# financial investment analysis

Project 2 ECON 475/675, Fall 2015

You must turn in hardcopy on 12/8 before class in my office, or in class on 12/8. If for any reason you cannot be on campus to turn this in on 12/8 it is up to you to arrange for someone else to turn it in for you (or turn it in before 12/8). Projects handed in after 12/8, but on or before the day of the final exam, will lose 5 of the 15 points automatically. No projects will be accepted after the final exam.

This purpose of this is to:

• be sure that you can correctly apply the 2-stage dividend discount model to value a stock.

• be sure you can use online option pricing calculators.

• make you aware of the resources available to access research on investment management topics.

For Part A and Part B you can use either of the two stocks you used for Project 1. You can use the same stock for parts A and B, or one for A and the other for B.

Part A

Value one stock using the dividend discount model of stock valuation with two periods of constant growth. See chapter 18 of the textbook, the problems we did in class, or the practice problems for Exam I, to review of this model. Make the following assumptions:

• For the growth rate during the first growth period (g) use the analyst 5-year growth forecast. From Yahoo! Finance enter the stock symbol in the Quote Lookup (click Go) and get to the stock’s page. From there go to Analyst Estimates and then find Growth Estimate Next 5 years for the stock (bottom of the screen). This is EPS growth (g), but assume DPS growth = EPS growth. For D1 use the Forward Annual Dividend Rate (a $ amount) on the stock’s Yahoo! Finance page (with Key Statistics). Recall that the corporation had to have an annual dividend per share ≥ $1 for you to use it. Assuming that the DPS will grow at the analysts growth estimate (g), you can find D2 through D5 as: D2 = D1(1 + g), D3 = D2(1 + g), and so on out to D5 = D4(1 + g). Note that g is in decimals (like 0.07), not percent (7%), when using this formula.

• At year 5 year assume that growth is 0.03 per year (3%) thereafter. In other words, the year 6 dividend estimate is D6 = D5(1.03). Therefore the year 5 expected stock price is E(P5) = D6/(k – 0.03), because at that point we are in constant growth forever and can use the simple constant growth formula to get E(P5).

• For the market capitalization rate (k) use the capital asset pricing model (CAPM) as in Project 1. For the risk-free rate, rF, use the 10-year Treasury Bond rate shown on from the Yahoo! Finance website homepage. For example, if Yahoo shows 2.7% you would use the decimal form, 0.027. For the market risk premium, [E(rM) – rF], use 0.06 (6%). Find the beta that Yahoo! shows for the stock (this is with with Key Statistics). Calculate the adjusted beta as in Project 1 and use this when you calculate k (k = rf + βadjusted[0.06]). Be sure that you use the decimal value for k not the percent value, when you calculate the present values below.

What value do you find for the stock today (V0)? That is, V0 = D1/(1 + k) + D2/(1 + k)2 + D3/(1 + k)3 + D4/(1 + k)4 + D5/(1 + k)5 + E(P5)/(1 + k)5. The sum of these will be your stock value estimate today, V0.

What is the current market price of the stock price, P0? How does the V0 you found compare with P0? Unless it’s an amazing coincidence, V0 and P0 will be different. Does what you find imply that this stock is an “undervalued” or an “overvalued” stock? State which, undervalued or overvalued. Does what you find imply that this stock would be a “buy” or a “sell” recommendation? State which, a buy or a sell.

By what percent is the value you find for V0 above or below P0? (For example if you find V0 is $58, and the current market price, P0, is $50, then V0 is 16% above P0.) If your answer is outside of the range of +/- 5% (as in the example I just showed) of the current market price (which is likely, but a few of you might be within +/- 5%), continue with the next part of this question. If your answer in inside the range of +/- 5% you have completed Part A.

Suppose now that you want to “prove” that the intrinsic value is equal to the market price, V0 = P0. Change only ONE of the following 3 assumptions until you can get your valuation to “equal” the current market price*: (1) the assumed [E(rM) – rF] value (make it higher or lower than 0.06 as needed), OR (2) the 5-year assumption of the first stage of growth (make it more or less than 5 years as needed), OR (3) the constant growth rate after 5 years (make it more or less than 0.03 as needed). You will be able to make it work (after some trial and error–use Excel!) by changing only ONE of these.

*When you get an answer that is within +/- 5% of the current market price this is close enough to say “equal” to the current market price. Clearly state what assumption you changed and show me the calculation that illustrates that you now have the V0 within +/- 5% of P0.

Summarize all of your answers and calculations in the spreadsheet you turn in.

Part B

Again, choose one of the stocks you used for Project 1.

Now go to: www.cboe.com

From there:

• Tools & Resources

• Calculators

• Options Calculator

Enter the ticker symbol of the corporation you will be using, click on Stock or Index Symbol, and click on Go!

On the left side of the screen you will see that it is now filled out for you. Change the Expiration Date with the drop down menu to the latest date in 2016. The website automatically chooses the option with the exercise (strike) price closest to the current stock price (so you can leave that as is).

Now click “calculate” in the middle of screen. Print this screen and circle the call option value that is calculated on the right side at the top. Also circle the Volatility value in the left side column—you will need this later.

Now go back and increase the volatility % on the left side by 10 (for example, if it was 25 make it 35). Now click “calculate” in the middle of screen. Print this screen and circle the call option value that is calculated. What happened to the call option value as compared to (is it higher or lower?) its value you circled on the first page when you assume a higher volatility? You can just write what happened on the page you printed.

Now go back and make volatility what is was before you changed it. On the bottom right of the screen you see Implied Volatility and under that Option Price and Vola % (now these should be blank and 0). From here leave it as “Call” and in the blank under Option Price (under Implied Volatility) enter a value that is higher (by say $3) than the call option value you circled in the first screen you printed. Now click the “calculate” at the bottom right. A number will appear under Vola %. This is the implied volatility of the stock given the call option price you entered (all the other variables held constant). Print this screen and circle the implied volatility. How does the implied volatility you found compare to (is it higher or lower?) the volatility you circled on the first page you printed? You can just write this on the page you printed.

Part C

An investment professional should be able to conduct research on a topic using the professional literature. In this part you will choose an article from an academic journal that is related to this course. This will allow you to examine a particular topic in which you might have an interest. You will write a three-page maximum (double-spaced, 12 point font) review of the article. The review should start with the citation of the article: title, author(s), journal, date of publication. Then go on to explain the objective of the article, summarize what the author(s) did to achieve this objective, summarize what the important results were, and explain why the results would be useful for an investment manager. You must include a copy of the article when you hand in the assignment (double-sided printing preferred). This must be a PDF of the full text of the article. With so many possibilities I do not expect any duplication of articles chosen by those in the class (it’s possible, but highly unlikely).

Where do I find the article?

You must choose any article related in some way to a topic that was covered in the course. The article must also be: (1) current (published in 2007 or after), (2) at least seven pages in length, and (3) from one of the journals listed below. Points will be deducted for not meeting any of these criteria. The two major journals in investment management are: Financial Analysts Journal, and Journal of Portfolio Management. Others that you can choose from are: Journal of Investing, Journal of Fixed Income, Journal of Private Equity, Journal of Alternative Investments, Journal of Real Estate Portfolio Management, Journal of Derivatives, Real Estate Finance, Journal of Asset Management, Journal of Wealth Management, Journal of Financial Planning, and Financial Services Review. DO NOT USE AN ARTICLE THAT IS NOT FROM THE PUBLICATIONS LISTED.

From the UMBC website go to the UMBC library website and login and go to Resources→ Research Port→ Databases→ Search for Databases then enter “Business Source Premier” where you search “by database name.” This gets you where you need to be: Business Source Premier. From there you can do a variety of searches, such as on journal name and word(s) in the article title. For example, if you are interested in “emerging markets” investments, you could search on Journal of Investing (Publication Name from drop down menu where is has select a field) and “emerging markets” (in the Title from drop down menu). When I did this recently I got 8 hits for articles published in 2007 or after with PDF Full Text (remember, you must have the PDF). A search on Journal of Investing (Publication Name) and “options” (in the Title) got 4 hits for articles published in 2007 or after. A search on Financial Analysts Journal (Publication Name) and “beta” (in the Title) got 2 hits for articles published in 2007 or after. A search on “beta” (in the Title), but for Journal of Investing had 4 hits. A search on Journal of Portfolio Management (Publication Name) and “alpha” (in the Title) got 17 hits for articles published in 2007 or after. A search on Journal of Portfolio Management (Publication Name) and “active management” (in the Title) got 9 hits for articles published in 2007 or after. A search on Journal of Alternative Investments (Publication Name) and “hedge funds” (in the Title) got 50+ hits for articles published in 2007 or after. A search on Journal of Investing (Publication Name) and “hedge funds” (in the Title) got 15 hits for articles published in 2007 or after. A search on Journal of Asset Management (Publication Name) and “risk” (in the Title) got 17 hits for articles published in 2007 or after. A search on Journal of Fixed Income (Publication Name) and “municipal bonds” (in the Title) got 2 hits for articles published in 2007 or after. A search on Journal of Wealth Management (Publication Name) and “retirement” (in the Title) got 6 hits for articles published in 2007 or after. Get the idea? If you pull up an article that sounds good, but then find that it is too advanced for you to understand (too mathematically or statistically advanced) keep looking until you find one that you can handle.

As before, your cover sheet will look something like:

ECON 475/675 Project 2

Your Name (#XX)

Professor Lamdin

Fall 2015

Pages: 12 (or whatever) including cover sheet

Next to your name put which number student you are in the class (see class roster file I posted on Blackboard which lists all students enrolled). This will be a number from 1 to 72. This number makes it easy for me to keep the projects in order for posting the grades, and for sending out an e-mail notice to you saying PROJECT NOT TURNED in if you don’t have this done by the due date.

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