1
Chapter 11
Stock Valuation and Risk
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
2
Chapter Outline

Stock valuation methods

Determining the required rate of return to value stocks

Factors that affect stock prices

Role of analysts in valuing stocks

Stock risk

Applying value at risk

Forecasting stock price volatility and beta

Stock performance measurement

Stock market efficiency

Foreign stock valuation, performance, and efficiency
3
Stock Valuation Methods


Valuing A Stock Using the PE
Method
A firm is expected to generate earnings of $2 per
share next year. The mean ratio of share price
to expected earnings of competitors in the
same industry is 14. What is the valuation of
the firm’s shares according to the PE method?
$2814$2
ratio) PEindustry (Meanshare) per firm of earnings Expected(share per Valuation
=×=
×=
6
Stock Valuation Methods (cont’d)

Dividend discount model

John Williams (1931) stated that the price of a stock
should reflect the present value of the stock’s future
dividends:

D can be revised in response to uncertainty about the firm’s
cash flows

k can be revised in response to changes in the required rate
of return by investors
∑
∞
=
+
=

∞
=1
)1(
Price
gk
D
k
D
t
t
t
−
=
+
=
∑
∞
=
1
1
)1(
Price
8
Valuing A Stock Using the
Dividend Discount Model
Example 1: A firm is expected to pay a dividend
of $2.10 per share every year in the
foreseeable future. Investors require a return
of 15% on the firm’s stock. According to the
dividend discount model, what is a fair price

50.17$
%3%15
10.2$
)1(
Price
1
1
=
−
=
−
=
+
=
∑
∞
=
gk
D
k
D
t
t
t
10
Stock Valuation Methods (cont’d)

Dividend discount model (cont’d)

Relationship between dividend discount model

Adjusting the dividend discount model

The value of the stock is:

The PV of the future dividends over the investment
horizon

The PV of the forecasted price at which the stock will be
sold

Must estimate the firm’s EPS in the year they plan to sell
the stock by applying an annual growth rate to the
prevailing EPS
13
Using the Adjusted Dividend
Discount Model
Parker Corp. currently has earnings of $10 per
share. Investors expect that the EPS will
growth by 3 percent per year and expect to
sell the stock in four years. What is the EPS
in four years?
26.11$)03.1(10$
)1( yearsn in earnings Forecasted
4
=×=
+=
n
GE
14
Using the Adjusted Dividend

++++=PV
16
Stock Valuation Methods (cont’d)

Adjusting the dividend discount model
(cont’d)

Limitations of the adjusted dividend discount
model

Errors can be made in deriving the PV of dividends over
the investment horizon or the forecasted price at which
the stock can be sold

Errors can be made if an improper required rate of return
is used
17
Determining the Required Rate of
Return to Value Stocks

The capital asset pricing model:

Assumes that the only important risk is systematic
risk

Is not concerned with unsystematic risk

Suggests that the return on an asset is influenced by
the prevailing risk-free rate, the market return, and
the covariance between a stock’s return and the

Fantasia Corp. has a beta of 1.7. The prevailing
risk-free rate is 5% and the market risk
premium is 5%. What is the required rate of
return of Fantasia Corp. according to the
CAPM?
%5.13
%)5%10(7.1%5
)(
=
−+=
−+=
fmjfj
RRBRR
20
Determining the Required Rate of
Return to Value Stocks (cont’d)

The capital asset pricing model (cont’d)

Limitations of the CAPM

A study by Fama and French found that beta is unrelated to
the return on stock over the 1963–1990 period

Chan and Lakonishok:

Found that the relation between stock returns and beta
varied with the time period used

Concluded that it is appropriate to question whether beta is

)(
22
Factors That Affect Stock Prices

Economic factors

Impact of economic growth

An increase in economic growth increases expected cash
flows and value

Indicators such as employment, GDP, retail sales, and
personal income are monitored by market participants

Impact of interest rates

Given a choice of risk-free Treasury securities or stocks,
stocks should only be purchased if they offer a sufficiently
high expected return
23
Factors That Affect Stock Prices
(cont’d)

Economic factors (cont’d)

Impact of the dollar’s exchange rate value

The value of the dollar affects U.S. stocks because:

Foreign investors purchase U.S. stocks when the dollar is

Many portfolio managers invest in riskier small stocks at the
beginning of the year and shift to larger companies near the end
of the year

Places upward pressure on small stocks in January
25
Factors That Affect Stock Prices
(cont’d)

Firm-specific factors

Some firms 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

Price movements of the industry’s products

Market participants focus on announcements that signal
information about a firm’s sales growth, earnings, or
characteristics that cause a revision in the expected cash flows