Stock Market Analysis &

Equity Valuation

Lecture Slides
I

Rates of Return
The total holding-period return (HPR) measures by how much the
value of initial investment has grown over the investment period:

HPR

Dollar Return
Beginning Price

Ending Price - Beginning Price Dividend

Beginning Price

Dividend Yield Capital Gains Yield

The Beauty of Compounding

There are different conventions for quoting returns on different assets. Mortgage
payments and bond coupon payments, for instance, are quoted as annual nominal
percentage rate (APR):
APR = Per-period rate Periods per year
Suppose that your money earns interest at an APR of 6% per year compounded
semiannually. What is your effective annual rate of return, accounting for compound
interest?
r (1.03) 2 1 6.09%
EFF

The general formula for the effective annual rate is

APR
rEFF 1
1
n

where n is the number of compounding periods per year.

Annual Effective Rates for APR of 6%

Note 1: As the compounding frequency increases (1+APR/n) n gets closer to eAPR, where
e is a magic number approximately equal to 2.718. This is exactly the same as
exp(APR). Your pocket calculator should have the exp() or e x function.
Note2 : The difference between the Effective Annual Rate and APR has oftentimes
been exploited by bankers trying to evade part of the capital gain tax. For instance,
with weekly compounding we get almost 18 basis points that are potentially tax-free.

Estimating Expected Value and Variance From a Sample of

Historical Returns

Returns on stocks, bonds and T-bills

Sample average can

be used as estimate of
expected value, i.e.

E (r )
Estimate
variance

1
N

of

sample

1
(rt E (r )) 2

N 1

For a technical reason

the sum of squared
deviations is divided
by (N-1), rather than
N.

Cumulative Real Returns in the UK

Frequency Distribution of Annual Holding Period Returns in the U.S., 1926-2006

Risk Premium Puzzle

The size of equity premium

cannot be easily accounted for
by simple economic models.
This
fact
has
been
first
highlighted by Mehra and
Prescott.

Quantitative Review: Covariance

Consider the two following random variables;

bungee jumps and the number of bungeerelated accidents. The covariance between the
two is:

Cov( BJ , BA)

( BJ
t

E ( BJ ))( BAt E ( BA))

N 1

A positive covariance would imply that the

more you jump on bungee the more likely you
are to injure yourself. A negative covariance
would be difficult to interpret.
Note: Due to the adjustment for the lost
degree of freedom we have (N-1) in the
denominator rather than N.

Quantitative Review: Covariance and Correlation Coefficient

Correlation Coefficient
Sign aside, the covariance itself is rather uninformative. The correlation
coefficient, on the other hand, always varies between 1 and 1, which gives us a
deeper insight into the strength of the relationship.

BJ , BA

cov( BJ , BA )

BJ BA

4330
0.79835
22628000 1.3

Quantitative Review: Regression Analysis

Regression Analysis

Suppose that the relationship between bungee-related accidents and the number
of bungee jumps is linear:

The parameters a and b can be estimated as follows:

Cov( BA, BJ )
4330
b

0.000191
2
BJ
2262800
a E ( BA ) b E ( BJ ) 2.4 0.00019113340 - 0.153
As predicted, the estimate of b is positive and a is close to zero.

Quantitative Review: Regression Analysis

Quantitative Review: Regressions in Excel

Markowitz Portfolio Theory

The exact relationship between portfolios risk and return was
firstly described in a rigorous, mathematical manner by Harry
Markowitz, a Nobel prize laureate.
Let us start with a
Simple Two Asset Case
Imagine you invested a proportion of your wealth w 1 in Asset 1
and
w2=(1- w1) in Asset 2, then

E ( R portfolio) w1 E ( R1 ) w2 E ( R2 )
2
portfolio
w12 12 w22 22 2 w1w2 cov( R1 , R2 )

w12 12 w22 22 2w1w2 1, 2 1 2

Markowitz Portfolio Theory

Markowitz Portfolio Theory

Markowitz Portfolio Theory: Multiple Risky Assets

If the number of securities is raised

the area representing the whole
population of potential risk-return
combinations comes to resemble an
umbrella battling against the wind.

All risk-return combinations within

the shaded region are available to
an investor. However, most of them
will be unattractive because they
are
dominated
by
other
alternatives. In fact, the rational
investor will be interested in
portfolios lying on the upper part of
the frontier (part of hyperbola
above apex).

The efficient frontier is a solution to

a maximisation problem: For any
given portfolio maximise E(Rportfolio).

Dont Put Your Eggs Into One Basket

The firm-specific factors diffuse in a portfolio,

which makes the variability of portfolio
return small. The remaining risk can be
attributed to macroeconomic fluctuations.

Diversification: Practical Issues

Solnik (1974) investigated the issue of how many

securities should be included in a portfolio to
achieve a reasonable degree of risk reduction. He
looked at the extend to which risk is reduced as
additional securities are added to a portfolio.
Solnik randomly generated portfolios containing
between one and 50 shares. Risk is reduced in a
dramatic manner by the addition of the first four
securities to the portfolio. Most of the benefits of
diversification are generated by a portfolio of 10-15
securities. Thus up to 90 per cent of the benefits of
diversification can be gained by holding a relatively
small portfolio. Beyond this level the marginal risk
reduction becomes relatively small.

Solnik (1974). Why not Diversify Internationally, rather than

Domestically?, Financial Analysts Journal, July-August, 48-54.

Solnik (1974). Why not Diversify Internationally, rather than

Domestically?, Financial Analysts Journal, July-August, 48-54.

The
benefits
of
international
diversification shown in the exhibit
are significant. An internationally
diversified portfolio can reduce risk
to less than half the level of the USA
domestically held portfolio.

The
benefits
to
international
diversification will be transparent as
long as the correlation between
national stock markets is less than
+1.

With international portfolio your

definition of the systematic (nondiversifiable) risk changes. You are
concerned with the global, rather
than domestic trends.

Capital Asset Pricing Model and Diversification

The Capital Asset Pricing Model

states (CAPM) that:

E( Ri ,t ) RFRt ( E( RM ,t ) RFRt )
Expressed as a regression
equation it reads:

( Ri ,t RFRt ) ( RM ,t RFRt ) t

Capital Asset Pricing Model and Diversification II

Total Risk Systematic risk Unsystematic risk

The systematic risk cannot be eliminated,
as it pertains to risk factors common to all
firms (e.g. GDP growth, monetary policy).
These common risk factors determine the
market movement.

The unsystematic (firm-specific) risk is

diversifiable, i.e. it diffuses out in a large
portfolio.

Technical Problems with the CAPM

Measuring Beta / The Impact of the Time
Interval
The theory does not provide any hints as to the
frequency of data that should be used to estimate
Beta, i.e. should we use daily, weekly or monthly
observations on returns?
The approach to estimate Beta varies between
different institutions:
Value Line Investment Services - weekly
observations

Merrill Lynch 60 monthly observations

Apparently
these
two
procedures
produce
somewhat different results, see: Statman, M.
(1981). Betas Compared: Merrill Lynch vs. Value
Line, Journal of Portfolio Management 7, 41-44.

Technical Problems with the CAPM

The Benchmark Error / Market Portfolio is
Unobtainable
Roll (1977) criticised the tests of the CAPM. In fact
he claimed that CAPM is, in general, not testable.
This is because we cannot construct the real market
portfolio which should include all risky assets.
Although there are world stock indices (e.g. Morgan
Stanley
World
Stock
Index),
there
is
no
comprehensive index which will include assets such
as real estate, human capital, precious metals, stamp
collections, or antiques.
Some of the Assumptions may be Unrealistic
E.g no taxes or transaction costs, borrowing at riskfree rate of interest.

Empirical Evidence on the CAPM

Ironically, up until the time of

development of the CAPM in the mid1960s, the model seems to work
reasonably well; but following its
development the relationship breaks
down.
Consider dividing all stocks according
to their beta into decile portfolios
(i.e. portfolio 1 consists of the 10 per
cent of shares with the highest
betas). The average risk premiums
on portfolios are plotted against beta
on the graph for the period 19311991. Generally, this picture supports
CAPM.

Empirical Evidence on the CAPM

The problem starts when we split

the data into two periods. The post1965 data shows complete absence
of a relationship. Both the high beta
portfolio and the low beta portfolio
show average annual return over
the risk-free rate of 6 per cent.

Possible Alternative to CAPM - Multifactor Models

Multi-factor models are based on the notion that portfolios return may be
sensitive to a variety of factors:

Factors could either represent macro-variables (GDP growth, inflation,

changes in exchange rates) or firm-specific characteristics. CAPM can be
viewed as a single factor model.

The terminology changes slightly:

Systematic risk Factor Risk
Unsystematic Risk non-factor risk

Multifactor Model of Fama and French

The model of Fama and French (1993) has been
created to improve on the CAPM. Although it
seems to provide much better description of the
risk and return relationship, it does not have such
a strong theoretical background like the CAPM.

( Ri ,t R f ,t ) i i1 ( Rmt R f ,t ) i 2 SMBt i 3 HMLt eit

SMB (i.e., small minus big) is the return to a portfolio of small capitalisation
stocks less the return to a portfolio of large capitalisation stocks
HML (i.e., high minus low) is the return to a portfolio of stocks with high
book-to-market ratios less the return to a portfolio of low book-to-market
stocks.
The data on three factors for the U.S. market can be found on:
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

The Fama and French Three Factor Model: An Illustration

Regression Estimates of Risk Factor Sensitivities
Stock

Market

SMB

HML

Intel
JP Morgan Chase
Whole Foods Market

0.62
1.37
1.93

-0.64
-0.39
0.82

-1.48
0.58
1.68

Consider the Fama-French model for 3 stocks. First, all stocks are positively
correlated with the general stock market movement. The coefficients on the SMB
factor confirm that Intel and JP Morgan Chase produce returns consistent with the
large-cap stocks. Finally, JP Morgan Chase and Whole Foods Market are more likely to
be considered value stocks.

The data given in the two tables can be used to estimate the expected return for
each of the stocks.

Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) (no taxes):

E
D
* Cost of Equity
* Cost of Debt
E

D
E

WACC

E equity
D debt
Weighted Average Cost of Capital (WACC) (with taxes):

E
D
* Cost of Equity
* Cost of Debt * (1 t )
ED
ED

WACC

t tax rate