Ch 9 Behavorial Finance Technical Analysis Information Processing Errors 1 P E effect when firm does well expected P E is usually forcasted too high bad investment extrapolation bias 2 Overconfidence result is bid stock prices too high 3 Conservatism anchoring bias earnings too slow in updating beliefs in response to new evidence momentum strategy buy past winners sell past losers Framing Errors 1 Mental accounting ex when cash is needed investors rather spend div than sell small portion of stocks to raise 2 Regret Avoidance ppl blame selves more for unconvential choices that turn out badly regret from losses joy from gains Prospect Theory theory that investory utility depends on gains losses from starting position not starting level of wealth becomes risk seeking w losses Standard Utility Theory wealth provides diminishing marginal utility gain 1000 utility than loss of 1000 Limits to Arbitrage 1 Fundamental Risk s in fundamentals can wipe out arbitrage profits making strategy risky 2 Short sale constraints make it difficult to abritrage overpriced securities 3 Model risk model may be giving wrong signals on mispricing Problems no coherent theory some behaviors contradict others many ideas come from 1 time period late 1990s behavioral lit very weak at providing solutions to probs Technical Analysis Rules TA assumes there are recurring predictable patterns in stock p which can be exploited to earn abnormal returns market p conform to new data only slowly giving rise to price trends prices affected by predictable behavioral psych Factors Types 1 Identifying trends using moving averages 2 Dow Theory trys to discern LT ST trends 3 types of trends only 2 import every stock has price peaks troughs if series are irsiing buy 3 Relative Strength ratio P Index ratio outperforming stock BUY 4 Breadth extent to which mvments in broad index are reflected widely in movements of individual stocks 5 Cumulative breadth add current days net advances declines to previous days total gauge trend 6 Odd Lot Index uninformed investors 7 Short interest high short interest may indicate stocks price expected to fall 8 Trin Statistic V declining declining V advancing advancing TA Sentiment Indicators 1 Confidence Index average yield on 10 top rated c bonds average yield on 10 intermediate grade c bonds 2 Put Call ratio change can be given a bullish or bearish interpreation Ch 13 Equity Valuation Book Value value of C E based on original cost not floor value for MV of equity if MV BV extreme distress Market Value measure current value of A L based on stock price better measure of value than BV Liquidiation Value net amt realized from sale of assets paying off all debt if MV liquidation value takeover target better measure of a floor stock price Replacement Cost cost to replace firms assets MV can t be replacement cost tend towards 1 for long b c competitors would replicate Tobin s Q MV Replacement cost over time Assessing value of firm Expected HPR E R E Div E P1 P0 P0 E R expected div yield capital gains yield Dt 1 Pt Required Return CAPM k rf E RM rf Stock priced correctly E R k Underpriced E R k Intrinsic Value V0 E Div1 E P1 Pt 1 Pt Pt 1 k V0 Vt 1 r t Vt Dt 1 r g If V0 P0 then BUY If V0 P0 then SELL or sell short In equilibrium V0 MV 2 Dividend Discount No growth model perpetuity V0 D k Constant growth model V0 D0 1 g OR V D1 g ROE x b k g b 1 dividend payout PVGO D0 1 g E1 k k g k g Multi stage growth model 3 V0 D1 D2 D3 D4 1 k 1 1 k 2 1 k 3 k g2 1 k 3 V0 D1 D2 D3 D4 P4 1 k 1 1 k 2 1 k 3 1 k 4 E1 k g where E1 E0 1 g 3 Price Earnings Ratio inverse relationship w required RoR k direct relationship w expected growth in div V0 P E x E1 Et Et 1 x 1 EPS growtht Dt Et x 1 div payut r Positive growth P0 1 b Zero growth P0 1 E1 k When ROE k investors indifferent b c stock price unaffected by b When ROE k investors prefer div payments over reinvements b c value as b When ROE k value as b growth always w b Riskier stocks will have lower P E multiples higher k s P E fall when inflation spikes b c lower quality earning OTHER Ratios P book high ratio large prem over BV floor value that is often far below market price P CF less subject to accounting manipulation than P E P Sales useful for firms w low negative earnings in early growth stage 4 Free Cash Flow useful for firms that don t pay div FCFF EBIT 1 TC Depre Cap Exp NWC Terminal value2 FCFF2 1 g WACC g Firm value PV Future FCFF CALC npv WACC CF0 CF1 CF2 TV Current stock price P0 Firm value Cash0 Debt0 Shares outstanding0 Equity value Firm value MV of Debt FCFE FCFF Int Exp 1 TC Pro Forma Sales sales EBIT NWC capex dep FCF Ch 18 Portfolio Performance Evaluation Passive Mgmt capital allocation btwn cash risky porfolio asset allocation within risky portfolio passiveness varies can either change weights or not Active Mgmt forecast future RoR on either both asset classes individual securities requires differential private info R P average excess return Abnormal performance risk adjusted performance positive alpha manager is doing well skilled Measure normal performance 1st Single index model RPt pRMt P ept E Rp Rf p RMt Rf P Measure abnormal return index 0 Jensen s Alpha Measure P R P P R M Possible conceptual problem greater abnormal return may be due to greater risk unless you can hedge out the risk w short sales you should rank portfolio performance w adjusted alpha P P Sharpe Ratios use when choosing among competiting optimal portfolios that WILL NOT BE MIXED Sharpe Ratio r P r f Choose option w largest ratio P P Treynor Ratios use when ranking many portfolios that WILL BE MIXED to form optimal risky portfolio Treynor Ratio r P r f ex mutual fund hedge fund very large funds Problems measures assume fund maintains constant level of risk doesn t recognize shift in mean as result of strategy change makes it appear riskier than it is in large universe of funds some funds have abnormal performance ine very period just by chance luck vs skill Style Analysis complex method of performance evaluation recent studies of mutual fund perform Hsow that 90 of variation in returns can be explained by funds allocation to bills bonds stocks explaining returns by allocation to style Morning Star s Risk Adjusted Rating RAR premier source of info on mutual funds companies are put into peer groups based on style def returns risk are measure based on fund perform in its worst years ranked on scale of 1 5 5 being best star ratings highly correlated to Sharpe measure rankings