Question

Suppose you are looking for some investment opportunities in the stock market.

1. You observe that Google or Alphabet Inc. (goog) is currently traded at $1133 per share. However, it has never paid any dividends to its shareholders. Your friend concluded that the stock price of google is totally overvalued by applying the dividend discount model. Do you agree? Explain your answer.

2. A portfolio manager recommends you his mutual fund. He claims that the mutual fund he manages obtained a 10%, 6% and 8% return in the past three years, while the market return was only 8%, 4.8%, and 6.4% in the past three years. Based on this information, do you believe this manager is good at picking stocks? If not, what other information do you need?

Answer 1

1. Dividend discounting model is not to be applied to stocks lwho are not paying any dividend because dividend discounting model will be discounting all the future dividend associated with the company at the present in order to arrive intrinsic value.

In this case, the argument of the friend is wrong because Alphabet is not paying any dividend and it is not to be discounted using dividend discounting method because this method is not applicable in case of non diffident paying companies.So, argument about over valuation of stock due to non payment of dividend according to dividend discounting model is completely wrong.

2. It can be seen that the fund manager had consistently outperformed the index rate of return in past three years and it can be seen that he is also having a better market timing skills and market execution skills so it can be said that the manager is also having in knack of selecting good stock and diversifying them in order to beat the rate of return of the index and the the ability of the manager to beat the index consistently will make me believe that he is good at picking stocks because he is continuously outperforming the index by a higher margin.

To reassure myself about his ability ,I will also be needing his overall portfolio allocation and risk weighting of those portfolios in order to make excess rate of return because he may be taking excessive risk also.