Stock Valuation and Behavioral Finance - Case Study Example

?INTRODUCTION The report has been divided into two parts; first part will estimate the fair price of Royal Dutch Shell and then compare this price with the actual market price of the stock. Stock valuation technique such as dividend growth model and Price to Earnings (P/E) ratio will be used to estimate the price of the stock. The second part of the report will discuss the behavior of individual investors and more sophisticated investors such as equity managers. Part I – Comparing The Estimated Price Of The Stock With The Current Price There are different techniques to estimate the price of the stock and one of the techniques that have been used to estimate the price is the dividend growth model. Following formula is used to estimate the price of the stock using dividend growth model: Growth of the stock is calculated using the dividends paid by Shell since 2008 and it is shown in the appendix 1. Discount rate is calculated using the CAPM equation which is as follows: Rf = 4% Rm = 0.59% B = 0.078 So, using the above equations Re is found to be 3.9997% So, the price of the stock using the values identified is 84.86 The current price of shares of Shell is 2,246.5 however the estimated price is 84.86 which is well below. Price to Earnings (P/E) Ratio is the other technique used to estimate the price (Gitman, 2003). Price to earnings ratio is the market price of the company with the earnings per share. The higher value of P/E ratio shows that the investors are paying more for per unit of income they are getting from the share and it can be said that the stock is more expensive (McLaney, 2009). To estimate the price, earnings per share is taken from the annual report of Shell. Price 2,246.50 EPS 4.98 P/E Ratio 451.104 So the price is 2,246.50 and PE is 451.1. However, if the estimated price is considered to calculate the PE ratio then it is 17.04 P/E ratio of the company is very high and it indicates that the shares of Shell are very expensive. However important reasons for this would be that Shell is an important player in the market and investors are eyeing stocks of Shell for investment purpose, so with higher demand the price of Shell’s stock is high. Part 2 – Individual Investors and Sophisticated Investors There are different techniques and valuation methods that investors use to estimate the price of the stock and then make their investment decision. Not all the techniques would give the same kind of results; however these techniques are helpful in giving a signal or a hint to the investors. Investors have different aspects and factors to consider while making the investment decision. Investors have different socio-economic background, qualification, believe, emotions. Moreover, differences in race and age of investors also influence the investment decision and therefore the decision of one investor could differ from other investor and this has been the main role of behavior finance i.e. to define and discuss why people are not only concerned about the market decisions but they have their own perception and opinion and judgment as well while making the investment decision. Behavior finance has been defined as the study of how people understand and take actions on the financial information they have in making investment decisions (Simon, 1987). Every investor would like to earn higher return on his investment however he or she needs to define his or her risk tolerance level, goals of the investment and other factors that could influence the decision. Different investment and stock valuation techniques are used by investors and it is up to the investor to choose which technique he or she would like to use to make the investment decisions. Some would prefer using PE ratio whereas others would like to use PEG ratio. Some would fancy going for Gordon Growth Model whereas others would like to analyse the previous price and identify the ‘hi and low prices’ and believe that the stock price would go in the same way as in the last few years. Even after using different techniques, no one can guarantee that the results shown by the technique would yield in profit maximization. However, different studies have claimed that individual investors make different systematic errors as their investment decisions are influenced more by emotions than sophisticated investors like equity fund managers. Even though investors believe that they make rational investment decisions however often investment decisions are taken from heart rather than head and therefore it results in systematic errors (TIAA CERF, 2007). Richard Thaler, a professor of Behavioural Science and Economics has stated that many financial decisions are influenced by how people interpret it and it does not lead to rational decision (TIAA CERF, 2007). Individual investors can achieve more returns by investing in different companies that are actively participating in the market rather than creating their own portfolio and achieving lower returns however still many investors prefer creating their own portfolio despite of the fact that they have less knowledge, experience and expertise. This also shows that the behavior of the investors differs and behaviors of the investors also influence their investment decision. There are different reasons that influence the decision of individual investors and these factors or reasons do not allow them to make rational decisions. These factors and reasons are as follows: a. Overconfidence of the investors b. Madness of the crowd c. More information d. Prospect Theory - Too much focus on risk aversion Overconfidence can influence the investors to go for overtrading which would eventually result in higher transaction cost and high tax liabilities and this would lead to lower returns at the end of the day. Thus, overconfidence of the individual investors leads to lower return and their decision making does not remain rational (Elan, 2010). The other factor that influences the individual investors’ decision is the madness of the crowd. There are occasions when hype has been created and generally individual investors go in the same direction as others and they tend to invest on stocks or securities on which everyone else is investing and this reduces the profitability of that particular investment and leads to lower returns Cunningham, 2002). Sophisticated investors are able to achieve higher as well as more stable returns than individual investors and there are several reasons for this; one of the reasons is that they do not allow emotions to influence their decisions that much than the individual investors do (Cunningham, 2002). The other reason is that sophisticated investors are working in formal organizations and they are more aware about the market and factors that could influence the market and therefore they have more information than the individual investors thus their decision making is more rational than the individual investors (Elan, 2010). Prospect theory is one of the widely appreciated theories in the field of behavioral finance and this theory analyses how people maximize value when they have to choose among different alternatives involving risk. According to this theory, investors concentrate a lot on incremental profits or less while making investment decision. Investors tend to focus a lot on avoiding losses rather than to achieve more profits and this leads to subpar returns on the investment instead of maximizing the profits of the investment. If the main focus of the investors is on minimizing risk rather than maximizing profits, then it would not be a rational idea and thus their investment decisions would not be rational (Elan, 2010). Sophisticated investors are able to perform better than the individual investors and consistently outperform the market because of the reasons and factors discussed above. List of References Cunningham, L. (2002). ‘Behavioral Finance and Investor Governance’. Washington & Lee Law Review, vol. 59, pp. 767. Elan, S. (2010). ‘Behavioral Patterns And Pitfalls Of U.S. Investors’. Federal Research Division, Available at http://www.loc.gov/rr/frd/pdf-files/SEC_Investor-Behavior.pdf [Accessed 3 November, 2012] Gitman, L. (2003). Principles of Managerial Finance. Addison-Wesley Publishing: Boston. McLaney, E. (2009). Business Finance: Theory and Practice, Pearson Education: New Jersey. Royal Dutch Shell. (2011). Annual Report and Form 20-F for the year 2011. Available from http://reports.shell.com/annual-report/2011/servicepages/downloads/files/entire_shell_20f_11.pdf [Accessed 3 November, 2012] Simon, H. (1987). ‘Behavioral Economics’. The New Palgrave: A Dictionary of Economics, vol. 1. pp. 221–24. TIAA CERF. (2007). Are You a Rational Investor?. Available at https://www.tiaa-cref.org/public/pdf/C38907.pdf [Accessed 3 November, 2012] Yahoo Finance. London Stock Exchange Group Plc. Available from http://uk.finance.yahoo.com/q/hp?s=LSE.L&b=23&a=06&c=2001&e=1&d=03&f=2012&g=m [Accessed 31 March 2012] Yahoo Finance. Royal Dutch Shell plc. Available from http://finance.yahoo.com/q/hp?s=RDSB.L&a=04&b=15&c=1998&d=10&e=5&f=2012&g=m [Accessed 31 March 2012] Appendix Appendix 1: Growth Rate Dividends growth rate Dividends in 2012 0 Dividends in 2011 168 -100% Dividends in 2010 42 300% Dividends in 2009 42 0% Dividends in 2008 24.540001 71% Growth rate 68% Appendix 2: Market returns and Stock returns Table 1 Table 2 - Returns Month Month Market Index Stock Price Market Index Stock Price 1 8/31/2006 1,429.00 1,663.12 2 6/1/2007 1,355.00 1,815.66 -5.18% 9.17% 3 7/2/2007 1,353.00 1,708.45 -0.15% -5.90% 4 8/1/2007 1,366.00 1,685.79 0.96% -1.33% 5 9/3/2007 1,643.00 1,753.77 20.28% 4.03% 6 10/1/2007 1,680.00 1,826.12 2.25% 4.13% 7 11/1/2007 1,780.00 1,701.48 5.95% -6.83% 8 12/3/2007 1,979.00 1,821.76 11.18% 7.07% 9 1/1/2008 1,691.00 1,520.17 -14.55% -16.55% 10 2/1/2008 1,359.00 1,552.42 -19.63% 2.12% 11 3/3/2008 1,208.00 1,478.33 -11.11% -4.77% 12 4/1/2008 1,077.00 1,756.39 -10.84% 18.81% 13 5/1/2008 1,027.00 1,834.84 -4.64% 4.47% 14 6/2/2008 780.00 1,760.75 -24.05% -4.04% 15 7/1/2008 831.00 1,553.29 6.54% -11.78% 16 8/1/2008 793.00 1,649.18 -4.57% 6.17% 17 9/1/2008 863.00 1,375.48 8.83% -16.60% 18 10/1/2008 558.50 1,446.08 -35.28% 5.13% 19 11/3/2008 609.00 1,514.11 9.04% 4.70% 20 12/1/2008 510.00 1,524.71 -16.26% 0.70% 21 1/1/2009 481.25 1,464.64 -5.64% -3.94% 22 2/2/2009 434.25 1,310.93 -9.77% -10.49% 23 3/2/2009 565.50 1,352.45 30.22% 3.17% 24 4/1/2009 749.00 1,375.42 32.45% 1.70% 25 5/1/2009 689.50 1,520.11 -7.94% 10.52% 26 6/1/2009 702.50 1,384.89 1.89% -8.90% 27 7/1/2009 712.00 1,410.30 1.35% 1.83% 28 8/3/2009 805.50 1,519.21 13.13% 7.72% 29 9/1/2009 856.00 1,575.47 6.27% 3.70% 30 10/1/2009 851.00 1,597.25 -0.58% 1.38% 31 11/2/2009 752.50 1,576.38 -11.57% -1.31% 32 12/1/2009 718.00 1,643.99 -4.58% 4.29% 33 1/4/2010 641.50 1,518.30 -10.65% -7.65% 34 2/1/2010 665.00 1,557.78 3.66% 2.60% 35 3/1/2010 710.50 1,647.62 6.84% 5.77% 36 4/1/2010 685.00 1,792.37 -3.59% 8.79% 37 5/4/2010 642.00 1,589.54 -6.28% -11.32% 38 6/1/2010 563.50 1,480.18 -12.23% -6.88% 39 7/1/2010 647.00 1,524.20 14.82% 2.97% 40 8/2/2010 660.50 1,514.21 2.09% -0.66% 41 9/1/2010 681.00 1,685.28 3.10% 11.30% 42 10/1/2010 734.00 1,813.70 7.78% 7.62% 43 11/1/2010 758.50 1,767.53 3.34% -2.55% 44 12/1/2010 838.00 1,959.29 10.48% 10.85% 45 1/4/2011 846.00 2,011.16 0.95% 2.65% 46 2/1/2011 900.00 2,076.81 6.38% 3.26% 47 3/1/2011 832.50 2,134.90 -7.50% 2.80% 48 4/1/2011 871.50 2,199.57 4.68% 3.03% 49 5/3/2011 980.50 2,116.79 12.51% -3.76% 50 6/1/2011 1,061.00 2,140.86 8.21% 1.14% 51 7/1/2011 997.00 2,155.78 -6.03% 0.70% 52 8/1/2011 920.50 2,040.34 -7.67% -5.35% 53 9/1/2011 809.46 1,974.11 -12.06% -3.25% 54 10/3/2011 900.00 2,193.41 11.19% 11.11% 55 11/1/2011 860.50 2,286.00 -4.39% 4.22% 56 12/1/2011 795.00 2,454.00 -7.61% 7.35% 57 1/3/2012 870.00 2,308.50 9.43% -5.93% 58 2/1/2012 902.00 2,329.50 3.68% 0.91% 59 3/1/2012 1,034.00 2,199.50 14.63% -5.58% 60 4/2/2012 1,066.18 2,246.50 3.11% 2.14% 61 5/1/2012 979.95 2,078.50 -8.09% -7.48% 62 6/1/2012 983.87 2,225.00 0.40% 7.05% 63 7/2/2012 969.50 2,249.50 -1.46% 1.10% 64 8/1/2012 993.50 2,271.50 2.48% 0.98% 65 9/3/2012 943.00 2,198.00 -5.08% -3.24% 66 10/1/2012 975.50 2,190.50 3.45% -0.34% 67 11/1/2012 963.00 2,246.50 -1.28% 2.56% Average Monthly returns 0.05% 0.69% Average annual returns 0.59% 8.23% Appendix 3: Beta Beta Market Stock 1.000 0.078 Read More