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.I do not agree with my friend's contention that Google is overvalued according to dividend discount model because dividend discounting model is not applied to the valuation of Google as Google is a non dividend paying company and Google is not to be valued according to dividend discounting model.

Dividend discounting model will be discounting the futuristic dividend associated with the company at present in order to arrive at the intrinsic value and Google is not paying any dividend in future and it has no history of payment of dividend in past so discounting of Google to arrive at intrinsic value using dividend discounting model is completely irrational so I would be not agreeing to the contention of my friend.

2. I would not be believing that manager has better quality of picking stocks because he has just outperformed the index.

The manager may have outperformed the index because he has taken an excessive risk and excessive risk can also lead to outperformance on the downside when the fund will be exposed to higher risk, and I will always be trying to look upon the diversification strategies of the fund manager and I will always be looking for Risk Management ability so just because he has outperformed the index rate of return will not make him a better stock picker and I will be sceptical of his performance and I will analyse it through his overall allocation in the Asset classes, diversification of the portfolio, along with risk management strategies.