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Competitive Market Assumption(WACC and Growth Rate) In Finance

             The most common method in academics to find the intrinsic value of a company is using Gordon growth model. However, this method isn't without its drawback. The biggest challenge we need to face is making correct assumptions. We have to find two variables: Discount rate(WACC) and growth rate. In general, the discount rate can be calculated by using company's financing structure and the growth rate is set to be higher initially and then lower to the normal growth of the economy in the end. Let's talk about WACC. By definition, WACC is minimum rate of return in the eyes of investors. It is a good thing that ROE(return on equity) is higher than WACC. However, it will not be sustainable. It is human nature that people like to invest money to a company which can generate higher profits than any other companies.
  • If ROE > k, the V(stock price) is increasing. In this situation, the higher the growth rate is, the higher the V will be.
  • If ROE=k, the V stays constant no matter what the growth rate is.
  • If ROE

If the first situation holds, people will most likely invest in this company as much as possible.
Under competitive market assumption, ROE will eventually fall into the one of industry average, which is close to WACC. 
                Likewise, growth rate of a company can't be At a high level forever. If a company is growing higher the the economy. That company will become the whole economy, which is impossible. So we usually set growth rate same as GDP growth.


So when we try to find a undervalued stock, we take these things into consideration.



Rising speculation on NQ

          I have been keeping an eye on NQ since last year. The stock price of NQ has been going down after the muddy water report came out. Actually, most of what muddy water claimed on the report is true. NQ exaggerated the user base in Chinese market. Dating back to NOKIA dominated era, NQ forced phone users to download its software sneakily by bundling itself with other software without users'  permission. I did some research on NQ in different Chinese newspaper and forums regarding this issue.

          By now, it is hard to make any fundamental analysis on NQ since their 10K may contain frauds. The price of the stock swings along the news lately. There is no way to predict it's price movement.  I also check its implied volatility using January call 2015; it's as high as 140%.  If you are risk averse investor, I suggest you'd better stay away from this stock. What does the implied volatility tell us?  Should we short or long the stock? I don't know. What I know is we can use a strategy with Option  to limit our downside.  Since the volatility is so high, we are able to apply Straddle. We can buy a call option and put option at the same time. The potential loss will be purchase price for the options.


         We can buy a call option at $5 for 2.14 and put option at $5 for 1.81 with a total of $3.95.  If something goes wrong, what you potentially lose is $3.95. But the upside will be huge. 
         The stock price today is $5.37. If the audit report comes out and it turns out to be positive, you may end up gaining more than $3.95 within couple days. If NQ's Financial reports are fraudulent, it may go bust.