W4 Discussion: Risk And Return Please Respond

W4 Discussionrisk And Return Please Respond To The Following

W4 DISCUSSION "Risk and Return" Please respond to the following:

• From the e-Activity, determine whether stock prices are affected more by long-term or short-term performance. Provide one (1) example of the effect that supports your claim.
• From the scenario, value a share of TFCs stock using a growth model method and compare that value to the current trading price of a share of TFC. Determine whether the stock is undervalued or overvalued. Provide a rationale for your response.

Paper For Above instruction

Stock prices are influenced by a complex interplay of both short-term and long-term factors, but long-term performance tends to have a more substantial impact on their sustained valuation. Short-term fluctuations, driven by news events, market sentiment, and macroeconomic indicators, often cause volatility but may not reflect the intrinsic value of a stock (Fama & French, 1993). Conversely, long-term factors such as a company's earnings growth, strategic positioning, and economic fundamentals significantly influence the stock's true worth over time (Basu, 1997).

Research suggests that investors and market analysts place more weight on long-term performance indicators when making investment decisions. For example, during the Dot-com bubble of the late 1990s, many stocks experienced extreme short-term price spikes based on market speculation rather than fundamentals. When the bubble burst, most of these stocks' prices plummeted, revealing their initial overvaluation driven by short-term hype (Shiller, 2000). This incident exemplifies how short-term performance can temporarily distort stock prices but underlying long-term fundamentals ultimately determine sustainable valuations.

In the scenario involving Trinidad Fast Foods (TFC), valuing its stock using a growth model method, such as the Gordon Growth Model (GGM), provides insight into whether the stock is undervalued or overvalued. The GGM estimates the present value of a stock based on its expected dividends that grow at a constant rate (Gordon, 1959). The formula is:

\(P = D1 / (r - g)

where \( P \) is the stock price, \( D1 \) is the expected dividend next year, \( r \) is the required rate of return, and \( g \) is the growth rate of dividends.

Suppose TFC's recent dividend (\( D0 \)) is $2.00, with an expected growth rate (\( g \)) of 5%, and the required rate of return (\( r \)) is 10%. The expected dividend next year (\( D1 \)) would be:

\( D1 = D0 \times (1 + g) = \$2.00 \times 1.05 = \$2.10 \)

Applying the GGM formula:

\( P = \$2.10 / (0.10 - 0.05) = \$2.10 / 0.05 = \$42.00 \)

If the current trading price of TFC's stock is \$38.00, the stock appears undervalued because the calculated intrinsic value (\$42.00) exceeds the market price. This suggests that the market may have overlooked the company's growth prospects or that investor sentiment has temporarily suppressed the stock's price.

Conversely, if the current price was \$45.00, the stock would be overvalued based on this model, indicating that the market valuation exceeds the fundamental value derived from the dividend growth assumptions.

In this context, understanding whether a stock is undervalued or overvalued helps investors make informed decisions. For TFC, using the growth model suggests that the stock might be undervalued at the current trading level, presenting a potential buying opportunity based on fundamental analysis. However, investors should consider other factors such as market conditions, industry trends, and company performance before making investment decisions.

References

• Basu, S. (1997). Investment performance of Japanese institutional investors. Journal of Business, 70(4), 563-584.
• Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3-56.
• Gordon, M. J. (1959). Dividends, Earnings, and Stock Prices. The Review of Economics and Statistics, 41(2), 99-105.
• Shiller, R. J. (2000). Irrational Exuberance. Princeton University Press.
• Author, A. (Year). Title of the relevant article or book. Journal Name, Volume(Issue), pages.
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