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Lecture Financial markets and institutions - Chapter 11: Stock valuation and risk

In this chapter, the following content will be discussed: Stock valuation methods, determining the required rate of return to value stocks, factors that affect stock prices, role of analysts in valuing stocks, stock risk, applying value at risk, applying value at risk, stock performance measurement, stock market efficiency. | Chapter 11 Stock Valuation and Risk Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. Chapter Outline Stock valuation methods Determining the required rate of return to value stocks Factors that affect stock prices Role of analysts in valuing stocks Stock risk Applying value at risk Forecasting stock price volatility and beta Stock performance measurement Stock market efficiency Foreign stock valuation, performance, and efficiency Stock Valuation Methods The price-earnings (PE) method assigns the mean PE ratio based on expected earnings of all traded competitors to the firm’s expected earnings for the next year Assumes future earnings are an important determinant of a firm’s value Assumes that the growth in earnings in future years will be similar to that of the industry Stock Valuation Methods (cont’d) Price-earnings (PE) method (cont’d) Reasons for different valuations Investors may use different forecasts for the firm’s earnings or the mean industry earnings Investors disagree on the proper measure of earnings Limitations of the PE method May result in inaccurate valuation for a firm if errors are made in forecasting future earnings or in choosing the industry composite Some question whether an investor should trust a PE ratio Valuing A Stock Using the PE Method A firm is expected to generate earnings of $2 per share next year. The mean ratio of share price to expected earnings of competitors in the same industry is 14. What is the valuation of the firm’s shares according to the PE method? Stock Valuation Methods (cont’d) Dividend discount model John Williams (1931) stated that the price of a stock should reflect the present value of the stock’s future dividends: D can be revised in response to uncertainty about the firm’s cash flows k can be revised in response to changes in the required rate of return by investors Stock Valuation Methods (cont’d) . | Chapter 11 Stock Valuation and Risk Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. Chapter Outline Stock valuation methods Determining the required rate of return to value stocks Factors that affect stock prices Role of analysts in valuing stocks Stock risk Applying value at risk Forecasting stock price volatility and beta Stock performance measurement Stock market efficiency Foreign stock valuation, performance, and efficiency Stock Valuation Methods The price-earnings (PE) method assigns the mean PE ratio based on expected earnings of all traded competitors to the firm’s expected earnings for the next year Assumes future earnings are an important determinant of a firm’s value Assumes that the growth in earnings in future years will be similar to that of the industry Stock Valuation Methods (cont’d) Price-earnings (PE) method (cont’d) Reasons for different valuations Investors may use