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STOCK INVESTMENT PAGE 7

Stock Investment rev

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Running Head: STOCK INVESTMENT

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Stock Investment Evaluation

Abstract

The analyses undertaken in the paper evaluates the potential of the three stock investments in generating capital gains for an investor. The assessment on the viability of the three stocks has been undertaken by considering the present value of the stocks compared to the prevailing prices of the stocks at the capital market. In addition, the risk factor of the three stocks has evaluated in determining if the stocks are unlikely to generate the returns they promise an investor. Accordingly, the analyses reveal the three stocks current price in the market is above the intrinsic value. Thus, the price of the stocks is likely to decline in the future that will cause capital losses to an investor. Similarly, the riskiness of the stocks has been established to be high due to the high volatility of the stocks’ price. Consequently, the recommendation given is that a rational investor should not consider selling the here socks currently.

Introduction

Stock investment in the modern environment of capitalism has become one of the prominent investments that investors are undertaking. The equity or stock investment has become a popular investment due to the high investment return it promises the investors in the future. However, the extent of determining if a stock investment is able to generate returns for an investor is determined by its present valuation and risk factor. The present valuation is vital because it determines if a stock is undervalued or overvalued under the prevailing stock market price. Similarly, the risk factor is vital because it measures the possibility of the stock return in failing to generate the returns it promises to the investor. Consequently, the paper examines the ability of the Verizon, Motorola, and AT&T stocks in maximizing the wealth of an investor.

Literature Review

The valuation of stocks is one of the intensive studies that have been undertaken in determining if a given stock is undervalued or overvalued when compared to the current trading price. The ability to determine if a given stock is undervalued or overvalued enables an investor in determining if the stock has the potential of generating capital gains in the future (Reilly & Brown, 2012). Consequently, the capital asset pricing model (CAPM) is one of the valuation methods that are employed in determining the present value of a stock. The rationale behind the CAPM approach is relating the expected return and risk of the stock in assessing if the price of the stock is above or below the market price prevailing (Hackel, 2011). Accordingly, the formula that is employed in determining the present value of a stock using the CAPM method is illustrated below.

Ra = rf + Beta*(rm – rf) (Damodaran, 2012)

Where rf is the risk free rate and rm is the expected market return.

CAPM approach of determining the present value of a stock is derived the rationale that investors demands to be compensated in two ways on their capital investment of risk premium and time value of money. The risk free rate in the CAPM model is used to in representing the time value of money that an investor employs in investing in the given stock investment (Damodaran, 2012). In Contrast, , the beta value is used to measure the risk of the given stock investment by comparing the returns of the stock to the expected return of a market.

Gordon growth model is another vital approach that is employed in determining the present value of a stock. The Gordon growth model determines the intrinsic value of a stock using the future expected dividend series of the stock. The Gordon discount assumes that the future cash flows or dividends of the stock will continue growing constantly (Damodaran, 2012). Accordingly, the approach that is employed in deriving the present value of a stock using the Gordon discount method is demonstrated below.

Po = Div1/ r – g

Where Po is the stock price, Div1 is the forecasted dividend of the stock in coming period, r is required rate of return, and g is the growth rate (Damodaran, 2012).

The concept employed under the Gordon growth model indicates that the company’s stock been valuated need to have a high cash inflow and stable leverage patterns. This is because the growth rates of the dividends the investors expect in future have to be stable. However, the limitation of the Gordon discount method is that it can only be employed in determining the present value of a stock whose company has a constantly growing dividend issuance.

Risk analysis is another critical aspect that enables an investor in determining if a stock investment is capable of maximizing his/her wealth. Accordingly, some risk assessment theories have been developed in helping an investor undertaking stock investment if it is able to generate returns in the future. The various approaches that are employed in assessing the risk extent of a given stock investment include Sharpe ratio, beta, alpha, and r-regression. The Sharpe ratio involves evaluating the risk-adjusted return of a given stock. A Sharpe ratio is necessary in demonstrating to a shareholder if the returns of a stock investment return are motivated by high additional risk. Consequently, the formula that is employed in determining the Sharpe’s ratio is reflected below.

Sharpe ratio = (mean return – risk-free rate)/ standard deviation

R-squared regression measure of a stock risk measures the trend of a security’s return compared to the benchmark index. The benchmark index that has been employed in determining the R-squared ratio of the three stocks is the S&P 500 index. Accordingly, the R-squared ratio of a stock in relation to the market benchmark is evaluated using the rationale given in the table below.

Percentage	Correlation
70-100%	good correlation between the portfolio's returns and the benchmark's returns
40-70%	average correlation between the portfolio's returns and the benchmark's returns
1-40%	low correlation between the portfolio's returns and the benchmark's returns

Source (MorningStar, 2015).

Similarly, standard deviation is another variable that is employed in determining the risk factor of a given stock. The standard deviation determines the riskiness of a stock investment by measuring the potential of the stock return in the future failing to give expected return. The extent of the standard deviation in reflecting the possibility of a stock in failing to generate the expected return is vital in enabling an investor in determining if the stock is a prudent capital investment. Consequently, the various risk assessment approaches are vital in determining if a given stock investment is risky for an investor.

Data

The data employed in determining if the three stocks are able to enhance the wealth of the investor are demonstrated below.

Stock	Intrinsic value
Verizon	$18.52
Motorola	$8.33
AT&T	$7.59

In contrast, the market price of the three stocks in the market currently is as reflected in the table below.

Stock	Intrinsic value
Verizon	$$49.2
Motorola	$61.61
AT&T	$32.75

Methodology

The approach that has been employed in deriving historical data of the given stocks is the use of the online platforms. The historical data has been derived from the financial publications listing the historical prices and dividend payouts.

Findings

The computations undertaken in the attached spreadsheet demonstrates that the three stocks are overvalued compared to the intrinsic stock value. The overvaluation of the stock value implies the current price of the stocks is likely to fall in the future. If the price of the stocks falls in the future, an investor will suffer huge capital loss. Thus, a rational investor should consider selling the stocks at the current price to avoid incurring huge financial loss in the future.

Conclusion and Recommendation

Portfolio management approaches are vital in enabling an investor to make an informed capital investment decision. The portfolio analysis of the three stocks demonstrates the potential of the three stocks in generating capital gains or losses. Accordingly, the analyses undertaken demonstrate the three stock investments will generate capital loss in the future. The overvaluation of the stocks demonstrates that an investor is likely to face price declines in the future that will cause capital loss. Similarly, the bet value of the stocks demonstrates the three stocks are quite volatile on price movements. Consequently, it is recommended a rational investor should consider selling the stocks to avoid suffering capital loss in the future.

References

Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset. (Investment valuation.) . Hoboken, N.J: Wiley.

Hackel, K. S. (2011). Security valuation and risk analysis: Assessing value in investment decision making. New York: McGraw-Hill.

MorningStar. (2015). R-squared. Retrieved 2015, from http://www.morningstar.com/InvGlossary/r_squared_definition_what_is.aspx

Reilly, F. K., & Brown, K. C. (2012). Investment analysis and portfolio management. Mason, Ohio: South-Western Cengage Learning.