WHAT IS THE VALUE OF A STOCK?

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1 THE STOCK MARKET STOCK a security that gives the holder a share of the ownership of that company - The holder is entitled to dividends (if paid) + price changes in that stock - Technically, the stock holder has a claim on part of the earnings and assets of that company and the right to vote at stock holder meetings - Stockholders are residual claimants (they get assets only after everyone else) DIVIDEND a portion of company profits paid to share holders (quarterly) WHAT IS THE VALUE OF A STOCK? - Value and price are not always synonymous Price is determined by supply and demand Value technically this is the present value of expected future cash flows over the time the stock will be held - This can include dividends and future price One-Period Valuation Model - Pertains if you expect to hold a stock for a year PRICE = DIV/(1+r*) + Price (end of period)/(1+r)* Where: DIV = dividend received (if it exists) r* = rate of return you desire to earn Ex: if r* = 12%, DIV = $0.16, and P(end period) = $60 PRICE = 0.16/ /1.12 = $53.71 The expected future cash flow from owning this stock is $ If the actual stock price is less than $53.71, you should buy it (although your assumptions might turn out to be incorrect!) Multi-Period Valuation Model - Extends the simple model to n periods PRICE = DIV 1 /(1+r*) + + DIV n /(1+r*) n + P(end)/(1+r*) n - Need to know P(end) to accurately get PRICE - If n is large (far into future), present value of P(end) will be small, so PRICE present value of dividends - This is called the Generalized Dividend Model Q: For stocks that don t pay dividends, how is PRICE determined? A: Mishkin: Buyers of the stock expect that the firm will pay dividends someday. - IS HE KIDDING??? This is an ad hoc interpretation to justify a formula

2 If dividends won t come into existence at all or very far into the future, according to this model, PRICE 0, so this model doesn t deal with that situation Q: What about stocks that don t pay dividends? A: Use the P/E Method, where P = stock price, E = earnings (called the price-earnings ratio) 1) Analysts identify comparison firms and decide what the appropriate P/E should be, call it (P/E)* 2) Estimate future earnings for this company 3) P(future) = (P/E)* x Projected Earnings Potential Problems: a) The estimate of earnings is often WRONG (the basis for earnings surprises ) b) (P/E)* => homogenization of firms (apples + oranges) c) Future P/E increases are difficult to forecast d) Too much focus on P/E makes this one dimensional A SUGGESTED ECONOMIC APPROACH (BY ME) 1) Model P/E using economics and fundamentals criteria 2) Model Earnings with economic and industry specific variables E = f(r, input costs, demand (is this cyclical?), ) 3) SIMULATE future price under several scenarios (ex: optimistic, pessimistic, middle) and determine the range of likely values 4) Use this information as basis for your price projection ECONOMIC ANALYSIS OF STOCK PRICES: EXPECTATIONS Market prices of financial assets contain information that is useful to both buyers & sellers. Q: How are future price expectations formed? A: Expectations in general matter - Expected wealth affects bond demand - Expected profit influences investment & bond supply - Expected of growth and inflation affect nominal rates MODELING PRICE EXPECTATIONS 1) Adaptive expectations uses past prices as basis for future expectations - Price expectations change gradually over time as more old data comes available - Can make systematic errors where consistently underestimate or over-estimate prices 2) Rational Expectations - uses all information, past and present - current market price = current best guess, based on all available information available, of present value of future returns (FUNDAMENTAL VALUE) = (expected = (optimal forecast price) using all data) This does not imply perfect accuracy!

3 Implications of Rational Expectations Theory 1) If the general behavior of a variable changes, the way expectations of this variable are formed (and thus expectations overall) will also change; and 2) Forecast errors in expectations will, on average, equal zero and cannot be predicted ahead of time. So:, the error predicting next period's price (the deviation of expected from actual future price) will have a mean of 0 through time. Derived from this: When price > or < fundamental value profit opportunities exist - When traders and investors use rational expectations (incorporate all available information into decisions) and transactions costs are low, the equilibrium price of asset will equal the market s optimal forecast of fundamental value *EFFICIENT MARKETS HYPOTHESIS* - optimal price forecast (using all available information) = equilibrium price According to Investopedia.com: Efficient Market Hypothesis - EMH What Does Efficient Market Hypothesis - EMH Mean? An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. Investopedia explains Efficient Market Hypothesis - EMH Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis. Meanwhile, while academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.

4 Underlying the Efficient Markets Hypothesis is: Arbitrage: the process moving toward and eliminating unexploited profit opportunities (i.e., security prices or returns unjustified by the underlying characteristics of that security or asset) If optimal forecast of return exceeds the current equilibrium return, the price of that asset will be bid up, lowering the actual and optimal forecast of the asset's return (unexploited profit opportunity exist) If optimal forecast of return is below the current equilibrium return, the price of the asset will be bid down, raising the actual and optimal forecast of the asset's return (unexploited loss opportunities exist) Neither of these can be an equilibrium, since these result in changes in the market This will continue until: = - which is the equilibrium condition This implies that in equilibrium for an efficient market, all unexploited profit (loss) opportunities will be eliminated This does not require that everyone in a financial market must be well informed about a security or have rational expectations concerning its price Q: What determines the price of a financial asset ( )? A: This depends on its returns relative to other assets with similar risk, liquidity, and informational characteristics INCOME = CURRENT + VALUE OF EXPECTED RETURN FUTURE RETURNS = where: is current asset price; expected periodic return (ex: dividend or coupon); is expected price next period; and is the risk-adjusted interest rate (discount factor) The right side = Present value of future expected returns from owning this asset Using this equation, is "high" if: (a) Expected periodic return ( ) is large; (b) This asset is not very risky (low ) (c) This asset is expected to generate future capital gains (the higher is )

5 Q: What causes to fluctuate? News concerning changes in fundamental value (thru or different risk and ) Changing interest rates (given risk): as, the present value of future income falls Changing default risk What does the Efficient Markets Hypothesis tell us about investing? All above normal profit opportunities will be exploited you should have a diversified portfolio (don t risk money on one or a few investments) Regular buying/selling of assets (churning of assets) will not be profitable since prices reflect all available information. You should "buy and hold" stocks (ugh!!) Good news will generally not raise the price of a stock unless it is totally unexpected (otherwise it is built into the stock's existing price) The use of historical information only to predict future price does not give an optimal forecast (since this omits recent and current data) BUT Technical analysis does rely only on past data and often does fairly well. According to EMH, there should be no such thing as trends. You could have fooled me!! Psychological factors DO affect asset markets. Q: Are markets efficient? Eugene Fama found evidence supporting the efficient markets hypothesis, but other evidence says no This hypothesis implies that nobody can consistently earn above-normal profits since prices embody all available information Small Firm Effect Since the 1920 s, stocks of small firms have tended to outperform the overall market (even taking greater risk into account) January effect For many years returns to stocks were higher in January - many say this results from tax considerations sell at the end of the year for tax considerations buy at the beginning of the year to rebalance portfolios, But institutional investors don t pay capital gains taxes Mean Reversion Stocks with above-average returns now tend to (revert to) below-average returns in the future this implies that currently available information can change asset prices

6 Excessive Volatility Since price = best estimate of fundamental value price fluctuations should mirror fluctuations only in fundamental value Schiller found evidence consistent with this The Crash of 1987 is consistent with excess volatility (the explanation noise traders caused the 1987 crash this is not very convincing) Bubbles Periods when asset prices exceed their fundamental values The crash of 1987 was the result of a speculative bubble bursting With upward price momentum, some persons bought stocks only to sell them quickly at a profit (speculation feeds on itself) "Greater Fool Theory a person is not a fool for buying at an inflated price as long as it is possible to find a fool to buy from you later at an even higher price - Brady Task force studying the 1987 crash found that the large volume of sell orders overwhelmed the specialists (persons who have stocks to match buy with sell orders) - They made recommended changes for specialists and wanted circuitbreakers (that temporarily halt trading) Value Investing Large investors have sometimes found that investing in value stocks (those with price low relative to earnings, dividends and other measures) can beat the market (ex. Warren Buffett) According to Investopedia.com What Does Value Investing Mean? The strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company's long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated. Typically, value investors select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields. Investopedia explains Value Investing The big problem for value investing is estimating intrinsic value. Remember, there is no "correct" intrinsic value. Two investors can be given the exact same information and place a different value on a company. For this reason, another central concept to value investing is that of "margin of safety". This just means that you buy at a big enough discount to allow some room for error in your estimation of value. Also keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and don't place any value on future growth. Other value investors base strategies completely around the estimation of future growth and cash flows. Despite the different methodologies, it all comes back to trying to buy something for less than it is worth.

7 How do rising interest rates affect stock prices? Rising interest rates make CD's and other interest earning (i.e., fixed income) assets relatively more attractive as investments than stocks CD's & Bonds - substitutes for stocks Higher interest rates lower demand for stocks, causing stock prices to fall P Stocks (DJIA) P e P e Q e Qe D 1 S D Q Stocks Rising interest rates are a head wind for the stock market. This explains generally poor stock market performance when the Fed tightens. Recall: Higher expected inflation higher nominal interest rates, now see: Causes stock prices to fall (stock market sell off) Interest Rates and Stock Prices (again) Bonds become relatively more attractive when interest rates are expected to fall (ex: a slowing economy or lower expected inflation translate into lower rates and higher bond prices try telling that to a senior citizen!) Assume the economy is expected to slow in the future (and no inflation worries): Stocks: expected future profit falls, making stocks relatively less attractive, lowering their demand Bonds: this lowers expected future inflation making bonds relatively more attractive, raising their demand bond for stock substitution Result: lower stock prices AND lower interest rates (which reflects higher bond prices) - This makes bonds a recession hedge, their higher demand called a flight to safety All of this becomes less obvious when both growth and inflation are expected to change Ex: oil prices rise enough to bring recession fears. This generally causes a bond market rally which lowers interest rates, as it is believed that weakness or recession will lower inflation

8 Q: Assuming costs of production rise due to higher input costs, how much will P e rise? A: This depends on the percentage of total costs the higher-priced input accounts for. - The more intensively the higher-priced input is used, the greater will be the increase in marginal cost and the farther left will supply shift - Other things being equal, this leads to larger prices increases (exercise: draw this in a graph) Q: Will price always rise when input costs rise? A: No. This also depends on how well the overall economy is performing. Other things are not always equal demand might also be changing. - In a recession, demand is lower. So, either price will not rise (constant or falling in extreme cases), or rise by less than otherwise (exercise: draw this combination in a graph) - In recessions, firms are less able to pass on cost increases to consumers. Check out product characteristics then (ex: smaller dinners, side orders now optional, or product size shrinks) SUPPORT AND RESISTANCE You should buy low and sell high Add imperfect information and emotions and often the opposite occurs Stocks often trade within ranges: - Lower end: SUPPORT a price where the stock is viewed as being a bargain. When price hits this level, buyers jump in (buying pressure (demand) exceeds selling pressure (supply)), and price rises - Higher end: RESISTANCE a high price where the stock is viewed as being overpriced and its price likely to fall. Here, sellers jump in (selling pressure (supply) exceeds buying pressure (demand)), and price falls - Ideally, you should buy at or close to support. When you add emotions, and people often buy close to resistance (they falsely assume the price will keep going up) - Ideally, you should sell at or close to resistance. Often people do the opposite

9 Actual graph of Wal-Mart s stock (WMT) SUPPORT AND RESISTANCE AGAIN Don t focus only on closing price each time period (ex: day), but to open, high, low, and close use OHLC bars HIGH CLOSE OPEN Resistance at $57.70 Support around $52 RULES: 1. NEVER buy a stock when it is close to resistance (unless you have some relevant information on it) 2. NEVER sell a stock at close to the support price (unless you have some information to justify this) 3. Your reward-risk ratio should be about 3 to 1 or better. Above, in November (at $56.50) the potential reward was $1/share, the risk was $4/share. YOU SHOULD WAIT until the stock breaks through prior resistance before buying it. LOW SUPPORT: Use LOWS a support line should lie below (at the bottom) of the price bars, connecting at least two LOWS - UPTREND higher lows and higher highs connect lows Uptrend in GOLD

10 RESISTANCE: Use HIGHS a resistance line should be above (at the high points) of the price bars, connecting at least two HIGHS - DOWNTREND lower highs and lower lows connect highs COMBINING SUPPORT AND RESISTANCE PRODUCES TRIANGLES Downtrend in Commodities (based on the CRB Index) Triangles suggest an eventual breakout (higher) or breakdown (lower). Above, GOLD had a breakout (higher). -Breakouts (such as this) and breakdowns provide critical real-time economic information. -In this case, look for markets with breakdowns and ascertain the intermarket implications

11 Extending the above: Include the RSI(9) and Relative Strength Indicators So, find the next level of resistance. - Either use moving averages or a recent high. Using a recent high, resistance is just below $ Given that GOLD is now overbought, it is very likely that resistance near $940 will hold for the short-term Relative Strength (below) has been rising since mid- November, showing that over that period GOLD outperformed stocks (here the S&P 500) As Gold has broken out, the RSI has moved into slightly overbought territory (above 70), suggesting the possibility of a short-term pull back soon. How can we determine more systematically whether resistance will hold? -Use economic theory and intermarket analysis. Identify the factors that determine the price of gold and predict what those factors will do in the short term.