BU5201: Business Finance

Topic 6: Equity Valuation and

Efficient Market Hypothesis

Dr. James Kwan

PhD Finance (UWA), MBA (Strathclyde), MBA Investment & Finance (Hull),
MSc Applied Positive Psychology and Coaching Psychology (UEL), MBR (UWA),
MSc Educational Assessment (Oxford), MSc Digital Education (Edinburgh),
MRes (Lancaster), MSc Marketing (KCL), BAcc (NTU), FCA Singapore, ASEAN CPA,
FCPA (Australia), FAIA (Acad), FHEA, SDALT, BokTC (Harvard), ACTA
 Overview

• Features of Common Stock

• Intrinsic Value and Stock Price
• Determining Common Stock Values
• Discounted Dividend Model
• Corporate Valuation Model
• Other Approaches
• Preferred Stock

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 Facts About Common Stock

• Represents ownership

• Ownership implies control

• Stockholders elect directors

• Directors elect management

• Management’s goal: Maximize the stock price

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 Intrinsic Value and Stock Price

• Outside investors, corporate insiders, and analysts use a variety of approaches

to estimate a stock’s intrinsic value (Pˆ 0 ).

• In equilibrium we assume that a stock’s price equals its intrinsic value.

• Outsiders estimate intrinsic value to help determine which stocks are attractive to buy and/or
sell.

• Stocks with a price below (above) its intrinsic value are undervalued (overvalued).

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Different Approaches for Estimating the
Intrinsic Value of a Common Stock

Discounted dividend model

Corporate valuation model

Models based on market multiples

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 Discounted Dividend Model

• Value of a stock is the present value of the future dividends expected to be

generated by the stock.

D1 D2 D3 D
P̂0     ... 
(1  rs )1
(1  rs ) 2
(1  rs ) 3
(1  rs )

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 Constant Growth Stock

• A stock whose dividends are expected to grow forever at a constant rate, g.

D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
• If g is constant, the discounted dividend formula converges to:

D0 (1  g) D1
P̂0  
rs  g rs  g
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Future Dividends and Their Present Values

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 What happens if g > rs?

• If g > rs, the constant growth formula leads to a negative stock price, which
does not make sense.
• The constant growth model can be used only if:
• rs > g
• g is expected to be constant forever.

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 Use the SML to Calculate the Required
Rate of Return (rs)
• If rRF = 3%, rM = 8%, and b = 1.2, what is the required rate of return on the
firm’s stock?
rs = rRF + (rM – rRF)b
= 3% + (8% – 3%)1.2
= 9%

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 Find the Expected Dividend Stream for the
Next 3 Years and Their PVs
D0 = $2 and g is a constant 4%.

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 What is the stock’s intrinsic value?

• Using the constant growth model:

D1 $2.08
P̂0  
rs  g 0.09  0.04
$2.08

0.05
 $41.60

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 What is the stock’s expected value, one year
from now?
• D1 will have been paid out already. So, expected P1 is the present value (as of
Year 1) of D2, D3, D4, etc.
D2 $2.1632
P̂1  
rs  g 0.09  0.04
 $43.26

• Could also find expected P1 as:

P̂1  P0 (1.04)  $43.26

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 Find Expected Dividend Yield, Capital Gains
Yield, and Total Return During First Year
• Dividend yield
= D1/P0 = $2.08/$41.60 = 5.0%
• Capital gains yield
= (P1 – P0)/P0
= ($43.26 – $41.60)/$41.60 = 4.0%
• Total return (rs)
= Dividend yield + Capital gains yield
= 5.0% + 4.0% = 9.0%

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 What would the expected price today be,
if g = 0?
The dividend stream would be a perpetuity.

PMT $2.00
P̂0    $22.22
r 0.09
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 Supernormal Growth

• What if g = 30% for 1 yr., 20% for 1 yr., and 10% for 1 yr. before achieving
long-run growth of 4%?
• Can no longer use just the constant growth model to find stock value.

• However, the growth does become constant after 3 years.

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 Valuing Common Stock with Nonconstant
Growth
D0 = $2.00.

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 Find Expected Dividend and Capital Gains Yields
During the First and Fourth Years (1 of 2)
• Dividend yield (first year)
= $2.60/$62.78 = 4.14%
• Capital gains yield (first year)
= 9.00% – 4.14% = 4.86%
• During nonconstant growth, dividend yield and capital gains yield are not
constant, and capital gains yield ≠ g.
• After t = 3, the stock has constant growth and dividend yield = 5%, while capital
gains yield = 4%.

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 Nonconstant Growth: What if g = 0% for 3
years before long-run growth of 4%?
D0 = $2.00.

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 Find Expected Dividend and Capital Gains Yields
During the First and Fourth Years (2 of 2)
• Dividend yield (first year)
= $2.00/$37.19 = 5.38%
• Capital gains yield (first year)
= 9.00% – 5.38% = 3.62%
• After t = 3, the stock has constant growth and dividend yield = 5%, while capital
gains yield = 4%.

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If the stock was expected to have negative growth (g = −4%),
would anyone buy the stock, and what is its value?

• Yes. Even though the dividends are declining, the stock is still producing cash
flows and therefore has positive value.

D1 D0 (1  g)
P̂0  
rs  g rs  g
$2.00 (0.96) $1.92
   $14.77
0.09  (  0.04) 0.13

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 Find Expected Annual Dividend and Capital
Gains Yields
• Capital gains yield

= g = –4.00%

• Dividend yield

= 9.00% – (–4.00%) = 13.00%

• Since the stock is experiencing constant growth, dividend yield and capital
gains yield are constant. Dividend yield is sufficiently large (13%) to offset
negative capital gains.

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 Corporate Valuation Model

• Also called the free cash flow method. Suggests the value of the entire firm
equals the present value of the firm’s free cash flows (which is the MV of its
operations) plus the market value of its non-operating assets.
• Remember, free cash flow is the firm’s after-tax operating income less the net
capital investment.

FCF   EBIT(1  T)  Depreciation and amortization 

  Capital expenditures  ΔNOWC

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 Applying the Corporate Valuation Model

• Find the market value (MV) of the firm’s operations, by finding the PV of the
firm’s future FCFs.

• Add the market value of the firm’s non-operating assets.

• Subtract MV of firm’s debt and preferred stock to get MV of common stock.

• Divide MV of common stock by the number of shares outstanding to get

intrinsic stock price (value).

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 Issues Regarding the Corporate Valuation
Model
• Often preferred to the discounted dividend model, especially when considering
number of firms that don’t pay dividends or when dividends are hard to
forecast.

• Similar to discounted dividend model, assumes at some point free cash flow
will grow at a constant rate.

• Horizon value (HVN) represents value of firm’s operations at the point that
growth becomes constant.

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 Use the Corporate Valuation Model to Find
the Value of the Firm’s Operations
Given: Long-Run gFCF = 5% and WACC = 7%

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 What is the firm’s intrinsic value per share?

• The firm has $40 million total in debt and preferred stock, $5 million of non-
operating assets, and 10 million shares of common stock.

MV of equity  MV of operations  MV of nonoperating assets  MV of debt and preferred

 $877.50  $5  $40
 $842.50 million

Value per share  MV of equity/# of shares

 $842.50/10
 $84.25
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 Firm Multiples Method

• Analysts often use the following multiples to value stocks.

• P/E

• P/CF

• P/Sales

• EXAMPLE: Based on comparable firms, estimate the appropriate P/E.

Multiply this by expected earnings to back out an estimate of the stock price.
• Enterprise-Based Multiples
• EV/EBITDA

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 Preferred Stock

Hybrid security

Like bonds, preferred stockholders receive a fixed dividend that

must be paid before dividends are paid to common
stockholders.

However, companies can omit preferred dividend payments

without fear of pushing the firm into bankruptcy.

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If preferred stock with an annual dividend of $5 sells for
$100, what is the preferred stock’s expected return?
D
Vp 
rp
$5
$100 
rp
$5
r̂p 
$100
 0.05  5%
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Efficient Market Hypothesis
• Definition
• Types of Efficiency
• Forms of Efficiency
• Weak Form
• Semi-Strong Form
• Strong Form
• Semi-Efficient Market Hypothesis
• Security Prices and Random Walks

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Definition
• The efficient market hypothesis (EMH) is the theory supporting
the notion that market prices are in fact fair
• Under the EMH, security prices fully and fairly (i.e., without bias) reflect all
available information about the security
• Since the 1960’s, the EMH has been perhaps the most important
paradigm in finance
• Whether markets are efficient has been extensively researched and
remains controversial

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Forms of Market Efficiency
• Eugene Fama’s original formulation of the Efficient Market Hypothesis
established three forms of market efficiency, based on the level of
information reflected in security prices:
1. Weak form = prices reflect all past market level (price and volume)
information
2. Semi-strong form = prices also reflect all publicly available fundamental
company and economic information
3. Strong form = prices also reflect all privately held information that would
affect the value of the company and its securities

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Weak Form
• Definition
• Charting
• Runs Test

34
Definition
• The weak form of the EMH states that it is impossible to predict
future stock prices by analyzing prices from the past
• The current price is a fair one that considers any information contained in
the past price data
• Charting techniques are of no use in predicting stock prices

35
Charting
• People who study charts are technical analysts or chartists
• Chartists look for patterns in a sequence of stock prices
• Many chartists have a behavioral element

36
Semi-Strong Form
• The semi-strong form of the EMH states that security prices fully
reflect all publicly available information
• e.g., past stock prices, economic reports, brokerage firm
recommendations, investment advisory letters, etc.

37
Semi-Strong Form (cont’d)
• Academic research supports the semi-strong form of the EMH by
investigating various corporate announcements, such as:
• Stock splits
• Cash dividends
• Stock dividends
• Examined through “event studies”
• This means investors are seldom going to beat the market by
analyzing public news

38
Semi-Strong Form (cont’d)
• Market seems to do a relatively good job at adjusting a stock’s valuation for
certain types of new information
• Determining how much the new info. will change the stock’s value and then adjusting the
price by an equivalent amount
This is what event studies examine

• But it does seem to have problems developing an overall valuation for a stock
in the first place
• E.g., What is the correct value for IBM as a whole is a very difficult question to answer,
but how much IBM’s value should change if it is awarded a specific new contract is
much easier to determine

39
Semi-Strong Form (cont’d)
• Burton Malkiel points out that two-thirds of professionally
managed portfolios are consistently beaten by a low-cost index
fund
• Suggests that securities are accurately priced and that in the long run
returns will be consistent with the level of systematic risk taken
• Supports semi-strong form of the EMH
• Also would suggest that portfolio managers do not possess any private
information that is not already reflected in security prices
• Supports the strong form of the EMH

40
Strong Form
• The strong form of the EMH states that security prices fully reflect
all relevant public and private information
• This would mean even corporate insiders cannot make abnormal
profits by using inside information about their company
• Inside information is information not available to the general public

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Security Prices and
Random Walks
• The unexpected portion of news follows a random walk
• News arrives randomly and security prices adjust to the arrival of the
news
• We cannot forecast specifics of the news very accurately

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Anomalies
• Definition
• Low PE Effect
• Low-Priced Stocks
• Small Firm and Neglected Firm Effect
• Market Overreaction
• January Effect

43
Anomalies (cont’d)
• Day-of-the-Week Effect
• Turn-of-the Calendar Effect
• Persistence of Technical Analysis
• Behavioral Finance

44
Definition
• A financial anomaly refers to unexplained results that deviate from
those expected under finance theory
• Especially those related to the efficient market hypothesis

45
Low PE Effect
• Stocks with low PE ratios provide higher returns than stocks with
higher PEs
• And similarly for high P/B (hence lower Book/Market) stocks
• Supported by several academic studies
• Conflicts directly with the CAPM, since study returns were risk-
adjusted (Basu)
• Related to both semi-strong form and weak form efficiency

46
Low-Priced Stocks
• Stocks with a “low” stock price earn higher returns than stocks
with a “high” stock price
• There is an optimum trading range

47
Small Firm and Neglected Firm Effects
• Small Firm Effect
• Neglected Firm Effect

48
Small Firm Effect
• Investing in firms with low market capitalization will provide
superior risk-adjusted returns
• Supported by academic studies
• Implies that portfolio managers should give small firms particular
attention

49
Neglected Firm Effect
• Security analysts do not pay as much attention to firms that are
unlikely portfolio candidates
• Implies that neglected firms may offer superior risk-adjusted
returns

50
Market Overreaction
• The tendency for the market to overreact to extreme news
• Investors may be able to predict systematic price reversals

• Results because people often rely too heavily on recent data at

the expense of the more extensive set of prior data

51
January Effect
• Stock returns are inexplicably high in January
• Small firms do better than large firms early in the year
• Especially pronounced for the first five trading days in January

52
January Effect (cont’d)
• Possible explanations:
• Tax-loss trading late in December (Branch)
• The risk of small stocks is higher early in the year (Rogalski and Tinic)

53
 January Returns by Type of Firm

Average Average January Average January

January return minus average return after
return monthly return in rest adjusting for
of year systematic risk
S&P 500
Companies
Highly 2.48% 1.63% -1.44%
Researched
Moderately
4.95% 4.19% 1.69%
Researched
Neglected 7.62% 6.87% 5.03%
Non-S&P 500
Companies
Neglected 11.32% 10.72% 7.71%
Source: Avner Arbel, “Generic Stocks: The Key to Market Anomalies,” Journal of Portfolio Management, Summer 1985, 4–13.

54
Day-of-the-Week Effect
• Mondays are historically bad days for the stock market
• Wednesday and Fridays are consistently good
• Tuesdays and Thursdays are a mixed bag

55
Day-of-the-Week
Effect (cont’d)
• Should not occur in an efficient market
• Once a profitable trading opportunity is identified, it should disappear

• The day-of-the-week effect continues to persist

• However – there are confounding effects between the levels and
the volatilities of returns across different days

56
Turn-of-the-Calendar Effect
• The bulk of the return comes from the last trading day of the
month and the first few days of the following month
• For the rest of the month, the ups and downs approximately
cancel out

57
Persistence of
Technical Analysis
• Technical analysis refers to any technique in which past security
prices or other publicly available information are employed to
predict future prices
• Studies show the markets are efficient in the weak form
• Literature based on technical techniques continues to appear but
should be useless

58
 Behavioral Finance
• Concerned with the analysis of various psychological traits of
individuals and how these traits affect the manner in which they act as
investors, analysts, and portfolio managers
• Growth companies will usually not be growth stocks due to the
overconfidence of analysts regarding future growth rates and
valuations
• Notion of “herd mentality” of analysts in stock recommendations or
quarterly earnings estimates is confirmed

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