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Lecture4 2017-18 Upload
Lecture4 2017-18 Upload
Lecture4 2017-18 Upload
Panagiotis Couzo↵
Outline
Equity securities
Stock Valuation
E↵ects of diversification
Lecture 4: Stock valuation and stock portfolios
Equity securities
Outline
Equity securities
Stock Valuation
E↵ects of diversification
Lecture 4: Stock valuation and stock portfolios
Equity securities
Equity
Equity securities
Outline
Equity securities
Stock Valuation
E↵ects of diversification
Lecture 4: Stock valuation and stock portfolios
Stock Valuation
Stock returns
XT X0
X0 (1 + RT ) = XT () RT =
X0
Lecture 4: Stock valuation and stock portfolios
Stock Valuation
Stock valuation
I Notice that the stock price today, P0 , depends on its expected price
one period from now, P1 .
I For exposition purposes, let’s drop the expectation factors E (but
keep in mind they are still there!).
I Assuming that the expected return remains constant, we can use the
same formula to determine the stock price one period from now:
D2 + P 2
P1 =
1+r
I Plugging back into the previous formula yields
D1 D2 P2
P0 = + 2 + 2
1+r (1 + r ) (1 + r )
Lecture 4: Stock valuation and stock portfolios
Stock Valuation
T
X Dt
D1 D2 Dt
P0 = + 2 + ... + t + ... = t
1+r (1 + r ) (1 + r ) t=1
(1 + r )
D t = Dt 1 (1 + g )
g = (1 p) ⇤ ROE
I A word of notice: this formula does not imply that a firm can
increase its growth by simply decreasing the payout ratio, as this
could a↵ect the ROE at the same time (it is fair to assume that
there is a finite number of high return projects that wait to be
financed at any point in time).
Lecture 4: Stock valuation and stock portfolios
Stock Valuation
I Suppose the expected return of Food Inc. is 10% and earnings per
share are expected to be $3.
I The company pays out 40% of its earnings each year in dividends,
while the rest is invested in projects generating 15% annual return.
What is the current value of Food Inc.?
D1 = $3 ⇤ 0.4 = $1.20
g = (1 0.4) ⇤ 0.15 = 0.09
$1.20
P0 = = $120
0.10 0.09
I What would your answer be if Food Inc. was paying out all earnings
as dividends?
Lecture 4: Stock valuation and stock portfolios
Stock Valuation
I If Food Inc. paid all earnings out as dividends, its share price would
be
$3
Pno growth = = $30
0.10
I The latter price represents the value of assets in place, and the
di↵erence between the two prices ($120 $30 = $90) represents the
value of Food Inc.’s growth opportunities:
Earnings1
P0 = + PVGO
r
Lecture 4: Stock valuation and stock portfolios
Measures of risk and return
Outline
Equity securities
Stock Valuation
E↵ects of diversification
Lecture 4: Stock valuation and stock portfolios
Measures of risk and return
Risk in finance
Source: Berk, J. and P. DeMarzo, 2014. Corporate Finance, 3rd (global) edition
Lecture 4: Stock valuation and stock portfolios
Measures of risk and return
A refresher in statistics
I Consider a data series X1 , X2 , . . . , XN .
I A measure of the average value of the series is the sample average:
X1 + X2 + . . . + XN
X =
N
I Two measures of the dispersion of the series around the average
value are the sample variance:
2 2 2
X1 X + X2 X + . . . + XN X
sX2 =
N 1
and the sample standard deviation:
q
sX = sX2
A refresher in probabilities
I We can also define the expectation, variance, and standard deviation
in a probability sense, for a random variable Z .
I Suppose that Z takes values Z1 , Z2 , . . . , ZN with respective
probabilities p1 , p2 , . . . , pN .
I The expectation of Z is:
E[Z ] = p1 Z1 + p2 Z2 + . . . + pN ZN
I Using past data, one can find that the average return of S&P 500
firms is 11.7%.
I Hence, an estimate of the expected return of S&P 500 firms is
11.7%.
I This does not mean that S&P 500 firms will have a return of 11.7%
next year.
I The return of S&P 500 firms next year will be the realised return.
Lecture 4: Stock valuation and stock portfolios
Risk and return of portfolios
Outline
Equity securities
Stock Valuation
E↵ects of diversification
Lecture 4: Stock valuation and stock portfolios
Risk and return of portfolios
Source: Berk, J. and P. DeMarzo, 2014. Corporate Finance, 3rd (global) edition
Lecture 4: Stock valuation and stock portfolios
Risk and return of portfolios
Portfolios
I Let’s have a closer look at what happens when individual stocks (or
more generally assets) are combined in a portfolio.
I Consider n individual assets with a fraction wi of your wealth
invested in each asset i.
I This is an investment in a portfolio of n assets, where the fractions
wi are the portfolio weights.
Lecture 4: Stock valuation and stock portfolios
Risk and return of portfolios
Portfolio weights
I Note that the above condition does not exclude negative weights nor
weights higher than one!
I A positive weight implies a positive quantity of the asset in the
portfolio (also called a long position).
I A negative weight implies a “negative” quantity of the asset in the
portfolio (also called a short position).
I Short positions are achieved through short sales, i.e. the sale of a
stock that we do not own.
Lecture 4: Stock valuation and stock portfolios
Risk and return of portfolios
Portfolio returns
I The covariance and the correlation of two variables have the same
sign. They are
I positive, if X and Y tend to move to the same direction;
I zero, if X and Y are un(cor)related; or
I negative, if X and Y tend to move in opposite directions.
I The correlation is a number taking values between 1 and 1.
I A correlation
I equal to 1 indicates an exact linear relation with positive slope
between X and Y (perfectly positively correlated);
I equal to 1 indicates an exact linear relation with negative slope
between X and Y (perfectly negatively correlated).
Lecture 4: Stock valuation and stock portfolios
Risk and return of portfolios
Portfolio variance
or equivalently
N X
X N
2
P = wi wj ⇢ij i j
i=1 j=1
Lecture 4: Stock valuation and stock portfolios
Risk and return of portfolios
An example
I You are considering investing $300 in Disney and $100 in IBM.
I The weights of each stock in the portfolio are
300 3
wD = =
400 4
and
100 1
wI = =
400 4
I Assuming average past returns of 21.8% and 12.6% respectively, the
expected return of the portfolio is
⇥ ⇤ ⇥ ⇤ ⇥ ⇤
E r P = wD E r D + w I E r I
3 1
= ⇤ 0.218 + ⇤ 0.126 = 19.5%
4 4
Lecture 4: Stock valuation and stock portfolios
Risk and return of portfolios
An example (cont’d)
I The past standard deviations of the two stocks are 40.1% (Disney)
and 29.8% (IBM), and that the historical correlation between the
returns of the two if 0.17.
I The variance of the portfolio is
2
P = wD2 D
2
+ wI2 I2 + 2wD wI ⇢DI D I
✓ ◆2 ✓ ◆2
3 2 1 3 1
= 0.401 + 0.2982 + 2 ⇤ ⇤ ⇤ 0.17 ⇤ 0.401 ⇤ 0.298
4 4 4 4
= 0.10362
Outline
Equity securities
Stock Valuation
E↵ects of diversification
Lecture 4: Stock valuation and stock portfolios
E↵ects of diversification
Diversification
Graphically
I Plotting portfolios in the standard deviation/expected return space:
Lecture 4: Stock valuation and stock portfolios
E↵ects of diversification
E↵ect of diversification
I The key observation from the table and the graph is that
diversification can substantially reduce risk.
I Notice that a lot of portfolios have a lower standard deviation than
pure Disney or IBM investments.
I A diversified portfolio can have lower risk because the individual
stocks do not always move together.
I A second observation is that diversification does not necessarily
reduce expected return
I By including Disney in a pure IBM investment raises the expected
return (but not always the standard deviation)
I Basic fact: There may be benefits to diversification. By holding
a diversified portfolio, we can reduce risk without sacrificing
expected return.
Lecture 4: Stock valuation and stock portfolios
E↵ects of diversification
Stand-alone stocks
I Let’s have a look at the two stand-alone stocks:
Lecture 4: Stock valuation and stock portfolios
E↵ects of diversification
I However, this is not the case for variance (nor for standard
deviation).
I The variance of this portfolio is not the weighted average of the
variances of the individual assets:
2 2
P = w2 2
1 + (1 w) 2
2 + 2 w (1 w ) ⇢12 1 2
2
= [w 1 + (1 w) 2] 2 w (1 w) 1 ⇢12 1 2
2
< [w 1 + (1 w) 2]