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FIN 260 Lecture Notes - Lecture 63: Amos Tversky, Daniel Kahneman, John Von Neumann

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School
Pace University
Department
Finance
Course
FIN 260
Professor
Morey

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• Behavioral Finance:
➢ Overconfidence:
o People think they know more than they actually do.
o Past success in the stock market makes them think they have more ability
in the stock market.
▪ That causes bubbles.
o Research from Shiller shows survey data up around 2000 bubble.
➢ Feedback Loop:
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Document Summary

Feedback loop: higher prices higher confidence higher prices higher confidence, etc. Nuemann-morgenstern math, but rather fall back on rule of thumb & biases. Very strong challenge to orthodox economics & finances: kahneman & tversky"s first major paper came out in (cid:883)974, found that people have a tendency to generalize on basis of insufficient evidence. Ex: if i toss a coin 5 times & it comes up heads each time, i may conclude that the coin is unfair. But it"s more likely that the coin is fair & the string of heads is merely product of random chance. If you repeat this a thousand times, in game of tossing a coin 5 times, you get 5 heads every 1 in 32 trials. We take a few observations and conclude that is the way it is: ex: israeli training of pilots & mean reversion, pilots are learning to fly. Their skill is slowly improving through flight training, but very slowly.

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Related Questions

Multiple Choice Quiz
PLS EXPLAIN ALL YOUR ANSWERS AND SHOW THE CALCULATIONS
1
A share of common stock represents:
A) A claim from a lender against a borrower.
B) A share in the company's debts.
C) A share of ownership of the company.
D) An unlimited liability to the owner of the stock.



2
The fact that common stockholders are residual claimant'smeans:
A) The stockholders have a claim against the revenue that remainsafter everyone else is paid.
B) The stockholders receive their dividends before any otherresiduals are paid.
C) The stockholders are paid any past due dividends before otherclaims are paid.
D) The stockholders are paid before the bondholders but after anytaxes are paid.



3
The concept of limited liability says a stockholder of acorporation:
A) Is liable for the corporation's liabilities, but nothingmore.
B) Cannot receive dividends that exceed his/her investment.
C) Cannot lose more than his/her investment.
D) Is only responsible for any taxes that the corporation may owebut not its other debts.



4
You have a portfolio valued at $1000. Over the next twelve monthsit loses 80% of its valuWhat return does the portfolio need to earnover the following twelve months to restore the portfolio to itsoriginal value?
A) 75%.
B) 200%.
C) 400%.
D) 25%.



5
The theory of efficient markets assumes that:
A) Prices of bonds, but not stocks, reflect all availableinformation.
B) The prices of all financial instruments reflect all availableinformation.
C) Stock prices are relatively rigid because it takes a while forinformation to efficiently move through the market.
D) The best approach to determining stock prices is to follow thechartists.



6
The notion that stock prices reflect all current availableinformation:
A) Makes the risk of holding stocks greater.
B) Indicates that mutual fund managers will not, on average,outperform market averages.
C) Says stock prices should be more rigid than they are.
D) Makes it easier to predict the movements in the price of astock.



7
Why are stock market bubbles costly for the economy?
A) They imply that the actual stock price is equal to thefundamental value of the stock.
B) They hurt consumers more than corporations.
C) They lead to a reduction in real investment in both theshort-term and long-term.
D) They lead to a misallocation of resources in both the short-termand long-term.



8
Stock market bubbles impact consumers by:
A) Encouraging greater consumption of luxury goods and greatersaving.
B) Encouraging greater consumption of luxury goods and lesssaving.
C) Encouraging more work and delaying retirement.
D) Resulting in less investment in home ownership and more intostocks.



9
If a public corporation goes bankrupt and does not have enoughassets to pay off all creditors:
A) The stockholders are personally liable for the balance.
B) The fact that stockholders are residual claimants means they mayhave to pay in additional capital to cover the obligations.
C) The stockholders receive any dividends due before the othercreditors are paid.
D) The stockholders cannot lose more than their investment.



10
The Dow Jones Industrial Average:
A) Gives equal weight to a change in the price of the stock of anycompany in the index.
B) Reflects that a 10% increase in a share of stock selling for $30will have the same affect on the index as a 10% increase in theprice of a stock selling for $60.
C) Is a value-weighted index.
D) Gives greater weight to shares with higher prices.



11
The Standard & Poor's 500 Index differs from the Dow JonesIndustrial Index because:
A) It takes into account the stock prices of 500 of the largestfirms, which is less than the DJIA.
B) It is a price-weighted index, where the DJIA is a value-weightedindex.
C) Larger firms are less important in the S&P 500 than in theDJIA.
D) It takes into account the prices of more stocks and it uses adifferent weighting scheme.



12
The theory of efficient markets implies:
A) Stock prices should be highly unpredictable.
B) The price at which stocks currently trade only reflects pastinformation.
C) Expectations do not play a role in stock prices because thisisn't real information.
D) The chartists are in fact correct that there are patterns instock prices.



13
The theory of efficient markets me
A) Professional fund managers should be able to consistently beatthe market average.
B) A professional fund manager should really not expect to beat themarket average consistently.
C) A professional fund manager who beats the market average oneyear should expected to beat the market average the nextyear.
D) A professional fund manager who beats the market average oneyear should be expected to not beat the market average the nextyear.



14
Stocks appear to present risk, yet many people have substantialparts of their wealth invested in them. This behavior could beexplained by the fact that:
A) People are irrational in their investment behavior, onlyfocusing on positive outcomes.
B) People are not very risk-averse and do not require a riskpremium for stocks.
C) Investing in stocks over the long run is not as risky asshort-term holdings.
D) People are not efficient users of information.



15
The price of a stock is currently $750 and the stock will pay a $43dividend. The interest rate is 7.5%. Based on the dividend-discountmodel, what is the expected price of this stock for nextyear?
A) $651.17.
B) $657.67.
C) $691.17.
D) $763.25.


2. Get ready

Read the following conversation that Sharon Rodriguez, assistant in the Finance Department, and Derek Opazo, tour developer for the Americas, are having about what Derek can do to increase reservations for his tours.

1

Sharon: I looked up the results of recent studies on some travel trade association Web sites. Adventure Travel magazine also had a couple of great articles about tour sales.

Derek: Interesting. What did they have to say?

2

Sharon: According to one survey I found, right now you could work on building your relationships with existing customers. Current customers are more likely to take another tour with us than new customers, especially if they have a personal connection to the company.

Derek: So I should personally contact customers that have already taken one of my tours.

3

Sharon: That sounds like it might be helpful in the short term. Anything else?

Derek: Oh, I don’t know. People just don’t want to travel right now. They’re nervous about the economy.

4

Sharon: Why do you think reservations are declining for your tours?

Derek: I’m not really sure. I think I need to expand my mailing list and send out a fresh batch of brochures to new prospects.

5

Sharon: Yeah, that’s what a lot of people think. I did some research to find out if that’s the case throughout the travel industry.

Derek: Really? What kind of research did you do?

6

Sharon: I’m actually going to write a brief report on what I found, but overall, customers report that they are waiting to see what happens with the economy before spending money on travel. The good news is that they are delaying their plans, not abandoning them.

Derek: That’s good to know. So people expect to start traveling again in the near future.

7

Sharon: When they have a good sense of their future finances, our typical customers say that they will start traveling again. Also, when they start traveling again, customers will be looking for high-value experiences like the adventure and cultural tours that you develop.

Derek: Really? But what should I do right now?

8

Sharon: Exactly. That means a lot of phone calls, but you are likely to get good results. Also, people say they are looking for value—they want extra services and special experiences, not just the usual guided tours. Biking, diving, sailing, and surfing are fairly popular.

Derek: That means I need to update my tours.

9

Sharon: Right. Updating your tours will take some time, but when you do, they’ll stand out from the competition.

Derek: I guess I need to get busy. Thanks for all the helpful information.

3. Now you try it

In the following space, reorganize the conversation according to the guidelines in the “Working with Problem Owners and Stakeholders” lesson.

Click here to reorganize the conversation. You can list each part of the conversation in order as identified by number. For example, if part 7 comes first following by part 2, list 7, 2, etc.

International Research Journal of Applied Finance ISSN 2229 – 6891

Vol. VI Issue – 8 August, 2015 Case Study Series

A Stock Valuation Case: An Application of the “Method of Comparables” for Macy’s Shares

Halil D. Kaya* ,Julia S. Kwok

Abstract

The primary focus of this case is the application of the “Method of Comparables” in the estimation of the value of a security. An investment decision will be made based on the comparison of the selling price and the estimated value. A security will be good for purchase if the estimated value is higher than the market price. This method utilizes basic financial ratios that are commonly provided by financial web sites. First, using Yahoo Finance website, the pricing, sales, book value of equity and shares outstanding data are collected for both the target firm and the competitor firms. Then, the pricing multiples (i.e. price earnings ratio, price to sales ratio and price to book ratio) of the competitors are calculated. After that, those multiples along with the target firm’s earnings, sales, book value and shares outstanding data are used to estimate target firm’s share value. The case also examines the impact of treating “negatives” in the data. Students will learn that replacing negative earnings with zeros tend to induce less bias in target firm’s value estimation than excluding the “negative” data altogether.

Introduction

March 14, 2015 was a sunny day. Mary took advantage of the nice weather to have lunch at the Mall. On her way back to work, she walked by Susan’s investment office. Susan was Mary’s college roommate. They both liked shopping together to find new fashionable clothes. Looking at her watch, Mary realized she had half an hour to spend. She thought she would drop by and say hello to Susan.

The Performance of Macy’s

“Hi, Susan, how are you?” How is your business?” said Mary. Susan was a recent finance graduate. Susan replied, “I am doing fine. Thank you. After so many years, the market is still recovering from the mortgage crisis; many investors have been buying back stocks that they have sold during the crisis. What are you up to?” “I want to start my investment in securities, too. I have a couple thousand dollars, would Macy’s be a good stock to invest in now? That was our favorite store to shop among all of the department stores,” Mary exclaimed. She added, “Also, I read from Motley’s Fool’s article on Macy’s today about its earnings per share growth for the last 16 quarters” (Zahid Waheed, 2014).

In response to Mary’s questions, Susan checked the monthly adjusted returns of Macy’s in Yahoo Finance. She found that, since March 2010, Macy’s stock price had an average annual increase of 23.5% over the last 5 years. The stock rose from $19.98 to $57.38. Susan then told Mary that Macy’s was indeed a growing stock. She added that its success could be attributed to the omni-channel integration, e-commerce and magic selling strategies which allowed merging of sales channels, online shopping and better customer care. Since investment strategy 101 is to buy low, and sell high, given Macy’s stock price had been going up, Susan was not sure whether Macy’s was currently overvalued or undervalued by the market.

The Method of Comparables

Susan remembered her class lecture on the two types of valuation of stocks, namely absolute and relative evaluation. The absolute evaluation focuses on finding the intrinsic value of the security based on fundamentals. That involves more complicated models of discounting cash flows from dividends, operations and residual income.

On the other hand, relative evaluation is quick and easy to use. It assumes two similar securities should sell for one price in an efficient market, i.e. “Law of One Price.” So an analyst can estimate its stock price by multiplying target company’s specific earnings, sales and equity value data by the earning, sales and equity “per share” financial multiples of its competitors.

Since Mary was not familiarized with financial models, Susan decided to use the easy-toperform-and-analyze “Comparables Method” to estimate the relative value of Macy’s stock.

The Financial Data

Dillards, JC Penney and Nordstrom were selected as competitors of Macy’s as they were all in retail department store business. Susan would need some financial data regarding these companies. She went to SEC’s (i.e. Securities and Exchange Commission) website and downloaded these companies’ most recent balance sheet and income statement data. Out of those statements, she knew that she would need the EPS (i.e. earnings per share), the sales number, the number of outstanding shares, and the book value of equity. She also knew that she would need the current share price for each company. After some work, she had found all the necessary information to run the analysis. Below were the data that she had gathered:

All data are in US$ except for the number of outstanding shares. The share price as of March 15, 2014 is shown in the first column. The “Earnings per share” is shown in the second column. The third column reports the book value of equity. The last column shows the number of outstanding shares.

Firm

P ($)

EPS ($)

Sales ($)

BV of equity ($)

# of shares

Macy's

58.58

3.93

27,931 mil.

6,249 mil.

378.3 mil.

Dillard's

90.61

7.10

6,532 mil.

1,992 mil.

45.6 mil.

JC Penney

8.71

-5.57

11,859 mil.

3,087 mil.

249.3 mil.

Nordstrom

61.33

3.77

12,166 mil.

2,080 mil.

194.5 mil.

The Decision

Susan thinks that the following steps would be necessary to perform the analysis:

1.Based on the data above, calculate Sales per share, BV of equity/share values of all firms. Note that EPS is directly given.

2.Calculate P/E, P/Sales, and P/B for all of Macy’s competitors based on the data obtained.

3.Find the average of the P/E, P/Sales, and P/B multiples for the three competitors.

4.Multiply those averages calculated in step 3 with Macy’s EPS, Sales per share, and BV of equity/share values, respectively to get three value estimates for Macy’s shares.

5.The average of the three estimates would then be Susan’s best estimate of Macy’s value per share.

answer # 1-5 please