Streetbites from the media perspective Stocks and technical versus fundamental analysis

Streetbites from the media perspective Stocks and technical versus fundamental analysis

Streetbites from the media perspective Stocks and technical versus fundamental analysis See textbook page 368 for related content on this topic. Videos for Module 8, Unit 1-of-2 o Speculative v enterpreneurial factor (4:27) CHAPTER 8: TIME VALUE APPLICATION 3, STOCK VALUATION Famous books from the 1930s, Security Analysis by Benjamin Graham and David Dodd, The Theory of Investment Value by John Burr Williams, and The General Theory of Employment, Interest, and Money by John Maynard Keynes, recognize two factors determining stock prices. The speculative factor relates stock price movements to market psychology and investor trading behavior. The entrepreneurial factor relates stock price movements to consensus expectations about the discounted value of company cash flows.

From http://www.afajof.org/details/news/5372091/financial-economists-win-nobel-prize.html

Years before he won the Nobel prize Prof. Fama gave this interesting interview: http://bama.ua.edu/~fi302/eugene%20fama%20fen%20one%20on%20one%20interview%20 with%20eugene%20fama.htm

Chapter 8, Unit 1 of 2 Equity markets and securities

The moving average trading rule, preferred stocks, and intrinsic value! See textbook pages 369-385 for relevant readings. Videos for Module 8, Unit 1-of-2 Speculative v enterpreneurial factor (4:27) Moving avg trading - overview (5:02) Find signal reversal price (5:25) [TK4] Fundamental intrinsic value (5:35) Find stock ROR on counteroffer (2:14) [Example 4] Find V for nondividend startup (4:29) [ST20] Preferred stock and normal dividend yield (5:20) [ST25] The speculative factor relates stock price movements to market psychology and investor trading behavior. FORMULA 8.1 Simple moving average stock price N period moving average stock price v N 1 t0 price N vt Consider the daily stock prices in Table 8.1. day - 1 - closing price - 2 - long run moving average (5 day) - 3 - short run moving average (signal) (1 day) (2 day) - 4 - - 5-1 $40.00 2 $41.50 3 $42.25 4 $40.75 5 $42.50 $41.40 $42.50 (buy) $41.63 (buy) 6 $41.00 $41.60 $41.00 (sell) $41.75 (buy) 7 $40.25 $41.35 $40.25 (sell) $40.63 (sell) 8 $39.85 $40.87 $39.85 (sell) $40.05 (sell) 9 $41.50 $41.02 $41.50 (buy) $40.68 (sell) 10 $40.25 $40.57 $40.25 (sell) $40.88 (buy) TABLE 8.1 Computing moving average stock prices

RULE 8.1 The moving average trading strategy A buy signal results when the short-run moving average becomes bigger than the longrun moving average.. Conversely, a sell signal results when the short-run moving average becomes smaller than the long-run moving average. $ 4 3.0 0 $ 4 2.5 0 $ 4 2.0 0 SELL Long-run moving average $ 4 1.5 0 SELL $ 4 1.0 0 $ 4 0.5 0 BUY $ 4 0.0 0 $ 3 9.5 0 Short-run moving average $ 3 9.0 0 $ 3 8.5 0 day 5 6 7 8 9 10 FIGURE 8.1 Moving average trading strategy based on data in table 8.1

TR34 T/F Moving average trading strategy A mainstay of technical analysis is comparison of moving averages with different lengths. Is the following statement of the moving average trading strategy True or False: A buy signal results when the short-run moving average becomes smaller than the long-run moving average. a. True b. False

Most knowledgeable investors and finance professors believe that the stock price history cannot predict where the price is going next. Predicting the effect of the speculative factor on stock prices seems as imprecise as predicting which fads or sayings will catch-on, or predicting the next turn in direction for a flock of flying birds. For this reason, training in speculation, however intelligent and thorough, is likely to prove a misfortune to the individual, since it may lead him into market activities which, starting in most cases with small successes, almost invariably end in major disaster. Benjamin Graham and David Dodd. Security Analysis, 1934, page 12. Keynes s speculative factor gives rise to the preceding TECHNICAL ANALYSIS Secrets that work in the short term (at best) Keynes s entrepreneurial factor gave rise to FUNDAMENTAL ANALYSIS Cash flow drives value! FORMULA 8.4 Intrinsic value, general version stock value CF t t t1 (1 r ) 0 The intrinsic value relation contains three components: a cash flow stream, a discount rate, and the stock value. Given any two components, the third is pre-determined. The stock value represents intrinsic value when the known variables are the cash flow stream and discount rate. The stock value represents the actual stock price when either the discount rate or cash flow stream is the unknown variable. Intrinsic value, like beauty, often is in the eye of the beholder. Comparison of intrinsic value with the actual trading price enables insight about whether the stock is under or overvalued. Rule 8.2 summarizes the investment strategy. RULE 8.2 The intrinsic value trading strategy The signal a fundamental analysis generates is that: if intrinsic value t actual price t then buy sell. When intrinsic value exceeds the actual price the asset is undervalued. The asset is

worth more than it costs. Always buy undervalued assets. When intrinsic value is less than the actual price then the asset is overvalued. ST12 Find rate of return given lump-sum cash flows A stock you are buying today promises no dividends for a long time. In exactly 10 years you expect the stock will pay its first annual dividend of $1.90. At that time, you also believe that the stock could be sold for $41.00. If today you can buy the stock for $15.95, what is the expected annual rate of return on the stock investment? ANSWER: C a. 11.4% b. 9.5% c. 10.4% d. 7.8% e. 8.6% EXAMPLE 4 Find the rate of return on a counter-offer You offer $23 for the share that you expect to return dividends of $1.40 one year from now, $1.75 in 2 years, $2.00 in 3 years, and also in 3 years you believe the share could be sold for $30. Your offer is rejected and instead a counter-offer of $24 is accepted. What is the rate of return if you buy at the counter-offer price and receive the expected cash flows? SOLUTION Use formula 8.4 and set stock value equal to the actual stock price. Solve for r: $24.00 $1.40 $1.75 $2.00 $30.00 1 r 1 1 r 2 1 r 3 Use the calculator to find that r, the geometric average annual rate of return, equals 14.29%. EXERCISES 8.2 1. The stock for a start-up company probably will pay no dividends until exactly 8 years from today. At that time it will pay $6.80 per year forever. You assess the intrinsic value of the stock with a 10.3% discount rate. Find the stock s intrinsic value today. ST20. Easily search the book for ST20 and get a calculator clue too for this! Preferred stocks trade on exchanges by the same procedures as common stocks. The preferred dividend for a particular stock is constant. The preferred stock for AMR (American Airlines) in the table above, for example, promises to pay $6.40 per annum forever. What do you think would happen to the price of AMR preferred stock if American Airlines suddenly won major flight contracts with every government in Europe and South America? The answer: probably nothing! Maybe the price of the

common stock would skyrocket as investors suddenly realize future profits will be larger than previously expected. The preferred dividend, however, is fixed at $6.40 per year forever. The price of preferred consequently responds more to discount rate changes than to the good fortunes of the company. Because the dividend is constant, the formula for value relation simplifies to the perpetuity formula: FORMULA 8.5 Intrinsic value, stocks with constant dividends stock value 0 t1 dividend t (1 r ) dividend r There are many variations of problems using the same formula! ST21 Find ROR given P 0, zero dividends until time N, and perpetuity thereafter A stock you are buying today promises no dividends for a long time. In exactly 7 years you expect the stock will pay its first annual dividend of $8.00 which you expect will be paid annually forever. If today you can buy the stock for $31.57, what is the expected annual rate of return on the stock investment? ANSWER: B a. 13.8% b. 12.5% c. 15.1% d. 11.4% e. 16.6% ST22 Find preferred V(0) given dividend, CD rate, and risk premium The company preferred stock pays a $5.20 annual dividend. The local bank pays 5.4% interest (compounded annually) on 5-year CDs. You consider the preferred stock an attractive investment if its ROR is 175 basis points more than the CD rate. Find your assessment of the preferred stock intrinsic value. ANSWER: C ; CLUES: r = 7.15% a. $60.11 b. $49.67 c. $72.73 d. $54.64 e. $66.12

ST24 Find preferred risk premium and buy-or-sell given dividend, CD rate, P(0), and target risk premium The company preferred stock yesterday paid $7.60 annual dividend and today s stock price is $76.80. The local bank pays 5.5% interest on CDs. You consider the preferred stock an attractive investment if its ROR is 350 basis points more than the CD rate. Find the actual risk premium and is this stock a buy or a sell? ANSWER: D ; CLUES: target risk premium = 9.00%; intrinsic value = $84.44 a. the actual risk premium is 581 BP and the stock is a sell b. the actual risk premium is 506 BP and the stock is a buy c. the actual risk premium is 581 BP and the stock is a buy d. the actual risk premium is 440 BP and the stock is a buy e. the actual risk premium is 440 BP and the stock is a sell EXERCISES 8.2A 5. The company preferred stock just yesterday paid its annual dividend of $6.00 per share. Today s share price is $52.25. You believe the dividend yield is abnormally high but that it will revert to its normal value of 7.0%. Your strategy is to buy the stock today and receive annual dividends for 4 years. Upon receiving the last dividend you expect the dividend yield will be normal. Your strategy is to sell the stock at that time. Compute the expected annual rate of return for the strategy. ST25. ANSWER: You pay $52.25 at time 0 and receive $6 at times 1-3. Then at time 4 you receive $6 plus the sell price. The sell price satisfies the perpetuity formula price = PMT/r, or price = $6 / 0.07, or price = $85.71. The annual rate of return equals 22.9% and satisfies constant annuity formula 5.1 wherein CF = $6, FV = $85.71, PV = $52.25, and N = 4: $52.25 = [$6 (1 (1+r) -4 ) r] + ($85.71 (1+r) -4 )