Pre and Post Merger P-E Ratios

MFE 230G: 2007
Key Formulas: Risk, Valuation, Behavioral Finance
Risk Modeling
Problems with historical risk modeling:
 Data requirements. Need the number of periods of history to exceed the
number of stocks.
 Handling of new assets.
 Handling of assets whose characteristics (and variances and covariances)
have changed over time.
Single Factor Model (Simplified version of Sharpe’s Market Model):

Cov { d n , d m } = 0 if n �m
V = e�T
eΔ s B2 +
�
 Note that the active covariance matrix is diagonal. Under this assumption,
our active positions take the simple form:
an
hPA ( n ) =
2l �
wn2
Factor Models:
r = X�
b+u
V = X ��
F XΔ T
+
 Each month, we separate returns into common factor components, and a
specific component.
 Our covariance matrix consists of a common factor piece, and a specific
piece. We assume specific returns are uncorrelated. We choose common
factors to completely capture the common components of returns.
 There are three main approaches to determining factors:
o Fundamental factors: we specify exposures and estimate monthly or
daily factor returns.
o Macroeconomic factors: we specify changes in macreconomic
variables, and estimate individual stock exposures to those factors via
time series regressions for each stock.
o Statistical factors: We jointly estimate factors and exposures, under
the assumption that exposures do not change over our estimation
period.
 Given a covariance matrix, we can estimate betas more accurately than by
simply running historical regressions.
Marginal Contributions to Risk

Key Formulas and Concepts: Risk, Valuaton page 2
1/15/2019
The marginal contribution to active risk measures the change in active risk given a
small change in position:
�w V� h PA
MCAR = TP =
� h PA wP
At optimality these marginal contributions are directly related to alphas:
α = 2l �wP � MCAR
� IR � MCAR
This allows us to back out implied alphas from a given portfolio P.
Testing Risk Forecasts:

Given a set of observed returns {r(t)}, and risk forecasts {s(t)}, we can calculate
the standardized outcomes:
r ( t)
x( t) = .
s ( t)
To test the accuracy of these forecasts after T observations, calculate the bias:
bias = StDev { x ( t ) t = 1,...T }
If the bias>1, we have underestimated risk. If the bias<1, we have overestimated
risk. We can estimate the statistical significance of the difference from 1 using
the standard error of a sample standard deviation (assuming normal distributions):
bias
SE { bias} =
2T
Valuation
We discussed several approaches to valuation, from those firmly grounded in
theory, to those more ad hoc in nature. We also discussed approaches focused on
the stock price, and approaches focused on stock returns.
Stock Price: Theory

In theory, today’s stock price represents the present value of all future dividend
payments. One approach to implementing that theory is the constant growth
dividend discount model (constant growth DDM). This model assumes that
dividends grow at a constant growth rate, g; and that we discount future dividends
at a constant internal rate of return, y:
d ( 1)
P ( 0) =
y-g
In Equation we represent current price at P(0), and assume a dividend payment of
d(1) at the end of 1 year. We can rewrite Equation in terms of the internal rate of
return:
d ( 1)
y = iF + f B + a = g +
P ( 0)
1/15/2019
We discussed how to model growth, assuming that growth follows from

reinvesting earning in the company at the same return on equity, . If  represents
the constant payout ratio (the fraction of earnings paid out as dividends) then:
g = � ( 1-  )
There are two ways we can use the DDM:
 Internal Rate of Return: For each stock, back out the internal rate of
return, y, that equates P(0) to the market price. Then use Equation to
estimate an alpha. This approach assumes that market mispricings remain
forever.
 Net Present Value: For each stock, calculate the fair internal rate of return
( iF + f B ), and the growth rate, and then estimate the fair price. Estimate a
time over which the market price will return to fair value. This leads to an
alpha estimate.
We also discussed returns to value investing under several different
circumstances. We start at t=0 with a market price and a true price (Equation ).
We used the payout ratio to replace the dividends with the payout ratio times
earnings, so that we could discuss both the true price/earnings ratio and the
market’s current price/earnings ratio. At t=1, our returns are:
d (1) + Pmkt (1)
r= -1
Pmkt (0)
We calculated this under two different circumstances:
 At t=1, the market price matched the t=1 true price.
 At t=1, the market multiple was the same as at t=0.
Stock Price: Ad Hoc

We also discussed comparative valuation approaches. These extended Equation ,
assuming that stock prices we based on multiples of various fundamentals:
d ( 1)
PDDM ( 0 ) = d ( 1)
= c�
y-g
PCV ( 0 ) � c1 �
d + c2 �
earnings + c3 �
book + K
Stock Return: Theory

We discussed the arbitrage pricing theory (APT). This theory started from a
factor model (Equation ), and imposed no-arbitrage conditions to assert that
expected specific returns must be zero. Hence, expected returns must arise from
expected factor returns, where the factors represent sources of risk that some
market participants must bear. Under this model, expected returns hence have the
form:
f = X� m
m = E { b}
Stock Return: Ad Hoc

1/15/2019
The most general approach is to extend the APT framework to also allow us to
forecast specific returns. In general, we construct models that look like:
r = X�b+ A� gε+
We can forecast the factor returns as in Equation . We can also forecast the
coefficients g. In fact, we typically pick signals A such that g are relatively
constant. So if A represented analyst estimate revisions, the coefficient g would
tell us the expected return given such revisions.
Behavioral Finance
Behavioral finance research has uncovered several types of systematic
irrationality:
 Social interactions (conforming, follow-the-crowd behavior)
 Heuristic simplification (generalizing from personal experience and recent
events)
 Self-deception (over-confidence)
Behavioral finance has two implications for active management:
 It helps make active management possible.
 In principle, it can lead us to develop new active strategies.
One example of behavioral research was Sloan’s work, “Do Stock Prices Fully
Reflect Information in Accruals and Cash Flows about Future Earnings.” Part of
that research was econometric: cash flows are more persistent than accruals. But
another part—and the part that made this of interest to active managers—was that
the market didn’t understand this difference.

Pre and Post Merger P-E Ratios

Uploaded by

Copyright:

Available Formats

Pre and Post Merger P-E Ratios

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Pre and Post Merger P-E Ratios

Uploaded by

Copyright:

Available Formats

MFE 230G: 2007

Key Formulas: Risk, Valuation, Behavioral Finance

Single Factor Model (Simplified version of Sharpe’s Market Model):

Marginal Contributions to Risk

Testing Risk Forecasts:

Stock Price: Theory

We discussed how to model growth, assuming that growth follows from

Stock Price: Ad Hoc

Stock Return: Theory

Stock Return: Ad Hoc

You might also like