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Fin 525 Week 7: 

Fin 525 Week 7 Common Stock

100 Total Points Possible for an Exam, Which are then Converted to GPA points: 

100 Total Points Possible for an Exam, Which are then Converted to GPA points Points convert to GPA equivalent number according to the following formula: GPA equivalent = 4.33 – (100 – Test score)/15 For example, 95 = 4.00 = A 88 = 3.53 = lowest A- 83 = 3.20 = lowest B+ 73 = 2.52 = lowest B- Monday night “curve” GPA equivalent = 4.33 – (95 – Test score)/18

No More Problems Sets, Just Projects: 

No More Problems Sets, Just Projects Stock Prediction and Hedging Prediction and hedging portfolio due 6pm on Sunday, November 12, 2006 Write-up due at the beginning of class on Monday, November 13 or Wednesday, November 15 GE 401(k) Portfolio and write-up due at the beginning of the class on Monday, December 4 or Wednesday, November 29

Common Stock: 

Common Stock A share in the ownership of a company (equity) and a right to share of its profits Stock holders have the last claim on the assets of a company (a residual interest) Ownership of stock has limited liability, you lose at most what you paid for the stock Common stock includes not only profits, but also voting rights (sometimes limited, as in the case of Google)

The Big Picture: 

The Big Picture Like bonds, stocks generate cash flows Unfortunately, the nature of these cash flows is very different because The cash flows are not only not guaranteed, there are basically “leftovers” It is not obvious what interest rate to use to determine the PV of the cash flows The cash flows can potentially go on forever—stocks never “mature” Bankruptcy will usually end the cash flows Being acquired by another company can abruptly create a single, giant cash flow

Two Special Kinds of “Stock”: 

Two Special Kinds of “Stock” ADRs (or ADSs) Shares of international companies that trade on U.S. exchanges For example, Sony (SNE) & Nokia (NOK). ETFs (Exchange-Traded Funds) Shares in portfolios that usually track specific stock indexes ETFs can also hold specific assets or commodities, like gold (IAU) For example, SPDRs (SPY) & Quads (QQQQ)

How Stocks are Traded in the United States: 

How Stocks are Traded in the United States Exchanges New York Stock Exchange (NYSE) American Stock Exchange (AMEX) (owned by the NASD) Various regional exchanges (Philadelphia, etc.) Dealer Networks Nasdaq (the computer network of the NASD) ECNs (Electronic Communications Networks) INET (part of Nasdaq) NYSE ARCA (formerly Archipelago)

Key Stock Info for Wal-Mart (from Yahoo! Finance on October 13, 2006): 

Key Stock Info for Wal-Mart (from Yahoo! Finance on October 13, 2006)

The Two Critical Things to Know About a Stock: 

The Two Critical Things to Know About a Stock Market Cap(italization) The total value of the company’s stock Higher market cap usually goes with: Less volatile More liquid Price/Earnings (P/E) ratio Growth stocks tend to have high P/E ratios Surprisingly, value stocks historically have higher returns The overall level of market P/E ratios changes over time

The Concept of Efficiency: 

The Concept of Efficiency Technical economic definition: No way to make anyone better off without making someone else worse off For an individual: Doing the best you can do with what you have For portfolios: No way to rearrange things to get more return without taking on more risk For financial markets: No way to use market data and information to “beat the market”

Efficient-Market Hypothesis (EMH) and Technical Analysis: 

Efficient-Market Hypothesis (EMH) and Technical Analysis The efficient-market hypothesis (which comes in three forms) states basically that there is no way to make “excess profits” by looking at any past public information about a company In particular, this means that “technical analysis” (look at stock graphs, etc.) does not work It also means that whatever “behavioral anomalies” exist in financial markets are too small and fleeting to exploit profitably

Consequences of the EMH: 

Consequences of the EMH Stock prices are efficient aggregators of information about a company Returns that appear excessive can be interpreted as the return for bearing risk (we will see that only certain risks are rewarded) The path of a stock’s price may not allow us to predict the future, but they can tell us a lot about the company and its risk

Consequences of the EMH (continued): 

Consequences of the EMH (continued) Prices are a more reliable source of information than accounting-based data Stock prices are extremely rarely falsified or restated Stock prices are difficult, but not impossible, to manipulate Severely misstated accounting numbers can still work their way into stock prices (Enron, Worldcom, Refco, etc.)

Consequences of the EMH (continued): 

Consequences of the EMH (continued) EMH supports investing in index funds rather than trying to pick individual stocks Greatly reduces management fees Provides cheap diversification (we will see that diversification is a good thing) Low-turnover indexes generate low capital gains taxes

Consequences of the EMH (continued): 

Consequences of the EMH (continued) EMH supports investments that go beyond traded U.S. stocks Despite increasing globalization of U.S. company, adding international companies to a portfolio aids diversification Prudent venture capital investments provide opportunities not available in traded stocks with much higher risk Real estate can also enter into the mix

The Two Sources of Returns from Stock: 

The Two Sources of Returns from Stock Dividends Quarterly payments by established companies Stock yields used to be higher than bond yields The price of a stock drops by the amount of its dividend the day it goes “ex-dividend” Capital Gains Appreciation in the price of the stock Not guaranteed Usually taxed at a lower rate than dividends Aided by companies buying back their own shares

Discounted Dividend Model (DDM): 

Discounted Dividend Model (DDM) Notice that if one holds a stock indefinitely, dividends are the only cash flow that one receives Basic Idea: Value(stock) = NPV(future dividends) For a constant discount rate and dividend growth rate, this is just a growing perpetuity Hence, Value(stock) = Next dividend/(r-g), where r = stock discount rate, g = dividend growth rate The main problem is knowing r and g

Warren Buffett: Sage of Omaha: 

Warren Buffett: Sage of Omaha Chairman of Berkshire Hathaway (BRKa) Protégé of Benjamin Graham: The father of fundamental analysis Proponent of “value investing,” skeptical of paying for growth and technology

Fundamental Stock Valuation: 

Fundamental Stock Valuation Stocks are valued based on their ability to generate future cash flows Higher cash flows are good The most popular measure (but not always the best) measure of the relative cash flow generated by a company is its P/E (Price/Earnings) ratio Published “Book Values” are rarely used in fundamental analysis

Fundamental Stock Valuation (continued): 

Fundamental Stock Valuation (continued) Fundamental valuation methods are not limited to the discounted dividend model Free cash flows can also be discounted This makes the most sense for a company that is an acquisitions target Valuation is still very dependent on growth rates This article, which later paints a grim picture of the prospects for the stock market, presents an argument that Google is vastly overpriced based on expected future cash flows

“Stocks” You Will Get to Know This Semester: 

“Stocks” You Will Get to Know This Semester Green Mountain Coffee Roasters (GMCR) Nasdaq 100 Trust (QQQQ) S&P Depository Receipts (SPY) Starbucks (SBUX) Wal-Mart (WMT) Google (GOOG)

Green Mountain Coffee Roasters (GMCR): 

Green Mountain Coffee Roasters (GMCR) Purchases raw coffee, roasts it, and sells it Most of its sales come through large chain and specialty retailers It is highly concentrated in the Northeastern U.S. Recently acquired Keurig, maker of a highly-regarded single-cup “pod” coffee-making system A “micro-cap” company listed on Nasdaq and headquartered in Waterbury, Vermont

Nasdaq 100 Trust (QQQQ): 

Nasdaq 100 Trust (QQQQ) Among the most-traded shares in the U.S. 40 times the price of the QQQQ is roughly the Nasdaq 100 Index A substitute for trading in the virtually untradeable Nasdaq Composite Index Great for speculation and program trading Dominated by a handful of tech companies (Microsoft, Intel, Cisco, Qualcomm, etc.) since the Nasdaq 100 has roughly the 100 largest Nasdaq companies in it

S&P Depository Receipts (SPY): 

S&P Depository Receipts (SPY) Tracks the S&P 500 Stock Index 10 times the price of SPY is approximately the S&P 500 Index Less speculative than QQQQs—it has more legitimate owners like Bill and Melinda Gates Some people make a living (or go broke) betting on the spread between the QQQQ and SPY

Starbucks (SBUX): 

Starbucks (SBUX) Dominant firm in the coffee roasting industry Unlike GMCR, has a vast network of retailers A component of Nasdaq 100 and S&P 500 Definitely a large-cap company, far from the largest, but already over half the size of McDonald’s (MCD) An extreme growth stock with a P/E ratio over 50 (as of 10/13/06)

Wal-Mart (WMT): 

Wal-Mart (WMT) Largest retailer in America and one of the largest stocks by capitalization A component of the Dow Jones Industrial Average and S&P 500 Closely watched by analysts as a leading indicator of the state of the American consumer Its Sam’s Club division sells Green Mountain coffee

Google (GOOG): 

Google (GOOG) A quirky company that went public in August 2004 An even more extreme growth stock than Starbucks (P/E ratio over 60 as of 10/13/06) Has periods of high volatility

The Two Main Places to Go to Get Detailed Information about U.S. Companies: 

The Two Main Places to Go to Get Detailed Information about U.S. Companies Edgar at the Securities and Exchange Commission Contains most filings that are legally required Generally includes quarterly and annual reports Some key documents are still filed on paper The company’s own website The most reliable source of actual dividend payment dates, splits, etc. Full-color annual reports and other goodies usually reside in a section called “Investor Relations”

Historical Stock Prices: 

Historical Stock Prices Yahoo! Finance is the best source of free data Data files can be opened directly into Excel Historical stock prices are far from error-free Errors are especially abundant for quotes prior to the year 2000 is good for checking suspicious prices but is not designed for mass downloading of data

Holding-Period Return (HPR): 

Holding-Period Return (HPR)

Holding-Period Return Example: WMT between August 11 and 18, 2006: 

Holding-Period Return Example: WMT between August 11 and 18, 2006 Closing price on August 11: $44.69 August 16 dividend: $0.168 Closing price on August 18: $44.49 HPR = ($44.49 – $44.69 + $0.168)/$44.69 = –$0.032/$44.69 = –.00072 = –0.072% One small detail: The dividend is not actually received on August 16, but on September 6

Dividends with Less Pain: 

Dividends with Less Pain Yahoo! Finance provides “adjusted” closing prices that are designed to take dividends and splits into account automatically You can then use the HPR formula, but omit the dividends and everything (approximately) works Warning: “Adjusted” prices change over time You cannot mix adjusted prices downloaded on different dates without risking massive problems

Annualizing HPRs: 

Annualizing HPRs With few exceptions, everything to do with stock returns is reported as an annualized figure Weekly returns are annualized by compounding them up 52 times (we usually ignore the extra day or two), so: Annual return = (1+Weekly Return)52 – 1 In the previous example, Annual return = (1 – 0.00072) 52 – 1 = – 3.68%

More On HPR: 

More On HPR A single week’s HPR can be misleading HPRs can change a lot from week to week More useful info is the mean and standard deviation of the weekly return (daily and monthly returns can also be used, depending on the purpose) over many (at least 30) observations Finally, one may want to consider only the excess return relative to a benchmark rate; usually, “cash” or an indexed investment

Capital Asset Pricing Model (CAPM): 

Capital Asset Pricing Model (CAPM) Risk comes in two varieties Market or systematic risk Diversifiable (or specific) risk You are stuck with market risk You can diversify away diversifiable or specific risk CAPM is based on the notion that the only kind of risk that the market will reward you for bearing is market risk CAPM explicit assumes that markets are efficient and that markets are dominated by risk-averse individuals

The CAPM Equation: 

The CAPM Equation Expected return = Risk-free return + Premium for risk Where E(ri) is the expected return for stock i rf is the risk-free rate of return i is the beta for stock i E(rM) is the expected market rate of return

Very Important!!!!: 

Very Important!!!! The CAPM equation is not an accounting identity It is the result of a useful—but to various degrees flawed—theory In theory, the “market” in CAPM consists of a basket of every capital asset; in practice, the S&P 500 Index (annual return between 9% and 11%) is most often used to represent the market

So What?: 

So What? When CAPM works, we can use it to predict stock prices for weeks, months, even years, into the future Problems The predictions, while possibly the best we can do, may not be very accurate CAPM does not handle “event risk” well All the variables in the model are abstractions that have only rough real-world approximations

An Example from this Past Spring (2/14/06): What Will GE Be Worth in 2 weeks?: 

An Example from this Past Spring (2/14/06): What Will GE Be Worth in 2 weeks? Useful facts Closing price on February 14: $33.46/share Beta = 0.99 (according to Reuters Investor) Other necessary parameters rf was roughly 4.5% back then rm was roughly 10%, so the risk premium is 5.5% Annual return for GE is 4.5% + 0.99(5.5%) = 9.945% For 1/26 of a year (2 weeks), that’s about 0.38% So the FV of GE in 2 weeks is $33.46(1.0038) = $33.59

One Problem: GE Went “Ex-Dividend” on February 23: 

One Problem: GE Went “Ex-Dividend” on February 23 The expected dividend was $0.25/share, so we have to net that out, because stocks drop by approximately the entire amount of the dividend when the stock opens on the ex-dividend date $33.59 – $0.25 = $33.34 Note that the dividend is not received until April 23, 2006

Last, But Not Least, Beta: 

Last, But Not Least, Beta Next week we will explore how to get it The value of beta can be quite arbitrary Websites that carry it often disagree on its value for a particular company GMCR’s beta is not particularly easy to get a handle on (neither was Google’s)

Assignment for Week 8: 

Assignment for Week 8 Read Chapter 6 of BKM as well the as material from RWJ concerning the valuation of stocks (like growing perpetuities) Look over Chapters 7–9 of BKM

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