CHAPTER 3: STOCK VALUATION METHODS AND EFFICIENT

MARKET HYPOTHESIS
NEEDS FOR VALUATION OF SHARES
To fix an issue price for an unquoted company to be listed.
Takeover bid and the offer price for the purpose of merger and acquisition activities.
For the purposes of taxation and as collateral for a loan made by a company.
When a group holding company is negotiating the sale of its subsidiary to a management
buyout team or to an external buyer.
When a shareholder wishes to dispose of his holding especially if a large or controlling
interest is being sold..
When a company is being broken up in a liquidation situation or the company needs to
obtain additional finance or refinance current debt.
STOCK VALUATION METHODS
1. The asset-based valuation method
Determines a companys ordinary share value by analyzing the value of the
companys assets.
The difficulty in an asset valuation method is establishing the asset values to use.
Bases of asset-based valuation method:
a) Historic cost basis/book value
Based on figure stated on balance sheet which is on historic costs
b) Replacement basis
Provide a measure of the maximum price that a purchaser should
pay for the company if assets are to be use don an on-going basis
c) Realizable basis/break-up value
In a situation when a company ceases to be a going concern due to
financial difficulties or;
When a company is purchased to be broken up and assets are sold
separately for their realizable value
Normally represents minimum price which should be accepted for
sale of business as a going concern
USEFULNESS
As a measure of the security in the
share value for comparison with other
valuation approaches.
As a measure of comparison in a
scheme of merger asset backing
valuation.
As a floor value for a business that is
up for sale or to set a minimum price
in a takeover bid

WEAKNESSES
Assumes that investors normally buy
a company for its balance sheet
assets.
Ignores non-balance sheet intangible
assets which may include a strong
and experienced management team
and highly skilled workers

2. The income-based valuation method

One of the most common methods for valuing share price.
Apply the price-to-earnings ratio (P/E) which is based on historic ratios and statistics
P/E ratio = Market price per share/Earnings per share.
By selecting a suitable P/E ratio and multiplying this by the EPS, the market price per
share or the the total value of a company can be computed.
The market price per share = EPS x P/E ratio.
3. The cash flow-based valuation method
May include dividend valuation model, dividend growth and discounted cash flow
basis
4. The dividend valuation method
The equilibrium price for any security depends on the future expected stream of
income from the security discounted using an appropriate cost of capital or a
required rate of return.
Williams (1938) stated that the price of a stock should reflect the present value of
the shares future dividends. In equation form, this is the statement of the DVM:
The general model can be formulated if the companys dividends are expected to
follow these basic patterns:
a) Zero growth
Same amount of dividend paid every year
b) Constant growth
Amount of dividend grows at a constant rate every year
c) Differential growth
Amount of dividend grows at a various rate
FACTORS AFFECTING SHARE PRICES
Earnings announcements
Industry performance
Dividend
Stock splits
Share buy-back
Product innovation
Takeover or merger
Major contracts
Insider trading
Analyst upgrade/downgrade
STOCK RISK
Risk can be defined as the uncertainty that actual returns will not match expected returns.
Standard deviation is a statistical measure of the degree to which actual returns are spread
(disperse) around the mean actual return.
A higher standard deviation means higher risk
The diversification of risk variabilities of returns of the individual assets in the portfolio
offset one another and as more securities are added, the risk of the portfolio is reduced.
2

SOURCES OF INVESTMENT RISK

Systematic risk risk attributed to relatively uncontrollable external factors.
1. Exchange rate risk: The risk that an investments value will be impacted by changes
in the foreign currency market.
2. Interest rate risk: The risk attributed to the loss in market value due to an increase in
the general level of interest rates.
3. Market risk: The risk attributed to the loss in market value due to declining
movement of the entire market portfolio.
4. Purchasing power risk: The risk attributed to inflation and how it erodes the real
value of an investment over time.
Unsystematic risk risk attributed to the underlying investment.
1. Business risk: The risk attributed to a companys operations, particularly those
involving sales and income.
2. Financial risk: The risk attributed to a companys financial stability and structure,
namely the companys use of debt to leverage earnings.
3. Industry risk: The risk attributed to a group of companies within a particular
industry. Investments of companies tend to rise and fall based on what their peers in
the industry are doing.
4. Liquidity risk: The risk that an investment cannot be purchased or sold at a price at
or near market prices.
5. Call risk: The risk attributed to an event where an investment may be called prior to
maturity.
6. Regulation risk: The risk that new laws and regulations will negatively impact the
market value of an investment.
Total risk is equal to the sum of systematic and unsystematic risk.

BETA
The risk of a single stock can be defined in terms of the contribution it makes to the risk
(standard deviation) of the market portfolio. This risk measure is called beta.
Beta is the ratio of the standard deviation of the stock to the standard deviation of the
market portfolio, multiplied by the correlation coefficient between the stock and the market
portfolio.
The formula of beta of a stock A can be presented as follows:
Beta (A) = Relative risk of Stock A
= (Total risk of Stock A)/(Total risk of market portfolio)
Reasons in difference beta estimates:
1. Some sources use daily returns while others use monthly returns
2. Different market proxies
3. Some sources adjust the historic beta values for their expectations of future

STOCK PERFORMANCE MEASUREMENTS

1. Treynor Index
This index therefore relates excess return over the risk-free rate to the additional
risk taken.
The focus of risk is on systematic risk instead of total risk.
This performance measure should really only be used by investors who hold
diversified portfolios.
The higher the Treynor Index, the higher the return relative to the risk-free rate, per
unit of risk.
The formula is as follows:

2.

Sharpe Index
The Sharpe ratio is almost similar to the Treynor measure, except that the risk
measure used is the standard deviation of the portfolio instead of considering only
the systematic risk, as represented by beta.
The higher the portfolios mean return relative to the mean risk-free rate and the
lower the standard deviation p, the higher the Sharpe Index will be.
The formula can be expressed as follows:

Sharpe Index
3.

Rp R f

Jensen Index
This measure is also known as alpha.
The Jensen Index measures how much of the portfolio's rate of return is attributable
to the manager's ability to deliver above-average returns, adjusted for market risk.
A portfolio with a consistently positive excess return will have a positive alpha, while
a portfolio with a consistently negative excess return will have a negative alpha.
The higher the ratio, the better are the risk-adjusted returns
The formula is as follows:

All the three measures combine risk and return performance into a single value. This makes it easier
to compare the performance of competing portfolios.

EFFICIENT MARKET HYPOTHESIS (EMH)

A theory that tries to explain the movement of share prices.
It hypothesizes that at any given time, share prices fully reflect all available information and
the stock market reacts immediately to all the information that is available.

FORMS OF FINANCIAL MARKET EFFICIENCY

1. Weak form efficiency
asserts that all past market prices and data are fully reflected in share prices
since new information arrives unexpectedly, changes in share prices should
occur in a random fashion
2. Semi-strong form efficiency
asserts that all publicly available information as well as information about
past price movements are fully reflected in securities prices
if semi-strong form efficiency holds, weak form efficiency holds as well
3. Strong form efficiency
asserts that all information, whether publicly available or private or insider
information, if fully reflected in securities prices

ROLES OF PORTFOLIO MANAGERS

If markets are efficient, the primary role of a portfolio manager consists of analyzing and
investing appropriately based on an investor's tax considerations and risk profile.
Optimal portfolios will vary according to factors such as age, tax bracket, risk aversion and
employment.
The role of the portfolio manager in an efficient market is to tailor a portfolio to those
needs, rather than to beat the market.
Investors will be best served by constructing broadly-diversified portfolios that correspond
to the level of systematic risk they are willing to bear, and adopting a buy-and-hold strategy.