FNCE 625 – Investment Analysis and Management

FNCE 625 – Investment Analysis and Management

Individual assignment

Introduction:

Create a portfolio comprising a collection of three asset classes (two traditional assets, namely stocks and bonds) and one alternative asset class (any one of your choice) taking into consideration risk-return and modern portfolio theory.

You are expected to explain the rationale behind your portfolio selections, and more importantly explain why the portfolio you have constructed using these assets is a robust, well constructed, efficient portfolio in line with the discussion on the subject in class and material covered.

Use data, and analysis to support your explanation!

Deliverables: Written report (5 pages max).

Weight: 20% (see rubric for more details)

Your written report should be structured with the following sections:

Introduction
Summary of Portfolio
Rationale for asset classes selected
Portfolio assessment
Conclusion

Submission:

The report should be in PDF format and not exceed 5 pages (extra pages will not be counted for grading purposes). The cover page, and reference page do not count towards the 5-page limit.
The report should be submitted before the due date as specified in the course outline.
Please find all the attachements of study material for refernce and understanding of the ask.

Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 1

Understanding Investments

Objectives

To understand the investments field as currently practiced

To help you make investment decisions that will enhance your economic welfare

To create realistic expectations about the outcome of investment decisions

Being able to recognize pitfalls and scams is extremely important

Investments Defined

Investments – the study of the process of committing funds to one or more assets

Emphasis on marketable securities

Concepts also apply to real assets

Funds to be invested come from assets owned, borrowed money, savings, foregone consumption

Portfolio is the set of assets owned

Why Study Investments?

Desire to manage and increase wealth

All individuals make investment decisions

Especially important for retirement

Essential part of a career in the field

Investment banker, security analyst, portfolio manager, financial adviser, Chartered Financial Analyst

Investment Decisions

Underlying principle is the tradeoff between risk and expected return

Expected and realized return usually differ

Risk: possibility that realized return will not equal expected return

Investors choose risk tolerance, then look to maximize return

Risk-return tradeoff is ex ante: made before investment

Ex post: after the fact (known)

Risk and Expected Return

Risk and return are the two most prominent characteristics in finance

Fundamental principle: there is a positive relationship between risk and expected (required) return

Referred to as the risk – return tradeoff

A strategy that yields consistently higher returns should be regarded as riskier unless documented otherwise

The Tradeoff Between Risk and Expected Return

Investors manage risk at a cost → lower expected return (E R)

Any level of risk and expected return can be attained

The Investment Decision Process

Two-step process:

Security analysis and valuation

Estimate risk and expected return

Portfolio management

Once portfolio is constructed, it must be evaluated

Evaluations used to revise portfolio

Factors Affecting the Process

Uncertainty: the future is unknown and must be estimated

Foreign financial assets: offer opportunity to diversify

The Internet and investment opportunities

Institutional investors

Ethics

All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 19 76 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 2

Investment Alternatives

Nonmarketable Financial Assets

Commonly owned by individuals

Personal transactions between owner and issuer

Owner opens, closes, and maintains account

In contrast, marketable securities trade in impersonal markets

Usually very liquid or easy to convert to cash without loss of value

Examples: Savings accounts, M M D As, and C Ds

Marketable Financial Assets

Fixed-income: payment specified by a contract

Money market securities and bonds (fixed & floating rate)

Equity: represents ownership share in a firm

Common and preferred stock

Derivative securities: value is derived based on the prices of other assets

Options, futures, forwards, swaps

Types of Securities

Money Market Securities – securities with an original maturity of 1 year or less

Include: T-bills, commercial paper, banker’s acceptances, certificates of deposit (C Ds), repurchase agreements, etc.

Capital Market Securities – securities with more than 1 year in original maturity

Include: Common & preferred stock and bonds

Money Market Securities

Negotiable or salable in the marketplace

Short-term, highly liquid, relatively-low risk debt instruments—rates tend to move together

Issued by governments and private firms

Generally trade in large denominations

Generally sell on a discount basis

Generally are low risk securities

Treasury Bills (T-bills)

Obligations of the federal government

Commonly referred to as the risk-free security

Income earned on T-bills is exempt from state and local taxes

Auctioned regularly by the Treasury

Bids can be competitive or non-competitive

Sell in minimum denominations of $10,000

Certificates of Deposit (C Ds)

Sell on an add-on interest basis

Insured to $250,000 by the F D I C

For the larger banks the insurance level is assumed to be much larger

C Ds with denominations of $100,000 or more are negotiable

Commercial Paper (C P)

Basically a short-term, unsecured note (bond)

Maturities of 270 days or less are exempt from S E C registration requirements

Less liquid than other money market securities

Frequently C P is directly placed

Bankers Acceptances

A time draft drawn on and accepted by a commercial bank

Generally created by a transaction between exporters and importers in different countries

Maximum maturity is legally established at 180 days

The Market for Overnight Money

Federal Funds – short-term lending between banks generally to maintain required reserves

Other financial inst. have entered this market

Repurchase Agreements (Repos) – Sale of a security with the agreement to repurchase the security at a higher price in the near future

Eliminates price risk for the lender

Pricing Money Market Securities

Pricing formula for money market securities that trade on a discount basis e.g. T-bills

Where F is the security’s face value,

is its quoted

bank discount rate, and n is its days to maturity

Returns on Money Market Securities

Two principle return measures are: bond equivalent yield

and effective annual yield

Capital Market Securities

Marketable debt with maturity greater than one year and equity securities, which have no maturity date

Riskier than money market securities

Fixed-income securities have a specified payment schedule

Bond Characteristics 1

Bonds are long-term debt instruments/I O Us

Buyer of a newly issued coupon bond lends money to issuer, issuer agrees to pay interest and re-pay principal at maturity

Bonds are fixed-income securities

Buyer knows future cash flows – interest and principal payments

Major Bond Types

U.S. government/Treasury securities

Government agency securities

Federal agencies, G S Es, M B Ss

Municipal securities

General Obligation and Revenue

Exempt from federal taxes and potentially state and local

Corporate bonds

Treasury Notes & Bonds

Obligations of the federal government

Notes have less than 10 years to original maturity, bonds have 10 or more years

Income from T-notes and T-bonds is exempt from state and local taxes

Treasury strips: claims to a portion of either the interest or principal payments

Other Federal Government Bonds

Government Agency Bonds – obligations of agencies of the federal government

Most were established to finance housing; farming and student loans also exist

Either federally related or govt. sponsored

Many agencies issue debt with income that is exempt from state and local taxes

Example agencies include: Fannie Mae, Freddie Mac, Ginnie Mae

Bond Characteristics 2

Bond is worth exactly face value at maturity

Price changes depend on interest rates

Interest rates and bond prices move inversely

Bond buyer in secondary market must pay the price of the bond plus accrued interest

Price is quoted without accrued interest

Premium: amount above par value

Discount: amount below par value

Callable Bonds

Allow issuer to “call in” the bonds from investors

Option is attractive to issuer when market rate drops sufficiently below coupon rate

Issuer saves by replacing higher interest-cost bonds with new, lower rate bonds

Wise investors note the bond’s call provision

Most Treasury bonds cannot be called

Corporate Bonds

Usually unsecured and often callable

Receive payment priority in bankruptcy or liquidation

Convertible bonds may be exchanged for another asset at the owner’s discretion

Risk that issuer may default on payments

New Type: Inflation-protected securities

Bond Ratings 1

Reflect probability of default, relative rating

Rating organizations

Standard and Poor’s, Moody’s, Fitch

Rating firms perform credit analysis for investors, may disagree on ratings

Bond ratings and coupon rates are inversely related

Bond Ratings 2

Investment grade securities

Rated A A A, A A, A, B B B

Many institutional investors buy only these

Speculative securities

Rated B B, B, C C C, C C

Significant uncertainties

Junk bonds

Rated B B or lower

High-risk, high-yield bonds

Securitization

Packaging illiquid, risky individual loans into more liquid, less risky asset-backed securities (A B Ss)

A B S is a securitized interest in a pool of non-mortgage assets

Alternative assets include: auto loans, credit-card receivables, small-business loans, leases

A B Ss can be structured in tranches with different prices, credit ratings, maturities

State & Local Government Bonds

Municipal Bonds – obligations of state and local governments

Interest income is exempt from federal taxation and possibly state and local taxation

Returns on municipal bonds:

Where: RTEY = taxable equivalent yield; Rm = yield on tax exempt security; t = marginal tax rate

Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 3

Indirect Investing

Alternative to direct investment

Accomplishes essentially the same thing as direct investing

Refers to buying and selling the shares of intermediaries that hold security portfolios

Shares represent ownership in the security portfolio

Shareholders pay expenses and management fee

Investment Companies

Firms that sell shares and use the proceeds to invest in marketable securities

Act as a conduit for distribution of dividends, interest, and realized gains

Offer professional management

Regulated but not insured or guaranteed by any federal agency

Shareholders pay taxes as if they directly owned securities

Company Types 1

Unit Investment Trusts (U I Ts)

Typically hold an unmanaged, fixed-income portfolio

Relatively small share of market

Closed-End Investment Companies

Actively managed portfolio

Fixed number of shares

Trade on stock exchanges like other stocks

Company Types 2

Exchange Traded Funds (E T Fs)

Portfolio of assets that tracks a sector, region, or market

Trade like individual equities on exchange

Extremely low operating expenses

Typically unmanaged portfolios

Tax efficiency

Investor has greater control over realization of capital gains/losses than with a mutual fund

Company Types 3

Mutual Funds (Open-end Investment Cos.)

Investors buy fund shares from, and sell shares to, the investment company, not sold on exchanges

Number of shares outstanding changes constantly (unlike closed-end funds)

Offer diversification, divisibility, professional management, other services

Popular with investors, especially in retirement plans

Mutual Fund Categories 1

Money Market – hold money market securities

Equity:

Income (Value) – high yielding, low risk stocks

Growth – low yielding, high risk stocks

Small, Mid, Large-Cap

Bond – invest in fixed income securities

Balanced – hold a combination of bonds and stocks, generally low risk securities

Mutual Fund Categories 2

Index – track a market index such as the S&P 500

International – invest in foreign securities from various parts of the world

Other Miscellaneous –

Country, continent, or region of the world

Industry or sector

Tax exempt securities

Mutual Fund Categories 3

Money Market Funds (M M Fs)

Invest in money market securities

Taxable or tax-exempt

Investors pay a management fee, but no load

Not insured by the federal government

Attempt to keep price above $1/share

Offer broad diversification, great liquidity and a way to earn going money market rate

Index Funds

Mutual funds designed to match a market index

Unmanaged portfolio, typically with a low expense ratio

Expenses vary widely, though, so investors need to be sure expenses are reasonable

Often outperform actively managed mutual funds

Mutual Fund Charges

Front-end load – sales charge when purchased

Back-end load – fee incurred when shares sold

Operating expenses – costs incurred in managing the portfolio

12B-1 charges – costs incurred for advertising, fund reports, brokerage commissions etc.

No-load funds: no front- or back-end loads

Net Asset Value Per Share (N A V)

N A V is per share value of securities in a fund

N A V equals market value of securities, minus any liabilities, divided by shares outstanding

Changes daily and is calculated after markets close at 4 p.m.

N A V is price investors pay (receive) when a fund is purchased (sold)

This assumes the fund is a no-load fund

The Details of Indirect Investing 1

Closed-end funds

Market price often differs from N A V

Price may be less than N A V (discount) or more than N A V (premium)

Portfolio’s return calculated based on N A V

Shareholder’s return is based on fund price

Individual investors should avoid purchasing newly offered shares of closed-end funds

The Details of Indirect Investing 2

Mutual Funds

Investors can purchase directly or indirectly

Often require a small minimum investment

Investors can redeem shares anytime

Investors purchase/redeem at N A V ± sales fee

Fund’s prospectus discloses fees and expenses

Load funds charge a sales fee

No-load funds do not charge a sales fee

The Details of Indirect Investing 3

Mutual Fund Share Classes

Gives investors choice over fees

Each class has same claim on portfolio, same N A V

No-load funds

Purchased at N A V from investment company

No sales force expense to cover

Investors must seek out fund

Operating expenses paid from fund income

All funds charge an expense ratio

The Details of Indirect Investing 4

Exchange-Traded Funds (E T Fs)

Can be bought or sold any time during the trading day

Can be bought on margin or sold short

Have much lower expenses than actively managed funds

Can weight indexes differently, which can affect return

Exchange Traded Notes (E T Ns)

Exchange traded notes – a senior, unsecured debt security issued by a financial firm (G S, U B S etc.)

Linked to the performance of a benchmark (an index)

Objective is similar to E T Fs; provide exposure to an underlying asset

May not own the underlying asset

Fund Performance

Reported on a regular basis in popular press

Price performance not the same as total return

Total return includes price changes and dividend income

Costs and taxes should also be considered

Expenses may be the best indicator of a fund’s performance

International Funds

Some funds specialize in international securities

Often have higher costs

International funds differ from global funds

Single-country funds concentrate on one country

Some funds match foreign indexes

May or may not hedge against currency risk

The Future of Indirect Investing 1

Mutual fund “supermarkets”

Investors can buy/sell funds from various mutual fund families through a single source

Schwab and Fidelity are largest supermarkets

Offer fee and no-fee “aisles”

Management fee covers two levels of provider

The Future of Indirect Investing 2

Hedge Funds:

Relatively unregulated, pooled-investments

Invest primarily in publicly traded securities Employ combinations of long and short positions with alternative levels of leverage

Typical approach is to hedge general market conditions and focus on security selection

Returns accrue from long, short, and cash position

Hedge Funds

Common strategy is long/short strategy

Attempt to be market neutral

Broaden ability to capitalize on manager’s security selection skills

Higher unsystematic risk than long only funds

Unlimited loss on shorts

Reported performance is relatively good

Diversification potential

Major Types of Hedge Funds

Equity market neutral

Fixed-income arbitrage

Global macro

Hedged equity

Distressed securities

Merger arbitrage

Fund of funds

Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 6

The Risk and Return from Investing

Asset Valuation

Value is a function of risk and return

At the center of security analysis

Historical risk-return relationships are useful indicators

No guarantee future will be like past

No reason to assume future relative relationships will differ significantly from past

Historical relationships especially useful in the long-run

Return Components

Return consists of two elements:

Yield

Periodic cash flows such as interest or dividends

Capital gain (loss)

The change in asset price

Total Return = Yield + Percent Price Change

Investors sometimes focus only on one component

Measuring Returns 1

Return measures allow investors to compare performance over time and across securities

Total return (R) is a percentage relating all cash flows to the start of period price, PB

For a single period:

Measuring Returns 2

Returns can be either positive or negative

When cumulating or compounding, negative returns are problematic

A return relative (R R) solves this problem because it is always positive

Measuring Returns 3

To convert returns to wealth and compound over time, use the cumulative wealth index

Cumulative wealth index, C W In, over n periods =

W I0 = Starting wealth

Measuring International Returns

International investments incur exchange rate risk

Buying foreign assets subjects investors to exchange rate risk

Returns are reduced if foreign currency depreciates

Return in domestic currency equals,

Measures for a Return Series

How do you summarize returns over several time periods?

Arithmetic mean, or simply mean,

Arithmetic versus Geometric

Geometric mean captures compound growth rate over time

Reflects realized change in wealth over multiple periods

Reflects compound, cumulative returns over more than one period

Reflects true average compound growth rate over multiple periods

Arithmetic mean reflects typical return in a single period

Geometric Mean

Defined as the n-th root of the product of n return relatives (1 + R) minus one, or G =

Adjusting Returns for Inflation

Return measures are nominal, i.e., are not adjusted for inflation

Purchasing power of investment may change over time

Nominal return (R) = [1+ real return (Rr)] × [1+ expected inflation rate (Ir)] − 1

Consumer Price Index (C P I) is a possible measure of inflation

Risk

Risk and return are opposite sides of the same coin

Risk is the chance that a security’s actual return will differ from its expected return

Investors willing to assume large risks may gain large returns, but they may also lose money

Risk Sources

Interest Rate Risk

Market rates change

Market Risk

Recession, war, etc.

Inflation Risk

Purchasing power variability

Business Risk

Risk inherent in business

Financial Risk

Tied to debt financing

Liquidity Risk

Marketability of security

Currency Risk

Exchange Rate Risk

Country Risk

Political stability

Measuring Risk

Risk arises from variability of outcomes

Variance and standard deviation measure variability

Standard deviation is simply the square root of the variance

Returns for Major Asset Classes

Risk Premiums

Premium is additional return earned or expected for additional risk

Calculated for any two asset classes

Equity risk premium – difference between stock return and risk-free return

Stocks versus Treasury bills

Stocks versus Treasury bonds

The Risk-Return Record

From 19 26 to 2018, geometric average annual return was 10.0% for S&P 500

Arithmetic mean was 11.9%

Standard deviation was 19.8%

Smaller common stocks showed greater risk and return than large common stocks

T-bills showed lowest risk and return: 3.3% return and 3.1% standard deviation

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 7

Portfolio Theory

Investment Decisions

Involve uncertainty

Focus on expected returns

Estimates of future returns need to consider and manage risk

Investors often overly optimistic about expected returns

Goal is to reduce risk without affecting returns

Accomplished by building a portfolio

Diversification is key

Risk and Return Measures 1

Ex post Calculations

Mean (Average) Return

Variance of Return

Risk and Return Measures 2

Ex ante Calculations

Expected return:

Variance of Returns

Where, Ps equals probability of state s and Rs equals return in state s.

Dealing With Uncertainty

Risk – the fact that an expected return may not be realized

Investors must think about return distributions

Probabilities weight outcomes

Assigned to each possible outcome to create a distribution

History provides guide but must be modified for expected future changes

Distributions can be discrete or continuous

Calculating Expected Return

Expected return for asset “i” E(Ri)

Weighted average of all possible returns (Ri,s) included in the probability distribution

Each outcome weighted by probability of occurrence (Ps)

Referred to as expected return

Calculating Risk

Variance and standard deviation used to quantify and measure risk

Measure spread (dispersion) around the mean

Variance of returns is in percent squared

Standard deviation of returns (σ) is the square root of variance and is measured in percent

Modern Portfolio Theory

Framework for selection of portfolios based on risk and expected return

Used, to varying degrees, by financial managers

Quantifies benefits of diversification

Security correlations are crucial in determining portfolio risk

An asset with high volatility may have low risk

Portfolio Expected Return

Weighted average of the individual security expected returns

Each asset “i” has a weight, w, which represents the asset’s value as a percent of the portfolio value

Portfolio Risk 1

Portfolio risk is measured by the variance or standard deviation of portfolio returns

Portfolio variance is impacted by two characteristics:

The variance in returns for the individual assets included in the portfolio

The co-movement of returns for the individual assets included in the portfolio

Portfolio Risk 2

Portfolio risk is “not” the weighted average of individual security risks

The risk of individual securities is “not” the crucial consideration

Diversification almost always lowers risk

An asset with high σ may add little to portfolio risk

Portfolio Risk 3

Variance of a Portfolio

σij = covariance of asset i and asset j

Risk Reduction in Portfolios 1

Market risk affects all firms, cannot be diversified away

It is systematic i.e., part of the system

The larger the number of securities, the smaller the exposure to any particular risk

“Insurance principle”

Only issue is how many securities to hold

Risk Reduction in Portfolios 2

Random (or naïve) diversification

Diversifying without looking at how security returns are related to each other

Marginal risk reduction gets smaller as securities are added

Random diversification is beneficial but not optimal

Risk reduction kicks in as securities added

Research suggests it takes a large number of securities to eliminate majority of risk

Security Co-movement

Correlation (ρij) and covariance (σij) measure the tendency for security returns to move in the same or opposite directions

Correlation (ρij)

ρij > 0	securities move together
ρij < 0	securities move apart
ρij = 0	no tendency one way or the other
ρij = −1	perfect negative correlation
ρij = +1	perfect positive correlation

Correlation and Portfolio Risk

Returns to H-Tech

Returns to Giffen

Portfolio: 50% Giffen & 50% H-Tech

Correlation Coefficient

When does diversification pay?

With perfect positive correlation, risk is a weighted average, therefore, no diversification benefit

With perfect negative correlation, expected return can be assured

With zero correlation, significant risk reduction can be achieved

Cannot eliminate risk

Negative correlation or low positive correlation is ideal, but unlikely

Calculating Portfolio Risk 1

Three inputs to calculate portfolio risk

Variance (risk) of each security

Covariance between each pair of securities

Portfolio weights for each security

Goal: select weights to determine the minimum variance combination for a given level of expected return

Calculating Portfolio Risk 2

Generalizations

The lower the correlation/covariance between securities, the better

As the number of securities increases:

Number of covariances grows quickly

The importance of covariance relationships increases

The importance of each individual security’s risk decreases

Simplifying Markowitz Calculations

Markowitz full-covariance model

Requires a covariance between the returns of all securities in order to calculate portfolio variance

set of unique covariances for n securities

Markowitz suggests using an index to which all securities are related

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 8

Portfolio Selection

Building a Portfolio

Diversification is key to risk management

Asset allocation most important single decision

Using Markowitz Principles

Step 1: Identify optimal risk-return combinations using the Markowitz analysis

Inputs: Expected returns, variances, covariances

Step 2: Choose the final portfolio based on your preferences for return relative to risk

Portfolio Theory

Optimal diversification takes into account all available information

Assumptions in portfolio theory

A single investment period (one year)

Liquid position (no transaction costs)

Preferences based only on a portfolio’s risk and expected return

The Efficient Frontier

Efficient Frontier – represents the set of all mean/variance efficient (optimal) portfolios

Optimal portfolio has maximum return for a given level of risk or minimum risk for a given level of return

Portfolios on the efficient frontier dominate all other portfolios

No portfolio on the efficient frontier dominates another portfolio on the frontier

Efficient Portfolios

Efficient frontier or Efficient set (curved line from A to B)

Global minimum variance portfolio (represented by point A)

Portfolios on A B dominate all other possible portfolios

Selecting an Optimal Portfolio of Risky Assets 1

Portfolio weights are the output from Markowitz analysis

Assume investors are risk averse

Indifference curves (I Cs) determine individual’s optimal portfolio

I C, description of preferences for risk and return

I C reflects portfolio combinations that are equally desirable

I Cs match investor preferences with portfolio possibilities

The Optimal Portfolio

Goal is to achieve highest (most N W) attainable curve

Selecting an Optimal Portfolio of Risky Assets 2

International diversification unlikely to offer as much risk reduction as in the past

Markowitz portfolio selection model

Assumes investors use only risk and return to decide

Generates a set of equally “good” portfolios

Does not address the issues of borrowed money or risk-free assets

Cumbersome to apply

Selecting Optimal Asset Classes

Another way to use Markowitz model is with asset classes

Allocation of portfolio to asset types

Asset class, rather than individual security, is most important for investors

Can be used when investing internationally

Different asset classes offer various returns and levels of risk

Correlation coefficients may be quite low

Asset Allocation 1

Includes two dimensions

Diversifying across asset classes

Diversifying within asset classes

Asset classes include:

Equities – foreign and domestic

Bonds – foreign, domestic, and government

Treasury Inflation-Protected Securities (T I P S)

Alternative assets – real estate, commodities, private equity, hedge funds, etc.

Asset Allocation 2

Correlation among asset classes must be considered

Correlations change over time

For investors, allocation depends on

Time horizon

Risk tolerance

Diversified asset allocation does not guarantee against loss

Commodity Funds

Commodities:

Precious metals, industrial metals, livestock, grains, oil products, etc.

Types of commodity funds:

Bullion – hold physical asset

Synthetic – use derivative security

Equity – hold equities of firms engaged in business

Asset Allocation 3

Index Mutual Funds, E T Fs and E T Ns

Cover various asset classes: domestic and foreign stocks (all investment styles), alternative assets (e.g. real estate, commodities), bonds of all types

Life Cycle Analysis

Varies asset allocation based on investor age

Life-cycle funds (target-date funds) vary allocation as investor ages

No one “correct” approach to allocation

Systematic & Unsystematic Risk 1

The variance (risk) of a portfolio, or a single security, consists of both systematic risk and unsystematic risk

Systematic & Unsystematic Risk 2

Systematic risk is not diversifiable

Systematic risk – risk of an overall movement in the market

nondiversifiable  systematic  market risk

Unsystematic risk is diversifiable

Unsystematic risk – risk of an event that is unique to the asset or a small group of assets

diversifiable  unsystematic  unique risk

Portfolio Risk and Diversification

Number of securities in portfolio

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 9

Capital Market Theory and Asset Pricing Models

Capital Asset Pricing Model 1

Positive rather than normative

It is objective and fact-based, not subjective or opinion-based

Focus on the equilibrium relationship between the risk and expected return on risky assets

Builds on Markowitz portfolio theory

Each investor is assumed to diversify his or her portfolio according to the Markowitz model

Capital Asset Pricing Model 2

Assumes all investors:

Use the same information to generate an efficient frontier

Have the same one-period time horizon

Can borrow or lend money at the risk-free return

No transaction costs, no income taxes, no inflation

No single investor can affect the price of a stock

Capital markets are in equilibrium

Risk-Free Asset, Borrowing, Lending

Risk free asset

No correlation with risky assets

Usually proxied by a Treasury security

Adding a risk-free asset extends and changes the efficient frontier

Risk-free investing is “lending” because investor lends money to issuer

With borrowing, investor no longer restricted to personal wealth

Risk-Free Lending/Borrowing

Risk-free asset combined with port. T (T is part of efficient set AB)

RF to T: lending portfolios

T to L: borrowing portfolios

Portfolios on line R F to L dominate all portfolios below (e.g., Z and X)

The New Efficient Set

Risk-free investing and borrowing creates a new set of risk-expected return possibilities

Addition of risk-free asset results in:

A change in the efficient set from an arc to a straight line tangent to the original frontier

Chosen (optimal) portfolio depends on investor’s risk-return preferences

Capital Market Line 1

Line from RF to L is capital market line (CML)

x = risk premium = E(RM) − RF

y-intercept = RF

Capital Market Line 2

Slope of C M L is the market price of risk for efficient portfolios, or the equilibrium price of risk in the market

Relationship between risk and expected return for portfolio P (Equation for C M L):

Market Portfolio

Most important implications of C M L

The portfolio of all risky assets is the optimal risky portfolio (called the market portfolio)

The expected price of risk is always positive

The optimal portfolio is at the highest point of tangency between R F and efficient frontier

All investors hold the same optimal portfolio of risky assets

Characteristics of Market Portfolio

All risky assets must be in portfolio, so it is completely diversified

Includes only systematic risk

Unobservable but approximated with portfolio of all common stocks

In turn, approximated with S and P 500

All securities included in proportion to their market value

The Separation Theorem

Investors use their preferences (indifference curves) to determine optimal portfolio

Separation Theorem

The investment decision about which risky portfolio to hold is separate from the financing decision

Investment decision does not involve investor

Financing decision depends on investor’s preferences

Remaining Questions Not Addressed by CML

How do you determine the expected return for individual securities or undiversified portfolios?

How do investors determine the risk a security will add to their portfolio?

* Solution is achieved by assuming investors hold well-diversified portfolios

Security Market Line

C M L only applies to markets in equilibrium and efficient portfolios

The security market line (S M L) depicts tradeoff between risk and expected return for individual securities and portfolios

Under C A P M, all investors hold the market portfolio

Relevant risk of any security is, therefore, its covariance with the market portfolio

Beta – What does it tell us?

Standardized measure of systematic risk

Relative measure of risk: risk of an individual stock relative to the market portfolio of all assets

Relates an asset’s covariance with the market portfolio to the variance of the market portfolio

Beta (β) – What is it?

Risk an asset will add to a well-diversified portfolio

Measures an asset's nondiversifiable risk

Slope of the line formed when an asset’s returns are regressed against the market return

Measure of the sensitivity of an asset’s returns to changes in the market return

The relevant risk measure for well-diversified investors

Beta Characteristics

Beta > 1; security moves with the market, only more; security is riskier than average

0 < Beta < 1; security moves with the market, only less

Beta < 0; security moves counter to the market

Market beta equals 1

Portfolio beta is a weighted average of individual stock betas

Betas of Selected Companies

Company	Beta
Amazon	1.35
McDonald’s	0.72
Kellogg Company	0.64
Bristol- Myers Squibb	0.80
Walmart	0.87
FirstEnergy	0.50
Conoco Philips	0.74
Delta Air Lines	1.29
Goldman Sachs	1.35
Barrick Gold	0.32
FedEx	1.31

C A P M’s Expected Return-Beta Relationship

Required return on asset (ki) is composed of:

Risk-free rate (RF )

Risk premium

The greater the systematic risk, the greater the required return

Beta and the SML/CAPM

Beta = 1.0; equal risk to market (average)

Securities A and B are more risky than the market

Beta > 1.0

Security C is less risky than the market

Beta < 1.0

Estimating the S M L

Treasury bond rate used to estimate R F

Expected market return unobservable

Often estimated using past market returns and taking a mean value

Estimating security betas is difficult

Beta is only company-specific factor in C A P M

Beta estimation requires asset-specific forecast

SML and Under(Over)-Valued Assets

Securities ABC and XYZ are undervalued

Security L M N is overvalued

C A P M/S M L Implications

Higher risk assets require higher returns

Investors are only compensated for bearing non-diversifiable risk

Asset prices are not impacted by diversifiable risk

Undiversified investors have an inferior risk-expected return trade-off

Investors determine the risk they bear; market determines their compensation

Estimating Beta

Market model

Relates a stock’s return to the return on the market, assumes a linear relationship

Produces an estimate of return for any stock

Characteristic line

Line fit to a security’s return relative to the market index

Amazon’s Characteristic Line

Slope = rise ÷ run = Beta

Is AMZN’s beta > 1?

How Accurate Are Beta Estimates? 1

Betas change with a company’s situation

Estimating a future beta

May differ from the historical beta

RM represents the total of all marketable assets in the economy

Approximated with a stock market index

Approximates return on all common stocks

How Accurate Are Beta Estimates? 2

Methods for estimating beta vary by time period, market index, return interval, etc.

Therefore, estimates of beta vary

Regression estimates of true

from the

characteristic line are subject to error

Portfolio betas are more reliable than individual security betas

Tests of C A P M

Assumptions are mostly unrealistic

Empirical evidence has not led to consensus

Points widely agreed upon

S M L (C A P M) appears to be linear

Intercept is generally higher than R F

Slope of S M L is generally less than theory predicts

It is likely that only systematic risk is rewarded

Arbitrage Pricing Theory

Based on Law of One Price

Two assets with identical future cash flow streams cannot sell at different prices

Equilibrium prices adjust to eliminate all arbitrage opportunities

Unlike C A P M, A P T does not assume

Single-period investment horizon, absence of taxes, riskless borrowing or lending, mean-variance decisions

Factors

A P T assumes returns generated by a factor model that allows for more than 1 factor

Factor Characteristics

Each risk must have a pervasive influence on stock returns

Risk factors must influence expected return and have non-zero prices

Risk factors must be unpredictable to the market

A P T Model

Most important – the deviations of the factors from their expected values

Expected return is directly related to sensitivity

C A P M assumes only risk is sensitivity to market

Expected return-risk relationship for the A P T can be described as:

Problems with A P T

Risk factors are not specified ex ante

To implement A P T model, need factors that account for differences in security returns

C A P M identifies market portfolio as single factor

Studies suggest certain factors are reflected in security returns

Both C A P M and A P T rely on unobservable expectations

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 10

Common Stock Valuation

Fundamental Analysis

Discounted Cash Flow Techniques

Intrinsic value based on the discounted value of the expected stream of cash flows

Dividend discount model can be challenging to apply in many cases

Multiplier Approaches

Relative Valuation Metrics

Emphasize stock comparisons rather than valuation

Discounted Cash Flow Approach

Intrinsic value of a security is:

k = appropriate discount rate

Estimated intrinsic value is compared to current market price to make investment decision

Dividend Discount Model (D D M) 1

Special case of equity valuation model

Current value of stock is discounted value of all future dividends

Required return is minimum return that induces investor to buy stock

Implementing the D D M

Dividends must be valued for infinity

Practically is not an insurmountable problem

Dividend stream is uncertain

Dividends expected to grow over time

Estimated growth in dividends can be incorporated into D D M

Three growth cases: zero, constant, multiple

Dividend Discount Model (DDM) 2

Zero-Growth Rate Model

Fixed dollar amount of dividends – security is treated as a perpetuity

Commonly applied to preferred stock because dividend remains unchanged

Values future stream of dividends from now to infinity

Present Value Growth Opportunities (P V G O)

P V G O represents the value investors are assigning to a firm’s growth opportunities

P V G O is estimated by taking the difference between a firm’s current stock price (P) and its no-growth value

* E1 is the firm’s forecasted E P S for next year

Dividend Discount Model (D D M) 3

Constant Growth Rate D D M:

Dividends expected to grow at a constant rate, g, over time

D1 is expected dividend one period from now

D1 = D0  (1 + g), where D0 is current dividend

Model values all cash flows from now to infinity

Constant Growth Rate D D M

Constant growth model should be used to value stocks that pay a stable dividend with an expected persistent growth

Methods to obtain an estimate for g:

project from past growth in dividends

use formula  g = ROE × retention ratio

employ analysts’ estimates of g

Retention ratio = (1− dividend payout ratio)

Dividend Discount Model (D D M) 4

Implications of constant growth D D M

Stock price grows at same rate as dividends

Stock return grows at required rate of return

Growth in price plus growth in dividends equals k, the required rate of return

Lower required return or higher expected growth raises the price

Model is very sensitive to small variations in inputs

Dividend Discount Model (DDM) 5

Multiple-Growth Rate D D M

Two or more expected growth rates

Two-stage and three stage models assume unusual growth for n periods followed by steady/constant growth

H-Model

Special case of multi-stage D D M

Assumes dividends decline linearly from initial short-term growth (gs) to stable long-term constant growth (gc)

* H is the half life of the projected unusual growth period

Dividend Discount Model (D D M) 6

Multiple growth rates

First value covers the period of unusual growth

Second value covers the period of stable growth

Limitations

Very sensitive to inputs

Difficult to determine term of unusual growth

Assumes immediate transition to constant growth

What about Capital Gains?

D D M accounts for capital gains

Future price reflects expected dividends from that point forward

D D M assumes price appreciates at “g”

Valuing only dividends or a combination of dividends and price produces same result

Rearranging D D M shows two components of expected return:

Other Discounted Cash Flows

Free Cash Flow to Equity (F C F E): What firm could pay in dividends

F C F E = net inc. + deprec. − capital expend. − working cap. expend. + net borrowing

Free Cash Flow to Firm (F C F F): Cash available before any financing considerations

F C F F = F C F E + int. exp. (1 − tax rate) − net borrowing

Intrinsic Value

Estimated value of stock today

Derived from estimating and discounting future cash flows with a valuation model

If intrinsic value is:

greater than current market price, purchase (or hold) asset because it is undervalued

less than current market price, do not purchase (or sell) asset, it is overvalued

Remember that models produce value estimates

Multiplier Approach for Valuation 1

Alternative to discounted cash flow approach

Widely used approach due to ease of interpretation and calculation

Value estimate is the product of two inputs

Firm financial characteristic

Estimated price multiple (multiplier)

Multiplier Approach for Valuation 2

Used with a variety of price multiples

P/S, P/B, P/C F, E V/E B I T D A

P/E multiple (ratio) is the most commonly considered multiplier

Reflects price paid for each $1 of earnings

Approach is also used to value other asset types

Commonly applied to real estate

P/E Multiplier Approach

To estimate a stock’s value (V0), an analyst must forecast next period’s E P S (E1) and the appropriate current multiplier for next period’s estimated E P S  (P0/E1)A

Relative Valuation 1

Compare firm to peers, or the market, to assess relative valuation

Most applicable when comparison is between similar type firms

Apply the same multiples as used in the multiplier approach

P/E, P/B, P/S, P/C F and E V/E B I T D A

P/E ratios tend to be emphasized

Relative Valuation 2

Higher multiples imply greater expected growth prospects, more investor optimism

P/E – most commonly assessed multiple

P/B – most useful with firms with hard assets and liquid assets

P/S – advocated for intercountry comparisons within industry

P/CF – C F less prone to manipulation than E P S

Relative Valuation 3

Methods that combine financial measures

E V/E B I T D A – controls for debt differences across firms

Newer measure with strong empirical support

Economic Value Added (E V A)

Difference between operating profits and company’s capital cost

Emphasizes return on capital

Which Approach Is Best?

Discounted cash flow is theoretically best

Application is difficult in some cases

Price multiples serve dual role

Estimating intrinsic value of stock

Relative valuation

All methods subject to estimation error

Traditional methods apply to “new economy” stocks: revenues and profits do matter

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 11

Common Stocks: Analysis and Strategy

Impact of the Overall Market

Pervasive and dominant

The single most important risk affecting the price movement of common stocks

Particularly true for a diversified portfolio of stocks

Can account for 90% or more of the variability in a well-diversified portfolio’s return

Investors buying foreign stocks face the same situation

Building a Portfolio

Two step decision process:

Asset Allocation

% of wealth allocated to various asset classes such as stocks, bonds, real estate, and cash

This decision is the main factor in determining the risk and return of the portfolio

Security Selection

Determining the individual securities in each asset class

Passive Stock Strategies 1

Natural outcome of belief in efficient markets

No active strategy should be able to beat the market on a risk-adjusted basis over time

Aim, to do as well as the market

Emphasis is on minimizing transaction costs and time spent in managing the portfolio

No attempt to time market or find undervalued stocks

Assume benefits from active trading are less than the costs

Passive Stock Strategies 2

Forms of passive investing:

Buy & hold: investor purchases securities and holds them to meet some future objective

Indexing: investor purchases fund designed to match performance of a broad portfolio

Mutual funds, E T Fs and E T Ns

Enhanced indexing: fund that represents an index with a slight variation

WisdomTree fundamentally-weighted funds

Passive Stock Strategies 3

Buy-and-hold strategy

Avoids the transactions costs and errors that accompany active management

Relatively tax efficient strategy

Initial portfolio selection needs to be made

Investors still must take some actions

Reinvesting portfolio income

Adjusting to changes in risk tolerance

Passive Stock Strategies 4

Index funds

Mutual funds designed to duplicate the performance of some market index

No attempt is made to forecast market movements and trade on forecast

No attempt to select under- or over-valued securities

Low costs to operate, low turnover, tax efficient

Passive Strategies, Index Funds

Historical returns show index funds generally outperform actively managed funds

Index funds are available in many forms

Available as E T Fs, E T Ns and mutual funds

Funds track broad indexes e.g., S&P 500 and Nasdaq 100

Funds track foreign indexes e.g., E A F E and Nikkei

Funds track strategies such as small cap, value, large cap, growth, etc.

Active Stock Strategies 1

Assumes the investor possesses some advantage relative to market participants

Superior information, analytical skills, ability to do what other investors cannot

Most investors favor this approach despite efficient markets support

Both the potential rewards and risks are large

Active Stock Strategies 2

Traditional strategy is to select individual stocks

Majority of investment advice geared to stock selection

Investors focus on E P S forecasts

Growth stocks and value stocks

Value stocks “cheap” relative to fundamentals

Growth stocks have strong prospects

Value investing takes long-term, sometimes contrarian approach

Active Stock Strategies 3

Security analysts forecast stock value

Sell-side analysts: reports used to “sell” idea

Buy-side analysts: employed by money management firms to generate reports

Research typically only available to employers

Estimates provided by analysts

Expected performance, earnings estimates, price targets

Recommendations: Buy, Hold, or Sell

Active Stock Strategies 4

Recommendation changes often affect stock prices

Analysts focus on forecasting earnings

Typically overly optimistic about long-term E P S

Analysts rarely recommend selling

Analysts generally good at analyzing industries

Good independent info sources available

Value Line Investment Survey, S&P’s Outlook, Morningstar

Active Stock Strategies 5

Number of Analyst Recommendations by Type for the S&P 500 Stocks

Sector Rotation

Involves shifting sector weights in the portfolio

Over-weight sectors expected to perform well, under-weight those expected to perform poorly

Four broad sectors:

Interest-sensitive, consumer durables, capital goods, and defensive stocks

Subject to greater risk than investing in overall market

Can be pursued with sector mutual funds, E T Fs

Market Timing

Market timers attempt to earn excess returns by varying % held in equities

Shift to cash when stocks expected to do poorly

Success depends on the amount of brokerage commissions and taxes paid

Research suggests market timing is risky

Investors may not be in market at critical times and may miss out on returns

Rational Markets and Active Strategies

If market is efficient, prices reflect fair value

Active strategies are unlikely to be successful over time after all costs

Market efficiency proponents argue that little time should be spent on security analysis

Spend time on reducing taxes/costs and maintaining chosen portfolio risk

Investor’s beliefs affect strategy implemented

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 12

Market Efficiency

Efficient Markets 1

In perfectly efficient markets, all securities are priced correctly

Information is key

Prices quickly and fully reflect all available information

Prices offer expected return consistent with risk level

Prices reflect past, current, and reasonably inferred information

Price adjustments are not perfect, but are unbiased

Efficient Markets 2

The Adjustment of Stock Prices to Information

Conditions for an Efficient Market

Large number of rational, profit-maximizing investors

Actively participate in the market

Individuals cannot affect market prices

Information is costless, widely available, generated in a random/independent fashion

Investors react quickly and fully to new information

U.S. security markets are likely efficient

Market Efficiency Forms

Efficient market hypothesis (E M H)

To what extent do securities markets quickly and fully reflect particular information?

Three levels of Market Efficiency

Weak form – market-level data

Semistrong form – public information

Strong form – all (nonpublic) information

Weak Form

Prices reflect all past price and volume data

History of price information is of no value in predicting price changes

Technical analysis, which relies on past price history, is of no value in assessing future changes in price

Market adjusts or incorporates this information quickly and fully

Believer in weak form could trade actively

Semistrong Form

Prices reflect all publicly available information

Investors cannot benefit from new public information after its announcement

Encompasses weak form as a subset

Strong Form

Prices reflect all information, public and private

No group of investors should expect to earn abnormal returns by using publicly or privately available information

Encompasses weak and semi-strong forms as subsets

Investor who believes in strong form should be passive

Testing for Market Efficiency 1

Market efficiency tests are tests of two hypotheses:

The market is efficient

Abnormal returns are measured correctly

Market-adjusted returns

Risk-adjusted returns

C A P M and market model

Match to similar firm

Multi-factor models

Testing for Market Efficiency 2

Keys:

Consistency of returns in excess of risk

Length of time over which returns are earned

Economically efficient markets

Assets are priced so that investors cannot exploit any discrepancies and earn unusual returns

Transaction costs matter

Weak-Form Tests

Statistical tests for independence (randomness) of stock price changes

If independent, trends in price changes cannot be profitably exploited

Test specific trading rules that attempt to use past price data

Account for costs, compare to buy-and-hold

Statistical dependence not the same as economic dependence

Semistrong-Form Tests

Event studies

Empirical analysis of stock price behavior surrounding a particular event

Examine company-unique returns

Residual error between security’s actual return and index model prediction: abnormal return

Abnormal return (Arit) = Rit − E(Rit)

Cumulative abnormal return (C A R) is sum of Arit over time

Strong Form Evidence

Test performance of groups which have access to “true” nonpublic information

Corporate insiders have valuable private information

Evidence that many have consistently earned abnormal returns on their stock transactions

Insider transactions must be publicly reported

Information can mislead investors

Market Anomalies 1

Exceptions that appear to be contrary to market efficiency

Earnings announcements affect stock prices

Effect must be separated into expected and unexpected

Unexpected requires price adjustment

In efficient market, prices should adjust quickly

Research shows substantial post-announcement adjustment for some stocks

This lag is contrary to efficient market theory

Market Anomalies 2

Low Price Multiple Ratios (e.g. P/E, P/S, P/B)

Evidence that low price multiple stocks tend to outperform high price multiple stocks

Rigid adherence could lead to poor diversification

Size effect

Small firms tend to have higher risk-adjusted returns than large firms

January effect

Small-firms tend to produce abnormal returns in January

Market Anomalies 3

Past stock price performance

In the short-run, stocks continue recent performance – they have momentum

In the long-run, stock performance reverses

Firm quality – more profitable firms perform better

Asset growth – firms with greater asset growth show weaker performance

Market Anomalies 4

Value Line Ranking System

Advisory service that ranks 1,700 stocks from best (1) to worst (5)

Probable price performance in next 12 months

Best investment letter performance overall

Transaction costs may offset returns

Data mining could find patterns/techniques that have no basis

Behavioral Finance 1

Suggests that various psychological traits influence investor pricing of securities

Modern Portfolio Theory (M P T) assumes investors are rational, risk averse, and consider investment decisions in a portfolio context

Behavioral Finance assumes investors are irrational, loss averse, and separate investment decisions

Behavioral Finance 2

Assumes emotions and biases affect markets

Investors make errors, markets over- & under-react

Investors can profit from others’ errors

Market constraints prevent full price adjustments

Psychology can cause market prices to diverge from fundamental values for long periods

Behavioral biases are detrimental to wealth

Types of Behavioral Biases 1

Emotional biases – an irrational spontaneous reaction based on state of mind

Loss aversion – losses are over emphasized

Overconfidence – investors place too much confidence in their investment knowledge

Familiarity – familiar stocks are over-weighted

Other emotional biases: status quo, regret aversion, self control, endowment, snake-bit effect, house-money effect

Types of Behavioral Biases 2

Belief perseverance biases – irrational actions to avoid mental discomfort

Confirmation – investors gather info. supporting their beliefs

Hindsight bias – remember predictions as more accurate than true

Illusion of control – belief in undue control

Other B P biases: representativeness and conservatism

Types of Behavioral Biases 3

Information processing biases – processing and using information irrationally

Anchoring and reference points – establish a default number as basis of decision

Framing – decisions depend on format of issue

Mental accounting – funds considered as separate/independent accounts

Availability bias – memorable events are considered more likely

Conclusions About Market Efficiency 1

Many market observers convinced of efficiency

Others are convinced they can outperform market

This belief increases market efficiency

Historical returns suggest market is efficient

Some anomalies appear to exist, but could result from insufficient tests or data

Recent bubbles and crashes at odds with efficient market, may support behavioral finance

Conclusions About Market Efficiency 2

Operationally efficient markets imply that some investors with the skill to detect a divergence between price and semistrong value earn profits

Excludes the majority of investors

Anomalies offer opportunities

Controversy about the degree of market efficiency still remains

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 13

Economy/Market Analysis

Top-Down Approach

Analyze economy first

Understand economic factors that affect stock prices

Use economy-stock market relationship to apply valuation models to stock market

Stock market’s direction is of extreme importance to investors

Same analysis can generally be applied to foreign markets

Currency changes affect returns

Assessing the Economy

Gross Domestic Product (G D P)

Value of goods and services produced within a country

Real G D P is single best measure of overall economic activity in a country

Gross National Product (G N P)

Value of goods and services produced by domestic firms in, or outside, a country

Business Cycle 1

Business Cycle: Recurring pattern of aggregate economic expansion and contraction

Cycles have a common framework

trough  peak  trough

Peak to trough is recession

Trough to peak is expansion

Can only be precisely identified in hindsight

National Bureau of Economic Research

Officially determines turning points

Business Cycle 2

Composite indexes of economic activity

Leading, coincident, and lagging indicators indicate peaks and troughs in business activity

Foreign trade affects G D P

Economic Forecast Accuracy

Prominent forecasters produce similar predictions

Evidence indicates forecasts are informative

Forecast accuracy appears to have increased over time

U.S. Real G D P

Business Cycle 3

Monetary policy has an important effect on the economy

Increases in money supply tend to promote economic activity

Federal Reserve’s impact

Sets monetary policy, which impacts interest rates and the availability of money

Estimates vary on economic impact of some policy variables

Reading Yield Curves

Yield curve shows relationship between bond yields and time to maturity

Reflects investors’ views about future interest rates

Yield curve shape is related to business cycle

Upward sloping and steepening curve implies accelerating economic activity

Flat structure implies a slowing economy

Inverted curve may imply a recession

Treasury Yield Curves

Stock Market and the Economy 1

Stock market and economy are closely related

Stock market generally leads the economy

Stock market is the most sensitive indicator of business cycle

Relationship generally considered reliable

Market’s ability to predict recoveries is much better than its ability to predict recessions

By the time investors recognize economic change, stock market has usually already reacted

Stock Market and the Economy 2

Since 19 57 there have been nine U.S. recessions

Average recession length was about 12 months

Longest –18 months; Shortest –6 months

Average stock return during recessions was –1.5 percent

Market averaged 15.3% in year after recession

Booms, Slowdowns, Bond Markets

Stock market booms

Usually coincide with rapid economic growth

Productivity growth is also important

Stock market slowdowns

Bear market is a decline of at least 20%

Recession leads to higher investor risk premiums

Bond markets reflect interest rate changes, what bond traders think about economy

Understanding the Stock Market

Fundamental analysis approach based on P/E

Uses estimate of P/E

Estimating earnings is not easy

Real G D P growth may be best guide

E P S can be constructed in various ways

P/E ratios affected by several factors

Interest rates, inflation, variation from year to year

Market is always looking ahead, but how far ahead?

Market Returns and E P S

Making Market Forecasts 1

Accurate forecasts impossible to make consistently, especially for short-term

Important variables

Interest rates

Expected corporate profits

Best for investors is to realize forecasting is usually, but not always, futile

Making Market Forecasts 2

Grinold Kroner model – separates market return (RS) into 3 parts: income, earnings growth and repricing

Income = dividend yield (D/P) and share repurchases

Earnings growth = inflation (i)+real growth (g)

Repricing = change in market P/E

Using the Business Cycle to Make Forecasts 1

Leading relationship exists between stock market and economy

Investors need to anticipate business cycle turning points

Stock returns can be negative (positive) when business cycle peaks (bottoms)

Stock prices often rise shortly prior to trough

Stock prices have often remained steady or declined in initial phase of recovery

Using the Business Cycle to Make Forecasts 2

Fed Model

Compares earnings yield (E/P) to nominal yield on a long-term T-bond

Used to determine when stocks are relatively attractive

Used to determine “fair value” for S&P 500

Tends to not work well when interest rates are very low

Other Variables Used in Forecasting

Market’s P/E ratio

History suggests investors should pay attention to this measure

Interest rates

Monetary policy

Volatility

January market performance

U.S. Stock Market P/E Ratio

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 18

Bonds: Analysis and Strategy

Why Buy Bonds?

Attractive to investors seeking steady income and investors speculating on interest rate decreases

Yield appeals to long-term investors

Price change appeals to short-term investors

Promised yield to maturity is known at the time of purchase

Tend to have a low correlation with equities

Buying Foreign Bonds

Attractive because foreign bonds:

often offer higher yields than alternative domestic bonds

offer considerable diversification (low correlation)

Can be difficult to buy, so most investors buy foreign-bond mutual funds or E T Fs

Subject to currency risk, which can be hedged

Understanding the Bond Market

Bonds often benefit from a weak economy

Interest rates reflect expected inflation

Increased expected inflation tends to reduce bond prices, increase yields

These relationships do not always hold

Both exchange rates and global economic conditions affect bond prices

Passive Bond Strategies 1

Based on idea that bond market is rational

Risk is the portfolio variable to control

Have lower costs than active strategies

Returns are based on known inputs, not expectations

Investors must still assess market conditions

Evidence tends to support passive approach

Passive Bond Strategies 2

Buy and hold

No attempt to trade in search of higher returns

Ladder and barbell methods help reduce risk

Indexing

Attempt to match performance of a well-known bond index

Mutual funds, E T Fs offer bond index funds

Active Bond Strategies 1

Can be based on

Forecasting interest rate changes

Identifying abnormal yield spreads

Identifying relative mis-pricing

Requires expectations/forecasting

Inputs not known at time of analysis

Active Bond Strategies 2

Forecasting interest rate changes

Notoriously difficult to do accurately

Involves tradeoffs

Shape of yield curve contains valuable information

Horizon analysis

Project bond performance over planned investment horizon

Investor selects bond expected to perform best

Active Bond Strategies 3

Yield spread analysis

Yield spread is difference between two segments of bond market

Assumes there is a “normal” spread level

Attempts to profit from expected changes in differences

Investors sell bonds in one sector and buy in another to profit as yield spread moves to “normal” level

Forecasting the Credit Spread

Active Bond Strategies 4

Identifying mis-pricing

Temporary mis-pricings do occur

Bond swaps

Simultaneous buying and selling of different bonds

Bond market now more accessible to individual investors

Duration

Duration is a weighted measure of a bond’s lifetime

Commonly stated in years

Accounts for both size and timing of the bond’s cash flows

Present-value weighted average of the number of years that investors receive cash flows

Describes weighted average time to all payments

Calculating Duration

Sum of time-weighted P V of cash flows

Duration depends on three factors:

Maturity of the bond

Coupon payments

Yield to maturity

Duration Relationships

Duration increases with time to maturity but at a decreasing rate

For coupon paying bonds, duration is always less than maturity

For zero coupon-bonds, duration equals time to maturity

Duration is inversely related to yield-to-maturity

Duration is inversely related to coupon rate

Why is Duration Important?

Allows comparison of effective lives of alternative bonds

Used in bond management strategies, particularly immunization

Direct measure of interest rate risk

Measures bond price sensitivity to interest rate movements

This characteristic is most important for bond investors

Estimating Price Changes Using Duration

Bond price changes directly relate to duration

Duration indicates change in bond’s price for a given change in interest rates

Modified duration

can be used to calculate the bond’s percentage price

change for a given change in yield

Managing Price Volatility

To obtain maximum (minimum) price volatility, investors should choose bonds with the longest (shortest) duration

Duration is additive

Portfolio duration is just a weighted average

Duration measures volatility due to interest rate changes

Liquidity and default are also prominent types of risk

Convexity

As size of yield change increases, modified duration becomes poorer approximation

Duration equation assumes a linear price-yield relationship, but true relationship is curvilinear

Refers to the degree to which duration changes as the yield to maturity changes

Convexity largest for bonds with low coupon, long-maturity, and low yield to maturity

Bond Convexity

The true price/yield relation is convex; thus, a rate decrease raises prices more than the same increase in rates lowers prices

Yield Change

Decrease from 8% to 6%

Price rises by $231.15

Increase from 8% to 10%

Price drops by $171.59

Immunization 1

Used to protect a bond portfolio against interest rate risk

Interest rate risk composed of price and reinvestment risk

Move in opposite directions, offset each other

Price risk result of relationship between bond prices and rates

Reinvestment risk result of uncertainty about rate at which future coupon income invested

Immunization 2

Risk components move in opposite directions

Favorable results on one side can be used to offset unfavorable results on the other

Portfolio immunized if the duration (not maturity) of the portfolio is equal to investment horizon

In reality, immunization not easy to implement

Immunization requires frequent rebalancing

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 17

Bond Yields and Prices

Interest Rate

Rental rate for loanable funds

Basis point

100 basis points equals one percentage point

Riskless rate is foundation for other rates

Approximated by rate on Treasury securities

Other rates differ because of

Maturity differentials

Security risk premiums

Interest Rates 1

Opportunity cost of foregoing consumption

Real risk-free rate (real rate) unaffected by price changes or risk factors

Nominal (observed) risk-free rate (R F) includes a real component (r r) and expected inflation (e i)

Interest Rates 2

All interest rates are described according to the following formula

Where rp incorporates all risk premiums associated with features such as time to maturity, liquidity, credit quality, etc.

Term Structure of Interest Rates 1

Relationship between time to maturity and yield to maturity (yield curve)

Yield curves

Graphical depiction of the relationship between yields and time to maturity

Default risk held constant

Observations involve tendencies rather than exact relationships

Term Structure of Interest Rates 2

Upward-sloping yield curve

Typical, interest rates rise with maturity

Downward-sloping yield curves

Unusual, predictor of recession?

Term structure theories

Explanations of the shape of the yield curve

Pure expectations, liquidity preference, and preferred habitat

Forward Rates

Forward rates are unobservable rates expected to prevail in the future

Are not observable, but are commonly estimated from longer-term bond rates

For example, the rate on a 3-yr bond can be decomposed into the current 1-yr rate and 2 1-yr forward rates

Pure Expectations Theory

Long-term rates are an average of current and expected future short-term rates

No other considerations matter

According to the theory, forward rates derived from current longer-term rates equal expected future rates

Theory is not that forward rates will be correct, but that there is a relationship between them and current rates

What does the Yield Curve tell us?

Slope of the Yield Curve:

upward – investors expect interest rates to increase

downward – investors expect interest rates to drop

flat – investors expect interest rates to remain constant

Liquidity Preference Theory

Rates reflect current and expected short rates, plus liquidity risk premiums

Uncertainty increases with time

Investors prefer to lend for short run, borrowers to borrow for long run

Liquidity premium is required to induce long-term lending

Derived forward rates do not equal expected future rates

Preferred Habitat Theory

Market participants have preferred maturity segments

Must be induced to move out of their preferred segment

Market segmentation theory is a more extreme version

Interest rates are determined by supply and demand in each segment

Yield Spreads

Risk premiums

Result from differences in

Default risk (bond rating), maturity, call features, coupon rates, marketability, taxes

Borrower actions

Interest rates

Function of variables associated with issue or issuer

Inversely related to business cycle

Credit Spread/Default Premium

Bond Ratings – S&P/Moody’s

AAA	Aaa	Highest Quality
AA	Aa	High Quality
A	A	Upper Medium Grade
BBB	Baa	Medium Grade
BB	Ba	Speculative Elements
B	B	Speculative
CCC	Caa	Poor Standing
CC	Ca	Highly Speculative
CD	C	Extremely Poor Prospects of ever attaining investment standing

Measuring Bond Yields 1

Premium: price > par value

Discount: price < par value

Interest payments (coupons) on bonds usually paid semi-annually

Current yield: ratio of coupon interest to current market price

Does not account for difference between purchase price and redemption value

Measuring Bond Yields 2

Yield to maturity (Y T M)

Most commonly used measure of bond return

Promised return received from a bond purchased at the current market price

If held to maturity

And coupons reinvested at Y T M

Likelihood of meeting second condition is extremely small

Yield to Maturity 1

Solve for Y T M:

For a zero coupon bond the first term in the equation does not exist.

Yield to Maturity 2

Some bonds are callable after deferred call period

Y T M unrealistic for bonds likely to be called

Often uses end of deferred call period

Substitute number of periods until first call for date and call price (C P) for face value

Realized Compound Yield (R C Y)

Rate of return actually earned on a bond given the reinvestment of coupons at varying rates

Determined after investment concluded

Rarely equal to Y T M

Reinvestment Risk 1

Interest-on-interest

Reinvestment rate risk

Risk that future reinvestment rates will be less than the Y T M when bond is purchased

Total dollar return on a bond consists of

Coupons paid

Capital gains or losses

Interest income from reinvestment of coupons

Reinvestment Risk 2

Reinvestment increase in importance as coupon or time to maturity (or both) increase

For long-term bonds, interest-on-interest can be most important part of total return

Zero-coupon bonds eliminate reinvestment rate risk

Horizon return analysis

Bond returns based on assumptions about reinvestment rates and yield-to-maturity at end of investment horizon

Bond Valuation Principle

Intrinsic value

An estimated value

Present value of the expected cash flows

Required to compute intrinsic value

Expected cash flows

Timing of expected cash flows

Discount rate, or required rate of return by investors

Bond Valuation

Value of a coupon bond:

Biggest problem is determining the discount rate or required yield (r)

Required yield is the current market rate earned on comparable bonds with same maturity and credit risk

Bond Price Changes 1

Over time, bond prices move toward face

On bond’s maturity date, it must be worth its face value

Bond prices move inversely to market yields

Long-term bond prices fluctuate more than short-term

The change in bond prices due to a yield change is directly related to time to maturity and inversely related to coupon rate

Bond Price Changes 2

Bond Price Relative to Yield

Holding maturity constant, a rate decrease raises prices more than the same increase in rates lowers prices

Yield Change

Decrease from 8% to 6%

Price rises by $231.15

Increase from 8% to 10%

Price drops by $171.59

Implications for Investors

If anticipating a rate decrease, bond buyers should purchase low-coupon, long-maturity bonds

If interest rates are expected to increase, investors should consider bonds with large coupons or short maturities or both

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 16

Technical Analysis

What is Technical Analysis?

Use of published market data to analyze both aggregate and individual firm stock prices

Not based on firm fundamentals

Market data includes price and volume data

May produce insight into the psychological dimensions of the market

Technical analysts often believe that it’s extremely difficult to estimate intrinsic value

Technical Analysis Framework

Technicians believe that supply and demand produce price patterns

Charting

Using charts to analyze price and volume data

Trading signals are identified from price patterns

Volume data used to gauge market conviction behind price moves

Technical analysis has evolved to include other techniques

The Dow Theory 1

Oldest and best-known theory of technical analysis

Based on three types of price movements

Primary move: broad market move, lasts several years

Secondary moves: occur within primary move

Day-to-day moves: occur randomly around primary and secondary moves

Bull (bear) market refers to upward (downward) primary move

The Dow Theory 2

Bull market exists when successive rallies penetrate previous highs

Declines remain above previous lows

Bear market exists when successive rallies fail to penetrate previous highs

Declines penetrate previous lows

Secondary moves called technical corrections

Day-to-day “ripples” are of minor importance

The Dow Theory 3

Intended to forecast the start of a primary movement

Does not tell how long movement will last

Subject to a number of criticisms

Studies have not confirmed its success

Several versions available

Can predict different, even conflicting movements

The Dow Theory 4

Charting Price Patterns 1

Price changes can be recognized and categorized

Trendline: identifies a trend or direction

Support level: price level at which a significant increase in demand for stock is expected

Resistance level: price level or range at which significant increase in supply is expected

Momentum: indicates speed of price changes

Charting Price Patterns 2

Bar Chart

Price on vertical axis, time on horizontal

Vertical bar’s top (bottom) represents the high (low) price of the day

Candlestick adds open and close price

Point-and-Figure Chart

Compresses price changes into small space

X (O) used to indicate significant upward (downward) movement

Moving Averages

Used for analyzing both the overall market and individual stocks

Used specifically to detect both the direction and rate of change

New value for moving average calculated by dropping earliest and adding latest observation

Comparison to current market prices produces buy or sell signal

Show what prices have done, not what they will do

Relative Strength

Ratio of price to index value or price to past average price

Ratios plotted to form graph of relative price across time

Rising (falling) ratio indicates relative strength (weakness)

Can also be used to analyze industries

What if overall market is weak?

What if stock declining less than the market?

Breadth Indicators

Advance-Decline Line

Measures the net difference between number of stocks advancing and declining

Plot of running total across time is compared to a stock average to analyze any divergence

Divergence implies trend changing

Number hitting new highs (lows)

High trading volume regarded as bullish

Sentiment Indicators 1

Short interest is number of stocks that have been sold short but not yet bought back

Short interest ratio:

Total short interest/Ave. daily volume

Indicates number of days needed to “work off” the short interest

Short interest figures may be distorted

Sentiment Indicators 2

Contrary investing

Acting in opposite way of most investors

Many technicians take a high short interest ratio as a bullish sign

The more shares sold short, the more shares that must eventually be re-purchased

Mutual fund liquidity

If funds fully invested (low on cash), contrarians sell

If funds mostly liquid, contrarians buy

Opinions of Investment Advisory Services

Bearish sentiment index

Ratio of advisory services bearish to total number with an opinion

When at 55 to 60% (20%), bearish (bullish) attitude indicated

Advisory services assumed wrong at extremes

Services may follow trends rather than forecast them

C B O E Put/Call Ratio

Speculators buy calls (puts) when stock prices expected to rise (fall)

Relatively high (low) ratio indicates investor pessimism (optimism)

Contrarians buy (sell) when investors are pessimistic (optimistic)

Extreme readings (below .45 or above .8) convey trading information

Exact trigger levels subject to debate

Classification of Indicators – Contrary Opinion

Trading Rule	Bullish	Bearish
Cash holdings	High	Low
V I X	High	Low
I P O/S E O activity	Low	High
Opinion polls	Pessimistic	Optimistic
Put/Call ratio	High	Low
Short interest	High	Low
Margin debt	Low	High

Testing Technical Strategies

What constitutes a fair test of a technical trading rule?

Risk considerations

Include transaction and other costs

Consistency in performance

Out-of-sample validation

Filter rule tests

Trades based on price changes greater than predetermined filter

Efficiency and Evidence

Efficient market hypothesis (E M H) poses major challenge to technical analysis

Many tests suggest technical analysis does not produce superior returns when risk and costs accounted for

Academic studies generally do not indicate technical analysis works

Some research supports merits of technical analysis

Conclusions About Technical Analysis 1

Thorough tests of technical analysis typically have failed to confirm its value

Efficient markets argue against likelihood of profits

Several interpretations of technical tools and chart patterns are common

Successful rules self-destruct as they gain popularity

Conclusions About Technical Analysis 2

Strong evidence exists suggesting that stock market is weak-form efficient

Impossible to test all techniques of technical analysis

Technical analysis remains popular with many investors

Should be combined with fundamental analysis, if used

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 15

Company Analysis

Fundamental Analysis

Last step in top-down approach is company analysis

Goal: estimate company’s intrinsic value

Investors can use discounted cash flow approach or multiplier approach

Investors typically rely on the multiplier approach

Future profitability is most fundamental factor affecting stock prices

Accounting Aspects of Earnings

Investors should understand earnings

Various uses of the term

How E P S is determined

What it represents

Its components

Financial statements provide majority of financial information about firms

Accounting Standards

Financial Accounting Standards Board (F A S B)

Establishes Generally Accepted Accounting Principles (G A A P) in the U.S.

International Accounting Standards Board (I A S B)

Establishes International Financial Reporting Standards (I F R S)

* F A S B is working toward convergence with I F R S

Basic Financial Statements 1

Balance Sheet

Shows position at one point in time: assets, liabilities, owner’s equity

Assets

Liabilities

Retained earnings = previous earnings not paid as dividends

Investors should carefully analyze

Balance Sheet (in 000’s): Huskie Toys 1

ASSETS	2018	2019
Cash & Marketable Sec.	$41,325	$46,562
Accounts Receivable	152,976	161,025
Inventory	185,489	186,281
Total Current Assets	379,790	393,868
Gross Fixed Assets	126,974	131,271
Accumulated Depreciation	36,497	38,952
Net Fixed Assets	90,477	92,319
Total Assets	470,267	486,187

Balance Sheet (in 000’s): Huskie Toys 2

Liabilities & Equity	2018	2019
Accounts Payable	$49,761	$53,124
Accrued Expenses	59,992	61,347
Notes Payable	84,273	82,149
Total Current Liab.	194,026	196,620
Long-term Debt	110,368	92,982
Common Stock ($2 par)	6,160	6,240
Paid in Capital (PIC)	18,978	19,642
Retained Earnings	140,735	170,703
Total Liabilities & Equity	470,267	486,187

Basic Financial Statements 2

Income Statement

Sales or revenues

− Product costs

Gross profit

− Period Costs

Operating Income

− Interest

Income before tax

− Taxes

Net Income

E P S = net income/average shares outstanding

Income statement shows financial flows

Investors should pay attention to charges to earnings because of accounting changes

Income Statement (in 000’s): Huskie Toys

	2018	2019
Sales	$1,127,315	$1,339,736
COGS	676,389	803,842
Gross Profit	450,926	535,894
SG&A	259,282	301,345
EBIT	191,644	234,549
Interest Expense	89,891	92,341
EBT	101,753	142,208
Taxes	39,684	59,892
Net Income	62,069	82,316
Common Dividends	48,975	52,348
Addition to RE	13,094	29,968

The Financial Statements 1

Statement of Cash-Flows

Incorporates elements of both balance sheet and income statement

Cash from operating, investing, financing activities

Helps investors examine quality of earnings

Investors should examine write-offs

Companies may “massage” data

The Financial Statements 2

Certifying statements

Auditors do not guarantee the accuracy of earnings but only that statements are fair financial representation

Footnotes

Important for investors to examine

Provide information on accounting methods, ongoing litigation, revenue recognition, and more

Problems with Reported Earnings 1

E P S is not a precise figure that is readily comparable over time or between firms

Alternative accounting treatments used to prepare statements

Difficult to gauge the “true” performance of a company with only one method

Accountants caught between investors and management

Investors must be aware of these problems

Problems with Reported Earnings 2

F A S B’s accounting principles often result of compromises

Sarbanes-Oxley Act (S O X) passed in 2002 in response to accounting scandals

Reported earnings versus pro forma earnings

Financial standards offer flexibility in reporting items

Problems with Reported Earnings 3

Investors can

Examine 10-Ks

Read footnotes to financial statements

Obtain other opinions

Study statement of cash flows

Harder to disguise problems

Negative cash flows in mature companies signals problems

Analyzing Company Profitability 1

Return on Assets (R O A)

Measures profitability

Product of net income margin and asset turnover

Net income margin = net income/sales

Measures firm’s earning power in terms of sales

Asset turnover = sales/total assets

Measures efficiency

Shows how effectively and efficiently assets are utilized

Analyzing Company Profitability 2

Return on Equity (R O E)

Decomposed into two components to predict trends

Leverage = Total assets/Stockholders’ equity

R O E = R O A × Leverage (Equity multiplier)

R O E will be larger than R O A for typical profitable company that uses debt financing

Analyzing Company R O E & E P S

E P S

Bottom line measure of profitability

E P S = R O E × Book value per share

DuPont analysis:

N P M = Net profit margin (N I/Sales)

T A T = Total asset turnover (Sales/T A)

E M = Equity multiplier (T A/Equity)

Free Cash Flow Estimates

F C F F: cash flows to all the firm’s claimholders

F C F F = C F O – F C Inv. + interest(1 − t)

F C F E: cash flows to the firm’s common equity

F C F E = C F O – F C Inv. + Borrowings

* Where, C F O is cash flow from operations, F C Inv. is investment in fixed assets, Interest(1 − t) is interest expense times × (1 − tax rate), Borrowings is net change in debt

Estimating an Internal Growth Rate

Sustainable growth rate: rate at which company can grow from internal sources

Provides benchmark for assessing actual growth

g = (1 − Dividend payout ratio) × R O E

Estimate fluctuates considerably over time

Only reliable if company’s current R O E remains stable

What matters is future growth rate, not historical growth rate

Forecasts of E P S

Expected E P S is of the most value

Security analysts’ forecast of earnings

Consensus forecast superior to individual

Analysts often over- or underestimate earnings

Inaccurate earnings estimates can provide investors opportunities

If investors can better estimate earnings, they can profit

Earnings Surprises

Expectations affect stock prices

Difference between what investors expect and what company actually reports is important

Actual earnings > market expectation, price rises

Actual earnings < market expectation, price falls

Investors should assess both forecasts and actuals

Some companies no longer offer earnings guidance

The Earnings Game

Estimating, announcing, determining earnings has become a managed process

Company guides analysts’ expectations down

Company then likely to beat expectations

Less impact of positive earnings surprise now than in past

“Whisper forecasts”

Investors must understand the game in order to understand impact on stock prices

Using Earnings Forecasts

There appears to be a lag in stock price adjustment to earnings surprises

Investors can use revisions in analysts’ estimates

Steady upward adjustments indicate a buy signal

Steady downward adjustments indicate a sell signal

Investors should wait to purchase firms reporting bad news

Investors often look at sales growth also

Justified P/E Ratio 1

Indicates the P/E multiple justified by the firm’s fundamentals

A function of expected dividend payout ratio, required rate of return, and expected growth rate in dividends

Justified P/E Ratio 2

The higher the expected payout ratio, the higher the P/E, ceteris paribus

Higher payout → lower growth rate; however, which adversely affects the P/E

Less funds available to reinvest in business

Required return and P/E inversely related

Expected growth rate in dividend and P/E ratio directly related

The P/E Ratio

P/E ratios vary among companies

Investor expectations differ

Large spread between highest and lowest P/Es

Forward P/E

Uses estimated earnings in formula

Higher numbers indicate higher expectations

Investors often overestimate earnings growth

Investors must be increasingly concerned with effect of earnings game on P/E ratio

Justified P/B Ratio

Determinants of justified P/B:

Positively affected by higher growth, higher profitability, and lower required return (k)

The crucial relationship is R O E versus required return

Justified P/S Ratio

Where, (E0/S0) and (D0/E0) equal current net profit margin and dividend payout ratio, respectively

Determinant of P/S:

Positively affected by higher profit margin, higher growth, and lower required return

The P E G Ratio

Relates P/E ratio to earnings growth

Relating P/E ratio to growth may be better than P/E ratio alone

Only a rule of thumb

Different earnings growth rates can be used to calculate P E G ratio

Fundamental Analysis in Practice

Analysts and investors seek

Estimate of company’s earnings and P/E ratio

Determination of whether stock is under- or over-valued

Both return and risk are functions of systematic and company-unique components

Security analysis involves predicting an uncertain future

Mistakes are certain, outlooks differ by investor