The Iowa Electronic Markets
Stock Valuation
Curriculum using the IEM
Prepared for the Spring 2001 IEM*IDEA/NSF Conference
By: Dr. Roger Ignatius
Associate Professor of Finance
Husson College
Dr. Thomas A. Rietz
Associate Professor of Finance
University of Iowa
April 2001
Valuation Assignment
Introduction to the IEM
The Iowa Electronic Market (IEM for short) is a computerized market on which financial contracts can be traded (bought or sold). For this assignment, you will be using a series of contracts based on three popular companies, Apple Computers (AAPL), IBM (IBM) and Microsoft (MSFT), and an important index called the S&P500 index. Shares of the firms trade over the counter (NASDAQ) and on the New York Stock Exchange (NYSE). Similarly, a daily index value is determined for the S&P500 based upon the stock prices of the 500 companies that compose of it.
The contracts you will be using are based on the shares of Apple computers, IBM and Microsoft, and on the value of the S&P500. These contracts are listed on the IEM under the market label “Computer Industry Returns Market” or “Comp_Ret” for short. These contracts are described briefly later in this note and in more depth in the IEM prospectus for the market. The prospectus and other information for these markets are available at the IEM website:
http://www.biz.uiowa.edu/iem/markets/computer.html
Objectives
The objectives of the IEM assignments are to help you apply class concepts in a "real world," unstructured way to learn how to:
1. Apply valuation models to “real world” companies.
2. Understand what factors influence value.
3. Combine predictions and information to develop a trading strategy.
Opening an IEM Account
All students need to open an account with the Iowa Electronic Market. This involves a minimum deposit of ____ dollars. Funds remaining in your account are refundable at the end of the semester.
You can open an IEM account over the internet. To do so, go to the sign-up webpage:
http://iemweb.biz.uiowa.edu/signup/
and follow the instructions given to you by your instructor. (DO NOT use forms other than those given to you by your instructor. Using other forms may result in fees or decreased deposits in your account.)
After filling out your signup forms, you may need to deposit cash with the IEM office (W283 PBAB, phone 335-0881). Your instructor will give you details about any deposits you need to make.
Accessing the IEM
You can access the IEM through its website address:
http://www.biz.uiowa.edu/iem/
The IEM market has several contracts trading under it. The contracts of interest for our course are the Computer Industry Returns Market (Comp_Ret, for short).
You access your trading account from the market pages or directly at:
http://iemweb.biz.uiowa.edu/
Computer Industry Returns Contracts
The Computer Industry Returns Contracts consist of a series of contracts. Every month, existing contracts in the series are liquidated and payments are made as described below. Then, new contracts are created as described below. These events occur on the Monday after the exchange-traded options for the underlying stocks expire (the Monday after the third Friday of each month).
The liquidation values for the contracts in this market are determined solely by the rates of return of Apple Computers Common Stock (AAPL), IBM Common Stock (IBM), Microsoft Common Stock (MSFT) and the S&P500 index (SP500). Whichever of these has the highest rate of return as specified below will payoff $1.00 per share. The remaining contracts will payoff zero. Thus, to do well in this market, you will need to understand what determines real stock market returns.
Contracts are designated by a ticker symbol and a letter denoting the month of contract liquidation. Thus, the contracts traded in this market for liquidation in month “m” are:
Code / Underlying Asset / Liquidation ValueAAPLm
IBMm
MSFTm
SP500m / Apple Computers
IBM
Microsoft
S&P 500 Market Index / $1.00 if AAPL Return Highest
$1.00 if IBM Return Highest
$1.00 if MSFT Return Highest
$1.00 if SP500 Return Highest
In these contract codes, “m” refers to the month of expiration as given by the following table:
Month / Designation / Month / Designation / Month / DesignationJanuary
February
March
April / a
b
c
d / May
June
July
August / e
f
g
h / September
October
November
December / i
j
k
l
For AAPLm, IBMm and MSFTm, the dividend-adjusted rate of return is computed based on closing stock prices of the underlying listed firm between the third Friday in the liquidation month and the third Friday in the previous month. For these purposes, closing prices as reported in the Midwest edition of the Wall Street Journal are used. In particular, this return is calculated as follows. First, the raw return on the underlying stock is computed (as the closing price on the third Friday of the liquidation month, minus the closing price from the third Friday of the previous month, plus any dividends on ex-dividend dates). Then, we divide the raw return by the closing stock price from the previous month to arrive at the dividend-adjusted rate of return. This is represented by the equation:
,
where k is the dividend adjusted return, Pm is the price on the third Friday of month m, Pm-1 is the price on the third Friday of the previous month and Dm represents any dividends paid between these dates.
For the SP500 contract, the return is computed as the capital gains rate of return. To do this, subtract the closing index value on the third Friday of the previous month from the closing index value on the third Friday of the liquidation month. Then, divide by the previous month’s closing index value. This is represented by the equation:
,
where k is the capital gains index return, Pm is the index value on the third Friday of month m, and Pm-1 is the value on the third Friday of the previous month.
Trading on the IEM
You can trade on the IEM in several ways. First, you can buy or sell unit portfolios (called “bundles”). A unit portfolio is a set of all contracts in the market such as AAPLm, IBMm, MSFTm and SP500m for the Computer Industry Returns market. You can always buy or sell such portfolios for $1.00 each. Thus, when you start to trade and do not own any contracts, you can buy a unit portfolio and then start to trade. (To do this, select the appropriate contract under “Buy Bundles” or “Sell Bundles” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order” button.)
Second, you can buy or sell using a "market order." On the market screen, you will see that some individuals have posted an order to buy or to sell a contract (e.g., MSFTi, the contract for September liquidation in the Computer Industry Returns Market) at a specific price. If you believe that a posted order represents a good deal, you can buy or sell at the posted price. (To do this, select the appropriate contract under “Buy at Best Ask” or “Sell at Best Bid” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order” button.)
Third, you can buy or sell using a "limit order." To do so, you state the price at which you are willing to buy or sell a contract and post a limit order on the screen. In doing so, you are waiting for someone who is willing to buy or sell at your stated price. In this manner, when your order executes, it will execute at your stated price, not at somebody else’s. The disadvantage is that the order may never execute because nobody likes your price because it is too high or low. (To place a limit order, select the appropriate contract under “Post a Bid” or “Post an Ask” in the “Limit Order” drop down menu. Enter a price, quantity and expiration date and press the “Limit Order” button.)
Completing Your Assignments and Submitting Them
As you can see below, the IEM assignments are extensive, multi-part assignments that draw together many concepts from the class. It would be wise to work on the various parts of the assignments as we go over the relevant topics in class. To prepare the assignments for submission, please use the following guidelines:
1. Each assignment must be typed. Label clearly each assignment with a cover page giving your name, student number, and section number.
2. Complete each part in a separate section clearly labeling them Part 1, Part 2, etc.
3. Within each section, give the requested information, including sources of information gathered and equations used to calculate results.
4. Turn in your completed assignment to your instructor on the date it is due.
Stock Valuation Assignment
Part 1: Discounted Dividend Models DUE: ______
GOAL
In this part of the assignment, you will learn where to find information necessary to apply the discounted dividend models discussed in class. You will use this information to see what discounted dividend models imply for IBM.
Background Information
To complete this exercise, you will need to collect some basic information on IBM: the annual dividend, an estimate for the risk free rate, the beta for IBM’s stock and some information to help estimate the likely dividend growth rate. Most of what you need is available on the internet. You can collect this information from a variety of sources. What follows are instructions for collecting it from Microsoft’s MoneyCentral webpages.
To get information on IBM, go to the Microsoft MoneyCentral webpages at the address:
http://moneycentral.msn.com/
In the upper left corner, enter “IBM” as the ticker symbol and press the “go” button. Obtain the required information as follows:
1. Recent IBM Price: The recent price per share is given on the default screen or the “Quotes—Quote Detail” screen.
2. Dividend and Dividend Yield: The annual dividend per share and dividend yield are given on the default screen or the “Quotes—Quote Detail” screen.
3. Beta: Beta is listed on the “Company Report” screen at the bottom of the right hand column.
4. Return on Equity (ROE): ROE is listed on the “Financial Results—Highlights” page.
5. Payout Ratio: The payout ratio is also listed on the “Financial Results—Highlights” page.
6. Historical Dividend Growth Rate: The 5 year historical dividend rate is given on the “Financial Results—Key Ratios—Growth Rates” page.
7. Average Forecast Growth Rate from Analysts: The average forecast growth rates for the next five years is given on the “Analyst Info—Estimates—Earnings Growth Rates” page.
8. Current 3-Month Treasury Rate: Enter the ticker symbol TB3M to obtain the current rate on 3 Month Treasury bills.
Question 1: Estimating the Required Return
Use the Capital Asset Pricing Model (CAPM) to estimate the required (annual) return for IBM stock. Use the 3-month Treasury rate obtained above for the risk free rate, the beta obtained above for the beta and a risk premium of 8.74% (which is the historical average from 1926-1996).
Recall that the CAPM equation is:
Question 2: Constant Dividend Model
Suppose that IBM’s dividends will remain constant at their current level. Use the constant dividend model to value IBM’s stock. Does this number seem too high or too low when comparing it to IBM’s current stock price? Can you explain why that might be?
Recall that the Constant Dividend pricing relationship is:
Question 3: Estimating Dividend Growth
There are a variety of means of estimating IBM’s likely future dividend growth. Determine what the estimated growth rate would be using each of the following methods:
a. If the past can be used as an indicator of the future, then the historical average is a good estimate. What is the historical average dividend growth rate?
b. Analysts forecast growth and their average forecast is often used. What is the average estimated 5-year growth rate according to analysts?
c. Another commonly used estimate is the “sustainable growth” rate computed by the (1-Payout Ratio) x ROE. What is the growth rate estimated by these means?
d. Finally, since capital gains are driven by growth they should be approximately the same as growth. The total return in a stock (from Question 1) should equal the dividend yield plus the capital gain yield. Thus, you can estimate the growth rate by subtracting the dividend yield from the required return calculated in Question 1 above. What does this give for a growth rate?
Given all this information, what do you think is a reasonable long run growth rate for IBM’s dividend? (Remember that, in the long run, growth cannot exceed the required return, which is calculated in Question 1 above.)
Question 4: Constant Growth Model
Given the dividend, the required return calculated in Question1 and the growth rate calculated in Question 2, what should the price of IBM stock be given the constant growth model? Does this number seem too high or too low when comparing it to IBM’s current stock price? Can you explain why that might be?
Recall that the Constant Growth pricing relationship is:
Question 5: Implied Growth
There is one final way of forecasting the growth rate. Equate the price of the stock today to the value that should exist according to the constant growth model. If you assume that next year’s dividend will grow at the same rate as the projected growth rate and use the required return calculated in Question 1, you can solve for the growth rate. This is called the implied growth rate. What is it? How does it compare to your estimate from Question 3 above?
Recall that the Constant Growth pricing relationship implies:
Stock Valuation Assignment
Part 2: Discounted Cash Flow Models DUE: ______
GOAL
In this part of the assignment, you will learn where to find information necessary to apply the discounted cash flow models discussed in class. You will use this information to see what discounted dividend models imply for IBM, Apple and Microsoft.
Background Information
To complete this exercise, you will need to collect some basic information on all three companies to help estimate cash flows the likely cash flow growth rate. Most of what you need is available on the internet. You can collect this information from a variety of sources. What follows are instructions for collecting it from Microsoft’s MoneyCentral webpages.