Developing an efficient portfolio of stocks can seem daunting. The journey begins by understanding one’s financial objectives and associated appetite for risk. To assist with the development of the efficient portfolio numerous financial models and evaluation tools are available. These tools can lend insight into positive net present value (NPV) opportunities based on current conditions. These tools also assist with developing a portfolio capable of diversifying away the idiosyncratic risks.
Investors can identify value within the market however this value does not last long. Competition to realize a positive NPV brings the stock back into sync with the rest of the market. This adjustment is known as the efficient market hypothesis (Berk & DeMarzo, 2011). This hypothesis suggests the average investor will have a difficult time identifying positive NPV opportunities. To do this would require unique information the rest of the investment community has yet to learn (i.e. Insider information). The average investor is capable of developing a portfolio that offers the greatest return opportunities based on their aversion to risk. Higher risk (i.e. more speculative opportunities) requires greater payback to make them attractive versus low risk opportunities.
This assessment will evaluate two stock evaluation models; dividend discount and discounted free cash flow. The models will be applied to General Electric’s stock based on current information taken from Yahoo Finance on March 5, 2014. This evaluation will conclude with a discussion of differences between the two models and why these models lead to different estimates regarding value.
Assessment
General Electric (GE) is a global company serving customers in mor...
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... because it is so far removed from the current efficient market trading price. This illustrates the importance of having multiple methods at an investor’s disposal to avoid costly outcomes. If the true value was close to $83 the market would quickly swarm to buy up outstanding shares bringing the stock back into equilibrium.
Works Cited
Berk, J., & DeMarzo, P. (2011). Corporate finance: The core, second edition. (2nd ed.). Boston, MA: Prentice Hall.
Reuters - general electric. (2014, March 5). Retrieved from http://www.reuters.com/finance/stocks/companyProfile?symbol=GE.N
Yahoo finance. (2014, March 5). Retrieved from http://finance.yahoo.com/q;_ylt=AsSsPsK1mlhURru84yZxWVqiuYdG;_ylu=X3oDMTBxdGVyNzJxBHNlYwNVSCAzIERlc2t0b3AgU2VhcmNoIDEx;_ylg=X3oDMTBybHFhOHFvBGxhbmcDZW4tVVMEcHQDMgR0ZXN0AzUxMjAxNQ--;_ylv=3?uhb=&fr=uh3_finance_vert_gs&type=2button&s=GE
The stock price is currently 103.31, down from a recent high of 121.50. The P/E ratio is declining at 28 and beta at .67, which is expected to grow closer to 1.0. A recent earnings surprise last December yielded a 15% difference from the lower expectations and the latest earnings reports late last month also surprised investors. Estimates for the 2000 fiscal year are being raised by a large majority of analyst who believe that earnings per share will increase and the stock price will reach close to 150.
Based on the Terminal P/E and the cost of equity I made a sensitivity analysis chart through which I came up with a price of $33.37. This chart shows the different price ranges of the stock which could be possible if the Terminal P/E went higher or lower compared to the Cost of Equity.
... Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297.
The Efficient Market Hypothesis suggests that market prices fully reflect all information available to the public. However, practitioners and regulator are uncertain as to the validity of this hypothesis. The questions that Bloomfield raises are: If market prices truly reflect information, why do investors waste efforts by trying to identify mispriced stock prices? Why do managers try to hide bad news in footnotes? And why do regulators try to prevent them from doing this? Robert J. Bloomfield presents an alternative to EMH called the Incomplete Revelation Hypotheses. IRH suggests that statistical data which is more costly drives fewer trading interest. Therefore information that is more costly to extract from publicly available information is not fully reflected in the market prices.
There are many valuation methods that could be used to evaluate this company. Finding a method that valuates the stand-alone value is difficult. The stand-alone value should be dependent upon the firm’s own assets and projected future income. We decided to evaluate this company based upon two methods: The Discounted Cash Flow Method and the Comparable Companies Method.
Ross, S.A., Westerfield, R.W., Jaffe, J. and Jordan, B.D., 2008. Modern Financial Management: International Student Edition. 8th Edition. New York: McGraw-Hill Companies.
William Sharpe, Gordon J. Alexander, Jeffrey W Bailey. Investments. Prentice Hall; 6 edition, October 20, 1998
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).
According to Investopedia (Asset Allocation Definition, 2013), asset allocation is an investment strategy that aims to balance risk and reward by distributing a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. There are three main asset classes: equities, fixed-income, cash and cash equivalents; but they all have different levels of risk and return. A prudent investor should be careful in allocating each asset class to his portfolio. Proper asset allocation is a highly debatable subject and is not designed equally for everybody, but is rather based on the desires and needs of the individual investor. This paper discusses the importance of asset allocation, the differences and the proper diversification within the portfolio.
In the last few decades, America’s automotive industry has been losing revenue, decline of market share, and employment reduction but international business in the auto industry has been the opposite. For instance, General Motors (GM) have been doing poor in the automotive business while Honda, a Japanese manufacture have been increasing their sales, market shares and employment.
The efficient market hypothesis has been one of the main topics of academic finance research. The efficient market hypotheses also know as the joint hypothesis problem, asserts that financial markets lack solid hard information in making decisions. Efficient market hypothesis claims it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information . According to efficient market hypothesis stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments . In reality once cannot always achieve returns in excess of average market return on a risk-adjusted basis. They have been numerous arguments against the efficient market hypothesis. Some researches point out the fact financial theories are subjective, in other words they are ideas that try to explain how markets work and behave.
Block, S. B., & Hirt, G. A. (2005). Foundations of financial management. (11th ed.). New York: McGraw-Hill.
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.
Studying Banking and Finance at University of St.Gallen will help me further increase my proficiency of corporate finance and financial markets. The in-depth research of specific topics, as well as a comprehensive curriculum, is a possibility for me to focus on my topic of interest ...