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Investor Expectations Regarding Returns of a Stock
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What are reasonable market expectations in the way of return on a particular stock It depends in large part on the risk of the stock and the expected growth of the company s earnings and free cash flows. Remember the first principle of finance: With increasing risk, a rational investor should require increasing expected return.
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Let s assume that the risk-free, 10-year Treasury bond yields 7.0 percent, that the equity risk premium is 3 percent, and the stock is of average risk (beta 1.0) relative to the stock market as a whole. According to the Capital Asset Pricing Model that we described in Principle 10 of 2, our expected return for this stock is 10.00 percent. (We rigged this example to result in a nice round number.) The CAPM equation that follows shows the relationship between expected return, the risk-free rate, beta, and the equity risk premium. Expected Return from Stock Risk-Free Rate Beta*(Equity Risk Premium) 1) Stock 7.0% 1.0*(3.0%) 10%
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Beta is a measure of price volatility (risk) of an asset. If the risk of the stock is greater than average (e.g., the stock has more volatility and a beta of 2.0), a rational investor would require an expected return that is greater than that of a lower-beta stock. For example, based on a Treasury bond yield of 7 percent and an equity risk premium of 3 percent, the expected return of a beta 2 stock is: Expected Return from (Beta 2) Stock 7.0% 2.0*(3.0%) 13%
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If you buy a $100 (beta 1) stock on January 1 (which is difficult because the U.S. stock market is closed) that pays no dividend and has the risk characteristics described above, your expectation is that the stock will increase in value by 10 percent to $110 on December 31. Your hope is that it will become the next hot stock and will make you a millionaire. If you assume the same yield/risk profile, you expect that the stock will increase in price by another 10 percent to $121 by the following December 31st. If the $100 stock has a beta 2, your expectation is a progression in price to $113 (year 1) to $127.69 (year 2).3 As long as the stock performs in accordance with its perceived risk profile, your gain of 10 percent or 13 percent per year would have fulfilled your expectations. If the stock price exceeds your target levels, you re happy! If the stock price increases to less than your target levels, or decreases, you might still be happy, but you have been underpaid for the risk associated with owning that stock.
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If you pay too much for a stock it doesn t matter how good the company and its management are your investment will perform poorly. According to all measures of corporate performance, the company may be a great company, and its operations may be very efficient. Nevertheless, if the stock s price when you purchase it is much higher than the company s business operations can support, you ve made a bad investment decision. As an investor, your major concern is whether a stock s price is equal to, above, or below its true value at the time you buy it. This book and the ValuePro 2002 software show you how to estimate a stock s value and avoid purchasing overpriced stock.
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How Are Expectations of Growth Factored into Stock Prices
Many investors don t understand how expectations of future corporate performance are reflected in the current price of a stock. Suppose DEF Growth Company announces that quarterly revenue and earnings have increased by 10 percent and DEF s stock price immediately declines by 25 percent. Why would this happen Easy! If stock market analysts and institutional investors are expecting earnings or revenue growth for momentum stocks of 30 percent per year, those expectations are already factored into today s stock market price especially for growth stocks. Any performance that does not meet or exceed those growth expectations usually results in a sizeable drop in the stock s price. Growth stocks are companies whose rate of revenue or earnings growth (15 percent and up) greatly exceeds the growth rate of the economy as a whole (3 percent to 5 percent). If earnings growth for the stock meets market expectations, all other things equal, the stock return should be approximately equal to the return of a stock with a similar beta. For instance, according to our grossly hypothetical examples above, we would expect returns of 10 percent for a beta 1.0 stock, and returns of 13 percent for a beta 2.0 stock. We would not expect a return equal to the 30 percent associated with the earnings or revenue growth rate of the company! Read this paragraph again it is very important that you understand its implications!
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