Modelling Risk and Finance

Dr. Kevin Fleary

Stock Market Reporting
52 WEEKS YLD VOL N ET
HI LO STOCKSYM DIV % PE 100s CLOSE CH G
35.68 21.02 Gap Inc GPS 0.92 2.77 15 88298 31.61 0.45
Gap pays a
dividend of 92
Gap has cents/share. Gap ended trading at
been as high $31.61, which is up 45
as $35.68 in cents from yesterday.
Given the current
the last year. price, the dividend
yield is 2.77%.

8,829,800 shares traded

Gap has been as Given the current hands in the last day’s
low as $21.02 in price, the PE ratio is trading.
the last year. 15 times earnings.

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Change in Stock Price
• That's a common method for calculating daily price
changes in stocks. This formula helps you determine the
percentage change between two prices.
• Let's break it down: "New Stock Price" refers to the
most recent price of the stock. "Old Stock Price" is the
previous day's closing price or any other reference price
you're comparing against.
• Subtracting the old price from the new price gives you
the absolute change in price. Dividing this absolute
change by the old price and multiplying by 100 gives
you the percentage change. In Excel, you can use a
formula like this:
• =(B2 - A2) / A2
Change in Stock Price
• Percentage Change Approach 2: (New Stock Price / Old Stock Price) -
1This formula calculates the percentage change by first dividing the new
stock price by the old stock price.Then, subtracting 1 from the result gives
the percentage change.For example, if the new price is $110 and the old
price is $100, then (110 / 100) - 1 = 0.1, or a 10% increase.
• Logarithmic Approach: ln(New Stock Price / Old Stock Price)This
formula calculates the natural logarithm of the ratio of the new stock price
to the old stock price.The natural logarithm function, ln, is often used in
financial analysis because it has desirable mathematical properties, such
as scaling large changes similarly to small changes.For example, if the
new price is $110 and the old price is $100, then ln(110 / 100) ≈ 0.0953.
Difference in Approaches:
• Approach 1 measures the percentage change directly, providing a
straightforward interpretation of how much the price has changed in percentage
terms.
• Approach 2 also calculates the percentage change but in a different way, which
might be preferred for certain statistical analyses or comparisons.
• Approach 3 takes the logarithm of the ratio, which might be useful when you
want to analyze the data in terms of logarithmic changes, which can be helpful
in certain financial modeling and analysis scenarios. It's especially useful when
dealing with data that can have a wide range of values, as logarithmic scales can
compress this range for easier visualization and analysis.
• Each approach has its own advantages and may be chosen based on the specific
requirements of the analysis or personal preference.
Weighted Average Cost of Capital (WACC)
Financing of a firm: From Debt and Equity. Both will have attached cost in relation to its proportion.

Interest Bearing
Debt
Not all
liabilities
Returns
• Dollar Returns
the sum of the dividend income Dividends
and the capital gain or loss on the
investment Ending
market value

Time 0 1

Percentage Returns
Initial the sum of the dividend income and
investment the change in value of the asset,
divided by the initial investment.
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Returns
Dollar Return = Dividend income + Capital gain (or loss)

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Returns: Example - I
• Suppose you bought 100 shares of XYZ Co. one year ago today at $45.
Over the last year, you received $27 in dividends (27 cents per share × 100
shares). At the end of the year, the stock sells for $48. How did you do?

• You invested $45 × 100 = $4,500. At the end of the year, you have stock
worth $4,800 and cash dividends of $27. Your dollar gain was $327 = $27
+ ($4,800 – $4,500).

• Your percentage gain for the year is:

$327
7.3% =
$4,500
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Returns: Example – II
Dollar Return:
$27
$327 gain
$300

Time 0 1
Percentage Return:
$327
–$4,500 7.3% =
$4,500

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Holding Period Returns
• The holding period return is the return that an investor
would get when holding an investment over a period
of T years, when the return during year i is given as Ri:

HPR = (1 + R1) × (1 + R2) × …× (1 + Rn) – 1

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Holding Period Return: Example
• Suppose your investment provides the following
returns over a four-year period:

Your holding period return 

 (1 R1 )  (1 R2 )  (1 R3 )  (1 R4 ) 1
 (1.10)  (.95)  (1.20)  (1.15) 1
 .4421  44.21%


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Return Statistics
• The history of capital market returns can be summarized by
describing the:
• average return

• the standard deviation of those returns

𝑆𝐷= √ 𝑉𝐴𝑅= √ ¿ ¿ ¿
• the frequency distribution of the returns

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Historical Returns, 1926-2017

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Average Stock Returns and Risk-Free Returns
• The risk premium is the added return (over and above the risk-
free rate) resulting from bearing risk.
• One of the most significant observations of stock market data
is the long-run excess of stock return over the risk-free return.
• The average excess return from large company common stocks for
the period 1926 through 2017 was:
8.7% = 12.1% – 3.4%
• The average excess return from small company common stocks for
the period 1926 through 2017 was:
13.1% = 16.5% – 3.4%
• The average excess return from long-term corporate bonds for the
period 1926 through 2017 was:
3.0% = 6.4% – 3.4%

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 The Present Value of Common Stocks

• The value of any asset is the present value of its expected future cash
flows.
• Stock ownership produces cash flows from:
• Dividends
• Capital Gains
• Valuation of Different Types of Stocks
• Zero Growth
• Constant Growth
• Differential Growth

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Case 1: Zero Growth
• Assume that dividends will remain at the same level
forever

· Since future cash flows are constant, the value of a zero

growth stock is the present value of a perpetuity:

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Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g,
forever, i.e.,

Since future cash flows grow at a constant rate forever,

the value of a constant growth stock is the present value
of a growing perpetuity:

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Constant Growth Example
• Suppose Big D, Inc., just paid a dividend of $.50. It is
expected to increase its dividend by 2% per year. If the
market requires a return of 15% on assets of this risk level,
how much should the stock be selling for?
• P0 = .50(1 + .02) / (.15 – .02) = $3.92

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Case 3: Differential Growth – I

• Assume that dividends will grow at different rates in the

foreseeable future and then will grow at a constant rate
thereafter.
• To value a differential growth stock, we need to:
• Estimate future dividends in the foreseeable future.
• Estimate the future stock price when the stock becomes a constant growth
stock (Case 2).
• Compute the total present value of the estimated future dividends and future
stock price at the appropriate discount rate.

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Case 3: Differential Growth – II
· Assume that dividends will grow at rate g1 for N
years and grow at rate g2 thereafter.

..
.

..
.
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Case 3: Differential Growth – III
Dividends will grow at rate g1 for N years and grow
at rate g2 thereafter

…
0 1 2

… …
N N+1
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Case 3: Differential Growth – IV
We can value this as the sum of:
 a T-year annuity growing at rate g1

C  (1 g1 ) T 
PA  1  T 
R  g1  (1 R) 
 plus the discounted value of a perpetuity growing at
rate g2 that starts in year T+1



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Case 3: Differential Growth - V

Consolidating gives:

Or, we can “cash flow” it out.

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A Differential Growth Example

• A common stock just paid a dividend of $2. The dividend

is expected to grow at 8% for 3 years, then it will grow at
4% in perpetuity.
• What is the stock worth? Assume the discount rate is 12%.

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 With the Formula
$2(1.08) 3 (1.04) 
 
$2  (1.08)  (1.08)   .12  .04 
3
P 1  3 
.12  .08  (1.12)  (1.12) 3

$32.75
P  $54  1  .8966  3
(1.12)

P  $5.58  $23.31 P  $28.89

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With Cash Flows
Estimates of Parameters in the Dividend Discount
Model

• The value of a firm depends upon its growth rate, g,

and its discount rate, R.
• Where does g come from?
g = Retention ratio × Return on retained earnings

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Where Does R Come From?
• The discount rate can be broken into two parts.
• The dividend yield
• The growth rate (in dividends)
• In practice, there is a great deal of estimation error
involved in estimating R.

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Using the DGM to Find R
• Start with the DGM:

Rearrange and solve for R:

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Comparables

• Comparables are used to value companies based

primarily on multiples.
• Common multiples include:
• Price-Earnings Ratios
• Enterprise Value Ratios

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Price-Earnings Ratio
• The price-earnings ratio is calculated as the current
stock price divided by annual EPS.
• The Wall Street Journal uses last four quarters’ earnings

Price per share

P/E ratio 
EPS

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Enterprise Value Ratios
• The PE ratio focuses on equity, but what if we want the value of
the firm?
• Use enterprise value:
• EV = market value of equity + market value of debt – cash
• Like PE, we compare the value to a measure of earnings. From
a firm level, this is EBITDA, or earnings before interest, taxes,
depreciation, and amortization.
• EBITDA represents a measure of total firm cash flow
• The Enterprise Value Ratio = EV / EBITDA

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Market and Limit Orders
• Market orders:
• You specify ticker and quantity
• Immediate execution at best available price
• Market buy will be executed at lowest ask
• Market sell will be executed at highest bid

• Limit orders:
• You specify ticker, quantity, and price
• The order will be executed only if trade can be made at the limit price or
better
• Limit buy can only be executed at limit price or lower
• Limit sell can only be executed at limit price or higher

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Stop Orders
• The stop price is the trigger or activation point.
• If the stop price is reached or passed, the order
becomes a market order to be executed at the best
available price.
• Risk: price suddenly plummets or rises and the
execution price is much different than expected.

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NASDAQ

• Not a physical exchange—computer-based quotation system

• Multiple market makers
• Electronic communications networks
• Three levels of information
• Level 1—timely, accurate quotes, freely available
• Level 2—view quotes from all NASDAQ market makers, small fee
• Level 3—view and update quotes, market makers only
• Large portion of technology stocks

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End
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