestimate its risk. Both effects led to
a superficially high stock price.
Applying Market Multiples Given the difficulty of estimating cash flows
and the required rate of return, some investors may have tried to value Enron’s stock by
using market multiples. Determining the appropriate PE multiple for Enron was also
difficult, however, because its reported earnings did not represent its real earnings.
Another problem with applying the industry PE method to Enron was the
difficulty of identifying the proper industry. One of the company’s main businesses
was trading various types of energy derivative contracts. Enron did not want to be
known as a trading company, however, because the valuations of companies such as
investment banks that engage in trading are generally lower for a given level of earnings per share.
Enron’s Managerial Motives
One of the main reasons for Enron’s problems was its management. Managers are expected to maximize the value of the firm’s stock. Like many firms, Enron granted
stock options to some of its managers as a means of motivating them to make decisions that would maximize the value of its stock. However, Enron’s management
seemed to focus more on manipulating the financial statements to create a perception of strong business performance than on improving the actual performance. By
manipulating the financial statements, Enron consistently met its earnings forecasts
and increased its earnings over 20 consecutive quarters leading up to 2001. In this
way, it created a false sense of security about its performance, thereby increasing the
demand for its stock. This resulted in a superficially high stock price over a period in
which some managers sold their stock holdings. Twenty-nine Enron executives or
board members sold their holdings of Enron stock for more than $1 billion in total
before the stock price plummeted.
Internal Monitoring Some firms use internal monitoring to ensure some
degree of control over managers and encourage them to make decisions that benefit
shareholders. Unfortunately, Enron’s internal monitoring was also susceptible to manipulation. For example, managers were periodically required to measure the market
value of various energy contracts that the company held. Since there was not an active
market for some of these contracts, the prevailing valuations of the contracts were arbitrary. Managers used estimates that resulted in very favorable valuations, which in turn
led to a higher level of reported performance and higher managerial compensation.
Monitoring by the Board of Directors The board members serve
as representatives of the firm’s shareholders and are responsible for ensuring that the
managers serve shareholder interests. In fact, board members are commonly compensated with stock so that they have an incentive to ensure that the stock price is maximized. In the case of Enron, some board members followed executives in selling their
shares while the stock price was superficially high.
Enron’s Financial Statement Manipulation
Some of the methods Enron used to report its financial conditions were inconsistent
with accounting guidelines. Other methods were within the rules, but were mislead-
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Accounting for Partnerships One of the most common methods used
by Enron to manipulate its financial statements involved the transfer of assets to
partnerships that it owned called special-purpose entities (SPEs). It found outside
investors to invest at least 3 percent of each partnership’s capital. Under accounting guidelines, a partnership with this minimum level of investment from an outside investor does not have to be classified as a subsidiary. Since Enron did not have
to classify its SPEs as subsidiaries, it did not have to include the financial information
for them in its consolidated financial statements. Thus, the debt related to the SPEs
was removed from Enron’s consolidated financial statements. Since most investors focused on the consolidated financial statements, they did not detect Enron’s financial
problems.
In addition, whenever Enron created a partnership that would buy one of its business segments, it would book a gain on its consolidated financial statements from the
sale of the asset to the partnership. Losses from a partnership would be booked on
the partnership’s financial statements. Thus, Enron was booking gains from its partnerships on its consolidated financial statements while hiding their losses. On November 8, 2001, Enron announced that it was restating its earnings for the previous five
years because three of its partnerships should have been included in the consolidated
financial statements. This announcement confirmed the suspicion of some investors
that previous earnings figures were exaggerated. Enron’s previously reported earnings
were reduced by about $600 million over the previous five years, but the correction
came too late for many investors who had purchased Enron stock when the reported
earnings (and share price) were much higher.
APPENDIX 11
ing. Consequently, many investors invested in Enron without recognizing financial
problems that were hidden from the financial statements. Some of these investors lost
most or all of their investment.
Financing of Partnerships Enron’s partnerships were financed by various
creditors such as banks. The loans were to be paid off either from the cash flow generated by the assets transferred to the partnership or from the ultimate sale of the assets. When the partnerships performed poorly, they could not cover their debt payments. In some cases, Enron backed the debt with its stock, but as its stock price
plummeted, this collateral no longer covered the debt, setting in motion the downward spiral that ultimately led to the company’s bankruptcy.
Arthur Andersen’s Audit
Investors and creditors commonly presume that financial statements used to value a
firm are accurate when they have been audited by an independent accounting firm. In
reality, however, the auditor and the firm do not always have an arm’s length relationship. The accounting firm that conducts an audit is paid for the audit and recognizes
the potential annuity from repeating this audit every year. In addition, accounting
firms that provide auditing services also provide consulting services. Enron hired Arthur Andersen both to serve as its auditor and to provide substantial consulting services. In 2000, Arthur Andersen received $25 million in auditing fees from Enron
and an additional $27 million in consulting fees.
Although Arthur Andersen was supposed to be completely independent, it recognized that if it did not sign off on the audit, it would lose this lucrative audit and
consulting business. Furthermore, the annual bonus an accounting firm pays to its
employees assigned to audit a client may be partially based on their billable hours,
which would have been reduced if the firm’s relationship with such a large client was
severed.
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Part 4: Equity Markets
Oversight by Investment Analysts
Even if financial statements are contrived, some investors may presume that investment analysts will detect discrepancies. If analysts simply accept the financial statements, however, rather than questioning their accuracy, the analysts will not necessarily serve as a control mechanism. The difficulties analysts faced in interpreting
Enron’s financial statements are highlighted by a humorous list created by some Enron employees of why the company restructured its operations so frequently. Reason
number 7 was “Because the basic business model is to keep the outside investment
analysts so confused that they will not be able to figure out that we do not know what
we are doing.” The humor now escapes some analysts, as well as some creditors and
investors.
Another problem, though, is that like the supposedly independent auditors who
hope to generate more business for their accounting firm, investment analysts may encounter a conflict of interest when they attempt to rate firms. As explained earlier, analysts employed by securities firms have been criticized for assigning very high ratings
to firms they cover so that their employer may someday receive some consulting business from those firms.
As an example of what can happen to analysts who are “too critical,” consider
the experience of an analyst at BNP Paribus who downgraded Enron in August 2001,
a few months before the company’s financial problems became public. At the time,
BNP Paribus was providing some consulting services for Enron. The analyst was demoted and then fi red shortly after his downgrade of Enron. To the extent that many
other analysts were subjected to a similar conflict of interest, it may explain why they
did not downgrade Enron until after its financial problems were publicized. Even if
analysts had detected financial problems at Enron, they might have been reluctant to
lower their rating.
Market for Corporate Control
As explained earlier, if a firm’s managers are running a firm into the ground, a raider
has an incentive to purchase that firm at a low price and improve it so that it can
be sold someday for a much higher price. However, this theory presumes that the
stock price of the firm properly reflects its actual business performance. If the firm’s
financial statements reflect strong performance, a raider will not necessarily realize
that the firm is experiencing financial problems. Moreover, even if the raider is able to
detect the problems, it will not be willing to pursue a firm whose value is overpriced
by the market because of its contrived financial statements.
When Enron’s stock price was high, few raiders could have afforded to acquire it.
Once the stock price plummeted, Dynegy considered an acquisition of Enron. Dynegy quickly backed off, however, even though the stock price had fallen 90 percent
from its high. Dynegy said it was concerned about problems it found when trying to
reconcile Enron’s cash position with what its financial statements suggested (among
other reasons).
Monitoring by Creditors
Enron relied heavily on creditors for its financing. Since Enron’s consolidated financial
statements showed a superficially high level of earnings and a low level of debt, it had
easy access to credit from a wide variety of creditors. Enron maintained a low cost of
capital by using contrived statements that concealed its risk. Its balance sheet showed
debt of $13 billion, but by some accounts, the actual amount of its debt was $20 billion. The hidden debt concealed Enron’s true degree of financial leverage.
Bank of America and J.P. Morgan Chase each had exposure estimated at $500
million. Many other banks had exposure estimated at more than $100 million. They
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APPENDIX 11
would not have provided so much credit if they had fully understood Enron’s financial
situation.
Even the debt rating agencies had difficulty understanding Enron’s financial situation. On October 16, 2001, Enron announced $2 billion in writeoffs that would reduce its earnings. At this time, Standard & Poor’s, the debt rating agency, affirmed
Enron’s rating at BBB⫹, along with its opinion that Enron’s balance sheet should
improve in the future. Over the next 45 days, S&P became more aware of Enron’s
financial condition and lowered its rating to junk status.
Many of Enron’s creditors attempted to sue Enron once it became clear that the
financial statements were misrepresented. By this time, however, Enron’s value was
depleted, as its price had already fallen to less than $1 per share.
Oversight by Regulators
The Enron fiasco prompted questions about whether additional regulations should be
implemented to ensure proper disclosure of financial information. In particular, the
accounting guidelines for the SPE partnerships and the potential conflict of interest
between the audit and consulting segments of accounting firms are currently receiving much attention.
SPE Partnerships The FASB had discussed possible changes in reporting
standards for SPE partnerships over the 20 years prior to the Enron fiasco. Nevertheless, it never took any action to correct this obvious means of hiding debt from consolidated financial statements. Perhaps this event will prompt the FASB to take some
initiative.
Conflict between Audit and Consulting Duties In 2000, the
SEC proposed a rule to prevent the potential conflict of interest for accounting fi rms
that provide auditing and consulting services to a given client. It proposed that an
accounting firm should provide either auditing or consulting services, but not both
types of services. This proposal met strong resistance. Several accounting fi rms and
the American Institute of Certified Public Accountants (AICPA) lobbied members
of Congress to discourage the SEC from pushing this proposal. At least 50 members of Congress wrote to the SEC, objecting to the proposal. Most of the letters
came from members who had received donations from the accounting lobby. Of the
14 senators who wrote to the SEC, 11 were on the Banking Committee, which could
influence the future funding for the SEC. The chairman of that committee received
about $200,000 in contributions from the accounting lobby over the 1995–2000 period. His wife was on the board of directors at Enron. Twenty of the House members
who wrote to the SEC were on the Energy and Commerce Committee. The chairman of this committee received about $143,000 in donations from the accounting
lobby. Overall, the members of Congress who wrote letters to the SEC objecting to
the accounting proposal received more than $3.5 million from the accounting lobby.
Prevention of Accounting Fraud
In response to the accounting fraud at Enron and other firms, regulators are attempting to ensure more accurate financial disclosure by firms. Stock exchanges have instituted new regulations for listed firms. The SEC has been given more resources and
power to monitor financial reporting. Perhaps the most important regulatory changes
have occurred as a result of the Sarbanes-Oxley Act of 2002. Some of the act’s more
important provisions were summarized in Chapter 10.
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Part 4: Equity Markets
Discussion Questions
The following discussion questions focus on the use
of financial statements in the valuation of fi rms. They
should generate much discussion, especially when accounting and finance students are present. These questions can be used in several ways. They may serve as an
assignment on a day that the professor is unable to attend class. They are also useful for small group exercises. For each issue, one group could be randomly selected and asked to present their solution. Then, other
students not in that group may suggest alternative answers if they feel that the solution can be improved.
Each issue does not necessarily have a perfect solution,
so students should be able to present different points
of view.
1. Should an accounting fi rm be required to provide only auditing services or consulting services?
Explain your answer. If an accounting fi rm is allowed to offer only one service, might there be any
conflicts of interest due to referrals (and finder’s
fees)?
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 who is employed by a securities
fi rm and is assigned to rate fi rms face a conflict
of interest? What is a solution to this potential
conflict?
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 fi rm’s board of directors be structured so that the board members
will not be tempted to allow accounting or other
managerial decisions that could cause a superficially
high price over a short period?
2. Should members of Congress be allowed to set regulations on accounting and financial matters while
receiving donations from related lobbying groups?
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