FIN 311 AYU Finance The Investment Environment Exam Practice

Chapter One
The Investment
Environment
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Real Assets vs. Financial Assets
Real Assets
Financial Assets
• Used to produce goods
and services
• Claims to the income
generated by real assets
or claims on income from
the government
• Do not directly contribute
to the productive capacity
of the economy
• Examples: Land,
buildings, machines,
intellectual property
• Examples: Stocks, bonds
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Types of Financial Assets
• Fixed-income / Debt securities
• Promises either a fixed stream of income or a stream
of income determined by a specified formula (e.g.,
corporate bond)
• Equity
• Represents ownership share in a firm (e.g., common
stock)
• Derivative securities
• Payoff depends on the value of other financial
variables such as stock prices, interest rates, or
exchange rates
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Agency problems
• Separation of Ownership and Management
• Agency problems
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Agency problems
(Continued)
• Mechanisms to mitigate potential agency
problems (Corporate Governance):
• Compensation plans tie the income of managers
to the success of the firm
• Monitoring from the board of directors
• Monitoring by large investors and security analysts
• Threat of takeover for poor performers
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The Investment Process
• Portfolio: Collection of investment assets
• Asset allocation
• Choice among broad asset classes (e.g., stocks,
bonds, real estate, etc.)
• Security selection
• Choice of securities within each asset class
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The Investment Process
(Continued)
• Security analysis involves the valuation of
particular securities that might be included in
the portfolio
• “Top-down” approach
• Asset allocation followed by determination of
particular securities to be held in each asset class
• “Bottom-up” approach
• Investment based on attractively priced securities
without as much concern for asset allocation
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Markets Are Competitive
• Financial markets are highly competitive
• There will almost always be risk associated
with investments
• Risk-return trade-off – Higher-risk assets are
priced to offer higher expected returns than
lower-risk assets
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Markets Are Competitive
(Continued)
• You should rarely expect to find bargains in
the security markets
• See Ch. 11 for a discussion of the theory and
evidence of the efficient market hypothesis
• Efficient market hypothesis
• The prices of securities fully reflect available
information
• If this were true, there would exist neither
underpriced nor overpriced securities
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Markets Are Competitive
(Concluded)
• Passive management
• Highly diversified portfolio
• No attempt to improve investment performance
by identifying mispriced securities
• Active management
• Focus on improving performance by finding
mispriced securities or by timing the performance
of broad asset classes
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The Players
(1 of 4)
1. Firms
•
•
Net demanders of capital
Raise capital now to pay for investments in plant and
equipment
2. Households
•
•
Typically net suppliers of capital
Purchase securities issued by firms that need to raise
funds
3. Governments
•
Can function as borrowers or lenders, depending on
the relationship between tax revenue and
government expenditures
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The Players
(2 of 4)
• Financial intermediaries bring the suppliers of
capital (investors) together with the
demanders of capital (primarily corporations
and the federal government)
• Examples
• Investment companies
• Banks
• Insurance companies
• Credit unions
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The Players
(3 of 4)
• Investment bankers specialize in the sale of
new securities to the public, typically by
underwriting the issue
• Advise the issuing corporation on appropriate
price, interest rates, etc.
• New issues of securities are offered to the
public in the primary market
• Investors trade previously issued securities
amongst themselves in the secondary market
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The Players
(4 of 4)
• Venture capital (VC) refers to money invested
to finance a new, not yet publicly traded firm
• VC investors commonly take an active role in the
management of a start-up firm
• Private equity refers to investments in
companies whose shares are not publicly
traded in a stock market
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Systemic Risk
• Systemic risk is the risk of breakdown in the
financial system, particularly due to spillover
effects from one market into others
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Chapter Two
Asset Classes and
Financial
Instruments
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Financial markets
• Money markets are made up of short-term, marketable,
liquid, low-risk debt securities.
• Treasury Bills (i.e., T-bills)
• Certificates of Deposit (CD)
• Commercial paper
• Bankers’ acceptance
• Eurodollars
• Repurchase agreements
• Federal funds
• Capital markets include longer term and riskier securities
• Divided into four segments – longer term bond markets, equity
markets (stocks), and the derivative markets for options and
futures
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The Bond Market
• Bond market is composed of longer term
borrowing or debt instruments than those
that trade in the money market
• Treasury notes (up to 10 years) and Treasury
bonds (from 10 to 30 years)
• Corporate bonds
• Municipal bonds
• Mortgage securities
• Federal agency debt
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Equity Securities:
Common Stock
• Represent ownership shares in a corporation
• Each share entitles owner to one vote
• Corporation controlled by board of directors
elected by shareholders
• Residual claim
• Stockholders are last in line of all who have a claim on
the assets and income of the corporation
• Limited liability
• Most shareholders can lose in the event of failure of
the corporation is their original investment
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Equity Securities:
Stock Market Listings
• Dividend yield
• Annual dividend payment expressed as a percent of
the stock price
• Capital gains
• Amount by which the sale price of a security exceeds
the purchase price
• Price-earnings ratio
• Ratio of a stock’s price to its earnings per share
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Equity Securities:
Preferred Stock
• Preferred stock has features similar to both
equity and debt
• Like a bond, promises to pay a fixed amount of income
each year
• Does not convey voting power regarding the
management of the firm
• Contractual obligation to pay interest, but not
dividends
• Preferred stock payments are treated as dividends
rather than interest, so they are not a tax-deductible
expense for the firm
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Stock Market Indexes
• Dow Jones Industrial Average (DJIA)
• Includes 30 large blue-chip corporations
• Computed since 1896
• Price-weighted average
• Standard & Poor’s 500 (S&P 500)
• Improvement over DJIA in two ways
1. More broadly based index of 500 firms
2. Market-value-weighted Index
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Other Indexes
• U.S. market-value indexes
• NYSE, NASDAQ, Wilshire 5000, CRSP
• Equally weighted indexes
• Do not correspond to buy-and-hold strategies
• Foreign and international stock market indexes
• Nikkei, FTSE, DAZ, Hang Seng, TSX
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Derivative Markets
• Derivative asset is a claim whose value is
directly dependent on or is contingent o the
value of some underlying assets
• Options
• Futures
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Derivatives Markets:
Options
• Call option
• Gives holder the right to purchase an asset for a
specified price, called the exercise or strike price,
on or before a specified expiration date
• Put option
• Gives holder the right to sell an asset for a
specified exercise price on or before a specified
expiration date
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Derivatives Markets:
Futures Contract
• Futures contract
• Calls for delivery of an asset (or cash value) at a
specified delivery or maturity date for an agreedupon price, called the futures price, to be paid at
contract maturity
• Long position held by the trader who commits to
purchasing the asset on the delivery date
• Short position held by trader who commits to delivering
the asset at contract maturity
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Comparison
Options
Futures Contract
• Right, but not obligation,
to buy or sell
• Option is exercised only
when it is profitable
• Options must be
purchased
• Obliged to make or take
delivery
• Long (short) position
must buy (sell) at the
futures price
• Futures contracts are
entered into without cost
– The premium is the price of
the option itself
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Chapter Three
How Securities
are Traded
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How Firms Issue Securities
• Firms requiring new capital can raise funds by
borrowing money or selling shares in the firm
• Primary market is the market in which new issues of
securities are offered to the public
• Secondary market involves already existing securities
being bought and sold on the exchanges or in the OTC
market
• Shares of publicly listed firms trade continually in
markets such as the NYSE or NASDAQ, but the
shares of private corporations are held by small
numbers of managers and investors
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How Firms Issue Securities
Privately Held Firms
• Owned by a relatively small number of
shareholders
• Fewer obligations to release information to
the public
• Jumpstart Our Business Startups (JOBS) of
2012 allows up to 2,000 shareholders
• Raise funds through private placement
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How Firms Issue Securities
Publicly Traded Companies
• Initial public offering, or IPO
• A firm’s first issue of shares to the public
• Seasoned equity offering
• The sale of additional shares in firms that already
are publicly traded
• Public offerings of both stocks and bonds
typically are marketed by underwriters
• Advises the firm regarding the terms on which it
should attempt to sell the securities
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How Firms Issue Securities
Initial Public Offerings (Continued)
• Underwriter bears price risk
• IPOs are commonly underpriced compared
to the price they could be marketed
• Example: Dropbox
• Some IPOs are overpriced
• Example: Facebook
• Others cannot be fully sold
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Types of Markets
• Direct search market
• Least organized
• Buyers and sellers seek each other out directly
• Brokered markets
• Brokers offer search services to buyers and sellers
• Dealer markets
• Traders specializing in particular assets buy and
sell assets for their own accounts
• Auction markets
• All traders in an asset meet (physically or
electronically) at one place to buy and sell
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Bid and Ask Prices
Bid Price
Ask Price
• Bids are offers to buy
• In dealer markets, the bid
price is the price at which
the dealer is willing to buy
• Investors “sell to the bid”
• Ask prices are sell offers
• In dealer markets, the ask
price is the price at which
the dealer is willing to sell
• Investors must pay the ask
price to buy the security
Bid-asked spread is the difference between a dealer’s bid and ask price
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Types of Orders
• Market orders
• Buy or sell orders that are to be executed
immediately
• Trader receives current market price
• Price-contingent orders
• Traders specify buying or selling price
• Limit buy (sell) order instructs the broker to buy
(sell) shares if and when those shares are at or
below (above) a specified price
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Price-Contingent Order:
Example
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Trading Mechanisms
• Dealer markets
• Over-the-counter (OTC) market is an informal
network of brokers and dealers where securities can
be traded (not a formal exchange)
• Electronic communication networks (ECNs)
• Computer-operated trading network
• Register with the SEC as broker-dealers
• Specialist/DMM markets
• Designated market maker (DMM) accepts the
obligation to commit its own capital to provide quotes
and help maintain a “fair and orderly market”
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U.S. Markets:
NASDAQ
• NASDAQ
• Lists about 3,000 firms
• NASDAQ’s Market Center consolidates NASDAQ’s
previous electronic markets into one integrated
system
• Three levels of subscribers
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U.S. Markets:
NYSE
• Largest U.S. stock exchange, as measure by
market value of listed stocks
• Automatic electronic trading runs side-by-side
with broker/specialist system
• 1976 (and later) – DOT and SuperDot
• 2000 – Direct+
• 2006 – NYSE Hybrid
• Allowed NYSE to qualify as a fast market for the
purposes of Regulation NMS, but still offered
advantages of human interaction for complex trades
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U.S. Markets:
ECNs
• Electronic communication networks (ECNs)
are computer-operated trading network for
trading securities
• Some registered as formal stock exchanges, while
others are considered part of the OTC market
• Compete in terms of the speed they can offer
• Latency refers to the time it takes to accept,
process, and deliver a trading order
• Example: CBOE Global Markets advertises average
latency times of around 100 microseconds
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New Trading Strategies
(1 of 2)
• Algorithmic trading is the use of computer
programs to make trading decisions
• High-frequency trading is a subset of
algorithmic trading that relies on computer
programs to make extremely rapid decisions
• Dark pools are private trading systems in
which participants can buy or sell large blocks
of securities without showing their hand
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New Trading Strategies
(2 of 2)
• Bond trading
• Vast majority of bond trading takes place in the
OTC market among bond dealers
• Market for many bond issues is “thin” and is
subject to liquidity risk
• One impediment to heavy electronic trading is
lack of standardization in the bond market
• A single company may have dozens of outstanding
bond issues, differing by coupon, maturity and seniority
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Globalization of Stock Markets
• Pressure in recent years to make international
alliances or merges
• Much of the pressure is due to the impact of
electronic trading
• Wave of mergers has lead to a few giant
security exchanges
• ICE, NASDAQ, the LSE, Deutsche Boerse, the CME
Group, TSE, and HKEX
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Trading Costs
• Explicit cost – brokerage commissions
• Full-service versus discount brokers
• Execute orders, hold securities for safe-keeping,
extend margin loans, facilitate short sales, and provide
information and advice about investment alternatives
• Implicit costs
• Dealer’s bid-ask spread
• Price concession an investor may be forced to make
for trading in quantities greater than those associated
with the posted bid or ask price
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Buying on Margin
(1 of 2)
• Investors have easy access to a source of debt
financing called broker’s call loans
• Buying on margin means the investor borrows
part of the purchase price of the stock
• Margin in the account is the portion of the
purchase price contributed by the investor;
remainder is borrowed from the broker
• Board of Governors of the Federal Reserve
System limits the use of margin loans
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Buying on Margin
(2 of 2)
• Current initial margin requirement is 50%
• Maintenance margin
• Minimum equity that must be kept in the margin
account
• Margin call is made if value of securities falls
below maintenance level
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Short Sales
• Short sales allows investors to profit from a
decline in a security’s price
• Mechanics
1. Investor borrows stock from a broker and sells it
2. Must then purchase a share of the same stock in
order to replace the one that was borrowed
• Referred to as covering the short position
• Proceeds from a short sale must be kept on
account with the broker, per exchange rules
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Short Sale Mechanics
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Chapter Four
Mutual Funds and
Other Investment
Companies
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Investment Companies
• An investment company pools and invests the
funds of individual investors in securities or
other assets
• Record keeping and administration
• Diversification and divisibility
• Professional management
• Lower transaction costs
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Net Asset Value (NAV)
• Investment companies pool assets of
individual investors, but also need to divide
claims to those assets among investors
• Calculation of NAV
Market Value of Assets – Liabilities
Shares Outstanding
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Investment Companies:
Unit Investment Trusts
Unit Investment
Trusts
Investment
Companies
Managed
Investment
Companies
Other
Investment
Organizations
• Unit investment trusts are pools of money invested in a portfolio that is
fixed for the life of the fund
• Unmanaged
• Declined from $105 billion (1990) to $85 billion (2017)
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Investment Companies:
Managed Investment Companies
Unit Investment
Trusts
Investment
Companies
• Open-End
Open-end funds
Managed
Investment
Companies
Other
Investment
Organizations
Closed-end
funds
• Stand ready to redeem or issue shares at the NAV
• Priced at Net Asset Value (NAV)
• Closed-End
• Do not redeem or issue shares
• Shares outstanding constant; investors cash out by selling to new investors
• Priced at premium or discount to NAV
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Investment Companies:
Other Investment Organizations
• Commingled funds
• Partnerships of investors
that pool funds
• REITs
Unit Investment
Trusts
Investment
Companies
• Similar to a closed-end fund
• Equity versus mortgage
trusts
Managed
Investment
Companies
Commingled
Funds
Other
Investment
Organizations
REITs
Hedge Funds
• Hedge funds
• Vehicles that allow private
investors to pool assets to
be invested by a fund
manager
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Mutual Funds
• Common name for open-end investment
companies
• Dominant investment company today
• Accounts for 87% of investment company assets
• Assets under management (early 2018)
• U.S. – $18.7t
• Non-U.S. – $25t
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Mutual Funds: How Funds Are Sold
• How Funds Are Sold
• Directly by the fund underwriter (i.e., direct-marketed
funds)
• Sold through the mail, various offices of the fund, over the
phone, or over the Internet
• Indirectly through brokers acting on behalf of the
underwriter (i.e., sales-force distributed)
• Broker or financial advisers receive a commission for selling
shares
• Potential conflict of interest
• Financial supermarkets
• Sell shares in funds of many complexes
• Broker splits management fees with the mutual fund company
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Costs of Investing in Mutual Funds
• Fee structure
1. Operating expenses
2. Front-end load
3. Back-end load
4. 12 b-1 charges
• Fees must be disclosed in the prospectus
• Share classes with different fee combinations
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Fees and Mutual Fund Returns
• Example
• Initial NAV = $20
• Income distributions of $0.15
• Capital gain distributions of $0.05
• Ending NAV = $20.10
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Exchange Traded Funds (ETFs)
• ETFs are offshoots of mutual funds that allow investors
to trade index portfolios just as they do shares of stock
• Examples: “spiders,” “diamonds,” “cubes,” and “WEBS”
• Potential advantages
• Trade continuously like stocks
• Can be sold short or purchased on margin
• Cheaper than mutual funds
• Tax efficient
• Potential disadvantages
• Prices can depart from NAV
• Must be purchased from a broker (for a fee)
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Chapter Nine
The Capital Asset
Pricing Model
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Capital Asset Pricing Model (CAPM)
• CAPM is a precise prediction of the relationship that
we should observe between the risk of an asset and
its expected return.
• Based on two sets of assumptions
• Individual behavior
• Assume that investors are alike in most important ways.
• Market structure
• Asserting that markets are well-functioning with few
impediments to trading.
• With these assumptions, all investors hold
identical risky portfolios.
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Capital Asset Pricing Model (CAPM)
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Capital Asset Pricing Model (CAPM)
Example
Suppose that the risk premium on the market portfolio is estimated at 8%
with a standard deviation of 22%. What is the risk premium on a portfolio
invested 25% in Toyota and 75% in Ford, if they have betas of 1.10 and
1.25, respectively?
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The CAPM and Investment Industry
• Portfolio theory and the CAPM have become
accepted tools in the practitioner community
• Many professionals are comfortable with the use
of beta to measure systematic risk
• Most investors don’t beat the index portfolio
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The Security Market Line
• Security market line or SML is a graphical
representation of the returns expected to be
provided by security given the amount of
systematic risk taken in by it.
• The SML is used by investors to determine
whether to include security in their portfolio
or not.
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The Security Market Line
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The Security Market Line & Alpha
The difference between the fair and actually expected rate of return on a stock is
called the stock’s alpha, denoted by α.
Example: if the market return is expected to
be 14%, a stock has a beta of 1.2, and the
T-bill rate is 6%, the SML would predict an
expected return on the stock of
6 + 1.2(14 − 6) = 15.6%
If one believed the stock would provide an
expected return of 17%, the implied alpha
would be 1.4%.
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The difference between SML and CML
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Chapter Fourteen
Bond Prices and
Yields
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Chapter Overview
• Debt (i.e., fixed-income) securities promise
either a fixed stream of income or one that is
determined according to a specified formula
• Bond markets
• Treasury, corporate and international bonds
• Bond pricing and returns
• Impact of default or credit risk on bond pricing
• Fixed-income derivatives
• Credit default swaps or collateralized debt obligations
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Bond Characteristics
• A bond is a security that is issued in
connecting with a borrowing arrangement
• Issuer agrees to make specified payments to the
bondholder on specified dates
• Par value (i.e., face value) is the payment to
the bondholder on the bond’s maturity date
• Coupon rate is a bond’s interest payments per
dollar of par value
• Bond indenture is the contract between the
issuer and the bondholder
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Treasury Bonds and Notes
• Maturity
• Treasury notes – 1 to 10 years
• Treasury bonds – 10 to 30 years
• Both bonds and notes may be purchased
directly from the Treasury
• Denominations
• As small as $100, but $1,000 is more common
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Corporate Bonds
• Callable bonds typically come with a period of call
protection
• Convertible bonds give holders option to exchange
each bond for a specified number of shares of the
firm’s stock
• Put bond gives holder option to exchange for par
value at some date or to extend for a given number
of years
• Floating-rate bond has interest rate that is reset
periodically according to a specified market rate
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education
14-73
Preferred Stock
• Considered to be equity, but often included in
the fixed-income universe
• Like bonds, preferred stock promises to pay a
specified cash flow stream
• Unlike bonds, failure to pay the promised dividend
does not result in corporate bankruptcy
• Dividends owed simply cumulate
• Preferred stock commonly pays a fixed dividend
• Rarely gives holders full voting privileges in firm
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education
14-74
International Bonds
Foreign bonds
• Issued by a borrower from a
country other than the one
in which the bond is sold
• Denominated in the
currency of the country in
which it is marketed
– Samurai bonds
– Bulldog bonds
Eurobonds
• Denominated in one
currency, usually that of the
issuer, but sold in other
national markets
– Euroyen bonds
– Eurosterling bonds
• Not regulated by U.S.
federal agencies
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education
14-75
Bond Pricing
(1 of 2)
• First term of right-hand side of equation is the
present value of an annuity
• Second term is the present value of a single
amount, the final payment of the bond’s par
value
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education
14-76
Bond Pricing
(2 of 2)
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education
14-77
Bond Prices and Yields
• Inverse relationship between price and yield is
a central feature of fixed-income securities
• Interest rate fluctuations represent the main
source of risk in the fixed-income market
• The price curve is convex and becomes flatter
at higher interest rates
• The longer the maturity of the bond, the more
sensitive the bond’s price to changes in
market interest rates
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education
14-78
Bond Yields: Yield to Maturity
• Yield to maturity (YTM) is the interest rate
that makes the present value of a bond’s
payments equal to its price
• Interpreted as a measure of the average rate of
return that will be earned on a bond if it is bought
now and held until maturity
• To calculate YTM, solve the bond price
equation for the interest rate given the bond’s
price
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education
14-79
Yield to Maturity Example
• Suppose an 8% coupon, 30-year bond is
selling for $1,276.76. What is the YTM?
$40 1000
$1276.76 = 
+
60
t
(1+ r )
t =1 (1+ r )
60
• r = 3% per half year
• Bond equivalent yield = 6%
• EAR = ((1.03)2) – 1 = 6.09%
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education
14-80
Bond Yields: YTM vs. Current Yield
• Yield to maturity
• Bond’s internal rate of return
• Interpreted as compound rate of return over life
of the bond assuming all coupons can be
reinvested at that yield
• Proxy for average return
• Current yield is the bond’s annual coupon
payment divided by its price
• Premium bonds: Coupon rate > Current yield > YTM
• Discount bonds: Coupon rate < Current yield < YTM INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 14-81 Default Risk and Bond Pricing (1 of 2) • Credit risk, or default risk, is the risk the bond will not make all promised payments • Rating companies • Moody’s Investor Service, Standard & Poor’s, and Fitch Investor Service • Rating categories • Highest rating is AAA (or Aaa) • Investment grade bonds are rated BBB/Baa or above • Speculative-grade/junk bonds are rated below BBB/Baa INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 14-82 Default Risk and Bond Pricing (2 of 2) • Determinants of bond safety • Coverage ratios • Leverage (e.g., debt-to-equity) ratios • Liquidity ratios • Profitability ratios • Cash flow-to-debt ratio INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 14-83 Altman Z-Score • Z-scores below 1.2 indicate vulnerability to bankruptcy • Scores between 1.23 and 2.90 are a gray area • Scores above 2.90 are considered safe INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 14-84 Chapter Eighteen Equity Valuation Models INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education. Overview • Fundamental analysts use information concerning the current and prospective profitability of a company to assess its fair market value • Alternative measures of a company’s value • Dividend discount models • P/E ratios • Free cash flow models INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-86 Valuation by Comparables • Purpose of fundamental analysis is to identify stocks that are mispriced relative to some measure of “true” value that can be derived from observable financial data • Valuation ratios are commonly used to assess the valuation of one firm compared to others in the same industry INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-87 Limitations of Book Value • Shareholders are sometimes called “residual claimants” • Book values are based on historical cost, while market values measure the current values of assets and liabilities • Market values generally will not match historical values INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-88 Liquidation Value and Tobin’s Q • Net amount that could be realized by selling the assets of a firm after paying the debt is liquidation value • Good representation of a “floor” for the stock’s price • Replacement cost is the cost to replace a firm’s assets • Tobin’s q is the ratio of market value of the firm to replacement cost • Trends towards 1 INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-89 Financial Highlights of Microsoft INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-90 Intrinsic Value vs. Market Price • The return on a stock is composed of cash dividends and capital gains or losses Expected HPR= E ( r ) = E ( D1 ) +  E ( P1 ) − P0  P0 • The expected HPR may be more or less than the required rate of return • Variation based on the stock’s risk INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-91 Required Return • CAPM gives the required return, k: k = r f +   E ( rM ) − r f  • If the stock is priced correctly, expected return will equal required return • k is the required rate of return INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-92 Intrinsic Value and Market Price • The intrinsic value (V0) is the “true” value, according to a model • If intrinsic value > market value, the stock is
considered undervalued and a good investment
• Trading signal
• IV > MV → Buy
• IV < MV → Sell • IV = MV → Hold INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-93 Dividend Discount Models (DDM) D3 D1 D2 V0 = + + + ... 2 3 1 + k (1 + k ) (1 + k ) • V0 = current value • Dt = dividend at time t • k = required rate of return • DDM says V0 = the present value of all expected future dividends into perpetuity INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-94 Constant Growth DDM (1 of 2) D0 (1 + g ) D1 V0 = = k−g k−g • V0 = current value • Dt = dividend at time t • k = appropriate risk-adjusted interest rate • g = dividend growth rate INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-95 Constant Growth DDM (2 of 2) • A stock just paid an annual dividend of $3/share • Dividend is expected to grow at 8% indefinitely • Market capitalization rate is 14% D1 $3.24 V0 = = = $54 k − g .14 − .08 INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-96 DDM Implications • The constant-growth rate DDM implies that a stock’s value will be greater: 1. The larger its expected dividend per share 2. The lower the market capitalization rate, k 3. The higher the expected growth rate of dividends • The stock price is expected to grow at the same rate as dividends INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-97 Discounted Cash Flow (DCF) Formula • DCF formula often used in rate hearings for regulated public utilities • Focus on “fair” profit INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-98 Dividend Growth for Two Earnings Reinvestment Policies INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-99 Present Value of Growth Opportunities • Present value of growth opportunities (PVGO) is the net present value of a firm’s future investments • The value of the firm is the sum of the following: • Value of assets already in place (no-growth value) • Net present value of the future investments the firm will make, or PVGO E P0 = 1 k + PVGO INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-100 Financial Ratios in Two Industries INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-101 Price-Earnings Ratio and Growth Opportunities (1 of 3) • The ratio of PVGO to E/k is equivalent to the component of firm value due to growth opportunities to the value reflecting assets already in place INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-102 Price-Earnings Ratio and Growth Opportunities (2 of 3) • When PVGO = 0, P0 = E1/k • The stock is valued like a nongrowing perpetuity • As PVGO becomes an increasingly dominant contributor to price, the P/E ratio can rise dramatically • P/E ratio reflects the market’s optimism concerning a firm’s growth prospects INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-103 Price-Earnings Ratio and Growth Opportunities (3 of 3) • P/E increases: • As ROE increases • As plowback, b, increases, if ROE > k
• As plowback decreases, if ROE < k • As k decreases P0 1− b = E1 k − ROE x b INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-104 Effect of ROE and Plowback on Growth and the P/E Ratio INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-105 P/E and Growth Rate • Wall Street rule of thumb suggests the growth rate ought to be roughly equal to the P/E ratio • “If the P/E ratio of Coca Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.” Peter Lynch in One Up on Wall Street INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-106 P/E Ratios and Stock Risk • Holding all else equal, riskier stocks will have lower P/E multiples • Riskier firms will have higher required rates of return, that is, higher values of k, which means the P/E multiple will be lower P 1− b = E k−g INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-107 Chapter Eighteen Equity Valuation Models INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education. P1 a. MF Corp. has an ROE of 16% and a plowback ratio of 50%. If the coming year’s earnings are expected to be $2 per share, at what price will the stock sell? The market capitalization rate is 12%. g = ROE  b = 16%  0.5 = 8% D1 = $2  (1 – b) = $2  (1 – 0.5) = $1 INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-2 P1 Cont. b. What price do you expect MF shares to sell for in three years? P3 = P0(1 + g)3 = $25(1.08)3 = $31.49 INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-3 P2 Sisters Corp. expects to earn $6 per share next year. The firm’s ROE is 15% and its plowback ratio is 60%. If the firm’s market capitalization rate is 10%, what is the present value of its growth opportunities? INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-4 P3 The risk-free rate of return is 8%, the expected rate of return on the market portfolio is 15%, and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong pays out 40% of its earnings in dividends, and the latest earnings announced were $10 per share. Dividends were just paid and are expected to be paid annually. You expect that Xyrong will earn an ROE of 20% per year on all reinvested earnings forever. a. What is the intrinsic value of a share of Xyrong stock? k = rf + β [E(rM ) – rf ] = 8% + 1.2(15% – 8%) = 16.4% g = b  ROE = 0.6  20% = 12% INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-5 P3 Cont. b. If the market price of a share is currently $100, and you expect the market price to be equal to the intrinsic value one year from now, what is your expected 1-year holding-period return on Xyrong stock? P1 = V1 = V0(1 + g) = $101.82  1.12 = $114.04 INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 18-6

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