Corporate Valuation and Stock Valuation

Chapter 6. Risk and Return

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Chapter 7. Corporate Valuation and Stock Valuation

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Finance – Week 4 Lecture

Risk and Return

Ever wish you could invest in the stock market and earn the same kind of returns earned by big investors like Warren Buffet? Much research has been done on the market in an attempt to pinpoint a formula or magic theory that could explain the behaviors of the market and capitalize on above average returns. Several theories exist on how the market operates. One such theory is the efficient market hypothesis.

Under the efficient market hypothesis there are three proposed forms of the market: weak, semi-strong, and strong. A weak market exists when all general market information is readily available to everyone and functions on the assumption that we cannot use past performance as an indicator of future performance. The semi-strong market assumes the market to be efficient, all public information is available to all investors, and the average investor cannot beat the market rate of return. Finally, the strong market proposes that all public and private information is reflected in the price of stocks and no one could earn anything better than the market rate of return. The oversimplified difference between each type of market under this theory is that stocks may or may not change in price depending on the type of information available: market, private, or public. While information is readily available due to advances in technology, there is still the aspect of power. Information is power and it’s hard to believe that everyone would be willing to give up or go public with all information, for example, ‘insider information’.

Keep in mind, this is only a hypothesis! There are several market theories. It’s up to you to consider the theory and critically reflect on your experiences, beliefs, and what you see in the market around you to determine if you feel each theory is valid or not.

Another highly debated financial concept is the Capital Asset Pricing Model or CAPM for short. CAPM is a formula used to estimate the relationship between risk and return. This formula combines two key elements: risk and the time value of money. Included in the formula is best, the expected market return, and the risk free rate of return. The great debate, however, arises when we acknowledge the many estimates upon which this formula relies. Many feel that CAPM is not a reliable measure of return.

I think the key here is that the system of evaluation we have is flawed, but not completely worthless. It isn’t without its faults, but for all the criticism it receives, I haven’t yet seen a new model emerge to take its place. The general notion I hear in industry is that, while not perfect, it is the best method we have available. We must acknowledge that and use the data with a grain of salt rather than using the CAPM estimation and resulting NPV calculations as iron clad truths. It’s a great tool to use as a guide but can’t be relied upon to be accurate to a tenth of a penny. It’s also important to consider the risk involved with trying out a new method of evaluation. While we may be in need of something new, it does indeed carry some risk if we are wrong! Small projects may not take us too far out on a limb, but some investments require huge amounts of resources. These are the ones we want to be sure we have done the best job possible in assessing the possible return and of course the ones we would be hesitant to evaluate using a new, untested method.

CAPM is commonly used in the capital budgeting process which you will learn more about next week. Many firm’s use CAPM as their general rule for cost of capital. When assessing projects, the return must be greater than the firms CAPM. I found it interesting that many feel the hurdle rate is arbitrary and weeds out otherwise profitable projects. It does, indeed, weed out the lower profit projects, but in my experience, that’s the goal! We normally have a set budget to spend but also have about four times that amount of profitable projects we would like to do. Regardless of the method we use to evaluate, there will likely be profitable projects that do not get chosen. We simply can’t do them all!

There are several key issues here. First, we need something to use for a rate, this provides us a good ‘guestimate’ for lack of a better figure. Second, I appreciate the notion that this works particularly well when we have a range of projects to consider (aka – the capital budgeting process). When we have only one project, however, it’s less accurate. When working with only one project could we go out on a limb and say it’s just one – can we infuse our own common sense, feel for the accuracy, and consideration of other key factors to help us evaluate how helpful the CAPM figures are and what, if any, adjustments we need to make for risk and other factors? This would be nearly impossible to do with a long line up of projects in the capital budgeting process but if we are looking at just one special project it may be possible.

As you move through the week keep your eyes and mind open. You’ll learn lots of new information, theories, and concepts, many of which are quite debatable. Keep your mind open and question the theories you read. Do they seem valid? Which theories do your beliefs and experiences support?

Remember, that this is the half-way point in the course and you do have an assignment and the midterm to complete.  Please give yourself enough time to complete your homework and take your exam.  If you have any questions, please contact your instructor for assistance.

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