Seminar 3 –

Stock
 Stock valuation
• Constant growth
• Supernormal growth
 Stock market efficiency
 Risk and rates of returns
• Concept of risk aversion
• Investment risk in the world of stocks -
Market risk and diversifiable risk
• Capital asset pricing model (CAPM)
Formulas in shaded red/pink boxes
are formulas that you would need to
know
1
TVM applications
- Stock valuation
Value of any asset
= Present value of all its future cash flows
2
TVM application to stock
valuation
Value of the stock = Present value of all future cash flows

 Cash flows = Dividends plus share price you can sell the stock for at
the end of your holding period
 Discount rate = Required return based on the risk of the stock
Required return/
(Generally based on Capital Asset Pricing Model) Opportunity cost of
capital

How much would you be willing to pay for the stock of ABC
company if ABC is expected to pay a $3 year-end dividend
and you expect to be able to sell the stock for $81 at the
end of the year? Assume stocks of similar risk are expected
to give a 12%.
= $75
3
Valuing stocks: Dividend
discount model (DDM)
Discounted cash-flow model: Today’s stock price equals the
present value of all expected future dividends
0 r 1 2 3
….. ∞
Div1 Div2 Div3

^ 𝐷𝑖𝑣 1 𝐷𝑖𝑣 2 𝐷𝑖𝑣 3 𝐷𝑖𝑣 ∞

𝑃𝑟𝑖𝑐𝑒𝑜𝑓 𝑆𝑡𝑜𝑐𝑘𝑡𝑜𝑑𝑎𝑦 , 𝑃 0= + + +..+
(1+𝑟 ) (1+𝑟) (1+𝑟 )
2 3
(1+𝑟 )
∞

4
Constant Growth Stock (Gordon
growth model)
• A stock whose dividends are expected to grow
forever at a constant rate, g.
• E.g., Dividends grow at 5% every year ($1 in Year 1,
$1.05 in year 2, $1.1005 in year 3 and so on…)

• If g is constant, the discounted dividend formula

converges:
^ 𝐷𝑖𝑣 1 𝐷𝑖𝑣 2 𝐷𝑖𝑣 3 𝐷𝑖𝑣 ∞
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘𝑡𝑜𝑑𝑎𝑦 , 𝑃 0= + + +..+
(1+ 𝑟 ) (1+ 𝑟) 2 (1+𝑟 ) 3 ( 1+𝑟 )
∞

^ 𝐷𝑖𝑣 1
Price today , 𝑃 0=
(𝑟 − 𝑔)
5
Gordon Growth Model
Example
A stock has just announced a dividend of $2, i.e., Div 0 = 2.
The dividend is expected to grow at 6% indefinitely. What is

,
the value of the stock today if the required return is 13%?
Div1=
Div0*(1+g)
= $30.29

Suppose the perpetual growth rate for dividends is zero,

what would be the value of the stock?

6
Self-practice: Stock valuation
You are deciding whether to invest in Fairin Corp which is
currently trading at $75. You estimate that Fairin will pay a
year-end dividend of $5 and the dividend is expected to
grow at a rate of 3% indefinitely since it is a fairly mature
company. Suppose other stocks of the same risk are
expected to give a return of 10%, should you buy the shares
of Fairin Corp?

7
Supernormal Growth: What if
dividends grow at 30% for 3
years before achieving long-run
growth of 6%?
Can no longer use just the constant growth model to
find stock value.
However, the growth does become constant after 3
years.

^ 𝐷𝑖𝑣 1 𝐷𝑖𝑣 2 𝐷𝑖𝑣 3 𝐷𝑖𝑣 ∞

𝑃𝑟𝑖𝑐𝑒𝑜𝑓 𝑆𝑡𝑜𝑐𝑘𝑡𝑜𝑑𝑎𝑦 , 𝑃 0= + + +..+
(1+𝑟 ) (1+𝑟) (1+𝑟 )
2 3
(1+𝑟 )
∞

8
 What if the
Valuing common stock with supernormal
growth is for 4
nonconstant growth years? 5 years?

Step (1) Constant

growth starts
0 r = 13% 1 2 3 4
...
g1 = 30% g1 = 30% g1 = 30% g2 = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
Step (2) Calculate P̂3, +
terminal value (expected
price you can sell at t=3)

Step (3) Calculate P̂0

^ = 2.600 + 3.380 + ( 4.394+ 66.54) =$ 54.107

𝑃 0
1+ 0.13 (1+0.13) 2 (1+ 0.13)3
9
In-class group assignment: Valuing
stocks with non-normal growth
(Submit Excel or PPT)
Robin Corporation does not expect to pay any dividend for
the next 2 years (i.e. end of Year 1 and Year 2). At the end of
Year 3, the company expects to pay dividend of $0.50, and
this dividend is expected to grow at a high growth rate of
35% per annum for 3 years, before achieving a long-run
dividend growth rate of 5%. Suppose the required return on
Robin Corp is 10%, how much is Robin Corp’s stock worth
today?

10
Additional self-practice on
supernormal growth stock
TTC has been growing at a rate of 20% per year in recent
years. This same growth rate is expected to last for another
2 years, then decline to 6% per year forever. If TTC just paid
a dividend of $1.60, i.e., D0 = $1.60 and the required return
on the stock is 10%, what is TTC’s stock worth today?
Solution
Div0 = $1.60
Div1 = $1.60*1.2 = $1.92
Div2 = $1.60*1.22 = $2.304
Div3 = $1.60*1.22*1.06 = $2.442
Price at t=2 =
Price at t = 0 =
11
Notes on stock market
efficiency
Efficient market is one where stock prices are fairly priced on
average
Why? Because investors/traders compete to find good
bargains in the market
 If you heard about a drug company obtaining approval for a new drug,
many other people would have also know it
 Stock prices reflect all available information
Implication: Difficult to consistently find undervalued stocks
Under market efficiency, can stocks be mispriced?

 Yes! Market efficiency does not require that the market price be equal to
true value at every point in time.
 All it requires is that the mispricing be random.
12
Risk and Return
Concepts for
Stocks
Introducing Capital Asset Pricing Model

13
Return (Review)
FV = PV*(1+r)
Returns from any investment
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑚𝑒𝑛𝑡 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑅𝑒𝑡𝑢𝑟𝑛=
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

 Can be expressed as annual returns, monthly returns, weekly

returns, daily returns depending on investment horizon
 Unless otherwise stated, returns are denominated annually

14
 Expected Return and
Standard Deviation (Review)
 If ending value of investment is uncertain, we can calculate expected
returns. Example, suppose you invest $1000 in Company ABC at the
beginning of the year. The below gives the likely values of the
investment at the end of the year.
State Probabilit Ending Returns
y Value
Boom 25% $1120 (1120-1000)/1000 = 12%
Normal 50% $1070 (1070-1000)/1000 = 7%
Bust 25% $800 (800-1000)/1000 = -20%

 What is the expected return on the investment?

Expected Return = 0.25*12% + 0.5*7% + 0.25*(-20%) = 1.5%
 What is the standard deviation of the return on the investment?
Standard deviation = SQRT{0.25*(12%-1.5%)2 + 0.5*(7%-1.5%) 2 + 0.25*(-20%-1.5%) 2 } = 12.6%
15
Which investment would you choose?
Both investment cost $100 now

1. Investment A: 100% 1. Investment A: 100%

chance of getting chance of getting
$120 in one year’s $120 in one years’
time time
Risk aversion  Requires
2. Investment B: 50% 2. Investment
compensation for holding on C: 50%
chance of getting to morechance
risk of getting
$160 and 50% of $180 and 50% of
getting $80 in one getting $80 in one
years’ time years’ time
Risk and Return
Most investors are risk averse

 Risk-averse investors dislike risk and

expect to receive higher rates of
return before they are willing to
invest in risky assets
Does not mean that they will
always choose the lowest risk
investments!

17
Suppose Singtel stocks are expected to give a 3.74%
return, would you invest in Singtel stocks or the SG
Treasury bill or unsure? Why?

18
Fundamental Risk and Return
Relation
Expected return on risky assets = Riskfree rate + Risk premium

Riskfree rate – return on a riskless investment

 Examples: US Treasury securities,

Sovereign debt by governments with very Side
good note: US Treasury – Borrowings by US
credit standing
government, considered default free
 Compensation for waiting (inflation)
Risk premium - Serves as compensation for investors to hold riskier
securities
 Premium - Over and beyond riskfree rate
 Higher risk  higher risk premium  higher expected return
 Same risk  same expected return
Two basic questions for a risk-return model

 What is risk?
 How to translate this risk measure to risk premium? 19
Investment Risk
- Risk and return in the world of stocks

20
Stock Returns
The returns from investing in a stock are made up of two
components:
 Dividends: Cash distributions regularly made by corporations to their
stockholders. Not guaranteed!
 Capital Gains/Losses: Changes in the market price of the stock

 The rate of return from holding a stock is the sum of these

two components, expressed as a percent of the price paid
for the stock, i.e.,
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑚𝑒𝑛𝑡 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑅𝑒𝑡𝑢𝑟𝑛=
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

( 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑+𝐸𝑛𝑑𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 ) − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔𝑃𝑟𝑖𝑐𝑒

𝑅𝑒𝑡𝑢𝑟𝑛=
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔𝑃𝑟𝑖𝑐𝑒
21
Stock Returns – Dividend Yield
and Capital Gains Yield
Suppose you bought MSFT at $250 last year and sold it one
year later at $338. During this one year, MSFT paid $2.72 in
dividends per share. What is your return?
= 36.3%

Returns comprise of dividend yield and capital gains yield

 Dividend yield: Dividend as a percentage of beginning price

= 1.1%
 Capital gains yield: Change in price as a percentage of beginning
price
= 35.2%

22
Investment risk
Suppose you bought MSFT today for $338 and you
expect to sell it at the end of one month for $344,
based on the historical average monthly returns of
1.9%. You do not expect to get any dividends.

How likely would you get this return?

Is it guaranteed you will

get this return?

23
24
Investment risk
Suppose you bought Cavco Industries (CVCO) today for
$279 and you expect to sell it at the end of one month for
$284, based on the historical average monthly returns of
1.8%. You do not expect to get any dividends.

What is the likelihood of getting 1.8% returns?

Compared to MSFT, which stock is riskier to you?

25
26
What is investment risk?
Investment risk is related to the probability of earning a return that is different from expected.
The greater the chance of earning a return different from expected, the riskier the investment.

Total risk/Standalone risk: The investment risk from holding a single stock.
Total risk/Standalone risk can be measured by the standard deviation of its stock returns.

Standard deviation: A measure of the dispersion/spread of the stock returns around its average

Stocks with higher standard deviation has higher total risk/standalone risk.

27
Calculating average returns
and standard deviation in
Excel
Using the provided MBA_S03s_RiskReturns.xlsx, calculate
the monthly returns for MSFT
 Monthly returns = [Divt + (Pricet- Pricet-1)]/Pricet-1
Calculate the average returns and standard deviation of
monthly stock returns of MSFT and CVCO
 Excel Commands: Average and STDEV.S

What do you notice?

Which stock has a higher standard deviation and thus

higher standalone risk?
28
Portfolio – Expected Returns
Assume you bought $750 worth of MSFT and $250 worth
of CVCO. You expect the first month returns to be 1.9% and
1.8%, respectively. What would be the portfolio’s expected
returns during the first month?

….

750 250
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛= ∗1.9 %+ ∗ 1.8 %=1.875 %
1000 1000

How risky is this portfolio compared to holding just MSFT or CVCO alone? Do
you think the standard deviation of this portfolio would be higher or lower
than that of MSFT or CVCO? Refer to Excel 29
Portfolio – Risk and
Diversification
Diversification

 Reduces variability of portfolio returns by investing in many stock

 Portfolio diversification works as prices of different stocks do not move
exactly together
Specific Risk

 Risk factors affecting only that firm

Total risk/
 Also called diversifiable risk or idiosyncratic risk Standalone
 Can be eliminated through proper diversification risk

Market Risk

 Economy-wide sources of risk (macro risks) that affect all stocks

 Also called systematic risk
 Cannot be eliminated through diversification
30
General
comments about
diversification
Combining stocks
in a portfolio
generally lowers
risk due to
diversification.

Eventually the
diversification
benefits of adding
more stocks
dissipates.

The most diversified

portfolio would be
one that consists of all
stocks in the market 
market portfolio

31
 Breaking down sources of
investment risk
Total standalone risk of a stock

Market Risk: Specific Risk:

Stock’s exposure to market/macro Stock’s idiosyncratic risk that
risk that cannot be eliminated can be eliminated through
through diversification. Measured proper diversification.
by beta.

Higher risk higher expected return

Compensation for risk  But what risk?

If you are a rational investor holding a diversified portfolio, which risk(s) would
you care about when you are deciding to add another stock to your portfolio?
32
Capital Asset
Pricing Model
(CAPM)
- A model linking expected returns and market risk for stocks

33
 Capital Asset Pricing Model (CAPM)

Expected return on risky assets = Riskfree rate + Risk premium

Model linking risk and expected returns. CAPM suggests

that a stock’s expected return equals the risk-free return
plus a risk premium that reflects the stock’s market risk.
 Unnecessary, diversifiable risk is not compensated
Expected return = Riskfree rate + Market Risk Premium*Beta

Risk premium for

holding market risk

34
Market portfolio
Fully diversified portfolio consisting of all stocks in the
market
Changes in the value of market portfolio are due solely to
macro factors since all diversifiable risk are eliminated
Returns on the market portfolio is a good proxy for market-
wide events  provides a summary measure of the net
impact of macro factors

35
What is the market risk premium?
Difference between expected return on market portfolio and
return on risk-free Treasury bills, i.e.,
 The risk premium needed for investors before they are willing to invest in
the market portfolio
 Additional return over the risk-free rate needed to compensate investors
for assuming the risk of the market portfolio
Forward looking measure but we rely on history to estimate
 Generally estimated using historical return on a broad-based stock index
 Varies from year to year, but most estimates suggest that it ranges
between 4% and 8% per year for the US
 Available from data providers such as Bloomberg and Refinitiv. Also
available from Professor Damodaran’s website (Different methodologies)
 Go to Refinitiv  Type ERP in search bar
36
Beta
Beta: Measure of a firm’s market risk

 How sensitive is the stock’s returns to macro risk factors?

 How sensitive is the stock’s returns to fluctuations in the returns of
the market portfolio?

A stock’s beta is the expected change in its return given a 1%

change in the return of the market portfolio.
 Beta = 1  When the market’s return falls by 1%, the stock’s return is expected to also
fall by 1%
 Beta = 1.5  When the market’s return falls by 1%, the stock’s return is expected to fall
by 1.5%
 Beta = 0.75  When the market’s return falls by 1%, the stock’s return is expected to
fall by 0.75%

37
Calculating Betas
Well-diversified investors are primarily concerned with how a
stock is expected to move relative to the market in the future.
 Without a crystal ball to predict the future, analysts are forced to rely
on historical data.

A typical approach to estimating beta is to run a regression of

the security’s past returns against the past returns of the
market.
 The slope of the regression line is defined as the beta coefficient for
the security.

 Regression: Statistical tool used to understand the relationship

between two variables  Regression fits a line that shows the average
return to the stock at different market returns
38
Regression line to find MSFT’s Beta
(Jul 2010 to Dec 2022)
MSFT’s Beta = 0.96
In the past 12 years, when S&P500
return increased by 1%, MSFT return
on average increased by 0.96%
 To the extent that the past
reflects the future, in future
when market returns increase by
1%, MSFT return is expected to
increase by 0.96%

39
Application of CAPM:
What is the expected return on MSFT
shares?
Suppose US 10-year treasury: 4.09%

Market risk premium: 3.56%

What is the expected return on MSFT’s stock?

How do investors and executives make use of

this expected return in their decision-making?
40
What determines beta?
The beta value for a firm depends upon the sensitivity of
the demand for its products and services and of its costs to
macroeconomic factors that affect the overall market.
 Cyclical companies have higher betas than non-cyclical firms
 Firms which sell more discretionary products will have higher betas
than firms that sell less discretionary products

Which company has a higher beta?

 Unilever vs LVMH
 Singapore Airlines vs Sheng Siong Group

41
Finding Beta
Log in to Refinitiv Workspace (
https://workspace.refinitiv.com/web)
Find the beta for Alibaba

42
Portfolio Beta
Beta of a portfolio of stocks is the weighted average beta
of component stocks in the portfolio
….

Example. You have $1000, and you invested $500 in

Company A with a beta of 1.3 and $500 Company B with a
beta of 0.6. What is the expected return of the portfolio
based on CAPM? Assume risk-free rate: 4%; Market risk
premium: 5%

43
Limitations of CAPM
• The model makes unrealistic assumptions
• The parameters of the model cannot be
estimated precisely
• The model does not work well

Alternative models?

• CAPM is still widely used as the default risk-return model

in equity valuation and corporate finance
• CAPM – simple to use.
• Alternative models – more complicated, may not be
better than CAPM, and may not be worth the trouble

44
Surveys of CFOs.
What do companies use for their risk-
return model?

Source: Graham (2022) 45

Key Takeaways
Value of a stock can be estimated using the present value
of all future cash flows where the discount rate is based on
CAPM
 Gordon growth model where dividends grow at constant rate forever
(Constant growth dividend discount model)

^ 𝐷𝑖𝑣 1
Price today , 𝑃 0=
(𝑟 − 𝑔)

 Supernormal growth
Stock market efficiency: Stocks are fairly priced on average

46
Key takeaways
Risk-averse investors dislike risk and expect to receive higher
rates of return before they are willing to invest in risky assets
 Expected return on risky assets = Riskfree rate + Risk premium
 Due to opportunity cost of capital, assets with same risk have the same
expected returns
Total risk of stock can be measured by the standard deviation
of the stock returns. It can be decomposed into:
 Market risk: Exposure to macro factors, cannot be eliminated through
diversification. Measured using beta, which is the sensitivity of a stock’s
return to fluctuations in the return of the market portfolio
 Specific risk: Idiosyncratic risk that can be eliminated through
diversification
CAPM says only market risk will be compensated
47
Key Formulae
Formula list:

Expected return on risky assets = Riskfree rate + Risk premium

𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑚𝑒𝑛𝑡 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑹𝒆𝒕𝒖𝒓𝒏=
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

( 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑+𝐸𝑛𝑑𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 ) − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒

𝑺𝒕𝒐𝒄𝒌 𝑹𝒆𝒕𝒖𝒓𝒏=
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒

….
….

48
Next steps
Work through problem sets

Finish up TVM Excel Assignment (Due 18 Aug 2359Hrs)

Read through handouts on SVB collapse

Next week,

 Discuss TVM Excel Assignment

 Applying TVM to bond valuation
 Interest rates and yield curve

49