Fin 525 Week 7

1. Fin 525 Week 7 Common Stock

2. Exam Grade Conversion Formula • Points convert to GPA equivalent number according to the following formula: GPA equivalent = 4.33 – (97 – Exam score)/20 • For example, • 90 = 3.98 = A 81 = 3.53 = lowest A- • 74 = 3.18 = lowest B+ 61 = 2.53 = lowest B- Professor Ross Miller • Fall 2007

3. No More Problems Sets, Just Projects • Stock Prediction and Hedging • Prediction and hedging portfolio due 6pm on Sunday, November 4, 2006 • Write-up due at the beginning of class on Monday, November 5 or Wednesday, November 7 • GE 401(k) • Portfolio and write-up due at the beginning of the class on Monday, November 26 or Wednesday, November 28 Professor Ross Miller • Fall 2007

4. 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) Professor Ross Miller • Fall 2007

5. 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 Professor Ross Miller • Fall 2007

6. 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) Professor Ross Miller • Fall 2007

7. 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) Professor Ross Miller • Fall 2007

8. Key Stock Info for Wal-Mart (from Yahoo! Finance on Sept. 28, 2007) Professor Ross Miller • Fall 2007

9. 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 Professor Ross Miller • Fall 2007

10. 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” Professor Ross Miller • Fall 2007

11. Efficient-Market Hypothesis (EMH) andTechnical 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 Professor Ross Miller • Fall 2007

12. 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 Professor Ross Miller • Fall 2007

13. 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.) Professor Ross Miller • Fall 2007

14. 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 Professor Ross Miller • Fall 2007

15. 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 Professor Ross Miller • Fall 2007

16. 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 Professor Ross Miller • Fall 2007

17. 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 Professor Ross Miller • Fall 2007

18. 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 Professor Ross Miller • Fall 2007

19. 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 Professor Ross Miller • Fall 2007

20. 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 Professor Ross Miller • Fall 2007

21. A Big Problem with Fundamental Valuation • Valuation methods are different from industry to industry (and even within a given industry) • A good “ratio” in one setting can be a bad ratio in another • Lots of debt is bad for companies with unpredictable revenues • Lots of debt is good for solid companies (more “leverage” means more profits per dollar of equity) Professor Ross Miller • Fall 2007

22. “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) Professor Ross Miller • Fall 2007

23. 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. • 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 • Its stock split 3-for-1 on July 30, 2007 Professor Ross Miller • Fall 2007

24. 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 Professor Ross Miller • Fall 2007

25. 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 Professor Ross Miller • Fall 2007

26. 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) • Formerly an extreme growth stock with a P/E ratio over 50 (as of 10/13/06) that has recently fallen out of favor and so its P/E ratio has fallen Professor Ross Miller • Fall 2007

27. 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 • It sells Green Mountain coffee through its WalMart superstores and Sam’s Club Professor Ross Miller • Fall 2007

28. Google (GOOG) • A quirky company that went public in August 2004 • A growth company with a P/E ratio that is still over 40 (as of 9/28/2007) • Has periods of high volatility Professor Ross Miller • Fall 2007

29. 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” Professor Ross Miller • Fall 2007

30. 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 • Bigcharts.com is good for checking suspicious prices but is not designed for mass downloading of data Professor Ross Miller • Fall 2007

31. Holding-Period Return (HPR) Professor Ross Miller • Fall 2007

32. 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 Professor Ross Miller • Fall 2007

33. 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 Professor Ross Miller • Fall 2007

34. 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% Professor Ross Miller • Fall 2007

35. 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 Professor Ross Miller • Fall 2007

36. Can You Hold Negative Amounts of a Stock? • In other words, can you profit from holding a stock when its price goes down? • YES. It is called selling short. • How does selling short work? (Simplified version) • Your broker borrows the stock, sells it, and credits your account with the proceeds of the sale • Later, you buy it back • If the stock drops, you keep the savings • If it rises, you pay the difference • You must also make any dividend payments Professor Ross Miller • Fall 2007

37. Some Issues With Selling Short • The possibility of losing an infinite amount of money if the stock price goes up • Brokers require the posting of margin to protect them against this • What happens with the proceeds of the sale • If you are a small investor, the broker gets it • If you are a large investor, you get it • What if the entity that you borrowed the shares from wants them back • Too bad, you must give them back Professor Ross Miller • Fall 2007

38. Why Does Anyone Sell Stocks Short? • Because they are “bearish” on their prospects and wish to profit from a decline • Some types of brokerage accounts, especially tax-sheltered retirement accounts do not allow one to do this directly • Because they wish to create a hedged position • QQQQ and SPY are commonly used to hedge against the risk of tech stocks or large cap stocks going down • Similar stocks can be used to create a “pairs trade” Professor Ross Miller • Fall 2007

39. 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 Professor Ross Miller • Fall 2007

40. The CAPM Equation Expected return = Risk-free return + Premium for risk Where E(ri) is the expected return for stock irfis the risk-free rate of returniis the beta for stock iE(rM) is the expected market rate of return Professor Ross Miller • Fall 2007

41. 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 Professor Ross Miller • Fall 2007

42. 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 Professor Ross Miller • Fall 2007

43. An Example from the Past (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 • rfwas 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 Professor Ross Miller • Fall 2007

44. Something To Take Into Account: 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 Professor Ross Miller • Fall 2007

45. 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) Professor Ross Miller • Fall 2007

46. Assignment for Week 8 • Read Chapter 11 of BKM as well the as material from RWJ Chapter 5 concerning the valuation of stocks (like growing perpetuities) • Look over the other chapters of BKM Professor Ross Miller • Fall 2007