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CHAPTER 10
Capital Markets and the Pricing of Risk

Berk, DeMarzo, and Thampy
Financial Management
Pearson
Chapter Outline
10.1 A First Look at Risk and Return
10.2 Common Measures of Risk and Return
10.3 Historical Returns of Stocks and Bonds
Copyright 2007 Pearson Addison-Wesley. All rights reserved. 10-2
10.4 The Historical Tradeoff Between Risk
and Return
Chapter Outline (cont'd)
10.5 Common Versus Independent Risk
10.6 Diversification in Stock Portfolios
10.7 Estimating the Expected Return
10.8 Risk and the Cost of Capital
10.9 Capital Market Efficiency
Figure 10.1 Value of $100 Invested at the End of 1925
in U.S. Large Stocks (S&P 500), Small Stocks, World
Stocks, Corporate Bonds, and Treasury Bills
10.1 A First Look at Risk and Return
Small stocks had the highest long-term returns,
while T-Bills had the lowest long-term returns.
Small stocks had the largest fluctuations in price,
while T-Bills had the lowest.
while T-Bills had the lowest.
Higher risk requires a higher return.
Returns Concepts
Realized Return
The return actual return earned on a stock
Historical Return
The returns earned on a stock in the past
Expected Return
The return you expect to earn on a stock in the future
10.3 Historical Returns
of Stocks and Bonds
Computing Historical Returns
Realized Return
The return that actually occurs over a particular time period.
Div + P Div P P

R
t + 1
=
Div
t + 1
+ P
t + 1

P
t
1 =
Div
t + 1
P
t
+
P
t + 1
P
t

P
t
= Dividend Yield + Capital Gain Rate
10.2 Common Measures
of Risk and Return
Probability Distribution
When an investment is risky, there are different returns
it may earn. Each possible return has some likelihood
of occurring. This information is summarized with a
probability distribution, which assigns a probability, P
R
,
probability distribution, which assigns a probability, P
R
,
that each possible return, R , will occur.
10.3 Historical Returns
of Stocks and Bonds (cont'd)
Computing Historical Distributions
By counting the number of times a realized return
falls within a particular range, we can estimate the
underlying probability distribution.
Empirical Distribution
When the probability distribution is plotted using
historical data
Figure 10.4 The Empirical Distribution of Annual
Returns for U.S. Large Stocks (S&P 500), Small Stocks,
Corporate Bonds, and Treasury Bills, 19262004.
Table 10.3
Average Annual Return
Where R
t
is the realized return of a security in year t, for
the years 1 through T
( )
1 2
1
1 1

=
= + + + =

T
T t
t
R R R R R
T T
the years 1 through T
Using the data from Table 10.2, the average annual return
for the S&P 500 from 19962004 is:
1
(0.230 0.334 0.286 0.210 0.091
9
0.119 0.221 0.287 0.109) 11.4%
= + + +
+ + =
R
The Variance and Volatility of Returns
Variance Estimate Using Realized Returns
( )
2
1
1
( )
1
=
=

T
t
t
Var R R R
T
The estimate of the standard deviation is the square
root of the variance.
Example 10.3
Example 10.3 (cont'd)
Table 10.4
Using Past Returns to Predict the Future:
Estimation Error
We can use a securitys historical average return
to estimate its actual expected return. However,
the average return is just an estimate of the
expected return.
expected return.
10.4 The Historical Tradeoff
Between Risk and Return
The Returns of Large Portfolios
Excess Returns
The difference between the average return for an
investment and the average return for T-Bills
Table 10.5
Figure 10.5 The Historical Tradeoff Between
Risk and Return in Large Portfolios, 19262004
Note the positive relationship between volatility and average returns for large portfolios.
The Returns of Individual Stocks
Is there a positive relationship between volatility
and average returns for individual stocks?
As shown on the next slide, there is no precise
relationship between volatility and average return for
individual stocks.
individual stocks.
Larger stocks tend to have lower volatility than
smaller stocks.
All stocks tend to have higher risk and lower returns than
large portfolios.
Figure 10.6 Historical Volatility and Return
for 500 Individual Stocks, by Size, Updated
Quarterly, 19262004
10.5 Common Versus Independent Risk
Common Risk
Risk that is perfectly correlated
Risk that affects all securities
Independent Risk
Independent Risk
Risk that is uncorrelated
Risk that affects a particular security
Diversification
The averaging out of independent risks in a
large portfolio
10.6 Diversification
in Stock Portfolios
Firm-Specific Versus Systematic Risk
Independent Risks
Due to firm-specific news
Also known as:
Also known as:
Firm-Specific Risk
Idiosyncratic Risk
Unique Risk
Unsystematic Risk
Diversifiable Risk
in Stock Portfolios (cont'd)
Common Risks
Due to market-wide news
Also known as:
Also known as:
Systematic Risk
Undiversifiable Risk
Market Risk
in Stock Portfolios (cont'd)
When many stocks are combined in a large portfolio,
the firm-specific risks for each stock will average out
and be diversified.
The systematic risk, however, will affect all firms and
will not be diversified.
No Arbitrage and the Risk Premium
The risk premium for diversifiable risk is zero, so
investors are not compensated for holding firm-
specific risk.
If the diversifiable risk of stocks were compensated with
an additional risk premium, then investors could buy the
an additional risk premium, then investors could buy the
stocks, earn the additional premium, and
simultaneously diversify and eliminate the risk.
No Arbitrage
and the Risk Premium (cont'd)
By doing so, investors could earn an additional
premium without taking on additional risk. This
opportunity to earn something for nothing would quickly
be exploited and eliminated. Because investors can
eliminate firm-specific risk for free by diversifying their
portfolios, they will not require or earn a reward or risk
portfolios, they will not require or earn a reward or risk
premium for holding it.
No Arbitrage
The risk premium of a security is determined by
its systematic risk and does not depend on its
diversifiable risk.
This implies that a stocks volatility, which is a measure
of total risk (that is, systematic risk plus diversifiable
of total risk (that is, systematic risk plus diversifiable
risk), is not especially useful in determining the risk
premium that investors will earn.
No Arbitrage
Standard deviation is not an appropriate measure
of risk for an individual security. There should be
no clear relationship between volatility and
average returns for individual securities.
Consequently, to estimate a securitys expected
Consequently, to estimate a securitys expected
return, we need to find a measure of a securitys
systematic risk.
Example 10.7
10.7 Estimating the Expected Return
Estimating the expected return will require
two steps:
Measure the investments systematic risk
Determine the risk premium required to compensate for
Determine the risk premium required to compensate for
that amount of systematic risk
Measuring Systematic Risk
To measure the systematic risk of a stock,
determine how much of the variability of its return
is due to systematic risk versus unsystematic risk.
To determine how sensitive a stock is to systematic
risk, look at the average change in the return for each
risk, look at the average change in the return for each
1% change in the return of a portfolio that fluctuates
solely due to systematic risk.
Measuring Systematic Risk (cont'd)
Efficient Portfolio
A portfolio that contains only systematic risk. There is
no way to reduce the volatility of the portfolio without
lowering its expected return.
Market Portfolio
An efficient portfolio that contains all shares and
securities in the market
The S&P 500 is often used as a proxy for the
market portfolio.
Measuring Systematic Risk (cont'd)
Beta ()
The expected percent change in the excess return of a
security for a 1% change in the excess return of the
market portfolio.
Beta differs from volatility. Volatility measures total risk
(systematic plus unsystematic risk), while beta is a measure
of only systematic risk.
Measuring Systematic Risk
Beta ()
A securitys beta is related to how sensitive its
underlying revenues and cash flows are to general
economic conditions. Stocks in cyclical industries, are
likely to be more sensitive to systematic risk and have
likely to be more sensitive to systematic risk and have
higher betas than stocks in less sensitive industries.
Estimating the Risk Premium
Market Risk Premium
The market risk premium is the reward investors expect
to earn for holding a portfolio with a beta of 1.
[ ]
Market Risk Premium = E R r
[ ]
Market Risk Premium =
Mkt f
E R r
Estimating the Risk Premium (cont'd)
Estimating a Traded Securitys Expected Return
from Its Beta
[ ]
[ ]
Risk-Free Interest Rate Risk Premium
( )
= +
= +
E R
r E R r
[ ]
( ) = +
f Mkt f
r E R r
Example 10.9
Alternative Example 10.9
Problem
Assume the economy has a 60% chance of the market
return will 15% next year and a 40% chance the market
return will be 5% next year.
Assume the risk-free rate is 6%.
If Microsofts beta is 1.18, what is its expected
return next year?
Solution
E[R
Mkt
] = (60% 15%) + (40% 5%) = 11%
E[R] = r
f
+ (E[R
Mkt
] r
f
)
E[R] = 6% + 1.18 (11% 6%)
E[R] = 6% + 1.18 (11% 6%)
E[R] = 6% + 5.9% = 11.9%
10.8 Risk and the Cost of Capital
A firms cost of capital for a project is the
expected return that its investors could earn on
other investments with the same risk.
Systematic risk determines expected returns, thus the
cost of capital for an investment is the expected return
cost of capital for an investment is the expected return
available on securities with the same beta.
The cost of capital for investing in a project is:
[ ]
( ) = +
f Mkt f
r r E R r
10.8 Risk and the Cost of Capital (cont'd)
Equations 10.10 and 10.11 are often referred to
as the Capital Asset Pricing Model (CAPM). It is
the most important method for estimating the cost
of capital that is used in practice.
CHAPTER 9
Valuing Stocks
Berk, DeMarzo, and Thampy
Financial Management
Pearson
Chapter Outline
9.1 Stock Prices, Returns, and the
Investment Horizon
9.2 The Dividend-Discount Model
9.3 Total Payout and Free Cash Flow 9.3 Total Payout and Free Cash Flow
Valuation Models
9.4 Valuation Based on Comparable Firms
9.5 Information, Competition, and Stock Prices
9.1 Stock Prices, Returns,
and the Investment Horizon
A One-Year Investor
Potential Cash Flows
Dividend
Sale of Stock
Timeline for One-Year Investor Timeline for One-Year Investor
Since the cash flows are risky, we must discount them at the
equity cost of capital.
9.1 Stock Prices, Returns,
and the Investment Horizon (cont'd)
A One-Year Investor
1 1
0

1

+
=

+
E
Div P
P
r
If the current stock price were less than this amount,
expect investors to rush in and buy it, driving up the
stocks price.
If the stock price exceeded this amount, selling it would
cause the stock price to quickly fall.
Dividend Yields, Capital Gains,
and Total Returns
Dividend Yield
Capital Gain

1 0 1 1 1
0 0 0
Dividend Yield Capital Gain Rate

1
+
= = +
E
P P Div P Div
r
P P P
Capital Gain
Capital Gain Rate
Total Return
Dividend Yield + Capital Gain Rate
The expected total return of the stock should equal the
expected return of other investments available in the market
with equivalent risk.
Example
Problem
3M (MMM) is expected to pay paid dividends of $1.92
per share in the coming year.
You expect the stock price to be $85 per share at the
end of the year. end of the year.
Investments with equivalent risk have an expected
return of 11%.
What is the most you would pay today for
3M stock?
What dividend yield and capital gain rate would you
expect at this price?
$1.92 $85 + + Div P
1
0
$1.92
Dividend Yield 2.45%
$78.31
= = =
Div
P
Solution
1 1
0
E
$1.92 $85
$78.31
(1 ) (1 .11)
+ +
= = =
+
Div P
P
r
1 0
0
$85.00 $78.31
Capital Gains Yield 8.54%
$78.31

= = =
P P
P
Total Return = 2.45% + 8.54% = 10.99%
11%
A Multi-Year Investor
What is the price if we plan on holding the stock
for two years?
1 2 2
0
2
E E

1 (1 )
+
= +
+ +
Div Div P
P
r r
A Multi-Year Investor (cont'd)
The price of any stock is equal to the present
value of the expected future dividends it will pay.
3 1 2
0
2 3
1
E E E E

1 (1 ) (1 ) (1 )
=
= + + + =
+ + + +
n
n
n
Div Div Div Div
P
r r r r
9.2 The Discount-Dividend Model
Constant Dividend Growth
The simplest forecast for the firms future dividends
states that they will grow at a constant rate, g, forever.
9.2 The Discount-Dividend Model (cont'd)
Constant Dividend Growth Model
1
0
E

=
Div
P
r g
The value of the firm depends on the current dividend
level, the cost of equity, and the growth rate.
1
E
0
= +
Div
r g
P
Example
Problem
AT&T plans to pay $1.44 per share in dividends in the
coming year.
Its equity cost of capital is 8%. Its equity cost of capital is 8%.
Dividends are expected to grow by 4% per year
in the future.
Estimate the value of AT&Ts stock.
1
$1.44
$36.00 = = =
Div
P
Solution
1
0
E
$1.44
$36.00
.08 .04
= = =

Div
P
r g
Dividends Versus Investment and Growth
A Simple Model of Growth
A firm can do one of two things with its earnings:
It can pay them out to investors.
It can retain and reinvest them It can retain and reinvest them
Dividend Payout Ratio
The fraction of earnings paid as dividends each year
Retention Rate
Fraction of current earnings that the firm retains
Dividends Versus Investment and Growth
A Simple Model of Growth

Dividend Payout Rate
t
=Div
t
/
Earnings
t

Shares Outstanding
t
EPS
t

1 2 4 4 4 3 4 4 4

Retention Rate = (1 - Dividend Payout Rate)
If the firm keeps its retention rate constant, then
the growth rate in dividends will equal the growth
rate of earnings.
Retention Rate Return on New Investment = g

Retention Rate = (1 - Dividend Payout Rate)
Dividends Versus Investment
and Growth (cont'd)
Profitable Growth
If a firm wants to increase its share price, should it cut
its dividend and invest more, or should it cut investment
and increase its dividend?
The answer will depend on the profitability of the The answer will depend on the profitability of the
firms investments.
Cutting the firms dividend to increase investment will raise
the stock price if, and only if, the new investments have a
positive NPV.
Example 9.3
Example 9.4
Changing Growth Rates
We cannot use the constant dividend growth
model to value a stock if the growth rate is
not constant.
For example, young firms often have very high initial
earnings growth rates. During this period of high earnings growth rates. During this period of high
growth, these firms often retain 100% of their earnings
to exploit profitable investment opportunities. As they
mature, their growth slows. At some point, their
earnings exceed their investment needs and they begin
to pay dividends.
Changing Growth Rates (cont'd)
Although we cannot use the constant dividend
growth model directly when growth is not
constant, we can use the general form of the
model to value a firm by applying the constant
growth model to calculate the future share growth model to calculate the future share
price of the stock once the expected growth
rate stabilizes.
Changing Growth Rates (cont'd)
Dividend-Discount Model with Constant Long-
Term Growth
1
E

+
=
N
N
Div
P
r g
1 1 2
0
2
E E E E E
1

1 (1 ) (1 ) (1 )
+

= + + + +

+ + + +

N N
N N
Div Div Div Div
P
r r r r r g
Example 9.5
Limitations of the
Dividend-Discount Model
There is a tremendous amount of uncertainty
associated with forecasting a firms dividend
growth rate and future dividends.
Small changes in the assumed dividend growth Small changes in the assumed dividend growth
rate can lead to large changes in the estimated
stock price.
9.4 Valuation Based on Comparable Firms
Method of Comparables (Comps)
Estimate the value of the firm based on the value of
other, comparable firms or investments that we expect
will generate very similar cash flows in the future.
Valuation Multiples
Valuation Multiple
A ratio of firms value to some measure of the firms
scale or cash flow
The Price-Earnings Ratio The Price-Earnings Ratio
P/E Ratio
Share price divided by earnings per share
Valuation Multiples (cont'd)
Trailing Earnings
Earnings over the last 12 months
Trailing P/E
Forward Earnings
Expected earnings over the next 12 months
Forward P/E
Firms with high growth rates, and which generate
cash well in excess of their investment needs so
that they can maintain high payout rates, should
have high P/E multiples.
0 1 1
1 E E
/ Dividend Payout Rate
Forward P/E

= = =

P Div EPS
EPS r g r g
Example 9.9
Problem
Best Buy Co. Inc. (BBY) has earnings per share
of $2.53.
The average P/E of comparable companys stocks The average P/E of comparable companys stocks
is 19.3.
Estimate a value for Best Buy using the P/E as a
valuation multiple.
Solution
The share price for Best Buy is estimated by
multiplying its earnings per share by the P/E of
comparable firms.
P
0
= $2.53 19.3 = $48.83 P
0
= $2.53 19.3 = $48.83
Enterprise Value Multiples
0 1 1
1
/

=
wacc FCF
V FCF EBITDA
EBITDA r g
This valuation multiple is higher for firms with high
growth rates and low capital requirements (so that free
cash flow is high in proportion to EBITDA).
1 wacc FCF
Example 9.10
Other Multiples
Multiple of sales
Price to book value of equity per share
Enterprise value per subscriber Enterprise value per subscriber
Used in cable TV industry
Limitations of Multiples
When valuing a firm using multiples, there is no
clear guidance about how to adjust for differences
in expected future growth rates, risk, or
differences in accounting policies.
Comparables only provide information regarding Comparables only provide information regarding
the value of a firm relative to other firms in the
comparison set.
Using multiples will not help us determine if an entire
industry is overvalued,
Comparison with Discounted
Cash Flow Methods
Discounted cash flows methods have the
advantage that they can incorporate specific
information about the firms cost of capital or
future growth.
The discounted cash flow methods have the potential to
be more accurate than the use of a valuation multiple.
Stock Valuation Techniques:
The Final Word
No single technique provides a final answer
regarding a stocks true value. All approaches
require assumptions or forecasts that are too
uncertain to provide a definitive assessment of the
firms value. firms value.
Most real-world practitioners use a combination of
these approaches and gain confidence if the results are
consistent across a variety of methods.
Figure 9.2 Range of Valuation Methods for KCP
Stock Using Alternative Valuation Methods

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CHAPTER 10

Capital Markets and the Pricing of Risk

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