U U N IT

6
Analysis of Common Stock

Overview

Now that we know how to analyze company performance and growth potential from
financial analysis, we can now estimate the value of the firm’s stock. The purpose of
this analysis is to determine which stock should be added to a portfolio. The basic rule
to this analysis is to purchase when the stock is worth more than the current stock
price, and sell when if the price is higher than the value of the stock.

In this chapter, we will explore the Dividend discount model, which is one approach to
stock analysis. This will calculate the price of the stock, for the purpose of comparing
it to the market price. We will then be introduced to the different stock markets across
the financial industry, and finally analyze the approaches to equity acquisition in
portfolio management.

Unit 6 Learning Objectives

By the end of this Unit, students will be able to:

1. Assess a Discounted Cash Flow

2. Compare passive and active equity management strategies

This Unit is divided into three sessions as follows:

Session 6.1: Stock Valuation

Session 6.2: The Stock Market

Session 6.3: Passive vs Active Equity Portfolio Management Strategies

Video
Watch this introductory video: Accounting for Investments in Common Stock:
https://www.youtube.com/watch?v=8Oy5U0BSYo8&feature=youtu.be

73  © 2015 University of the West Indies Open Campus

 Readings and Resources
Required Reading
Hall, R. A. (2011). Corporate Valuation and Takeover. bookboon.com.
http://bookboon.com/en/corporate-valuation-and-takeover-ebook

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 SSession 6.1

Company Analysis and Stock Valuation

Introduction
Common stockholders are the owners of the firm, they elect the firm’s board of directors,
who in turn appoint the firm’s top management team. Common stockholders have the
right to the firm’s income that remains after bondholders and preferred stockholders
have been paid. The potential cash flow from investment in common stock is the
dividend payments and the revenue from the sale of stock.

Session Objectives
By the end of this session, you will be able to:

• Explain how investors use stock valuation models

• Examine a Dividend Discount Model

Procedure for valuing common stock

Three-Step Procedure for Valuing Common Stock

1. Estimate the amount and timing of future cash flows the common stock is expected
to provide.

2. Evaluate the riskiness of the future dividends, and determine the rate of return
an investor might expect to receive from a comparable risky investment, which
becomes the investor’s required rate of return.

3. Calculate the present value of the expected dividends by discounting them back to
the present at the investor’s required rate of return.

Value of Common stock = Present Value of future cash flows = Present Value of
(dividend + expected selling price)

Example:
Consider valuing a share of common stock that we plan to hold for only one year.
What will be the value of the stock today if it pays a dividend of $5.00, is expected to
have a price of $70 and the investor’s required rate of return is 15%?

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 Timeline for One-Year Investor

Value of common stock = ($5+$70) ÷(1+0.15)

=$75÷1.15

=$65.22

– If the current stock price were less than this amount, expect investors to rush in
and buy it, driving up the stock’s price.

– If the stock price exceeded this amount, selling it would cause the stock price to
quickly fall.

This is known as the Dividend Discount Model.

This model can be applied to equity investments held for any number of years.

Div1

P0 = +
Div2 L +
+ 
DivN
+
PN
1 + rE 2
(1 + rE ) (1 + rE ) N (1 + rE ) N

The price of the stock is equal to the discounted value of the future cash flows.

There are three variables that drive share value:

• The most recent dividend: The more, the higher.

• Expected rate of growth in future dividends: The higher, the higher.

• Investor’s required rate of return : The higher, the lower.

Thus, the value of a stock price under constant growth can be calculated as follows:

where: P0 = Div1 rE = Div1

+g
rE - g P0

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 We cannot use the constant dividend growth model to value a stock if the growth rate
is not constant. However, we can use the general form of the model to value a firm
by applying the constant growth model to calculate the future share price of the stock
once the expected growth rate stabilizes.

PN = DivN + 1
rE - g

This video walks through the Dividend Discount Model

https://www.youtube.com/watch?v=TlH3_iOHX3s

ACTIVITY 6.1
Exercise:
1. The P/E ratio of a normal-growth firm is 10. The dividend is DPS1 =
$10, and the stock price is $20. What is the growth rate (g)?

2. The Sugar Corporation’s dividends have been growing at 6% per year

for the past 15 years. The firm currently pays an annual dividend of
$5 per share. Determine the current value of a share of the firm’s
common stock to investors with the following required rates of return:
a. 12% b. 14% c. 6% d. 4%

Session Summary

The Dividend Discount Model is one of several methods that can be applied to
determine the price of a stock. As a portfolio manager, it is more important to identify
what makes the stock price move, and how to calculate the growth prospects of the
value of a share.

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 SSession 6.2

The Stock Market

Introduction
New securities trade in the primary market while currently outstanding securities
trade in the secondary market. The corporation receives money from the sale of its
securities only in the primary market.

There are two types of secondary markets:

1. Organized exchanges where trading occurs at a physical location; and

2. Over-the-counter market where trading occurs over the telephone or through

computer networks.

Session Objectives
By the end of this session, you will be able to:

• Describe basic stock market transactions

• Explain the two types of secondary markets

Organized Exchanges
The New York Stock Exchange (NYSE), also called the “Big Board”, is the oldest of all
organized exchanges and the largest organized exchange in the world. While the NYSE
is considered an organized exchange because of its physical location, the majority of
its trades are done electronically without a face-to-face meeting of traders.

To be listed on the NYSE, a firm must meet strict requirements dealing with profitability
and market value, and be widely owned.

Much of the trading on the NYSE is made up of block trades i.e. transactions involving
10,000 shares or more by a single individual or institution.

The American Stock Exchange (AMEX) is the nation’s second largest, floor-based
exchange. However, in terms of volume, the AMEX is a distant number two with less
than 5% of that on the NYSE.

AMEX merged with NASDAQ in 1998 but continues to operate as a separate entity.

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 Over-the-Counter (OTC) Market
The over-the-counter market is made up of a network of dealers that has no listing
or membership requirements. Today, the OTC market is electronic; Nasdaq leads the
way.

OTC listings generally include companies too new or too small to be eligible for listing
on a major exchange.

Nasdaq debuted in 1971 and is the world’s first electronic stock market.

While Nasdaq lists more companies than the NYSE, they are relatively smaller
companies (with a few exceptions).

There are about 1,000 market participants, trading firms that are linked electronically,
with price and trading information broadcast to over 350,000 terminals worldwide.

The Nasdaq stock market has two tiers of listed companies:

• Nasdaq National Markets, made up of around 4,000 companies like Dell (D), Intel
(INTC); and

• Nasdaq Smallcap Market, which includes over 1,000 smaller emerging growth
companies.

For more on Understanding the Stock Market view the following video resource:
https://www.youtube.com/watch?v=HuLIqNKwnZc

Session Summary

This session builds on our introduction to the stock market in Unit 1. Now that we
know how to determine stock value, we can apply this to making investment decisions
in equity securities.

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 SSession 6.3

Passive vs Active Equity Portfolio

Management Strategies

Introduction
Determining an investment style is useful in measuring performance relative to a
benchmark. The style identification allows an investor to diversify by portfolio and
allows control of the total portfolio to be shared between the investment managers
and a sponsor.

An individual with a passive approach invests in securities for the long term, while the
the person with an active approach seeks to take advantage of market inefficiencies.

Session Objectives
By the end of this session, you will be able to:

• Describe the two generic equity portfolio management styles

• Explain the techniques for constructing an equity portfolio

Passive versus Active Management

Passive equity portfolio management

• Long-term buy-and-hold strategy

• Usually tracks an index over time

• Designed to match market performance

• Manager is judged on how well they track the target index

Active equity portfolio management

– Attempts to outperform a passive benchmark portfolio on a risk-adjusted basis
by seeking the “alpha” value

An Overview of Passive Strategies

• Attempt to replicate the performance of an index
– May slightly underperform the target index due to fees and commissions

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 • Strong rationale for this approach
– Costs of active management (1 to 2 per cent) are hard to overcome in risk-
adjusted performance

• Many different market indexes are used for tracking portfolios

– S&P 500 Index

– NASDAQ Composite Index

Index Portfolio Construction Techniques

• Full Replication

– All securities in the index are purchased in proportion to weights in the index

– This helps ensure close tracking

– Increases transaction costs, particularly with dividend reinvestment

• Sampling

– Buys a representative sample of stocks in the benchmark index according to

their weights in the index

– Fewer stocks means lower commissions

– Reinvestment of dividends is less difficult

– Will not track the index as closely, so there will be some tracking error

• Quadratic Optimization (or programming techniques)

– Historical information on price changes and correlations between securities are

input into a computer program that determines the composition of a portfolio
that will minimize tracking error with the benchmark

– This relies on historical correlations, which may change over time, leading to
failure to track the index

Methods of Index Portfolio Investing

• Index Funds

– In an indexed portfolio, the fund manager will typically attempt to replicate

the composition of the particular index exactly

– The fund manager will buy the exact securities comprising the index in their
exact weights

– Change those positions anytime the composition of the index itself is changed

– Low trading and management expense ratios

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 – The advantage of index mutual funds is that they provide an inexpensive way
for investors to acquire a diversified portfolio

• Exchange-Traded Funds (ETF)

– EFTs are depository receipts that give investors a pro rata claim on the capital
gains and cash flows of the securities that are held in deposit by a financial
institution that issued the certificates

– A significant advantage of ETFs over index mutual funds is that they can be
bought and sold (and short sold) like common stock

– The notable example of ETFs

‧ Standard & Poor’s 500 Depository Receipts (SPDRs)

‧ iShares
‧ Sector ETFs

An Overview of Active Strategies

• The goal is to earn a portfolio return that exceeds the return of a passive benchmark
portfolio, net of transaction costs, on a risk-adjusted basis

– Need to select an appropriate benchmark

• Practical difficulties of the active manager

– Transactions costs must be offset by superior performance vis-à-vis the

benchmark

– Higher risk-taking can also increase needed performance to beat the benchmark

Fundamental Strategies
• Top-Down versus Bottom-Up Approaches

– Top-Down

‧ Broad country and asset class allocations

‧ Sector allocation decisions

‧ Individual securities selection

– Bottom-Up

‧ Emphasizes the selection of securities without any initial market or sector

analysis
‧ Form a portfolio of equities that can be purchased at a substantial discount
to what his or her valuation model indicates they are worth

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 • Three Generic Themes

– Time the equity market by shifting funds into and out of stocks, bonds, and
T-bills depending on broad market forecasts

– Shift funds among different equity sectors and industries (e.g., financial
stocks, technology stocks) or among investment styles (e.g., value, growth
large capitalization, small capitalization). This is basically the sector rotation
strategy

– Do stock picking and look at individual issues in an attempt to find undervalued

stocks

• The 130/30 Strategy

– Long positions up to 130 per cent of the portfolio’s original capital and short
positions up to 30 per cent

– The use of the short positions creates the leverage needed, increasing both risk
and expected returns compared to the fund’s benchmark

– Enables managers to make full use of their fundamental research to buy stocks
they identify as undervalued as well as short those that are overvalued

Technical Strategies
• Contrarian Investment Strategy

– The belief that the best time to buy (sell) a stock is when the majority of other
investors are the most bearish (bullish) about it

– The concept of mean reverting

– The overreaction hypothesis

• Price Momentum Strategy

– Focus on the trend of past prices alone and make purchase and sale decisions
accordingly

– Assume that recent trends in past prices will continue

Anomalies and Attributes

• Earnings Momentum Strategy

– Momentum is measured by the difference of actual EPS to the expected EPS

– Purchases stocks that have accelerating earnings and sells (or short sells) stocks
with disappointing earnings

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 • Calendar-Related Anomalies

– The Weekend Effect

– The January Effect

• Firm-Specific Attributes

– Firm Size

– P/E and P/BV ratios

Active vs Passive Portfolio Management:

h t t p : / / w w w. a i c p a . o r g / i n t e r e s t a r e a s / p e r s o n a l f i n a n c i a l p l a n n i n g /
resources/practicecenter/forefieldadvisor/downloadabledocuments/
ffactiveversuspassiveconceptpiece.pdf

ACTIVITY 6.2
Read the following debate on equity portfolio management strategies:
http://www.forbes.com/sites/investor/2013/01/31/finally-an-answer-to-
the-active-versus-passive-strategy-debate/
Do you agree with this view? Why?

Unit 6 Summary

Unit 6 has provided students with the information needed to make equity investments.
The following units will teach students how to assess the value of bonds.

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 References
Education Unlocked. (2013, December 19). Dividend Discount Model (DDM) [Video
file]. Retrieved from https://www.youtube.com/watch?v=TlH3_iOHX3s

Hall, R. A. (2011). Corporate Valuation and Takeover. bookboon.com.

http://bookboon.com/en/corporate-valuation-and-takeover-ebook

Riley, Alison. (2012, May 30). Accounting for Investments in Common Stock. [Video
file]. Retrieved from
https://www.youtube.com/watch?v=8Oy5U0BSYo8&feature=youtu.be

Stanford Graduate School of Business. (2013, October 7). Understanding the Stock
Market: Stocks and Bonds online course preview [Video File]. Retrieved from
https://www.youtube.com/watch?v=HuLIqNKwnZc

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